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Keywords:

  • F18;
  • Q56

Abstract

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. The Model
  5. 3. Multilateral Trade Liberalization
  6. 4. Regional Trade Liberalization
  7. 5. Comparison
  8. 6. Concluding Remarks
  9. Appendix
  10. References

The paper considers trade between identical countries with imperfectly competitive markets, and compares the impacts of regional and multilateral tariff reduction on strategic environmental taxation and welfare. While both forms of trade liberalization increase production and consumption in tariff-reducing countries, regionalism also reduces production in a non-participating country and may decrease its consumption. Consequently, regionalism and multilateralism change pollution tax and welfare in the tariff-reducing countries in similar ways when pollution is local, but in dissimilar ways for global pollution. When pollution is global, regionalism is likely to be preferred to multilateralism for the establishment of free trade among countries.

Libéralisation du commerce régional versus celle du commerce multilatéral : fiscalité environnementale et bien-être. Ce mémoire considère le commerce entre des pays identiques avec des marchés de concurrence imparfaite, et compare les impacts d'une réduction régionale et multilatérale de tarifs sur la fiscalité environnementale stratégique et le bien-être. Même si les deux formes de libéralisation accroissent la production et la consommation dans les pays qui réduisent les tarifs, le régionalisme réduit aussi la production dans un pays non-participant, et peut réduire sa consommation. Conséquemment, régionalisme et multilatéralisme changent la taxe sur la pollution et le bien-être dans les pays qui réduisent leur tarif d'une manière similaire quand la pollution est locale, mais de manière dissimilaire quand la pollution est globale. Quand la pollution est globale, le régionalisme est susceptible d'être préféré au multilatéralisme pour l'établissement du libre commerce entre pays.

1. Introduction

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. The Model
  5. 3. Multilateral Trade Liberalization
  6. 4. Regional Trade Liberalization
  7. 5. Comparison
  8. 6. Concluding Remarks
  9. Appendix
  10. References

In this paper, we analyze how regional trade liberalization affects the strategic incentives of countries to manipulate their environmental tax, and the welfare consequences of such manipulation. The results are then compared with those for multilateral trade liberalization. In a globalizing world, the issue of whether freer trade creates incentives for countries to weaken their environmental policy remains important and topical.

The existing literature has shown that, in the presence of imperfect competition and transboundary pollution, countries trading with each other have incentives to manipulate their environmental policy in order to increase their welfare in the non-cooperative equilibrium (e.g., Markusen 1975; Conrad 1993; Barrett 1994; Ulph 1996; Copeland and Taylor 2004; Lapan and Sikdar 2011). When oligopolistic firms compete in quantities, reducing domestic firms' environmental costs makes them more competitive internationally, enabling a country to extract additional rents. This “rent capture effect” tends to inefficiently weaken environmental policy. At the same time, a desire to shift polluting production from itself to its trading partners, or the “pollution-shifting effect,” motivates each country to make its environmental policy inefficiently stringent. The pollution-shifting effect is weaker when pollution is more transboundary. When symmetric countries impose a tax on pollution that is transboundary, the net impact of these strategic effects under free trade is a lowering of the pollution tax below its efficient level (Kennedy 1994).

Burguet and Sempere (2003) examine how trade liberalization, in the form of tariff reduction, affects strategic environmental policy and welfare. Using a model of bilateral trade with imperfect competition and local pollution, the authors find that trade liberalization can make environmental policy more or less stringent, depending on factors such as the emission intensity of output and convexity of the damage function. Further, when the environmental policy is a pollution tax, they find that bilateral tariff reduction always increases welfare in each country.

One limitation of the literature on trade liberalization and strategic environmental policy is that it typically considers a two-country framework and examines the symmetric case of trade liberalization by both countries. This is akin to an examination of the impact of multilateral trade liberalization, when there are more than two countries. However, much trade liberalization worldwide involves regional trade agreements (RTAs), where a sub-group of trading countries decides to gradually reduce tariffs on each others imports. In fact, while multilateral trade negotiations under the auspices of the WTO have fumbled in recent years, RTAs have proliferated.1 When tariff reduction takes such a regional form, the impacts on strategic environmental policy and welfare are likely to differ from those under multilateral tariff reduction. The current paper examines these impacts of RTAs and compares them with those under multilateral trade liberalization.

When environmental policy is strategically chosen by countries, our analysis indicates that the impacts of freer trade on environmental taxation and welfare depend on the nature of the trade liberalization process and the extent to which pollution is transboundary. The differences in outcomes for multilateralism vs. regionalism exist even when the countries are identical. While both forms of trade liberalization increase production and consumption in the tariff-reducing countries, regional trade liberalization reduces production in the non-participating country and may decrease its consumption as well. As expounded below, these changes have corresponding impacts on marginal damage and price of the polluting good in these countries, and ultimately on their incentives to manipulate the pollution tax, that differ for the two forms of trade liberalization.

Our analysis is related to the literature on policy substitution (e.g., Copeland 1990; Walz and Wellisch 1997; Ederington and Minier 2003). As shown in Copeland (1990), when trade agreements constrain a country's ability to protect domestic industry using negotiable trade barriers (e.g., tariff), they generate incentives for it to use non-negotiable trade barriers (e.g., environmental policy) as second-best instruments of trade policy. In our paper, the equilibrium pollution tax is distorted from its efficient level, owing to the presence of imperfect competition, transboundary externality, and exogenous tariffs. Trade liberalization changes the equilibrium by creating an additional incentive for the tariff-reducing countries to use the tax in lieu of the constrained tariff.

We proceed as follows. Section 'The Model' presents the model, where three countries with oligopolistic markets trade in a polluting good, and derives its equilibrium. Section 'Multilateral Trade Liberalization' deals with the benchmark scenario, where the countries undertake multilateral tariff reduction. In Section 'Regional Trade Liberalization' we analyze the case of a regional reduction in tariffs. The results from multilateral and regional trade liberalization are then compared in Section 'Comparison', while Section 'Concluding Remarks' concludes.

2. The Model

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. The Model
  5. 3. Multilateral Trade Liberalization
  6. 4. Regional Trade Liberalization
  7. 5. Comparison
  8. 6. Concluding Remarks
  9. Appendix
  10. References

Consider three identical countries, called 1, 2, and 3, with segmented markets. There are inline image firms in each country. All firms produce a homogeneous good, and face a constant marginal cost of production c. Each firm in country 1 sells inline image units of the good in country i, where inline image. Each firm in country 2 sells inline image units in country i. Each firm in country 3 sells inline image units of the good in country i. Inverse demand in each country is given by

  • display math

where inline image and inline image is total quantity sold in country i.

Countries 1 and 2 charge a tariff of inline image per unit of import from each other and a tariff of inline image per unit of import from country 3. Country 3 charges a tariff of Φ per unit of import from countries 1 and 2. The tariffs are given exogenously in our model. Initially, that is, before trade liberalization, the tariff rates are the same and inline image in the identical countries. Trade liberalization takes the form of a reduction in the relevant tariff rate. Two alternative forms of trade liberalization are considered. We define “multilateral trade liberalization” as an equal multilateral reduction in the tariff rates ϕ and Φ by all three countries. In contrast, “regional trade liberalization” is defined as an equal bilateral reduction in the tariff rate ϕ by countries 1 and 2, where Φ remains unchanged. Unlike multilateral trade liberalization, regionalism introduces an asymmetry among the three ex ante identical countries.

A by-product of production in this industry is pollution. With appropriate definition of units, it is assumed that for every unit of output produced the firms emit one unit of pollution.2 Total production undertaken in countries 1, 2, and 3 are respectively inline image inline image and inline image. Pollution damage in country i, inline image is a function of emission inline image affecting that country and is given by

  • math image(1)

where inline image is the pollution damage parameter, and inline image, inline image and inline image. A fraction inline image of pollution generated in one country affects each of the other two countries.3 For strictly local pollution we have inline image. When pollution is perfectly transboundary, pollution generated in each country affects all three countries equally and inline image. The environmental policy in country i is a tax imposed on domestic firms at the rate inline image per unit of emission. Given our assumption of constant emission intensity of output, the tax on pollution is equivalent to a production tax.

We model a game that unfolds as follows. In the first stage, each country chooses its pollution tax to maximize its own welfare, taking the other countries' pollution taxes and the tariffs as given. In the second stage, each firm takes the policies set by the countries and the output decisions of the inline image other firms as given, and chooses its own output. To obtain the subgame perfect Nash equilibrium, the model is solved using backward induction.

2.1. Equilibrium

In the second stage, the profit maximization problem of each firm in countries 1, 2, and 3 are respectively given by (2), (3), and (4):

  • display math(2)
  • display math(3)
  • display math(4)

The Cournot-Nash equilibrium quantities that maximize profits are computed in the usual manner. These second-stage quantities are functions of the tax and tariff rates.

Social welfare in country i, inline image is defined to be the sum of consumer surplus inline image producer surplus inline image tariff revenue inline image and pollution tax revenue inline image less pollution damage inline image:

  • display math(5)

In country 1, for example, we have inline image = inline image inline image = inline image inline image = inline image, inline image = inline image and D1 is as given by (1).

In the first stage of the game, the non-cooperative Nash equilibrium pollution taxes are computed by simultaneously solving the three FOCs, inline image, for inline image. We denote these taxes, which are a function of the tariff rates, as inline image and inline image. The SOCs are satisfied, as we have inline image. Substituting inline image into (5) gives the equilibrium welfare levels inline image and inline image. In equilibrium, production minus consumption, that is, net export, of country 1 and country 3 are respectively given by inline image and inline image where

  • display math(6)

and inline image.

3. Multilateral Trade Liberalization

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. The Model
  5. 3. Multilateral Trade Liberalization
  6. 4. Regional Trade Liberalization
  7. 5. Comparison
  8. 6. Concluding Remarks
  9. Appendix
  10. References

Here we consider the case of multilateral trade liberalization, where all three countries start from the same initial tariff rate, inline image, and undertake an equal marginal reduction in that rate. The results in this benchmark case are similar to those in Baksi and Ray Chaudhuri (2009) and are outlined here to facilitate comparison with the case of regional trade liberalization.4

Since tariff rates are equal across the countries both before and after trade liberalization, the outcomes are identical in the three countries for multilateral trade liberalization. Superscript m is used to denote the multilateral case. The equilibrium pollution tax, inline image in each country is distorted from its efficient level, owing to the presence of the rent capture and pollution-shifting effects. Note that these effects are absent when the market is competitive, inline image and the good is clean, inline image. In such a case, the equilibrium pollution tax is

  • display math(7)

Since free trade is optimal in this case, and the tariff effectively subsidizes domestic producers, the tax has to offset the distortion created by the tariff. This is a “tariff effect” that exerts an upward pressure on the equilibrium pollution tax. When tariffs are positive, each country enjoys tariff revenue on imports and has to pay for exports. This gives the countries an incentive to substitute foreign production for domestic production, and consequently to tax domestic firms.

Following Kennedy (1994), we define the efficient level of the pollution tax as the one that maximizes global welfare given the second-stage equilibrium behaviour of the firms. In the symmetric case, the efficient tax is identical across countries and is obtained by setting inline image and solving the FOC inline image as5

  • display math(8)

The SOC is satisfied, as we have inline image. The difference between the efficient and the equilibrium levels of the pollution tax is

  • math image(9)

The net impact of the above-mentioned strategic effects is a lowering of the equilibrium tax below its efficient level if and only if inline image.6

In the symmetric equilibrium, net export of each country is zero, and multilateral tariff reduction increases production and consumption equally so that net export remains unchanged. The consequent impacts on equilibrium tax and welfare are summarized in Proposition 1.

Proposition 1. Multilateral tariff reduction

  1. increases the equilibrium pollution tax in each country if and only if pollution is sufficiently harmful; that is, inline image if and only if inline image
  2. makes the equilibrium pollution tax more distorted if and only if the initial tariff rate inline image
  3. decreases equilibrium welfare of each country if and only if the initial tariff rate ϕ is sufficiently small; that is, inline image if and only if inline image.

Proof 1. Omitted. See Baksi and Ray Chaudhuri (2009) for similar proofs.

As protection provided by tariffs decreases, each country has an incentive to subsidize domestic producers by lowering its pollution tax (Copeland 1990). However, this policy substitution motive to lower the tax is dampened, and may even be overwhelmed, by the fact that production causes pollution damage. Hence, it is only when the pollution damage parameter is sufficiently small that the equilibrium pollution tax decreases. Moreover, when pollution is transboundary, the tariff serves to discourage foreign production and pollution spilling over from those countries. As a result, the policy substitution motive to reduce the tax for domestic producers is stronger when pollution is transboundary rather than local.7

When pollution is local, inline image and the equilibrium tax exceeds its efficient level as long as the tariff is positive. Multilateral tariff reduction then shrinks the negative gap between the efficient and the equilibrium levels of the pollution tax and improves welfare in each country. On the other hand, when pollution is transboundary and the tariff rate is sufficiently small, inline image and the equilibrium tax is distorted below its efficient level. Multilateral tariff reduction (in particular, near free trade) then distorts the equilibrium tax further away from its efficient level and detrimentally affects welfare.

4. Regional Trade Liberalization

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. The Model
  5. 3. Multilateral Trade Liberalization
  6. 4. Regional Trade Liberalization
  7. 5. Comparison
  8. 6. Concluding Remarks
  9. Appendix
  10. References

We now consider the case of regional trade liberalization, where only a subset of the trading countries reduce their tariff rate for each other. Specifically, starting from a pre-liberalization scenario where inline image, we analyze the impact of an equal bilateral reduction in the tariff rate ϕ by countries 1 and 2, where Φ remains unchanged. Now we have an asymmetric case where the impacts in the participating countries, countries 1 and 2, differ from those in the non-participating country, country 3.

The Nash equilibrium pollution taxes, inline image and inline image, are still subject to the strategic effects mentioned earlier. However, these effects differ across countries when ϕ decreases but Φ remains unchanged. For instance, when inline image and inline image, and the rent capture and pollution-shifting effects are absent, the equilibrium pollution taxes are given by

  • display math(10)
  • display math(11)

Lemma 1. Suppose inline image and inline image. A bilateral reduction in ϕ tends to reduce the equilibrium pollution tax in the participating countries and increase that in the non-participating country, through the tariff effect.

Lemma 1 follows from (10) and (11). By lowering distortionary tariffs in the participating countries, regional trade liberalization tends to lower the offsetting tax in such countries. The lower protection afforded to foreign producers also motivates the non-participating country to additionally tax its own producers.

In the regional case, the efficient level of the pollution taxes are identical in the participating countries but differ for the non-participating country when inline image. Setting inline image and solving the two FOCs inline image and inline image simultaneously, the efficient taxes are obtained as8

  • math image(12)
  • math image(13)

Because trade barriers restrict competition and production, the efficient taxes have to compensate for the distortion created by tariffs. When ϕ is reduced bilaterally, country 1's firms face tougher competition in their domestic market from imports from country 2, but are also able to export more cheaply to country 2 (and vice versa for country 2's firms). The increased competition enables the efficient tax to rise in the participating countries. The efficient tax in the non-participating country, however, remains unchanged by the reduction in ϕ.

Appropriate substitution of the equilibrium taxes yields the equilibrium quantities inline image, inline image and inline image. Lemma 2 summarizes the impacts of a bilateral decrease in ϕ on outputs produced and consumed. Proofs of all the results that follow appear in the Appendix.

Lemma 2. Regional trade liberalization increases production and consumption in the participating countries, but decreases production in the non-participating country. While global production increases, consumption in the non-participating country increases if and only if the pollution damage parameter is sufficiently small.

The changes in consumption or sales in the participating and non-participating countries lead to corresponding changes in the price of the polluting good and the strength of the rent capture effect, in these countries. The increase in sales in the participating countries implies a decrease in the price of the polluting good in these countries. This weakens the rent capture effect in the non-participating country and tends to raise its pollution tax. If β is sufficiently small, regional trade liberalization also increases sales and decreases price in the non-participating country. This tends to raise pollution tax in the participating countries through the rent capture effect. On the other hand, if β is large enough to decrease sales in the non-participating country, the rent capture effect in each participating country is then subject to counteracting forces. For example, country 1's rent capture effect tends to become weaker because of the fall in price in country 2 but stronger because of the rise in price in country 3.9

Further, regional tariff reduction diverts production from the non-participating to the participating countries. This weakens the pollution-shifting effect in the former and strengthens it in the latter countries. These changes in the pollution-shifting effect tend to decrease the pollution tax in the non-participating country and increase it in the participating countries.

In general, the above-specified changes in consumption, production, and the strength of the various strategic effects drive the changes in equilibrium pollution tax and welfare that arise, owing to regional trade liberalization. We examine these changes for the two polar cases where pollution is purely local and perfectly transboundary.

4.1. Local Pollution

This subsection examines the case of local pollution when inline image, and the pollution–shifting effect has its maximum strength. The impact of an equal bilateral reduction in tariffs by countries 1 and 2 on pollution taxes is given by Proposition 2.

Proposition 2. When pollution is local, regional trade liberalization

  1. increases equilibrium pollution tax in the participating countries if and only if the pollution damage parameter is sufficiently large; the tax in such a country becomes less distorted;
  2. decreases the equilibrium pollution tax and makes it less distorted in the non-participating country if and only if the pollution damage parameter is sufficiently large.

The previously mentioned policy substitution motive to lower the pollution tax operates in a similar manner in the participating countries. Although qualitatively similar, this motive to subsidize domestic firms is weaker compared with that under multilateral trade liberalization.10 This is because the tariff is not reduced for all trading partners in the regional case. Since the non-participating country does not reduce its tariff, it does not have a tariff substitution motive to lower its tax. Nevertheless, as noted earlier, the changes in the tariff and rent capture effects tend to increase the tax in the non-participating country, while the change in the pollution-shifting effect tends to decrease it. The last effect dominates when pollution is sufficiently damaging.

In the pre-liberalization equilibrium, with inline image, the pollution tax exceeds its efficient level in all countries. Regional trade liberalization makes the tax less distorted in the participating countries by shrinking the gap between the efficient and the equilibrium levels of the tax in these countries. In the non-participating country, the equilibrium tax decreases and moves closer to its efficient level only when pollution is sufficiently harmful.

As long as pollution is not too damaging, regional tariff reduction makes the participating countries net exporters, and the non-participating country a net importer, of the polluting good.11 The impact on welfare in each country is given in Proposition 3. For expositional ease, we focus on the welfare impacts in the neighbourhood of free trade that is, when ϕ and Φ are close to zero.

Proposition 3. When pollution is local, regional trade liberalization in the neighbourhood of free trade increases equilibrium welfare in the participating countries and decreases that in the non-participating country.

The increases in production and consumption in the tariff-reducing countries improve their welfare as long as price of the polluting good exceeds its marginal social cost. When inline image and tariffs are reduced multilaterally by all countries, their welfare is maximized at free trade or inline image (Proposition 1(iii)). In contrast, when ϕ is reduced regionally with Φ remaining unchanged, Proposition 3 indicates that the optimal tariff for the participating countries may be negative.12 Further, the decrease in production and possibly consumption in the non-participating country following regional tariff reduction worsens its welfare.

4.2. Transboundary Pollution

We now consider the case of perfectly transboundary pollution; that is, inline image. As a result, the pollution-shifting effect is absent – this approximates the situation with respect to global pollutants such as greenhouse gases. The implications of an equal bilateral reduction in tariffs by countries 1 and 2 for pollution taxes are given by Proposition 4.

Proposition 4. When pollution is perfectly transboundary, regional trade liberalization

  1. decreases equilibrium pollution tax in the participating countries; when the initial tariff rate is sufficiently small, the tax in such a country becomes more distorted;
  2. increases equilibrium pollution tax in the non-participating country; when the initial tariff rate is sufficiently small, the tax in this country becomes less distorted.

As the tariff targets foreign pollution, the policy substitution incentive for the participating countries to lower their tax is stronger when pollution is more transboundary. Further, global production increases to a lesser extent in the regional case than in the case of multilateral tariff reduction.13 When pollution is perfectly transboundary, this implies that pollution damage affecting a country, and its social cost of increasing production by lowering the tax, are also smaller in the former case. As a result, regional trade liberalization is observed to lower the tax in the tariff-reducing countries even though multilateral trade liberalization may increase it. In the non-participating country, changes in the tariff and rent capture effects increase the tax. Since the pollution-shifting effect is absent, there is no pressure on the tax to decline in this country.

When initial tariffs are not too large, that is, inline image, the pollution tax in each country is distorted below its efficient level in the pre-liberalization equilibrium. Regional trade liberalization then makes the tax more distorted in the participating countries by widening the gap between the efficient and the equilibrium levels of the tax in these countries. This gap, however, shrinks in the non-participating country where the equilibrium tax increases.

With bilateral tariff reduction, the participating countries become net exporters of the polluting good, while the non-participating country is a net importer.14 The impact on welfare in each country is as follows:

Proposition 5. When pollution is perfectly transboundary, regional trade liberalization in the neighbourhood of free trade (i) increases equilibrium welfare in the participating country if and only if the pollution damage parameter is sufficiently small, and (ii) decreases equilibrium welfare in the non-participating country.

When pollution is transboundary, while multilateral tariff reduction near free trade negatively affects welfare, a regional reduction in tariffs may improve welfare in the participating countries.15 Moreover, welfare worsens in the non-participating country that suffers the externality of the regional trade agreement. Even while production moves away from this country to the participating countries, its damage from transboundary pollution increases.

5. Comparison

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. The Model
  5. 3. Multilateral Trade Liberalization
  6. 4. Regional Trade Liberalization
  7. 5. Comparison
  8. 6. Concluding Remarks
  9. Appendix
  10. References

Table 1 summarizes the results for multilateral and regional trade liberalization. The results emerge due to the strategic incentives of the countries to manipulate their pollution tax, and changes in these incentives depend on the nature of the trade liberalization process as well as the extent to which pollution is transboundary.

Table 1. Effects of Multilateral vs. Regional Tariff Reduction on Equilibrium Pollution Tax and Welfare (Near Free Trade)
 Multilateral trade liberalizationRegional trade liberalization
 inline imageinline imageinline imageinline image
inline imageinline imageinline imageinline image[DOWNWARDS ARROW]
inline imageinline imageinline imageinline image[UPWARDS ARROW]
inline image< 0 ; [UPWARDS ARROW]>0 ; [UPWARDS ARROW]< 0 ; [UPWARDS ARROW]>0 ; [UPWARDS ARROW]
inline image< 0 ; [UPWARDS ARROW]>0 ; [UPWARDS ARROW]< 0 ;inline image>0 ; [DOWNWARDS ARROW]
inline image[UPWARDS ARROW][DOWNWARDS ARROW][UPWARDS ARROW]inline image
inline image[UPWARDS ARROW][DOWNWARDS ARROW][DOWNWARDS ARROW][DOWNWARDS ARROW]

In the tariff-reducing countries, the policy substitution motive to lower the pollution tax differs for regional vs. multilateral trade liberalization for two reasons. First, the policy substitution incentive to subsidize domestic producers is weaker in the regional case relative to the multilateral case. This is because the tariff is not lowered for all trading partners in the former case. Second, the contrasting manner in which production changes in country 3 between the two forms of trade liberalization implies that global production expands by a smaller amount in the regional case. When pollution is largely transboundary, this in turn makes the marginal social cost of lowering the tax smaller in the regional case. As a consequence, when pollution is local, the tariff reducing countries are less likely to lower their tax because of regional rather than multilateral tariff reduction (i.e, inline image). In contrast, when pollution is global, they are more likely to lower their pollution tax in the regional rather than the multilateral case.

Abstracting away from inter-country differences, we find that multilateral and regional trade liberalization affect the stringency of the pollution tax and the level of welfare in the tariff-reducing countries in similar ways when pollution is local, but in dissimilar ways for global pollution. Multilateral trade liberalization induces the tariff-reducing countries to increase their pollution tax if and only if pollution is sufficiently harmful. A similar result holds for regional trade liberalization when pollution damage is localized. However, for pollutants that have large inter-jurisdictional spillovers, regional trade liberalization always lowers the participating countries' pollution tax.

Further, with localized pollution damage, both forms of trade liberalization improve welfare in the tariff-reducing countries. On the other hand, when pollution is transboundary, countries undertaking multilateral trade liberalization near free trade experience a reduction in welfare. In contrast, regional trade liberalization near free trade may increase welfare in the participating countries. The diversion of production and possibly consumption from the non-participating to the participating countries tends to benefit the latter at the expense of the former. This points to one reason why regionalism may be preferred to multilateralism for the establishment of free trade by countries, especially when pollution is largely transboundary but not very damaging.

The extent to which the pollution tax is distorted in the tariff-reducing countries changes in a similar manner because of both forms of trade liberalization. When pollution is local, the equilibrium tax exceeds its efficient level and both regionalism and multilaterlism narrow the gap between the equilibrium and efficient levels of the pollution tax in these countries. Alternatively, when pollution is global and tariffs are not too large, the pollution tax is set below its efficient level and both forms of trade liberalization distort the tax further away from its efficient level in the tariff reducing countries. As well, regional trade liberalization is found to affect pollution tax and welfare in the participating and non-participating countries in starkly contrasting ways.

6. Concluding Remarks

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. The Model
  5. 3. Multilateral Trade Liberalization
  6. 4. Regional Trade Liberalization
  7. 5. Comparison
  8. 6. Concluding Remarks
  9. Appendix
  10. References

The paper considers trade between identical countries with imperfectly competitive markets and compares the impacts of regional and multilateral tariff reduction on strategic pollution taxation and welfare. While the existing literature has focused on analyzing the impacts of unilateral or multilateral trade liberalization, much tariff reduction in the world is undertaken through bilateral or regional trade agreements among a sub-group of trading countries. We find that the contrasting manner in which output changes in the countries that remain outside the RTAs leads to crucial differences between the two forms of trade liberalization. These differences exist for tariff-reducing countries between the different forms of trade liberalization, as well as between the participating and non-participating countries for regional trade liberalization.

The paper has modelled the analytically tractable case of identical countries facing linear demand and quadratic pollution cost.16 Moreover, we have considered Cournot competition among firms.17 Even when these assumptions are modified, production, consumption, and the associated strategic effects will continue to change differently across countries, leading to differential impacts of multilateral and regional trade liberalization on environmental taxation and social welfare. As well, the contrasting manner in which output changes in some of the trading countries suggests that the two forms of trade liberalization can have qualitatively different impacts even when a domestic policy instrument other than environmental tax (e.g., quality standard) is manipulated by countries to serve as a secondary trade barrier.

Appendix

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. The Model
  5. 3. Multilateral Trade Liberalization
  6. 4. Regional Trade Liberalization
  7. 5. Comparison
  8. 6. Concluding Remarks
  9. Appendix
  10. References

A.1. Proof of Lemma 2

After appropriate substitutions, in the regional case we have

  • math image
  • math image

Specifically, inline image if and only if inline image

A.2. Proof of Proposition 2

When inline image, we have

  • math image(A1)

where inline image, and

  • math image(A2)

From (A1) we have that M is concave in β, inline image, and inline image if and only if

  • display math

Moreover, from (A2), inline image if and only if inline image. Furthermore,

  • math image

A.3. Proof of Proposition 3

Assume inline image. The impact of regional trade liberalization on each country's welfare is derived as follows. We first differentiate inline image with respect to ϕ, and then evaluate the resulting expression, which is a function of both ϕ and Φ, at inline image. This gives the impact of marginal bilateral tariff reduction by countries 1 and 2 on welfare of country i, when evaluated in the neighbourhood of free trade, as follows:

  • math image
  • math image

Note that when pollution is local, inline image for inline image

A.4. Proof of Proposition 4

When inline image, we have

  • math image
  • math image
  • math image

A.5. Proof of Proposition 5

Assume inline image. The impact of regional trade liberalization on each country's welfare is obtained as earlier. Thus, we first differentiate inline image with respect to ϕ, and then evaluate the resulting expression, which is a function of both ϕ and Φ, at inline image. This yields

  • math image(A3)
  • math image

where inline image. Define the numerator of (A3), inline image. We have that N is concave in β, inline image, and inline image if and only if inline image, where

  • display math

Note that when pollution is perfectly transboundary, inline image if and only if inline image, where inline image. To restrict attention to positive values of welfare, we ignore values of β above inline image while analyzing welfare changes in the neighbourhood of free trade.

  1. 1

    As the WTO notes, “Regional trade agreements have become increasingly prevalent since the early 1990s. As of 15 January 2012, some 511 notifications of RTAs had been received by the GATT/WTO.” (see http://www.wto.org/english/tratop_e/region_e/region_e.htm).

  2. 2

    Thus, we are assuming a constant emission intensity of output. Emissions can be reduced through a reduction in output, with forgone profit being the abatement cost for a firm. Allowing firms to separately choose their level of abatement does not change our results qualitatively.

  3. 3

    A feature of the pollution spillover process underlying inline image is that, when pollution is trans-boundary inline image, total pollution affecting a country is not a function of the number of countries being modelled.

  4. 4

    Baksi and Ray Chaudhuri (2009) use an alternative specification of the pollution spillover process, which nonetheless yields similar results. Moreover, they do not examine how multi-lateral trade liberalization changes the extent to which the pollution tax is distorted from its efficient level.

  5. 5

    This level of the tax is efficient given the constraints on policy instruments (e.g., non-availability of a production subsidy to separately correct the distortion created by imperfect competition) and is not first-best.

  6. 6

    The prohibitive rate of tariff, at which imports become zero, is given by inline image. That is,

    inline image if and only if inline image. Note that the threshold tariff inline image is less than the prohibitive tariff inline image if and only if inline image.

  7. 7

    Thus, tariff reduction lowers the equilibrium tax for higher values of β when pollution is more transboundary; that is, inline image.

  8. 8

    Given the symmetric nature of the pollution spillover process, the global welfare-maximizing level of the tax rates, inline image and inline image, are independent of the spillover parameter γ. Also, the SOCs are satisifed as math image, math image and math image.

  9. 9

    This channel, through which the rent capture effect in the tariff-reducing countries may become stronger and tend to lower their tax, cannot exist in the multilateral case. Multilateral tariff reduction always increases sales and weakens the rent capture effect. This difference engenders the possibility that regional and multilateral tariff reduction may have qualitatively different impacts in the tariff-reducing countries.

  10. 10

    Hence, multilateral tariff reduction lowers the tax for inline image, while regional tariff reduction lowers the tax in participating countries for inline image, where inline image.

  11. 11

    When inline image and inline image, we have math image iff math image

  12. 12

    When inline image, we have that inline image is concave in ϕ, and inline image is maximized at math image.

  13. 13

    While both have negative signs, the absolute value of inline image is smaller in the regional case than in the multilateral case.

  14. 14

    When inline image and inline image, we have inline image

  15. 15

    When inline image, we find that inline image is concave in ϕ, and inline image is maximized at math image.

  16. 16

    These functional forms imply that the third derivatives of the total revenue and cost functions are zero. As long as these third derivatives are not too large, our results will remain qualitatively unchanged. Further, abstracting away from inter-country differences in preference, population, technology, and so on helps us to isolate the differential consequences of multilateral and regional tariff reduction.

  17. 17

    In those industries where capacity constraints are important, it can be assumed that firms compete in quantities rather than prices (Kreps and Scheinkman 1983). If the firms in our model competed à la Bertrand, the rent capture effect would tend to raise the environmental tax, which may change the results.

References

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. The Model
  5. 3. Multilateral Trade Liberalization
  6. 4. Regional Trade Liberalization
  7. 5. Comparison
  8. 6. Concluding Remarks
  9. Appendix
  10. References