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Abstract

In this paper, we analyze how the prospect of international negotiations over trans-boundary pollution shapes intracountry transfer schemes when the governments of the countries' polluting regions are in charge of environmental policy and negotiations. Federal governments can implement compensation payments between domestic regions and matching grants prior to the international negotiations between the polluting regions. The subgame-perfect transfer schemes fail to fully internalize the environmental externality, leading to an inefficient international environmental agreement. As the international spillover increases, the intracountry compensation rates increase while the matching rates decline, distorting the incentives for the regional governments in opposing directions. We also show that decentralization of environmental decision making arises endogenously.