Environmental Impacts on Optimal Trade Policies

Abstract

This paper examines the impacts of tightening environmental regulations on optimal trade and investment policies. We find that for a small open two-sector economy with an importable sector relying on foreign capital while emitting pollution, a more stringent environmental measure leads to a higher optimal tariff and possibly a higher optimal tax on foreign capital. This result holds whether or not there are capital tax credits in the foreign country. When such tax credits are in place in the foreign country, three possible cases regarding the domestic capital tax rate relative to the foreign rate are identified and examined. In one such case, multiple equilibria of optimal policies may exist.