Equilibrium Pollution Taxes in Open Economies with Imperfect Competition

Abstract This paper argues that imperfect competition in global markets creates a strategic interaction between governments that can lead to the inefficient distortion of pollution taxes. This distortion can be decomposed into a rent capture effect and a pollution-shifting effect. The rent capture effect lowers equilibrium taxes as each country attempts to gain a competitive advantage over its trading partner and thereby capture foreign rent through net exports. The pollution-shifting effect raises equilibrium taxes as each country attempts to transfer production and its associated pollution to the other country. This effect vanishes if pollution is perfectly transboundary because shifted pollution causes as much damage to the domestic environment as does domestic pollution. The net effect on symmetric equilibrium taxes is negative, except in the special case of perfect competition with no transboundary pollution. In this case the two effects are mutually offsetting and the Nash equilibrium is efficient. When pollution is at least partially transboundary there also arises the usual transboundary externality and this reinforces the negative net strategic effect, giving rise to equilibrium taxes that are lower than what is globally efficient.