We’ve been talking a lot about environment- related sources of comparative advantage. Aside from pollution regulation, we’ve been implicitly assuming everything else is “right” in these economies. Now we’re entering the section of the course in which we’ll look at trade and environment interactions when there are other types of market power.

We’ll go through the following list: – A government has revenue needs and taxes capital to raise those revenues – Voting – Lumpy investment – Market share and pollution shifting motives

Public Good Provision and Distortionary Environmental Policy

Notation τ=emission tax t k =capital tax Q=output P c =consumer price P s =seller price CS=consumer surplus CS   0 Q MPB(q)dq-P c Q PS=producer surplus PS  P S Q -  0 Q MPC(q)dq

Assume economy is closed to goods trade pollution is one for one with production – thus τ also equals production tax capital supply is endogenous and increasing in PS t k set exogenously t k > 0 Motive for t k > 0? – Use revenues to provide public goods

Math assume welfare =sum of consumer surplus (CS), producer surplus (PS), and tax revenue, less damages from pollution. W=

Note since Q s =Q c then  Q=P c Q-P S Q rewrite W as W=  0 Q MPB(q)dq -  0 Q MPC(q)dq +t k K(PS)-  0 Q MD(q)dq

Government’s Choice Choose  so as to maximize W. To find dW/dτ will need to use Leibnitz’s rule: the derivative of an integral ∫ a(x) b(x) F(u;x)du is as follows:

Apply this dW/dτ= [  0 Q MPB(q)dq -  0 Q MPC(q)dq -  0 Q MD(q)dq + t k K(PS)]

Simplify recall that MPB(Q)=P c and MPC(Q)=P s. Then MPB(Q) - MPC(Q) =  thus

Setting dW/dτ equal to zero and solving for  gives

Is τ > or < MD? We know dQ/d  dPS/dτ; we’ve assumed dK/dPS>0 Result: if the capital tax is positive, then is negative => government wants to set  <MD

Intuition Governments want capital around so that they can tax the profits that it earns One way to attract capital to a region is to raise the direct rents that it earns. This can be achieved by reducing env’l taxes, because this lowers the costs of doing business. So governments have an incentive to weaken local environmental policy so as to expand their tax base.

Note we said the reason why the government might want to tax capital was so that they could provide public goods. But the same result will hold even if capital tax revenue is merely an ego item for civil servants.

General? Does that mean that governments will always set inefficiently weak environmental policy if they need to finance public good provision?

No. Suppose instead t k =0 e.g. an international tax treaty restricts taxes but that there’s some public benefit from government revenue (e.g. public good provision) Can finance public goods out of env’l tax revenues. W=  0 Q MPB(q)dq-P c Q + P S Q -  0 Q MPC(q)dq +G(  Q) -  0 Q MD(q)dq where G( ) maps tax revenues into public good provision

Policy choice: choose τ to solve dW/dτ = [  -MD]dQ/d  +[G ’ - 1]d[  Q]/d  Interpretation: if a dollar spent on public goods is worth more collectively than 1$, then G ’ >1. If, in addition env’l tax revenues increase as you raise  then d[  Q]/d  >0 and so you’d like to set  >MD. That is, you would set inefficiently strict env’l taxes.

Conclusion public good financing has ambiguous effect on whether environmental tax is too strict or too weak

Digression Might we want to always overtax pollution for revenue-generating purposes? e.g. reduce capital taxes and raise pollution taxes?

Second-Best Environmental Policy Suppose there are pre-existing distortions in economy – e.g. labor taxes too much leisure – If leisure and environment are complements, then want to undertax environment so as to induce workers to choose more labor

For more on Double Dividend Hypothesis, Tax-Interaction Effects, and Second-Best Environmental Policy, see Bovenberg, A. Lans and de Mooij, Ruud A. (1994). “Environmental Levies and Distortionary Taxation,” The American Economic Review, 84(4): Fullerton, Don (1997). “Environmental Levies and Distortionary Taxation: Comment,” The American Economic Review, 87(1): Fullerton, Don and Metcalf, Gilbert (1998). “Environmental Taxes and the Double-Dividend Hypothesis: Did You Really Expect Something for Nothing?” Chicago-Kent Law Review, 73: Goulder, Lawrence H., Parry, Ian W.H., and Burtraw, Dallas (1997). “Revenue-raising versus other approaches to environmental protection: The critical significance of preexisting tax distortions,” The RAND Journal of Economics, 28(4):