Environmental policy competition and heterogeneous capital endowments

Abstract

In a model with monopolistic competition, international trade, and mobile capital, this paper aims to investigate the relationship between two countries with different capital endowments in terms of environmental regulations. The conventional result is that the capital-abundant country will charge a higher tax rate than the capital-scarce country. This present paper, however, finds that the opposite result may occur. Another feature of this paper is that governments strategically use the distribution of environmental rents as a tool to attract capital inflows. We show that in the absence of capital mobility, the two countries will distribute all of the pollution tax revenues to the general public. The presence of capital mobility induces the governments to allocate some or all of the environmental rents to the polluting firms to attract capital inflows. The capital-abundant country has a stronger incentive to allocate rents to the firms than the capital-scarce country. We also consider the case with global pollution, in which both countries tend to set less stringent regulations.