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Environmental Taxation and International Trade in a Tax-Distorted Economy

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Published/Copyright: May 30, 2023
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Economics
From the journal Economics Volume 17 Issue 1

Abstract

International environmental agreements have been met with the reluctance of some national authorities to accept general commitments aimed at reducing greenhouse gas emissions. While acknowledging the crucial significance of the climate change process, politicians and regulators in some countries have argued that pollution measures would have a negative impact on their domestic welfare. This article uses a standard general equilibrium model of perfect competition to examine the welfare effects of taxing a polluting-exported good through an explicit representation of the trade relations of the economy in the presence of pre-existing taxes. The equivalent autarky model is used to contrast the welfare impacts with the open economy situation. The results extend the scope of the literature on second-best environmental taxation by identifying the complexity of the components affecting welfare in open economies.

Keywords: environmental taxation; trade-substitution effect; autarky
JEL classification: F18; H21; H23

1 Introduction

According to United Nations, the fight against climate change requires a worldwide strategy, including a global commitment with the engagement of the industrialised countries.[1] This global approach is needed to address a generalised problem, having both causes and consequences beyond the administrative borders of individual countries. However, the history of the climate international agreements has revealed the reluctance of some countries to accept measures that could harm their domestic industry, especially in the case of export-oriented economies. In particular, the Kyoto Protocol showed an evident gap between the science of climate change, which predicts rapid and inevitable increases in global temperatures, and the policy responses to mitigate the anthropogenic phenomenon of climate change.[2] Until today, such policy measures have defined insufficient responses to reach an appreciable mitigation of impacts (Helm, 2008).

Indeed, obtaining a significant decrease in greenhouse emissions requires a structural transformation of the economic systems, adapting both the production and consumption processes to obtain energy from clean sources, and abandoning energy from fossil fuels. The required transformation of the energy system is not a trivial issue from the socioeconomic and technological points of view, at least in the short and medium term.

A common evidence materialised in international agreements is that countries’ willingness to reduce emissions is inversely related to a country’s openness to trade and propensity to export (Hoel, 2001). In addition, trade becomes an important issue when different environmental measures are applied at a national level, as climate interventions potentially reduce competitiveness and internal activity (Harrison, 2015; Simmons et al., 2009). As environmental measures generate an increase in effective prices for exported goods, international agreements are viewed as damaging for the competitiveness of domestic industries while benefiting the competitiveness of foreign industries, especially if the competing countries have weak environmental standards (Flannery, 2016). According to this point of view, international environmental commitments would generate a decline in exports and a subsequent negative knock-on effect on the domestic activity (Levinson & Taylor, 2008). This article contributes to this debate and analyses the domestic welfare impacts of new taxation on polluting goods, using a general equilibrium perspective of the interactions between trade and internal economy and considering the links of the new tax with the pre-existing tax system.

Over the last 40 years, the debate on trade and environment has been accompanied by an extensive literature, which has evolved in various research areas while making use of various methodological frameworks.[3] In particular, Antweiler et al. (2001) and Copeland and Taylor (2003) analysed the impacts of free trade on the environment by deriving, both theoretically and empirically, three different impacts of trade on the environment: the scale effect, the technique effect, and the composition effect.[4] The relationship between environmental regulation, competitiveness, economic growth, and the comparative advantage of countries and firms has also been studied by using both empirical and analytical approaches.[5] Within this body of literature, the interactions and potential conflicts between free trade and ecological policies have been analysed.[6]

Another set of contributions has analysed the welfare costs associated with environmental regulation, using a general equilibrium perspective that takes into account the initial tax distortions of a closed economy. In all these studies, pre-existing taxes are a crucial starting point that places this literature in a second-best setting. Within this field, the pioneering papers pointed out the existence of two welfare effects caused by environmental taxation:[7] the primary welfare effect, or the partial equilibrium impact of the new taxation on reducing the polluting good, and the revenue-recycling effect, or the benefit of replacing pre-existing distortionary taxes with the pollution taxation. The results of these contributions pointed out that environmental regulation could generate increases in welfare if pre-existing distorting taxes were replaced by the new environmental taxes.[8]

Subsequently, an extensive set of papers suggested the existence of an additional (negative) welfare effect: the tax-interaction effect, reflecting a loss of welfare due to the increase in real prices generated by the emission taxation, which reduces the real wage and subsequently diminishes the labour supply and aggravates the distortions inherent to the pre-existing tax system.[9] These papers demonstrated that the efficiency costs of environmental interventions are higher in a world with initial tax distortions in factor markets than in a situation where those distortions do not exist. The latest finding in this literature was proposed by Williams (2002, 2003), who defined an additional benefit-side tax-interaction effect to be added to the welfare impact measurement. This new component captures the positive contribution of environmental taxation on consumers’ health and labour productivity that can (partially or completely) offset the costs of environmental taxation.[10]

Later, Bento and Jacobsen (2007) extended the double dividend analysis by incorporating a fixed factor in the production of the dirty good, which involves the generation of Ricardian rents in the economy. In this context, the introduction of an environmental tax with revenues used to reduce pre-existing labour taxes can generate a double dividend situation. In addition, Liu (2013) proposed the introduction of a tax evasion effect to the welfare measurement when an environmental tax reform is applied. This additional component captures the change in real costs supported in case of evading taxes and allows to enhance welfare.

Broadly speaking, the welfare consequences of environmental taxes in open economies have been explored through the use of two differential general equilibrium approaches. The first one adopts the assumption of small open economy, focusing on the implications of the interplay between trade policies and environmental regulations within a specific economy. Examples in this field are studies performed by Bovenberg and van der Ploeg (1994), who explored the effects on public finance, unemployment, and domestic capital stock of increased concern for environment; Bovenberg and van der Ploeg (1998), who studied the effects on wage formation, employment, and environmental quality of environmental tax reforms; or Gulati and Roy (2008), who analysed the role of the national treatment principle in the environmental regulation of an open economy.

The second approach uses a (broader) perspective of large open economies, taking a global look at the trade–environment interaction. Turunen-Red and Woodland (2004), for instance, analysed the feasibility of Pareto-improving multilateral reforms of environmental and trade policies in a model of international trade. By using an empirical perspective, Fisher and Fox (2007, 2012) looked at the relationship between trade and environmental taxation in the context of pre-existing distortionary taxes, through the use of the computable general equilibrium (CGE) framework. By incorporating tax and trade distortions, the main conclusions of these CGE papers were the importance of the distributional and efficiency impacts due to the allocation of emission permits. Additionally, Vlassis (2013) proposed a perfectly competitive general equilibrium model of international trade to analyse the welfare impacts of environmental policy coordination reforms. Keen and Kotsogiannis (2014) studied the Pareto efficiency of trade instruments in global efficient climate policies through the use of a perfectly competitive general equilibrium model of international trade. By combining theoretical and empirical analysis, Larch and Wanner (2017) studied the effects of carbon tariffs on trade, welfare, and carbon emissions by developing a multi-sector, multi-factor structural gravity model.

The extensive coverage of the interplay between environmental policy and trade has usually analysed welfare impacts in an aggregate manner, without reflecting the various channels through which welfare is affected. In fact, an in-depth perspective of the trade–environment repercussions on welfare has received less attention in the literature. To the best of this author’s knowledge, the sole exceptions are Williams (1999), who used a second-best general equilibrium analysis and studied the various channels of welfare impacts caused by trade policies taking into account the pre-existing tax distortions in the labour market, and Parry (2001), who extended Williams’s contribution by numerically quantifying the significance of pre-existing factor taxation in the welfare effects caused by restrictive trade policies.

Against this background, the objective of this article is to provide a detailed analysis of the complexity of the general equilibrium welfare impacts of environmental taxation, by using a second-best approach that captures the link between ecological taxes, trade operations, and initial taxes of a small open economy. Among the welfare effects when an emission tax is implemented, the results enable identifying the impacts on the domestic economy that are channelled through the trade activity. In particular, apart from the primary impact on trade, which has traditionally been a latent impediment to international commitments, the model shows two additional general equilibrium trade contributions to welfare. The first is based on the tax revenues coming from abroad, which allow a cut in the (domestic) distortionary income tax. The second contribution shows the impact of a better environment on reducing labour supply and encouraging leisure after the detrimental effect of the environmental taxation on exports. The general equilibrium channels of trade and its effects on welfare proposed in this article, commonly ignored by (partial equilibrium) conventional wisdom, provide a better understanding of the consequences of an emission tax in the case of exporting open economies. Finally, the model is accommodated to reflect an autarky situation that is used to compare with the open economy framework.

The rest of the article is organised as follows. Section 2 describes the analytical general equilibrium model that explicitly defines the trade activity of the economy. Section 3 analyses the welfare impact of implementing an environmental tax on the polluting-exported good and gives details about the second-best optimal taxation and the trade’s partial equilibrium contribution to welfare. Section 4 adapts the model to the special case of autarky. Section 5 concludes the article.

2 The Analytical Model

The welfare effects of environmental taxes in an open economy are examined through a general equilibrium model. Parallel to Williams (1999), the model analyses the welfare effects in an open economy with pre-existing tax distortions. Unlike Williams’ approach, focused on trade policies, the present framework incorporates environmental externalities and derives the welfare impacts when the burden of (domestic) environmental taxation is partially translated to external agents through increases in the effective price of exports.

For the sake of simplicity, the model is limited to showing two consumption goods: X , the production of which generates air pollution, and Y , the production of which does not generate the negative externality. There is a representative household in the economy whose utility comes from the two consumption goods ( X and Y ). Households also enjoy utility from leisure ( l ) and environmental quality ( Q ). The utility function responds to the following:

(1) U ( V ( X , Y , l ) , Q ) ,

which is quasi-concave and continuous. Note that expression (1) assumes that environmental quality is a separable argument from consumption goods and leisure.[11]

The household’s time constraint is defined as follows:

(2) T = L X + L Y + l ,

where T is the total time endowment, L X and L Y represent the amount of labour used in the production of X and Y , respectively, and L X + L Y = L .

In order to simplify the trade relations, X is assumed to be exported and Y is assumed to be imported. The domestic consumption of each good therefore responds to total production net of trade relations, in the form:

(3) X = F X ( L X ) − M X ,

(4) Y = F Y ( L Y ) + M Y .

In these expressions, M X represents the exports of the economy and M Y represents the imports. In addition, F X ( L X ) and F Y ( L Y ) are the production functions that in case of not being homogenous of degree one will generate profits ( π ) that are assumed to be an income of households. By normalising wages to one, profits can be written in the following way:

(5) π = P X F X ( L X ) + P Y F Y ( L Y ) − L X − L Y ,

where P X is the price of X and P Y is the domestic price of Y .

The production of X generates pollution and therefore reduces environmental quality. The model assumes that Q responds to a negative relationship with the production of the polluting good:

(6) Q = Q ̅ − F X ( L X ) = Q ̅ − ( X + M X ) ,

where F X ( L X ) ≤ Q ̅ , so that Q ≥ 0 . Environmental quality is equal to the difference between an initial exogenous level ( Q ̅ ) minus the quantity of the dirty good produced. In expression (6), the units are equivalent so that the production of one unit of X reduces the baseline level Q ̅ by exactly the same amount.

Pre-existing tax distortions come from an initial income tax, which taxes all household income (labour earnings and profits) at a proportional rate τ L . By normalising wage to one, the consumers’ budget constraint can be written as follows:

(7) ( 1 − τ L ) ( L + π ) + G = P X X + P Y Y ,

where G is a government lump-sum transfer to households, which is assumed to be constant in real terms:

(8) G = τ L ( L + π ) .

The model does not incorporate trade barriers and the trade relations of the economy are assumed to be balanced so that:

(9) P ( M Y ) M Y − P X M X = 0 ,

where ∂ P ( M Y ) ∂ M Y ≤ 0 . In this expression, P ( M Y ) is the world price for the imported good which is decreasing with the amount of imports, and P X is the price of one unit of the exported good X .

Households maximise utility (1) subject to their time constraint (2) and budget constraint (7), by taking the income tax rate, the government transfers, the prices of final goods, profits, and environmental quality as given. This yields the corresponding first-order expressions for consumers:

U V V X = λ P X ; U V V Y = λ P Y ; U V V l = λ ( 1 − τ L ) ,

where the subscripts on U and V denote partial derivatives and λ is the marginal utility of income. The uncompensated Marshallian demand functions for both the consumption goods and leisure are then derived by applying these consumers’ first-order conditions, together with the households’ time constraint (2) and the households’ budget constraint (7):

X ( P X , P Y , τ L , π , Q ) ; Y ( P X , P Y , τ L , π , Q ) ; l ( P X , P Y , τ L , π , Q ) .

3 Effects of Taxing the Polluting Good

3.1 Welfare Measurement

The analytical model described previously is used to measure the welfare consequences of an emission tax implemented on the dirty-exported good. Specifically, the model assumes a tax rate falling on the production of X ( τ X ), and this implies that both domestic demand and external demand support the burden of the environmental taxation. Indeed, taxing the exported good raises its effective price, and, consequently, this measure creates a disincentive for both internal consumption and exports. However, as the interest lies in analysing the impacts on the internal economy that implements the environmental tax, the following welfare analysis is limited to showing the effects on domestic agents.

The emission tax modifies expression (5) corresponding to the firms’ profits, as follows:

(10) π = ( P X − τ X ) F X ( L X ) + P Y F Y ( L Y ) − L X − L Y .

Meanwhile, the government budget constraint is now modified to the following:

(11) G = τ L ( L + π ) + τ X F X ( L X ) .

In this situation, the first-order conditions for firms’ profit maximisation are as follows:

P X = 1 ∂ F X ∂ L X + τ X ,

(12) P Y = 1 ∂ F Y ∂ L Y ,

where P X is the tax-inclusive price of good X .

Totally differentiating the utility function (1) with respect to τ X , then substituting the first-order conditions of consumers, and subsequently dividing by the marginal utility of income ( λ ) yield the following:

(13) 1 λ d U d τ X = P X d X d τ X + P Y d Y d τ X + ( 1 − τ L ) d l d τ X − 1 λ ∂ U ∂ Q d X d τ X + d M X d τ X .

Taking the total derivative of the domestic consumption of good X (expression (3)) with respect to τ X , substituting it into equation (12) for the price of X , and solving for d L X d τ X give the following expression:

(14) d L X d τ X = ( P X − τ X ) d X d τ X + d M X d τ X ,

and a similar procedure for good Y gives rise to the following:

(15) d L Y d τ X = P Y d Y d τ X − d M Y d τ X .

Totally differentiating the consumers’ time constraint (2) with respect to τ X , using d T d τ X = 0 , introducing expressions (14) and (15), and then subtracting the result in (13) yields the following:

(16) 1 λ d U d τ X = [ τ X − τ P ] d X d τ X + d M X d τ X + P Y d M Y d τ X − P X d M X d τ X − τ L d l d τ X ,

where τ P = 1 λ ∂ U ∂ Q is the Pigouvian tax level that measures the marginal damage due to air pollution arising from the effects of the polluting good on utility.

Differentiating the government budget constraint (11), using d G d τ X = 0 , subsequently substituting into the total derivative of the demand for leisure l ( P X , P Y , τ L , π , Q ) , which is equal to d l d τ X = ∂ l ∂ P X d P X d τ X + ∂ l ∂ P Y d P Y d τ X + ∂ l ∂ τ L d τ L d τ X + ∂ l ∂ π d π d τ X + ∂ l ∂ Q d Q d τ X , and operating terms give the following:

(17) d τ L d τ X = − X + M X + τ X d X d τ X + d M X d τ X − τ L ∂ l ∂ P X d P X d τ X + ∂ l ∂ P Y d P Y d τ X + d π d τ X ∂ l ∂ π − 1 + ∂ l ∂ Q d Q d τ X L + π − τ L ∂ l ∂ τ L .

Substituting expression (17) into the preceding expression for d l d τ X , introducing the result into expression (16), using d Q d τ X = − d X d τ X + d M X d τ X , and finally grouping terms yield the following:

(18) 1 λ d U d τ X = [ τ X − τ P ] d X d τ X + d M X d τ X ︸ d W P + P Y d M Y d τ X − P X d M X d τ X ︸ d W T + ( μ − 1 ) X + M X + τ X d X d τ X + d M X d τ X + τ L d π d τ X ︸ d W R − μ τ L ∂ l ∂ P X d P X d τ X + ∂ l ∂ P Y d P Y d τ X + ∂ l ∂ π d π d τ X − ∂ l ∂ Q d X d τ X + d M X d τ X ︸ d W I .

This expression monetarily quantifies the welfare general equilibrium impact of the tax on X , which is obtained through a calculation of the marginal welfare effect of implementing the environmental taxation.

In expression (18), μ is the marginal cost of public funds and responds to the following:

(19) μ = τ L ∂ l ∂ τ L ( L + π ) − τ L ∂ l ∂ τ L + 1 .

Note that this is a partial equilibrium concept as it does not take into account the indirect effects of labour taxation on the emission tax revenues. The marginal cost of public funds shows the efficiency cost of an additional monetary unit of public revenues obtained by an increase in the income tax rate. In particular, the quotient in (19) is the welfare loss from a marginal increase in the income tax per monetary unit of new revenue: the numerator is the marginal rise in taxation and the denominator is the increase in government revenues from a marginal increase in τ L . The cost to consumers is therefore equal to the deadweight loss (the quotient) plus the additional income (one) of a marginal increase in the income taxation.

In expression (18), the total welfare effects of the environmental taxation are decomposed into four different components: the primary welfare effect ( d W P ), the trade-substitution effect ( d W T ), the revenue-recycling effect ( d W R ), and, finally, the tax-interaction effect ( d W I ). The primary welfare effect is the partial equilibrium impact of implementing τ X previously defined in prior literature, which is equal to the difference between the private costs of taxation and the social costs of the externality. The former is obtained by multiplying the tax rate on X by the reduction in the production of the polluting good; the latter is derived from multiplying the Pigouvian tax rate by the decrease in the production of X .

The second component in expression (18), d W T or the trade-substitution effect, is a welfare element that has not appeared in the previous contributions of the second-best literature, which have focused on the welfare impacts of environmental taxes in closed economies. This component captures the influence of the emission taxation on the trade balance. In specific terms, the trade-substitution effect is equal to the difference between the marginal change in imports, valued at the internal price, minus the marginal change in exports, valued at the effective price (i.e. final price including the environmental tax rate). Note that the trade-substitution effect is a partial equilibrium measurement, as it does not take into account the interactions of the emission tax with the pre-existing tax system.

The revenue-recycling effect, d W R , reflects the positive welfare impact of substituting the distortionary income tax by the environmental taxation. This efficiency improvement is equal to the product of the marginal revenue from the emission tax (in square brackets) and the welfare loss due to income taxation: ( μ − 1 ) . In contrast to the conventional approaches, the revenue-recycling effect in equation (18) distinguishes between revenues attributed to domestic economy and revenues attributed to exporting activity.

The last component in (18) contains the tax-interaction effect, d W I . This element measures the welfare loss generated by the emission tax on the labour market, which is channelled through an increase in final prices that also reduces real wage, decreases benefits, and improves environmental quality. All these impacts discourage labour supply, which simultaneously generates an increase in leisure. And any change in the labour supply–leisure decisions causes two different general equilibrium impacts on welfare. The first is based on the fact that as income tax revenue is directly related to the labour supply, when the labour supply increases (decreases) there is a simultaneous increase (decrease) in taxation revenues. The second impact is explained by the difference between the private cost of leisure (wage net of taxation) and its social cost (pre-tax wage), with the latter higher than the former. As a result of these two general equilibrium channels, when leisure increases there is an associated welfare loss, which is captured by the tax-interaction effect.

By considering the assumption that goods X and Y are equal substitutes for leisure, the tax-interaction effect can alternatively be written as follows (see the appendix for the details on derivation):[12]

(20) d W I = − ( μ − 1 ) γ X d P X d τ X + γ Y d P Y d τ x − μ τ L ε lm γ l d π d τ X + μ τ L ∂ l ∂ Q d X d τ X + d M X d τ X ,

where ε lm is the uncompensated after-tax income elasticity of leisure. Also in expression (20), γ X , γ Y , and γ l are the shares of consumption goods X and Y and leisure, respectively, in relation to pre-tax household income.

In expression (20), the tax-interaction effect is composed of three different elements. The first one captures the negative influence on welfare of the marginal changes in consumption prices, which is directly related to the consumption share of each good. The second element shows the negative influence of the lower benefits on the tax-interaction effect when the environmental tax is implemented, which directly depends on the uncompensated elasticity of leisure with respect to after-tax income and the proportion of leisure related to pre-tax household income. In particular, the higher the income elasticity of leisure and the higher the leisure share, the higher the welfare loss will be. Finally, the third element in (20) is the influence of the tax on reducing the production of the polluting good (i.e. increasing environmental quality) and its positive effects on welfare. Note that if environmental quality is assumed not to exert any influence on the consumer’s labour–leisure decision, this component would be null, and the positive effect of reducing the environmental externality would not appear in the tax-interaction effect. When the environmental quality is taken into account, expression (20) shows that the negative impact on welfare of τ X is (at least partially) counterbalanced.

3.2 Second-Best Optimal Emission Taxation

In a second-best setting, the neutral tax on good X ( τ X * ) is the level of emission taxation that ensures a null marginal change in welfare while considering the existence of an initial pre-existing tax on income. By setting expression (18) equal to zero, using expression (20), and then solving for τ X yields the following:

(21) τ X * = 1 μ d X d τ X + d M X d τ X τ P d X d τ X + d M X d τ X − P Y d M Y d τ X + P X d M X d τ X − ( μ − 1 ) X + M X + τ L d π d τ X + ( μ − 1 ) γ X d P X d τ X + γ Y d P Y d τ X + μ τ L ε lm γ l d π d τ X − μ τ L ∂ l ∂ Q d X d τ X + d M X d τ X .

On the right-hand side, the first term in the square brackets is the contribution of marginal damages to optimal taxation; the second and third terms represent the trade contributions to the optimal tax level; subsequently there is the (negative) influence of the revenue-recycling effect; the rest of terms in expression (21) capture the influence of the tax-interaction component, comprising specifically the positive effect to τ X * due to the changes in final prices and benefits, and the negative effect to optimal tax rate of changes in the demand for leisure.

In the absence of pre-existing tax distortions in the economy, that is τ L = 0 and μ = 1 , the optimal tax level simplifies to the following:

(22) τ X * = 1 d X d τ X + d M X d τ X τ P d X d τ X + d M X d τ X − P Y d M Y d τ X + P X d M X d τ X ,

which corresponds to the first-best (partial equilibrium) optimal taxation.

The differences between expressions (21) and (22) are the (negative) revenue-recycling components and the (positive) tax-interaction components, which disappear in a first-world setting. If these two effects together are positive, the second-best neutral tax rate will be higher than the neutral tax in a first-best world and the other way round.

3.3 The Trade-Substitution Effect

From the welfare impact of environmental taxation (expression (18)), the trade-substitution effect is defined as follows:

(23) d W T = P Y d M Y d τ X − P X d M X d τ X .

Totally differentiating expression (9) for the balanced trade with respect to τ X yields the following:

(24) M Y P ′ ( M Y ) d M Y d τ X + P ( M Y ) d M Y d τ X − P X d M X d τ X − M X d P X d τ X = 0 ,

where P ′ ( M Y ) is the marginal change in the world price for the imported good Y . This expression is equivalent to the following:

d M Y d τ X = P X d M X d τ X + M X d P X d τ X M Y P ′ ( M Y ) + P ( M Y ) .

By substituting this result into expression (23), it follows that:

(25) d W T = P X ⏟ EEP P Y 1 + M X P X   d P X d τ X d M X d τ X − ( M Y P ′ ( M Y ) + P ( M Y ) ) M Y P ′ ( M Y ) + P ( M Y ) ︸ RPD d M X d τ X ⏟ MEC ,

where the trade-substitution effect has been broken down into three multiplicative elements. The first one is the effective export price ( EEP ), showing the price of exported good. The second element is the rate price difference ( RPD ) of imports, containing the difference between the effective internal price for the imported good, which is equal to the price of imports ( P Y ) plus the change in exports in real terms M X P X d P X d τ X d M X d τ X , and the effective world price for imports, which is equal to the world price plus the marginal change in the world price multiplied by imports (or the marginal change in the cost for the imported goods), in relation to (i.e. divided by) the world effective price. Finally, the last element in equation (25) shows the marginal export change ( MEC ) when the environmental tax is implemented.

Given that the emission tax increases the effective price of exports, the economy loses competitiveness in the external markets and this implies that MEC = d M X d τ X < 0 .[13] The RPD is expected to be positive if the economy is importing from abroad ( RPD > 0 ).[14] Furthermore, the effective (tax-inclusive) export price is a non-negative element ( EEP = P X > 0 ).

Jointly, the three components in expression (25) made a negative contribution to welfare,[15] the magnitude of which depends on the combination of three well-known factors: the effective cost of exports, the imports’ price differential, and the exports’ response to τ X . The higher (lower) the EEP and the higher (lower) the RPD of imports, the higher (lower) the welfare loss for a given marginal change in exports. Alternatively, the higher (lower) the RPD of imports and the higher (lower) the marginal change in exports, the higher (lower) welfare loss for a given EEP.

By adopting the assumption of small economy (i.e. absence of market power in both the imported good Y and the exported good X ), the world price would not suffer any change after implementing the (national) environmental tax on X ( P ′ ( M Y ) = 0 ), and similarly the economy is the price-taker in the exported good d P X d τ X = 0 . In this situation, expression (25) simplifies to the following:

(26) d W T = P X ⏟ EEP P Y − P ( M Y ) P ( M Y ) ︸ RPD d M X d τ X ⏟ MEC .

Alternatively, from expression (24), it can also be written as follows:

d M X d τ X = 1 P X [ ( M Y P ′ ( M Y ) + P ( M Y ) ) ] d M Y d τ X − M X P X d P X d τ X .

Substituting this equation into expression (23) for the trade-substitution effect, it follows that:

(27) d W T = P Y − M Y P ′ ( M Y ) + P ( M Y ) − M X d P X d τ X d M Y d τ X ︸ IPD d M Y d τ X ⏟ MIC ,

where the trade-substitution effect has been divided into two different components. The first is the import price difference (IPD) containing the difference, in absolute terms, between the internal price of the imported good and the effective price for imports minus the change in the terms of trade M X d P X d τ X d M Y d τ X . The second term in expression (27) is the marginal import change (MIC) that shows the marginal (negative) impact of the pollution taxation on imports.[16]

If the economy does not exert any influence on the world price for the imported good ( P ′ ( M Y ) = 0 ) and is the price-taker in the market of the exported good d P X d τ X = 0 , expression (27) simplifies to the following:

(28) d W T = [ P Y − P ( M Y ) ] ︸ IPD d M Y d τ X ⏟ MIC .

The trade-substitution effect described previously captures the detrimental welfare impact when an environmental tax is applied to the polluting-exported goods. Although this component does not reflect general equilibrium channels, such as the revenue-recycling effect and the tax-interaction effect, this partial equilibrium outcome is consistent with the widespread idea that any policy affecting (i.e. increasing) the price of the exporting industries negatively affects the internal economy and domestic welfare.

4 Autarky Situation

To delve into the influence of trade on welfare, next consider the case of a closed economy. This situation implies a reformulation of expression (18) to accommodate the welfare impacts of emission taxes in an autarky situation, as follows:

(29) 1 λ d U d τ X = [ τ X − τ P ] d X d τ X ︸ d W P + ( μ − 1 ) X + τ X d X d τ X + τ L d π d τ X ︸ d W R − μ τ L ∂ l ∂ P X d P X d τ X + ∂ l ∂ P Y d P Y d τ X + ∂ l ∂ π d π d τ X − ∂ l ∂ Q d X d τ X ︸ d W I ,

where the various transmission mechanisms through which the trade activity alters welfare do not prevail.

By comparing the open economy (expression (18)) and the autarky (expression (29)), the welfare-damaging trade-substitution effect ( d W T )[17] does not appear in the closed model. Moreover, the autarchic situation does not include some general equilibrium channels inherent to export activity. In particular, the positive primary welfare effect due to exports is not present in expression (29). In addition, the revenue-recycling effect has a lower tax-base in autarky, implying a lower welfare contribution than in the open model. Finally, the positive tax-interaction effect of emission taxation on reducing exports and improving environmental quality do not prevail in an autarchic situation. The combination of the (opposite sign) trade transmission mechanisms does not allow us to clearly determine and compare which situation is preferable in terms of welfare. Whether emission taxation has a greater, equal, or lower welfare impact in autarky than in an open economy depends on the sign of the following components:

(30) [ τ X − τ P ] d M X d τ X + P Y d M Y d τ X − P X d M X d τ X + ( μ − 1 ) M X + τ X d M X d τ X + μ τ L ∂ l ∂ Q d M X d τ X ⋚ 0 ,

where a negative, null, and positive value of expression (30) implies, respectively, a lower, equal, and higher welfare in autarky compared to the open case.

The autarchic second-best optimal emission tax is obtained by setting expression (29) equal to zero, using expression (20), and then solving for τ X :

(31) τ X * = 1 μ d X d τ X τ P d X d τ X − ( μ − 1 ) X + τ L d π d τ X + ( μ − 1 ) γ X d P X d τ X + γ Y d P Y d τ X + μ τ L ε lm γ l d π d τ X − μ τ L ∂ l ∂ Q d X d τ X .

The right-hand side contains (square brackets) the contribution of marginal damages to optimal taxation, the (negative) influence of the revenue-recycling effect, and the influence of the tax-interaction component, comprising specifically the positive effect to τ X * due to the changes in final prices and benefits, and the negative effect to optimal tax rate of changes in the demand for leisure. Notice that the second-best optimal level of taxation in the closed economy will be greater, equal, or lower than in the open economy depending on the sign of expression (30).

In the absence of pre-existing tax distortions, that is τ L = 0 and μ = 1 , the optimal tax level simplifies to the following:

(32) τ X * = 1 d X d τ X τ P d X d τ X ,

which corresponds to the first-best (partial-equilibrium) optimal taxation in autarky.

5 Conclusions

Environmental taxation affects the competitiveness of a small country without power in the global market. The expected negative impacts on the domestic economy have proven to be a major argument for exporting-oriented countries to reject international climate agreements. As ecological measures increase the effective price of the exported goods, aprioristic views of environmental regulations postulate reductions in exports and negative welfare impacts in open economies.

The model presented in this article focuses on this issue. In particular, it uses a general equilibrium perspective to analyse the impact of an environmental tax by capturing the interactions with the existing tax system. In contrast to prior literature, the study explicitly defines the links between the domestic economy and the external sector, as well as environmental externalities in the calculation of welfare impacts. It also takes an in-depth look at the repercussions of emission taxes by disentangling various channels of affectation on private welfare.

Environmental regulation in the context of an open economy involves a more complex process of welfare consequences than previous contributions, based on closed economies. In particular, the trade welfare impact is explained by the negative influence of taxation on an economy’s terms of trade and exports, as has been claimed by some national authorities in international climate forums. However, the article shows that this is only part of the total effects involved. Indeed, the conventional arguments used to reject ecological agreements have neglected the potential positive influence of environmental taxes on generating tax revenues, and their ability to replace other pre-existing distortionary taxes. Furthermore, the impacts on the labour supply–leisure choice that reinforce the welfare loss have usually not been taken into account when analysing ecological measures applied to exporting economies.

By comparing the open economy model with the equivalent autarky model, it is possible to examine the general equilibrium implications of trade and its contribution to private welfare. In particular, whether emission taxation has higher or lower welfare impacts in a closed economy depends on the relative magnitude of opposite (positive/negative) effects. Although these results are not conclusive, they identify the transmission channels of emission taxes and give insights about the complexity of the underlying factors affecting domestic welfare in open economies. This evidence points out the complicated set of relations behind the welfare impacts caused by pollution regulation in open exporting countries.

The model used extends the scope of the ecological taxation literature, by adding trade welfare effects to the well-known domestic welfare effects. For further inquiry into this issue, however, the substitution possibilities between domestic and foreign goods might largely influence the welfare impacts of environmental taxation. Additionally, a multi-country general equilibrium analysis of the welfare effects that is able to explicitly capture the interconnections between trade partners would improve the definition of welfare interdependences when environmental measures are multilaterally implemented.

Finally, since the results in this article identify several aspects to be considered and evaluated in applied analyses, empirical research on all these questions seems to be crucial to clarify the potentialities of applying environmental measures and facilitate its acceptation for national authorities. Moreover, the theoretical findings presented might have important (practical) policy implications that can guide key aspects of national (domestic) measures, such as industrial policy, energy policy, and fiscal policy, and international measures, such as environmental (multilateral) protocols, trade agreements, or international cooperation. All these issues were beyond the scope of this article.

Acknowledgements

The author is particularly grateful to two anonymous reviewers for their helpful comments and suggestions, which have improved an earlier version of this manuscript. Financial support from the Universitat Rovira i Virgili (grant PFR2022) is also acknowledged.

  1. Funding information: The author gratefully acknowledges the financial support of the Universitat Rovira i Virgili (grant PFR2022).

  2. Author contributions: All the article’s content was done by the author.

  3. Conflict of interest: The author declares that she has no competing interest.

  4. Article note: As part of the open assessment, reviews and the original submission are available as supplementary files on our website.

  5. Ethics approval: Not applicable.

  6. Data availability statement: Not applicable.

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Received: 2022-10-13
Revised: 2023-03-03
Accepted: 2023-03-21
Published Online: 2023-05-30

© 2023 the author(s), published by De Gruyter

This work is licensed under the Creative Commons Attribution 4.0 International License.

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https://doi.org/10.1515/econ-2022-0038
Keywords for this article
environmental taxation; trade-substitution effect; autarky
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