More on Welfare Effects of Distortions Via Environmental and Trade Policy
CIES Working Paper No. 13
34 Pages Posted: 3 Aug 2000
Date Written: March 2000
Issues relating to the interaction of trade and the environment are a major international policy concern. They are likely to be a focal point during the next round of trade negotiations within the WTO. Free trade advocates contend that trade liberalization makes countries richer and as a result they adopt tougher environmental standards. Many environmentalists, by contrast fear that freer trade leads to lower environmental standards and thus more pollution. Polluting producers in high-income, high-standards countries fear competitors from abroad facing lower environmental standards. Yet, the WTO calls for environmental policies that have a minimal trade-distorting impact.
In this paper, we look at pollution problems related to the production of goods. Pollution is contained within countries but affected by policies and trade. We link the literature on optimal environmental policies and terms of trade shifts in response to domestic and trade policies. We distinguish output reductions from abatement and pollution prevention activities as separate but interrelated components of pollution reduction. In contrast to output reduction, which results in a profit loss, abatement and/or pollution prevention activities are cleaner production methods that involve input substitution at a direct cost to producers. In addition to private curtailment costs, pollution incurs the social costs of environmental damages when released. Furthermore, we distinguish environmental policies that primarily reduce output from policies that primarily induce abatement and/or pollution prevention activity. This is crucial because a government may for political reasons favor cleaner production methods rather than output reduction for political reasons. This setup allows us to address three general issues related to trade and environment: What are the environmental and welfare impacts of opening trade? How will environmental policy distort trade? What constitutes an environmentally friendly green trade tax?
Opening trade induces relative price changes. The resulting welfare impact depends on the efficiency of existing environmental policies and the environmental impact of production. Input substitution effects between home production and abatement activity and the initial output mix determine the environmental impact. Small countries gain from opening trade to import polluting goods unless the environmental impact of home production is negative. Then, the net savings through lower import prices may not outweigh increased environmental damages. Small countries gain from opening trade to export polluting goods when net export earnings outweigh the environmental damage effect of increased production of exportables.
Large countries implementing trade-reducing environmental policies not only alter their resource allocations but also affect world market prices which may concurrently improve domestic welfare and harm other countries. This could be viewed as a trade-distorting abuse of market power. From a global welfare perspective, large countries should therefore minimize the terms of trade welfare effects of domestic environmental policy on world market prices. From a domestic welfare perspective however, large countries should maximize the terms of trade welfare effects of domestic environmental policy on world market prices.
Large exporters that do not restrict their own exports may be better off taxing polluting production above and subsidizing abatement below their respective marginal impacts. When tariffs are bound at low levels, large importers may be better off to tax polluting production below and to subsidize abatement above their respective marginal impacts. It is then possible that production subsidies for importers may improve domestic welfare when the welfare effect of higher world market prices exceeds the environmental impact of home production on social welfare. Consequently, large importers may partly offset the welfare losses of their domestic producers due to tariff reductions with production and abatement subsidies (especially when environmental damages are small). Large agricultural importers may do this through production subsidies and/or generous incentives for a cleaner production after committing to tariff reductions.
Without concurrent environmental regulations, trade taxes are green in the sense that they can reduce pollution. For importers, optimal green tariffs may be at low levels when marginal damages are large relative to their induced effect on world market prices. Then, lower tariffs would lead to a relatively large improvement for the domestic environment, with only minor effects on world markets. For WTO negotiations this implies that large importers lowering tariffs but have lax environmental policies in place may only improve their domestic welfare and still distort trade. What they really should do is to significantly raise environmental standards. Therefore, rules about enforcing environmental policy may be as important as rules about reducing tariffs in order to improve world welfare. However, environmental regulations are not part of the WTO mandate policy and questions about greening the WTO arise once again.
Keywords: Trade, Environment, Terms of Trade, Abatement
JEL Classification: F13, Q28, Q38
Suggested Citation: Suggested Citation