Environmental Duties and International Harmonization of Standards.

AuthorEderington, Josh

Josh Ederington [*]

Demands by domestic industries for protection from foreign competition aided by lower standards have led to proposals to set trade barriers conditional on the environmental policies of other countries. This article shows that the threat of such environmental duties can assist in achieving global efficiency when countries cannot commit to a negotiated environmental standard. In addition, this article shows that, in a repeated game framework, the enforcement of a free-trade agreement may require some convergence in environmental standards across countries when trade is driven by differences in such standards. However, it is also shown that it is more efficient to enforce a trade agreement by setting tariffs to partially offset differences in policy standards than to attempt to harmonize standards within environmental side agreements.

  1. Introduction

    Substantial reductions in tariffs over the past several decades have exposed countries to more international competition, focusing attention on domestic policies such as environmental and labor standards as potential sources of comparative advantage. Consequently, many firms in the United States (and other advanced countries) have demanded protection from foreign competition, arguing that lower environmental standards in foreign countries place them at a disadvantage.

    An environmental duty is a trade tax that is set conditional on the environmental policies of one's trading partner. Such environmental duties are seen as a means of insulating domestic producers from the "unfair" competitive effects of differing foreign standards. For example, in the International Pollution Deterrence Act of 1991, former U.S. Senator David Boren proposed that environmental duties be applied to imports of products made abroad by industries that have lower environmental standards than in the United States. However, most trade economists are opposed to such proposals, arguing that tariffs aimed at offsetting differing standards across countries cannot be justified on economic efficiency grounds (e.g., see Bhagwati and Srinivasan 1996). Basically, their argument is that there are legitimate reasons for diversity in environmental regulations across countries (e.g., differences in preferences, natural endowments, or population density) and that differences in competitiveness arising from this dive rsity increase the gains to mutually beneficial trade. Indeed, one of the outcomes of the Uruguay Round of GATT was an explicit definition of a subsidy that rules out the use of countervailing duties based on lax standards in foreign countries. Thus, there appears to be substantial disagreement about the merits of allowing countries to set trade taxes that are conditional on the environmental standards/policies of other countries. This article proposes a theoretical analysis of the conditions under which environmental duties may be justified.

    I investigate this question within a standard model of trade in which countries have different preferences over the environment and the differing environmental standards of the two countries lead to mutually beneficial trade. The basis for the analysis is the assumption that a country's policies (both trade policies and domestic policies) affect the world market through their effect on world prices. As a result, countries will unilaterally set their policies with trade concerns in mind, and there will be a role for international negotiation in achieving global efficiency. A sizeable literature has established the theoretical ability of countries to use environmental policy (and other governmental standards) as an instrument of trade policy (e.g., Markusen 1975; Krutilla 1991; Kennedy 1994). In this article, I argue that environmental duties can be justified if countries set their environmental policies with trade concerns in mind.

    In section 3 of the article, I show that the threat of environmental duties may be desirable in that it deters countries from distorting their environmental policies away from efficient levels. Specifically, if the environmental duty is set to ensure that the world price remains constant as the foreign country adjusts its environmental tax, it eliminates the terms-of-trade incentives of the foreign country to distort its environmental standards. Thus, an environmental duty results in the foreign country setting the efficient standard. [1] This result suggests that, even when countries cannot commit to a negotiated environmental policy (and thus must set environmental policies unilaterally), they can still achieve the globally efficient outcome if they can commit to a tariff formula that involves environmental duties.

    In section 4, I investigate the case where countries cannot commit to either trade or environmental policy and thus must rely on punishment strategies to support the agreement. I follow the growing literature on self-enforcing agreements (e.g., see Dixit 1987; Bagwell and Staiger 1990; Ederington 2001) by modeling an international agreement covering trade and environmental policies as an infinitely repeated game in which countries threaten infinite reversion to the noncooperative equilibrium as punishment for deviations from the agreement. Therefore, when the discount rate is low (and thus countries heavily discount the future losses to triggering the punishment phase), the globally efficient outcome cannot be supported.

    I first show that, when the discount rate is low, free trade can only be supported if countries adjust their environmental policies away from the optimal standard. When trade is driven by differing environmental standards (i.e., the country exporting the dirty good has the weaker environmental standard), this adjustment entails partial convergence of standards in order to reduce the temptation to cheat on the agreement. This result provides a novel interpretation of various environmental side agreements that often accompany free trade agreements. [2] Under this interpretation, such side agreements represent a necessary attempt to manipulate environmental standards so that free trade (which is essentially required by the World Trade Organization for the formation of regional free-trade agreements) can be supported.

    Second, I show that, when the discount rate is low, an agreement involving efficient environmental policy can be supported by moving tariffs away from free trade. I show that, if trade is driven by differing environmental standards, the most cooperative tariff is, in effect, an environmental duty, as it is set to partially offset the differences in environmental standards across countries so as to mitigate the incentive to deviate from the agreement. I finally show that an implication of Ederington (2001) is that allowing such environmental duties to support a trade agreement is more efficient than trying to support free trade by manipulating environmental standards across countries through side agreements.

    In the following analysis, section 2 lays out the basic model and derives noncooperative and globally efficient trade and environmental policies. Section 3 investigates the use of environmental duties as a means of deterring countries from distorting their environmental policies. Section 4 analyzes the use of environmental duties and environmental side agreements as a means of enforcing an international agreement within a repeated game framework. Finally, section 5 concludes.

  2. The Model

    The analysis is conducted within a partial equilibrium model of trade similar to that used in Krutilla (1991). There are two symmetric countries, a home and foreign country (denoted by *) that have access to two policy instruments: trade and environmental policy. Demand and supply functions are given exogenously, with the home country being the natural importer of a homogenous good. Home country supply is given by the linear function Q([p.sup.s]) = [p.sup.s], where [p.sup.s] is the local producer price. Supply functions within the foreign country are identical and defined in terms of the foreign producer price [p.sup.s*]. Demand in the home (foreign) country is given by the function D([p.sup.d]) = 1 + [alpha] - [p.sup.d] [[D.sup.*]([p.sup.d*]) 1 - [alpha] - [p.sup.d*]], where [p.sup.d] is the local consumer price. [3] To ensure that trade volume is positive and that the good is consumed in each country, it is assumed that [alpha] [epsilon] (0, 1/6).

    The home-country production tax is denoted by t, and [tau] is the specific trade tax applied to imports. Likewise, [t.sup.*] and [[tau].sup.*] denote, respectively, the production and trade tax choices of the foreign country. Therefore, in the home country, producer and consumer prices (provided that trade taxes are not prohibitive) are given, respectively, by [p.sup.s]([p.sup.w], t, [tau]) = [p.sup.w] - t + [tau] and [p.sup.d]([p.sup.w], [tau]) = [p.sup.w] + [tau], with [p.sup.w] denoting the world (untaxed) price of the good. Prices in the foreign country are symmetrically defined as [p.sup.s*]([p.sup.w], [t.sup.*], [[tau].sup*]) = [p.sup.w] - [t.sup.*] - [tau].sup.*] and [p.sup.d*]([p.sup.w], [[tau].sup.*] = [p.sup.w] - [tau].sup.*].

    Given a positive trade volume, world markets will clear (i.e., world demand will equal world supply). From this market-clearing condition and the demand and supply equations, the market-clearing world price for the good can be derived as [p.sup.w](t, [tau], [t.sup.*], [[tau].sup.*]). [4] Using this world price, local producer and consumer prices for each country can be expressed as functions of trade and environmental policy in that country and the market-clearing trade volume can be calculated. Letting M be the import volume of the home country (M([p.sup.d], [p.sup.s]) = D([p.sup.d] - Q([p.sub.s])), it follows that M(t, [tau] [t.sup.*], [tau.sup.*]) = [2[alpha] - 2([tau] + [[tau].sup.*]) + t - [t.sup.*]]/2. The foreign export ([E.sup.*]) volume follows directly from the market clearing...

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