Environmental federalism: a survey of the empirical literature.

• Author: Millimet, Daniel L.
• Position: II. Environmental Federalism in Practice C. Interjurisdictional Externalities 2. Pecuniary Externalities through Conclusion, with footnotes, p. 1713-1757

2. Pecuniary Externalities

   The second category of externalities includes pecuniary externalities. This refers to situations where jurisdictions ignore the ramifications of their actions on prices in other areas. However, empirical evidence regarding pecuniary externalities is rare. One source of pecuniary externalities, in theory, is referred to as tax exporting and dates back at least to Gordon. (235) This refers to localities levying excessive taxes in situations where at least a portion of the tax bill is paid by nonresidents (for example, hospitality taxes). In the context of environmental regulation, environment importing (as opposed to tax exporting) can arise in either of two ways. First, a jurisdiction may enact excessive regulation if producers of polluting goods are located in other jurisdictions as long as the costs cannot be passed fully onto consumers located in the jurisdiction. Second, a jurisdiction where the pollution-generating production of goods occurs may enact excessive regulation if producers are able to pass at least a portion of the regulatory costs onto consumers in other jurisdictions.

   Anecdotal evidence of the first type of behavior is found in a paper by Elliott, Ackerman, and Millian. The authors provide a historical account of the development of the Motor Vehicle Air Pollution Control Act of 1965. (236) This was the first statute to provide the federal government with regulatory power over air pollution. The legislation was supported by the automobile industry, not because it favored reducing pollution, but rather because several states had adopted or were in the process of adopting stringent regulations regarding automobile emissions. (237) Since the production of automobiles is geographically concentrated in a few areas, the costs of these regulations were born predominantly by nonresidents. (238) Thus, prior to the passage of the federal statute, states were importing a cleaner environment at the expense of nonresidents.

   This history is repeating itself as states are once again pursuing regulations on automobile emissions for the purposes of achieving greenhouse gas (GHG) reductions. Professor Rabe writes:

   Still another state economic development incentive may relate to policy opportunities that, in effect, will shift most of the compliance costs to other jurisdictions. California's alliance with other states pursuing vehicle emissions reductions can be considered through this lens, as none of these jurisdictions host large vehicle manufacturing sectors that might be jeopardized through aggressive transition toward lower-emission vehicles.... In turn, some of the proponent states were actively developing next-generation vehicle technology within their boundaries that might receive a boost through a regulatory burden imposed on conventional vehicles generally manufactured elsewhere. (239) Professors McAusland and Millimet provide indirect evidence of environmental importing by subnational jurisdictions. (240) The authors use data on trade among U.S. states, among Canadian provinces, and between U.S. states and Canadian provinces from 1997 and 2002 to explore the effect of intranational and international trade on emissions reported in the TRI for the United States and the Canadian National Pollutant Release Inventory (NPRI). (241) McAusland and Millimet show theoretically that environmental regulation should become more stringent as trade increases because the resulting higher prices on locally produced goods are passed on to consumers in other jurisdictions. (242) Moreover, because environmental regulation in the United States and Canada is a mix of centralized and decentralized control, the effect on regulatory stringency should be stronger when higher prices are passed onto foreign consumers. (243) Thus, the theoretical model predicts that international trade should result in greater reductions in emissions than intranational trade. The authors' findings are consistent with the idea of environment importing. (244)

   Professors Chakravorty, Nauges, and Thomas provide additional evidence of price spillovers due to decentralized environmental policy making. (245) The authors examine the effect of clean fuel programs permitted under the CAA. Under the Act, states are permitted to implement their own clean fuel program for gasoline in an effort to reduce air pollution. The result is a proliferation of clean fuel blends; at least fifteen different fuel specifications are in use, which--when combined with three different octane levels--yield more than forty-five unique blends. (246) The authors examine the temporal and spatial variation in wholesale gasoline prices across states between 1995 and 2002 due to the required usage of so-called "boutique fuels." (247)

   Specifically, the authors estimate not only the direct effect on prices due to requirement of a cleaner gasoline blend, but also the indirect effect of market segmentation. (248) In other words, as the type of fuel required in one state becomes more distinct from the type of fuel required in neighboring states, prices should rise due to greater demands placed on refineries. (249) The results confirm not only that the market segmentation effect is important, but that it is nearly as important as the direct cost effect. (250) If a state changes from no gasoline regulation to requiring clean fuel (of the type considered in the analysis) for the entire state, wholesale gasoline prices are expected to rise by sixteen percent. (251) On the other hand, if a state transitions from requiring the same fuel as its neighbors to a completely unique blend not used by any of its neighbors, wholesale gasoline prices are expected to rise by at least fourteen percent. (252) To the extent that states do not take into account the higher prices occurring elsewhere when a state decides to require a unique fuel blend and thus increases its "regulatory distance" from its neighbors, decentralization in this case will lead to excessive heterogeneity in fuel blends. (253)

   In sum, the empirical evidence suggests that localities ignore interjurisdictional externalities related to transboundary pollution and resource exploitation and these externalities entail significant welfare loss. The evidence is less convincing when enforcement of environmental regulations is examined. However, the inability of the general deterrent effect of local enforcement to cross political boundaries is noteworthy. Finally, some evidence exists suggesting that localities ignore the impact of their policies on the prices paid and the profits earned by nonresidents. More empirical evidence on the prevalence of tax exporting (or environment importing) is needed.

3. Fiscal Externalities

   The final category of externalities is referred to as fiscal externalities--a holdover from the fiscal federalism literature. However, Wilson defines fiscal externalities more broadly as instances where the policy choices of one jurisdiction have effects on the policy choices of other jurisdictions through strategic policy making. (254) Thus, the presence of such externalities violates the assumptions required for decentralized policy making to be efficient just as in the case of resource or pecuniary externalities. Konisky writes: "The economic efficiency results emerge from local regulators making decisions solely based on intrajurisdictional, not interjurisdictional, factors." (255)

   Brueckner provides an excellent introduction to the notion of strategic interactions between governments. (256) Such interactions may arise for three reasons. First, jurisdictions are, or are perceived to be, in competition for mobile resources. Second, policies in one jurisdiction lead to spillovers (for example, transboundary pollution) that alter the payoffs to different policies in other jurisdictions. Third, voters may judge the performance of policy makers through interjurisdictional comparisons, thereby creating a situation referred to as yardstick competition. (257)

   Before discussing the existing empirical evidence on strategic interaction, three comments are warranted. First, all three sources of strategic interaction are empirically equivalent in that each predicts that the policy choices of one jurisdiction depend on the choices of other jurisdictions. (258) Thus, without more information, differentiating among the underlying causes is not possible.

   Second, whether strategic interactions occur depends upon policy maker perceptions. (259) For example, if resources--people or capital--are immobile, but policy makers mistakenly believe that resources are mobile, then strategic interactions may occur. However, if resources are mobile but policy makers naively assume they are not, then strategic interactions may be absent. Thus, the question of whether governments act strategically is fundamentally distinct from the question of resource mobility (and, similarly, the presence of actual spillovers or yardstick competition). (260)

   Third, strategic interaction is not synonymous with a race-to-the-bottom. In theory, strategic interaction may lead to decentralized policies that are inefficiently lax or inefficiently stringent (referred to as a race-to-the-top). (261) That said, one of the most common justifications given for centralization of environmental policy making is fear over a race-to-the-bottom. Engel states: "Of the numerous theoretical rationales used to justify federal environmental regulation, perhaps the most broadly compelling is the argument that without such regulation, states would engage in a welfare-reducing 'race-to-the-bottom' in environmental standard-setting." (262) Professors List and Gerking argue that "in a second-best world in which initial distortions are present, locally determined environmental regulations are likely to be suboptimal when jurisdictions compete with each other to attract capital." (263) Konisky states: "A principal objection to decentralization of...