Environmental protection without loss of international competitiveness

• DOI: http://doi.org/10.1111/jpet.12264
• Date: 01 October 2017
• Author: George Symeonidis,Sajal Lahiri
• Published date: 01 October 2017

Received: 6 October 2016 Accepted: 5 June 2017

DOI: 10.1111/jpet.12264

ARTICLE

Environmental protection without loss

of international competitiveness

Sajal Lahiri1George Symeonidis2

1SouthernIllinois University Carbondale

2Universityof Essex

Weare grateful to an anonymous referee, an

associateeditor, and the editor,Professor Rabah

Amir,for very constructive criticisms and sugges-

tions.

SajalLahiri, Department of Economics, Southern

IllinoisUniversity Carbondale, Carbondale, IL

62901-4515,USA (lahiri@siu.edu).

GeorgeSymeonidis, Department of Economics,

Universityof Essex, Colchester CO43SQ, UK

(symeonid@essex.ac.uk).

We develop a two-country Cournot oligopoly model with product

differentiation across countries and production-generatedpollution.

Theabatement of pollution by the firms in response to emission taxes

is endogenous, and the number of firms can be fixed or there may be

free entry and exit of firms in both countries. We propose particu-

lar unilateral and multilateral piecemeal policy reforms of emission

taxesand production subsidies such that domestic industries will not

suffer any loss of international competitiveness (defined in terms of

either marketshare or profits), emission levels will be lower, and wel-

fare could be higher in both countries.

1INTRODUCTION

Although it is widely acknowledged that serious attempts should be made to reduce environmental degradation, there

continues to be much reluctance in many countries to adopt stringent environmentalpolicies. An important reason for

this reluctance is the belief that environmentalpolicies in a country may have a negative impact on the competitiveness

of domestic industries (see, e.g., Baumol & Oates, 1988, ch. 16; Simpson & Bradford, 1996). This was apparently one of

the reasons why the Bush administrationwas against the ratification of the Kyoto agreement. Even in the Netherlands,

where the environmental lobby is powerful, there have been suggestions by the government that exportingsectors

should face less stringent environmental policies than other sectors because of the need to be competitivei n the inter-

national market.1

One response to the apparent trade-off between stricter environmental policy and industrial competitiveness has

been to argue that it might not exist,once one allows for dynamic effects of environmental policy on innovation (Porter

&van der Linde, 1995). However, this proposal remains controversial (see Xepapadeas & de Zeeuw,1999, for an assess-

ment). Moreover, a potential solution based on industry-specific exemptions from environmental taxes, which have

been introduced in several European countries, has been shown not to have the desirableresults for either the envi-

ronment or efficiency (Elkins & Speck, 1999). The issue therefore remains high on the agenda of policymakers and

international bodies (see, e.g., OECD, 2003, 2006 & 2010; United Nations Economic Commission for Europe, 2006 &

2007).

A comprehensive review of theory and evidence on the effects of environmental policy (OECD, 2006; see

also Cebreiro-Gómez, 2006) describes a number of options for alleviating the impact of environmental taxes on

1See, for example, Elbers and Withagen (2003) for a discussion of these issues. A strong case against preferential treatment for the exporting sectors has

been made by,among others, Rauscher (1994, 1997). Consistent with these fears, empirical work by Babool and Reed (2010) reports a negative relationship

betweennet exports and environmental regulations in most manufacturing sectors in 10 OECD countries over the period 1987–2003. A survey of recent evi-

denceon the impact of environmental regulations (Dechezlepretre & Sato, 2014) finds, on the whole, small negative effects on productivity and employment.

Journal of Public Economic Theory.2017;19:921–936. wileyonlinelibrary.com/journal/jpet c

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922 LAHIRI AND SYMEONIDIS

competitiveness, including the recycling of tax revenue to the industries affected through output subsidies.2It is this

idea—which has been explored in the literature—thatwe shall explore further.3

Before turning to the specific issue at hand, that is, the effect of environmental policies on competitiveness, it may

be helpful to discuss a related literature that examinesthe use of multiple instruments (including production subsidies)

in the presence of environmental externalities.An earlier literature has examined the joint effect of emission taxes and

abatement subsidies (e.g.,Conrad, 1993; Kohn, 1990). Strand (1998) has analyzed the joint effect of emission taxes and

various types of subsidies on employment in a perfectly competitive industry in the presence of unions. More recently,

Fullerton and Wolverton(1999) have proposed combining output taxes and environmental subsidies in circumstances

where polluting activities are difficult to tax, whereas Fullerton and Mohr (2003) haveshown that the joint use of out-

put taxes and input or abatement subsidies can increase welfare more than the use of just one of these instruments.

More generally,Bennear and Stavins (2007) have argued that under a fairly broad set of circumstances the use of mul-

tiple policy instruments is optimal in a second-best world.

Returning to the main issue at hand, Bovenberg,Goulder, and Gurney (2005) analyze the efficiency cost of a scheme

whereby tradable emission permits are given free to firms affected by environmental taxeson the basis of their his-

torical presence in the industry. Theyuse a model with two competitive vertically related pollution-generating indus-

tries.Bovenberg, Goulder, and Jacobson (2008) extend this frameworkto alternative environmental policy instruments

other than emission taxes. A number of recent papers analyze the welfare effects of “tax refunding schemes,” that is,

the partial or total recycling of environmentaltaxes to the firms affected on the basis of market shares, a policy that has

been applied to nitrogen oxide emissions in Sweden (Sterner & Hoglund-Isaksson, 2006). Thus, Gersbach and Requate

(2004) analyze conditions under which an optimal degree of refunding can be defined in a Cournot oligopoly.Bernard,

Fischer, and Fox(2007) examine the welfare implications of output-based tax refunds in a model with two perfectly

competitive sectors, one of which is unregulated. Fischer (2003) analyzes the effect of different forms of output-based

tax refunds on the incentive to abate in a Cournot duopoly.

Several of these previous studies examinevarious aspects of policies that combine environmental taxes with some

form of output subsidies in order to “compensate”the firms for their abatement efforts. However, the specific schemes

do not target competitivenessof the firms explicitly. Furthermore, only a handful of the papers consider an oligopolistic

framework, and eventhose papers do not address the question of competitiveness in an international context.4

In the present paper,we contribute to the existing literature in a number of ways. First, it is to be noted that although

politicians use the word competitiveness pervasively,it is not clear what exactly they mean by it. In terms of specifics,

the word competitiveness can have a number of different meanings. In this paper,we consider two alternative defini-

tions: competitiveness as reflected on (i) marketshares of domestic firms in the international market place, and (ii) the

levelsof profits of domestic firms. Second, we consider an international context with oligopolistic competition between

firms,with all the firmswithin a country being identical, while heterogeneity exists between domestic and foreign firms.

In this contextwe examine the effect of environmental and other policies on the relative competitiveness of the domes-

tic firms vis-à-vis the foreign firms. Third, we allow for cross-border pollution so that there are two channels for interna-

tional externalities of policies: via marketshares and via cross-border pollution. Fourth, we derive results both for the

case of a unilateral reform, where a policy is implemented by one country only,and for the case of multilateral reform.

Fifth, we examinethe effect of the proposed reforms on government tax revenue. Sixth, while our basic model assumes

free entry and exit of firms in both countries, we check the robustness of our results for the case of a fixed number of

firms. It is for this case that we can apply and compare the two alternative definitions of competitiveness described

2A related but different issue is the so-called “double-dividend hypothesis” of environmental taxes(see, e.g., de Mooij, 1999, for a survey of an extensive

literature),according to which environmental tax revenues can be recycled to reduce other taxes that create distortions such as income taxes.

3Sinceoutput subsidy is actionable under current World Trade Organization (WTO) rules, these schemes would require coordination between the WTOand

the international agencies responsible for coordinating environmentalpolicies. It is to be noted that discussions have been taking place in WTO for including

environmentalpolicies among its remits.

4Followingthe seminal papers by Spencer and Brander (1983) and Brander and Spencer (1985), there is also an extensive literature on the strategic use of

subsidies to increase international market shares. However,this literature does not specifically address the links between trade and environmental policy.

Lapanand Sikdar (2017) examine the impact of trade on environmental policy but do not discuss the question of competitiveness. On the other hand, Gautier

(2017)analyzes environmental policy options for countries aiming to attract foreign investment, which may be seen as a policy aim linked to competitiveness.