The political economy of trade liberalization and environmental policy.

• Author: Fredriksson, Per G.

1. Introduction

   The global trading system is currently undergoing another round of multilateral trade liberalization, and regional economic integration is occurring in several pans of the world. The trade-environment link has become an important pan of trade liberalization talks. It is commonplace for industry representatives to argue that less stringent environmental regulations give less developed countries (LDCs) a comparative advantage in pollution-intensive goods and that industries with high abatement costs will migrate to LDCs. Environmentalists argue that international differences in environmental laws and regulations may be reduced to their lowest common denominator through political pressure.(1) This is not a fear of trade liberalization itself but of the effects of lower trade barriers on the political determination of environmental regulation.

   There is little empirical work explicitly studying the effect of openness on the stringency of environmental regulations. Husted and Logsdon (1997) report that the North American Free Trade Agreement (NAFTA) has induced Mexico to strengthen its environmental policies.(2) In simulations by Perroni and Wigle (1994), trade policy is found to have little impact on the quality of the environment, given the level of environmental regulation. However, they found that global increases of pollution taxes to the optimal levels would improve environmental quality significantly. It follows that, if environmental policy determination is influenced by changes in the trade policy regime, environmental quality will be affected.

   This paper investigates the underlying forces determining environmental policy, in particular the nature of the political economy effects of trade liberalization on environmental tax policy. In the model used, the pollution tax policy choice of the government is influenced by industry and environmental lobby groups. The lobby groups offer the government prospective political contributions, the size of which corresponds to the pollution tax policy selected (see Bernheim and Whinston [1986] for the original model and Grossman and Helpman [1994], Fredriksson [1997, 1998], Schleich [1997], and Aidt [1998] for applications). In addition to contributions, the government values aggregate social welfare.

   This paper contributes to the literature by predicting and explaining the political equilibrium pollution tax policy in tariff-protected sectors when pollution abatement is possible, thus extending Fredriksson (1997) and Aidt (1998). The politically determined tax is compared to the welfare-maximizing pollution tax. Whereas the latter tax is found to be inefficiently stringent because of the need to correct the economy's two distortions (pollution and trade protection) with only one policy instrument, the politically determined tax depends also on the relative political pressures in equilibrium.

   Second, I show the effects of trade liberalization on the special interest groups' lobbying incentives on the pollution tax issue. Ceteris paribus, when output contracts in the polluting sector following trade liberalization, both lobby groups reduce their lobbying on the tax issue in the new equilibrium because the marginal return to a change in the tax decreases.(3) Thus, this paper contributes to the literature on "ecological dumping," which discusses the government's incentive to set environmental regulations such that marginal abatement costs deviate from the marginal damage from pollution. In a model of lobbying with sector-specific interest groups, Rauscher (1994) finds that export industry lobby groups have ambiguous lobbying incentives.(4)

   A change in environmental policy has implications for environmental quality. I show that, if the pollution tax falls (increases) sufficiently as a result of trade liberalization, pollution increases (decreases) through the political channel discussed.(5) These are new effects of economic integration not previously discussed in the literature.

   Fourth, I study the effect of trade liberalization on pollution tax revenues. Several OECD countries are currently considering implementing or raising pollution taxes in order to raise revenues (see Pearce 1991; Oates 1993; Barde and Owens 1996). I study the impact of freer trade on the amount of pollution tax revenues raised in political equilibrium. Tax revenues may fall due to the political economy effect on the pollution tax rate. This is consequently not a traditional Laffer curve effect. I also show that pollution may increase simultaneously as tax revenues decrease. Finally, the political economy effects on environmental policy may yield counterintuitive effects on trade patterns of lower trade protection.(6) Changes in tax policy accompanying trade reform may counteract or reinforce the basic effects expected from trade liberalization.

   Hillman and Ursprung (1992, 1994), Leidy and Hoekman (1994), and Schleich (1997) discuss political economy links between trade regimes and environmental policy. Hillman and Ursprung examine how environmental concerns influence the political determination of trade policy decisions. Leidy and Hoekman discuss the impact of environmental instrument choice on trade barriers. They argue that industry lobby groups will favor inefficient pollution control because this leads to an increase in the level of protection.(7) Schleich discusses the choice between environmental and trade policy instruments in the presence of consumption and production externalities.

   The paper is organized as follows. Section 2 outlines the model. Section 3 explains the game and characterizes the political equilibrium. Section 4 shows the welfare-maximizing tax rate, which is contrasted with the political equilibrium. It also examines the impacts of trade liberalization on lobbying, the pollution tax policy, environmental quality, pollution tax revenues, and trade patterns. Section 5 concludes.

2. The Model

   A small, open, competitive economy has two sectors: one produces the nonpolluting numeraire good z, the other produces the polluting good x. The economy is populated by industrialists (I), environmentalists (E), and workers (W). The population is normalized to one. All individuals have labor income, industrialists have factor income from production of good x, and environmentalists derive disutility from the pollution associated with the local production of good x. The environmentalists have an interest in the physical quality of the local environment because they are affected by pollution themselves.(8) Industrialists' and workers' utilities are given by

   [U.sub.I] = [c.sup.zI] + u ([c.sup.x]),

   [U.sub.w] = [c.sup.zW] + u([c.sup.x]), (1)

   and the environmentalists' utility is given by

   [U.sub.E] = [c.sup.zk] + u([c.sup.x]) - [Theta]X, (2)

   where [c.sup.zk] is consumption of the numeraire good z by an individual of type k [element of] I, W, or E and [c.sup.x] is the consumption of good x, with world market price equal to one and [p.sup.*], respectively.(9) u([c.sup.x]) is a strictly concave and differentiable subutility function.

   Production of good x is given by X, and [Theta] is per-unit damage that is a function of per-unit abatement A, that is, [Theta] = [Theta](A). The disutility suffered by an environmentalist equals total damage. Abatement requires labor alone and has decreasing returns, that is, [[Theta].sub.A] [less than] 0, [[Theta].sub.AA] [greater than] 0.(10) The government is restricted to one environmental policy tool, a pollution tax t [element of] T, T [subset] R, levied on pollution from production. Whereas the numeraire sector enjoys free trade, imports of good x have an ad valorem tariff denoted by [Tau] [greater than] 0, and thus the domestic price in the latter sector equals [p.sup.*](1 + [Tau]).(11) The ad valorem tariff is assumed to be determined by multilateral trade negotiations in which this small country has negligible bargaining power, and therefore the tariff rate is taken as given by all domestic agents.

   Industrialists' and workers' consumption of x is given by the individual demand curves, which are the inverse of [u.sub.[c.sup.x]]. The aggregate demand curve for good x is given by D([p.sup.*](1 + [Tau])) and the aggregate consumer surplus derived from consumption of good x is

   C([p.sup.*] (1 + [Tau])) = [summation over [for every]I, E, W] u [D([p.sup.*](1 + [Tau]))] - [p.sup.*] (1 + [Tau])D([p.sup.*](1 + [Tau])).

   The remaining income is spent on good z.

   Each individual has one unit of labor, and the total labor endowment equals l. The numeraire good z is produced by labor alone with constant returns to scale and an input - output coefficient equal to one. The economy's labor supply is sufficiently large for the supply of z to be positive, which implies that the equilibrium wage rate equals one. Disregarding labor costs, each producer faces a net price given by

   p = [p.sup.*](1 + [Tau]) - t[Theta](A) - A. (3)

   The inputs into production of good x are labor and an immobile sector-specific input.(12) The technology is constant returns to scale. With a wage rate equal to one and the world market price fixed, the specific factor reward [Pi] depends only on the producer's price, that is, [Pi](p). By Hotelling's lemma, the supply curve for good x is given by [[Pi].sub.p](p) = X(p), where [X.sub.p] [greater than] 0 and [X.sub.pp] [greater than] 0. Given t, the first-order condition of each firm's profit function with respect to abatement, omitting any firm-specific notation, yields

   d[Pi]/dA = -X(t[[Theta].sub.A] + 1) = 0. (4)

   Taking the total derivative of Equation 4 yields

   dA/dt = [[Theta].sub.A]/t[[Theta].sub.AA] [greater than] 0. (5)

   Assuming [[Theta].sub.AAA] is not too negative, [d.sup.2]A/d[t.sup.2] is unambiguously negative and A is a concave function of t, A = A(t). We define the tariff and tax revenue function as R(t) = t[Theta]X(p) +...