Public pollution abatement, regional capital mobility, and tax competition.

• Author: Hadjiyiannis, Costas
• Position: Pollution abatement and control

1. Introduction

   In response to growing environmental concerns, governments and international organizations have designed policies of pollution abatement and control (PAC). In a 2003 report the Organisation for Economic Co-operation and Development (OECD) defines PAC activities as

   ... the purposeful activities aimed directly at the preservation, reduction, and elimination of pollution nuisances arising as a residual of production processes or the consumption of goods and services .... In total, PAC expenditure comprises the flow of investment, internal current expenditure, subsidies and fees that is directly aimed at pollution abatement and control, and which is incurred by the public sector, the business sector, private households and specialized producers of PAC services.... (Linster and Zegel 2003, p. 9) In the same report, PAC expenditures in OECD countries vary from 0.7% (Portugal, 1994) to 2.6% (Austria, 1998) of Gross Domestic Product (GDP) per annum in the period extending from 1990 to 2000. A revealing stylized fact of this report is that a significant part of these expenditures are undertaken by the public sector. For most countries, public expenditures account for about 40-60% of total PAC. These statistics reveal two important stylized facts. First, PAC expenditures as a percentage of GDP are sizeable, and second, a significant part of these expenditures are incurred by the public sector. (1)

   Thus, it is important that both the private and the public sectors' abatement are taken into consideration in analyzing environmental policies, especially in light of the fact that emission tax revenue is often earmarked for pollution abatement activities by governments. For example, Brett and Keen (2000) note that in the United States it is quite customary for environmental taxes to be earmarked for specific environment-related public expenditure. In particular, such tax proceeds are commonly paid into trust funds that finance various clean-up activities or are spent on road and public transport networks. Yet by and large, the literature on pollution abatement has assumed that pollution abatement is entirely undertaken by the private sector in response to emission taxes on private producers (see, for example, Copeland and Taylor 1995; Copeland 1996; Ludema and Wooton 1997; Silva and Caplan 1997). (2)

   Hatzipanayotou, Lahiri, and Michael (2002, 2005) and Chao and Yu (1999) provide some of the very few studies that explicitly consider the simultaneous provision of pollution abatement by the private and public sectors. Chao and Yu (1999) examine the welfare implications of international transfers when public pollution abatement is financed by foreign aid and emission tax revenue. Hatzipanayotou, Lahiri, and Michael (2002) examine optimal policies for the donor and recipient countries in a similar framework but also incorporate cross-border pollution. Hatzipanayotou, Lahiri, and Michael (2005) examine the optimal policy implications of a number of multilateral reforms in a two-country model with cross-border pollution, in which public sector abatement is financed through a fraction of environmental tax revenue. These studies, however, ignore an important feature of open economies--that of international capital mobility. On the other hand, there is a large body of literature examining various aspects, including optimal environmental policies, of the interaction between international capital mobility and the environment but without accounting for the simultaneous abatement of pollution by the private and public sectors (e.g., Copeland 1994; Copeland and Taylor 1997; Rauscher 1997).

   The present paper bridges the gap in the literature by incorporating both capital mobility and public pollution abatement. To this end, we construct a general equilibrium model of a regional block (RB) with two non-identical countries and free commodity and capital flows. We assume that pollution, a by-product of production, is generated in each country, is transmitted across borders, and is abated partly by the private producers, in response to an emissions tax, and partly by the local governments. Governments finance their public pollution abatement activities using lump-sum and pollution tax revenue. We derive the cooperative and Nash optimal pollution taxes and relate them to the marginal cost of public pollution abatement.

   This paper offers two innovations. The first is the generalization of the existing models, which incorporate simultaneous provision of public and private pollution abatement. In this more general model, we incorporate all the features that different papers have stressed as important features in studying environmental policies, such as cross-border pollution and asymmetries between countries. The second innovation is the analysis of these policies in the presence of capital mobility. Changes in environmental policies in the presence of public pollution abatement create externalities between neighboring countries because of cross-border pollution. At the same time, such changes affect tax revenue and therefore public pollution abatement. On the other hand, environmental policies affect capital mobility, which in turn affects emissions.

   This generalized model allows us to identify interactions between these features that have been ignored by the literature thus far. Capital mobility affects the optimal choice of pollution taxes in the two countries since higher taxes lower the return to capital and drive capital out of the country. That restricts the ability of governments to finance public pollution abatement. We show that the coexistence of all these features affects optimal pollution taxes by comparing the general results to the special cases in which (i) there is no cross-border pollution; (ii) countries are identical; (iii) there is no capital mobility; and (iv) there is no public pollution abatement.

2. The Analytical Framework

   The Model

   We develop a general equilibrium model of a RB comprising two small open economies, Home and Foreign, which trade freely with each other and the rest of the world. (3) As a result, commodity prices in the two countries are constant and equal to the world commodity prices. In both countries pollution of the eyesore type is generated as a by-product of production and is transmitted across national borders. Identical residents, inhabiting each country, are adversely affected and suffer disutility from locally generated pollution and from pollution emitted by foreign producers and transmitted across borders. With respect to the flows of factors of production, it is assumed that capital is freely mobile within the RB but immobile between the region and the rest of the world. Other factors of production, such as labor, are intra-regionally and internationally immobile. (4)

   Without loss of generality, we call the capital-importing country Home; the model of Foreign, the capital-exporting country, follows analogously. Home's maximum value of production of private goods is denoted by the revenue function R(p, v, t, K), defined as

   [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII], (1)

   where p is the vector of exogenously given world commodity prices, [phi] (v, K) is the country's aggregate technology set denoting private production and abatement technologies, v is the endowment vector of the immobile factors, [bar.K] is Home's capital endowment, [k.sup.f] the amount of foreign capital operating in Home (and thus K is the domestic supply of capital), x is the vector of net outputs, and z is the amount of pollution emission by the private sector, net of the amount abated by the private sector. (5) In the present analysis, since (v) and (p) are invariant, for notational simplification the revenue function is written as R(t, K). By the envelop theorem, the partial derivative of the revenue function with respect to K (i.e., [R.sub.K]) is the marginal revenue product of capital, and by the same theorem, the level of pollution, z, generated by the private sector is given by (6)

   z = -[R.sub.t](t, K). (2)

   We assume that the R(t, K) function is strictly concave in K (RKK 0). The latter assumption implies that a higher emission tax level lowers the amount of pollution emissions by the private sector. We also assume that the polluting activity is capital intensive, that is, [R.sub.tK]

   Accounting for both private and public sector pollution abatement, the overall net pollution, r, affecting the home country residents is

   r = z - g + [THETA]([z.sup.*] - [g.sup.*]), (3)

   where the parameter [THETA][member of] [0, 1] is the rate of cross-border pollution or the spillover parameter, g is the level of public pollution abatement in the home country, and [z.sup.*] and [g.sup.*] denote the levels of pollution net of private abatement and the level of public pollution abatement, respectively, in the foreign country. (7) We also assume that private firms can only abate pollution by reducing production, and that they do not have access to the imported abatement good. This is because in some cases, it is in the best interest of the government to forbid its use by private firms. Allowing firms access to this good restricts the government's ability to use pollution taxes to capture terms of trade effects in the capital market. For example, if pollution taxes are higher than the cost of the abatement good, firms abate all pollution using the abatement good, avoiding pollution taxes altogether. That makes pollution taxes completely ineffective in capturing the terms of trade effect in the capital market.

   As for the country's public sector, we assume that it imports from the rest of the world, at a constant price [P.sub.g], a commodity used to provide public pollution abatement at the level g. The assumption of the constant world price [P.sub.g] for the public abatement good implies constant marginal abatement cost (MAC). The cost of the imported good (i.e., [P.sub.g]g), used for public pollution...