The Strategic and Effective Dimensions of the Border Tax Adjustment

• DOI: http://doi.org/10.1111/jpet.12131
• Date: 01 December 2015
• Author: LISA ANOULIÈS
• Published date: 01 December 2015

THE STRATEGIC AND EFFECTIVE DIMENSIONS OF THE

BORDER TAX ADJUSTMENT

LISA ANOULI `

ES

RITM, Universit´

e Paris-Sud, Universit´

e Paris-Saclay

Abstract

Between 2001 and 2011, the Kyoto Protocol has experi-

enced defections of two countries that took part in its

negotiation and accounted for around 44% of all parties’

emissions. The border tax adjustment, a tax levied on im-

ports to reproduce domestic taxation on similar goods, is

advocated to prevent such compliance failures as well as to

support unilateral pollution regulations by mitigating firms’

competitiveness losses and carbon leakages. The paper in-

vestigates whether this trade instrument can constitute a

decentralized solution to achieve the first-best in a non-

cooperative framework. It develops a two-country two-firm

reciprocal-market model of trade with global pollution and

country heterogeneity. Countries’ interactions are studied

following a noncooperative game theory approach, for two

scenarios defined by the possibility to implement a border

tax adjustment to sanction unilateral deviation from the co-

operative situation. The paper predicts first that this oppor-

tunity modifies the countries’ choices of strategies toward

more compliance; second that among the strategic and ef-

fective dimensions of the border tax adjustment, only the

former allows to achieve the first-best; finally that the border

tax adjustment fosters countries’ participation in the coop-

erative international environmental agreement.

Lisa Anouli`

es, RITM, Univ. Paris-Sud, Universit´

e Paris-Saclay, France (lisa.anoulies@

u-psud.fr).

I thank the Editor John P.Conley and two anonymous referees for their wise comments

and constructive suggestions. I am grateful to Philippe Martin for his guidance, and to

Brian Copeland, Jos´

e de Sousa, Thierry Mayer, and Gabriel Smagghue for stimulating

discussions. I also thank participants of the EEA 2012, ADRES 2012, and AFSE 2012 con-

ferences, as well as seminars participants at Sciences Po, IDDRI and the Paris School of

Economics for helpful comments and suggestions on earlier versions of this paper. All

remaining errors are mine.

Received August 20, 2014; Accepted August 25, 2014.

C2014 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 17 (6), 2015, pp. 824–847.

824

Border Tax Adjustment 825

1. Introduction

The Kyoto Protocol signed in 1997 defined quantified greenhouse gas emis-

sions limitations for the period 2008–2012 to 39 parties whose average emis-

sions per capita stood at 11.9 tons at that time, a performance more than

2.8 times higher than the world average. Among them, the United States

did not ratify the Protocol and Canada, unable to meet its binding tar-

get, announced its withdrawal from it in December 2011, two significant

breaches as each year since 1997 these two countries’ emissions have ac-

counted for around 44% of all parties’ emissions. The border tax adjust-

ment, defined as a tax levied on imports to reproduce domestic taxation on

similar goods, and which in its full form also makes provision for a refund of

domestic taxes on exports, is advocated first to prevent compliance failures

of the successor of the Kyoto Protocol, as well as to support and accompany

unilateral strong pollution regulations by mitigating firms’ competitiveness

losses and carbon leakages.1This paper takes into consideration these two

channels to answer the following question: can the border tax adjustment

constitute a decentralized solution to achieve the first-best in a noncoopera-

tive framework?

This issue is addressed in a model featuring strategic interactions

between two countries and two firms, quite standard in the trade and en-

vironment literature: the reciprocal-market model of trade introduced by

Brander and Krugman (1983), enriched since the 1990s with global envi-

ronmental concerns and strategic environmental policy (see, for instance,

Barrett 1994b, or Kennedy 1994). There is intra-industry trade of a homo-

geneous good produced by two imperfectly competitive firms, one in each

country. Pollution is a by-product of production, it is global and regulated by

a tax on domestically produced emissions. The adverse effects from global

pollution are unevenly distributed among countries, which are also asymmet-

ric in terms of population size. In a preliminary stage, countries’ executives

choose the environmental policy that maximizes global welfare; the corre-

sponding individual levels of emissions define the emissions caps and the co-

operative international environmental agreement. Self-interested countries

then play a noncooperative and static three-stage game: in the first stage

countries’ legislatures simultaneously choose to ratify or not the agreement,

in the second stage they simultaneously set the level of policy instruments,

and in the third stage firms compete `

a la Cournot on segmented markets.

The game is solved by backward induction for two different scenarios. In the

1For the first argument, see Barrett (2008). For the second one, Aichele and Felbermayr

(2013) find that commitment to the Kyoto Protocol has reduced the exports of Protocol

parties by 13 to 14%, and, according to a meta-analysis conducted by Branger and Quirion

(2014) on 25 ex ante quantitative studies, carbon leakage ratio estimates range from 5% to

25% without policy support.