Abstract

In a bilateral trade framework, we examine the impact of tariff reduction on the optimal pollution tax and social welfare when pollution is transboundary. Strategic considerations lead countries to distort their pollution tax in the non-cooperative equilibrium. Trade liberalization changes the distortion, and consequently the pollution tax and welfare, in ways that depend on the extent to which pollution is transboundary. We find that when the pollution damage parameter is sufficiently small (large), bilateral tariff reduction always decreases (increases) the pollution tax, irrespective of the value of the transboundary pollution parameter. However, when the pollution damage parameter takes intermediate values, bilateral tariff reduction decreases the pollution tax if and only if the transboundary pollution parameter is sufficiently large (or even sufficiently small, in certain cases). Moreover, with pollution being transboundary, the impact of trade liberalization on welfare is non-monotonic and concave. The greater the extent to which pollution crosses borders, the more likely is trade liberalization to reduce welfare.