Strategic Environmental Policy and Environmental Tariffs

This paper uses a three-stage game to analyze how environmental tariffs affect the strategic behavior of a government in designing environmental policy. The game is based on an international duopoly model with detrimental externality in production and asymmetric environmental policies between two countries. It shows that the welfare effect of the foreign country’s strategic environmental policy on the home country is ambiguous. In the circumstance that the home country would be worse off due to the lenient environmental policy of the foreign country, there exists an optimal environmental tariff. If the home country imposes the optimal tariff on the pollution-intensive imports, any deviation from the first best environmental policy by the foreign country would make the home country better off. In addition, the implementation of the environmental tariff would mitigate the motivation of the foreign country to pursue strategic environmental policy, and drive the lenient environmental standard toward the efficient level. The theoretical results imply that, in an open economy with non-harmonized environmental standards, imposing environmental tariffs on imports from the countries with lax environmental regulations would correct the adverse welfare effect, and more importantly induce the upward harmonization on environmental policy across countries.