Differing Environmental Preferences, Fiscal Competition, and Taxation of Goods and Pollution

We develop a two-country model of trade and global pollution in which country A values environmental quality whereas country B does not. Governments choose emissions and commodity taxes non-cooperatively under autarky and free trade. Under autarky, the principle of targeting holds: country A levies a Pigouvian emissions tax, whereas neither country uses a commodity tax. Opening borders fundamentally changes the design of corrective taxation. Country A subsidizes the polluting good to shift production toward its cleaner firms. The optimal subsidy depends on the marginal social damage of emissions despite the presence of an emissions tax, implying a violation of the principle of targeting. Contrary to the conventional pollution-haven prediction, the environmentally unconcerned country need not be the exporter of the polluting good. As country A's valuation of environmental quality increases, or country B's production-cost advantage narrows, production shifts toward A, which eventually becomes the exporter. Beyond a critical threshold, trade reduces global emissions relative to autarky. Welfare effects are asymmetric: trade always benefits country B but may either increase or decrease welfare in country A.