The Non-Neutrality of Border Tax Adjustments for Environmental Taxes Under Imperfect Competition

The appropriate treatment of imports is an important issue in the design and administration of domestic environmental taxes. With the aim of ensuring that foreign exporters do not attain a competitive advantage, border tax adjustments for domestic environmental taxes are used to neutralise this potential advantage. Since most environmental taxes apply to intermediate goods, the relevant border tax adjustment applies to the final (derivative) imported good. However, when both the intermediate and final goods markets are oligopolistic, border tax adjustments are likely to be non-neutral. This paper shows that the form and level of the appropriate border tax adjustment will depend on the nature of the firms' strategies in both the upstream and downstream stages. Most notably, when firms follow Bertrand strategies, the appropriate border adjustment should be an import subsidy rather than a tax. When firms play Cournot, even though an import tax is the appropriate instrument, setting this equal to the domestic environmental tax is unlikely to restrore neutrality. Consequently, the policy implication is that the tax authorities should account for market structure factors if border tax adjustments are to avoid being overly protectionist.