Emission taxes, firm relocation, and quality differences

This paper studies the effect of an emission tax on the relocation decision in a duopoly with exogenous vertical product differentiation. We establish the relationship between quality difference, relocation cost, and marginal damage of emissions in a two-country-setting for three cases: An environmental tax set only by one country, non-cooperative environmental taxation in both countries, and coordinated environmental taxation. We consider two different timings: a time-consistent government, and a committed government. The higher the quality difference, the more likely it is that at least one firm relocates to the foreign country. A lower marginal damage decreases the equilibrium tax rate and lowers the incentive for relocation. If also the foreign country applies an emission tax, there is no equilibrium in which both firms relocate to the foreign country. If both governments set taxes non-cooperatively, the low-quality firm never relocates in equilibrium. If both countries set taxes cooperatively, it is more likely that both firms remain in the home country. Also, relocation of the low-quality firm only is a possible outcome of cooperative taxation.