Policy Reform and Optimal Policy Mix in a Polluted Small Open Economy with Tourism

Abstract

Effects of trade and environmental policies on a small open economy, with pollution generated in a sector producing nontradable services consumed by foreign tourists, are examined. The nontradable good is exported via tourism and the induced tourism terms-of-trade (TOT) effect becomes an additional source of distortion. An increase in tariffs can cause a TOT improvement and an increase in pollution simultaneously, affecting the condition for a welfare-enhancing tariff policy. In addition, the welfare effect of a pollution tax reform is strongly linked to whether the reform improves the tourism TOT. The interactions between tourists' spending and domestic welfare are also examined.