Optimal policies in a small open economy with an environmental externality and shallow foreign exchange markets

This paper develops a small open economy model with a brown and green industry. Brown firms generate an environmental externality that reduces the utility of domestic households. Firms in both sectors rely on domestic and foreign capital to finance their production. Foreign exchange markets are assumed to be shallow and firms pay a higher return to borrow capital with respect to the exogenous foreign interest rate. This inefficiency contributes to a further decline in welfare. In this framework, the first-best allocation is attained through a tax on the output produced by the polluting sector combined with differentiated capital controls, with a higher tax rate applied to foreign capital inflows in the brown sector and a lower tax rate applied to foreign inflows in green firms. Looking at single policy tools, such differentiated capital controls are preferable to a tax on brown production for moderate values of the environmental externality.