Pareto Improving Reforms in the Presence of Spillovers and Spillbacks

In this paper, we contribute to the topical debate on the welfare effects of a centralized policy setting within the federal union in the presence of transboundary pollution externalities that affect production possibilities. It is shown that when the production of federal jurisdictions generates spillover effects, which in turn result in spillback effects, harmonization of their public policies towards the uniform optimal cooperative level does not ensure welfare improvement for the federation. We analyze and identify federal policies harmonizing reforms that deliver Pareto improvement in the presence of spillback in addition to spillover effects. These reforms are designed to neutralize all the spillback effects by maintaining the aggregate level of spillover effects constant while increasing the welfare of the federation. This result holds irrespective of the nature and sign of the spillover and spillback effects, as well as for both small and large open economies.