Optimal environmental and trade policy combination in the presence of transboundary pollution and other market distortions

ABSTRACT Adopting optimal environmental regulation in an open economy characterized by market distortions, policy constraints and transboundary pollution, is challenging. Absent first-best international agreements, coordinated environmental taxes and trade policies are derived in the presence of internal and external market failures. Existing theoretical models are extended by allowing for the possibility of transboundary pollution for small and large nations. For large nations, combining a Pigouvian tax with free trade is not optimal, and in certain circumstances import ‘carbon’ tariffs are recommended. In addition, if constrained from addressing market distortions optimally, available policy instruments should be adjusted to tackle unaddressed market distortions.