Tariffs and Environmental Taxes in the Presence of Environmental R&D

It is generally held that trade liberalization results in less-stringent environmental regulations, which suggests that policies regulating trade and the environment are positively correlated. This paper examines whether this monotonic relationship still holds true when pollution-reducing environmental research and development (ER&D) is undertaken by the home firm in a duopoly market. The link between tariffs and environmental taxes is examined under three possible scenarios—namely, when the home government has: (i) a tariff instrument only; (ii) an environmental tax instrument only; and (iii) both regulatory instruments, to correct for distortions relating to trade and the environment. We find that if it is not possible to abate pollution completely through ER&D, then the monotonic relationship between tariffs and environmental taxes is sustained. However, if it is possible to fully abate pollution through ER&D, then the optimal tariff (environmental tax) may not increase monotonically with taxes (tariffs). When both environmental taxes and tariffs are employed, these two policies may be strategic substitutes. A positive relationship between tariffs and environmental taxes may not be applicable.