Environmental Policy and Interjurisdictional Competition in a Second-Best World

Abstract: Existing models of tax competition predict that environmental quality is enhanced if jurisdictions cooperate over environmental policy choice. This result is generally achieved by modelling a static economy in a first-best world, that is were the only distortions are generated by pollution externalities. This paper challenges the standard view by showing that in a dynamic model of tax competition where saving behaviour is taken into account and there are distortive taxes in place (second-best world), interjurisdictional competition may be desirable. Our analysis suggest that, on the contrary, environmental policy may be stricter when jurisdictions are left free to compete over taxes on capital and pollution