Political institutions and the design of environmental policy in a federal system with asymmetric information

Policy debates on trade and the environment frequently refer to a need for countries linked by trade to co-ordinate their environmental policies even for entirely local pollution problems; co-ordination is often taken to imply harmonisation of environmental policies to provide a 'level playing field' for trade. Underlying this argument is a concern that national governments will not fully internalise environmental externalities. In the conventional small open-economy model with a welfare-maximising government such a concern is unfounded; moreover even if governments did not fully internalise externalities, policy reforms would not have to be co-ordinated and harmonisation would be undesirable if there are genuine differences between countries. To give some basis for international environmental policy, it is necessary to depart from the conventional small open-economy model and I consider a number of such departures, together with their implications for policy and institutions. I work within a framework where any co-ordination is achieved by a supra-national government agency, e.g. in the form of a federal government. I begin with a simple second-best argument where countries are large, national governments have not fully corrected environmental market failures, but they do not seek to manipulate terms of trade. This provides a justification for co-ordination of policy reforms, and in a special model this can be considered a form of harmonisation. However to consider appropriate institutions to achieve co-ordination one needs to consider why national governments have not fully corrected market failures. The first case I consider is a strategic trade model, where individual national governments may have incentives to set weak environmental policies (a 'race to the bottom'). While this provides a rationale for co-ordination of the domestic environmental policies of states, this is unlikely to require harmonisation, and a policy of minimum standards may also fail. If the federal government is poorly informed about environmental damage costs in individual states, this may require setting environmental policies in states with different damage costs which are more similar than would be the case with full information, but this does not amount to harmonisation of environmental policies. I next examine political economy models of how governments may set their environmental and trade policies when governments have objective functions which reflect the influence of special interest groups. This leads to an analysis of political institutions for limiting the discretion of governments subject to the influence of special interests, while recognising that governments have access to information not available to voters. In the context of the particular model employed, the relevant restriction of government discretion implies harmonisation of environmental policies, and I assess the incentives for restricting government discretion at both the federal and state level