Emission Tax Policy, Relocation of Polluting Firms and Pollution Abatement Investment

Abstract

Some developing countries have an incentive to relax environmental regulation in order to attract foreign direct investments. These so called “pollution havens” tempt relocation of firms from developed countries that have strict environmental regulations. The governments of developed countries must take this into consideration when they design domestic environmental policies. In this paper, I examine the emission tax policy for Cournot duopolists that relocate to another country with no emission tax. Introduction of a strategic emission tax for interruption of relocation to a “pollution haven” was found effective. However, there is still the possibility that duopolists in developed countries will relocate abroad even if the regulator pre-commits the emission tax rate. As pointed out by Petrakis and Xepapadeas [2003], the regulator faces a regulatory hold-up problem when the set-up cost of relocation is sufficiently low and environmental damage is serious. Therefore, adoption of an emission tax should only occur when the set-up costs are sufficiently large.JEL Classification: L13, L22, Q55, Q58