Which border taxes? Origin and destination regimes with fiscal competition in output and emission taxes

Abstract

This paper posits a two-stage game in tax regime and tax rates to study the property of second-best emission and output taxes in a two-country world with an atmospheric externality. It shows that (i) either the destination–destination or the origin–origin tax regime may constitute the subgame perfect Nash equilibrium of this game; (ii) either regime may Pareto-dominate the other; (iii) it is possible to have a prisoner's dilemma game where the origin–origin regime Pareto-dominates but the choice of the destination regime is the dominant strategy for each country. Other results include (iv) under origin–origin regime: the output tax is used for fiscal competition; the emission tax is set at a rate equal to the (national) marginal social damage of emissions; and public goods are provided suboptimally. (v) Under destination–destination regime: the output tax is ineffective as an instrument for fiscal competition; the emission tax is used not only for combating pollution but also for tax competition; the tax is set at a rate below the (national) marginal social damage of emissions; emissions are pushed above their closed-economy level; the provision of public goods are optimal.