Transboundary Externalities and Reciprocal Taxes: A Differential Game Approach

I investigate the interaction between a country that imports a commodity whose production contributes to a stock pollution from a country that produces that commodity. If the transboundary externality is priced improperly, the application of a tariff or border tax adjustment can provide an indirect policy instrument. But the imposition of such a tariff or tax creates an incentive for the producing country to deploy a domestic pollution tax. This, in turn, creates a strategic interaction between the two countries. Because the externality is linked to a stock pollutant, this strategic interaction will play out over time, which induces a dynamic game. In this modeling context, I describe the nature of the strategic interaction, and characterize the Markov-perfect equilibrium (MPE). Numerical results indicate that MPE can deliver long-run welfare levels similar to the social optimum program, and that the exporting country may be better off in the MPE than in the "business-as-usual" regime.