Greener taxes, freer trade? Environmental policy and tariff reduction in a second-best world

This paper studies how simultaneously liberalizing trade and tightening environmental policy affect welfare in a second-best world. We consider a three-good two-factor small open economy. We allow for non-tradables and for market power in the export market. The government is constrained to balance its budget at all times through distortionary taxes: a given income transfer has to be financed out of tariff and pollution tax revenue. We show that the switch from trade tariffs to environmental taxes can yield an increase in real income thus providing a second dividend in addition to the environmental improvement.