Eco-Dumping, Capital Mobility, and International Trade

A small open economy’s optimal environmental policy is studied in a model with international capital mobility and local pollution. The country produces traded as well as non-traded goods. Is it in the country’s interest to engage in ecological dumping by choosing generous pollution allowances for the traded-good sector? The answer depends decisively on the policy regime in use. Dumping is not optimal if the country ensures that the implicit rent on pollution is completely appropriated within the country. However, if the implicit factor reward on pollution leaves the country because it accrues to (foreign) owners of mobile capital, the local welfare maximizing government tends to discriminate against the traded-good sector, the opposite of ecological dumping.