Effect of environmental tax evasion on pollution havens within the EU’s dual regulation system

The EU Emissions Trading System (EU-ETS) has been experiencing the waterbed effect: it is difficult to achieve an overall reduction in emissions because some countries reduce the emissions covered by the EU-ETS, whereas others emit the same amount of CO2 via the ETS cap. This relates to pollution havens within EU’s dual regulation system. Thus, explaining how the dual regulation system with tax evasion creates pollution havens in the EU can help identify effective measures to improve the waterbed effect. I introduce an innovation-based agglomeration model for the international emission permits trading market. In this model, northern European polluting firms are charged higher environmental tax rates than southern ones; however, the former are more able to evade taxes by bribing bureaucrats, which determines pollution havens. I find that expanded tax evasion under capped pollution emissions leads to the waterbed effect via polluting firms’ relocation from the North to the South, and to a positive relationship between pollution havens and welfare in the South. I integrate the dual regulation system into political and economic factors and suggest new implications. Finally, the waterbed effect can be controlled via a policy to prevent tax evasion or by abandoning domestic environmental tax overlapping with EU-ETS.