Environmental Policy and Firm Selection in the Open Economy

In this paper, we analyze the effects of a unilateral change in an emissions tax in a model of international trade with heterogeneous firms. We find a positive effect of tighter environmental policy on average productivity in the reforming country through reallocation of labor toward exporting firms. Domestic aggregate emissions fall, due to both a scale and a technique effect, but we show that the reduction in emissions following the tax increase is smaller than in autarky. Moreover, general equilibrium effects through changes in the foreign wage rate lead to a reduction in foreign emissions and, hence, to negative emissions leakage. In case of transboundary pollution this exerts in turn a positive feedback effect on the domestic environment.