The suboptimal nature of applying Pigouvian rates as border adjustments

We consider a North-South trade model with cross-border environmental damage where the North imports the relatively dirty good. The North sets domestic production taxes according to each industry’s contribution to environmental degradation (Pigouvian taxes), but this exacerbates cross-border damages. It is well understood that a large economy in this situation can use border taxes to mitigate the damage, but a large economy also has an incentive to use trade policy to extract rents (Markusen, 1975). We formulate a model that neutralizes the rent-seeking incentives, through an endogenous transfer, to focus only on environmental incentives. We find that setting the North's import tariff at the Pigouvian rate is above the optimal, because it indirectly reduces the North's exports, favoring consumption of the dirty good in the South. Even in the case of full border tax adjustment, where the import tariff is partially canceled out by an export subsidy set at the Pigouvian rate for the export industry, trade is taxed too much. Considering the inherent general equilibrium nature of trade policy, the North's optimal border adjustment to mitigate the cross-border damage is a net import tariff set below the Pigouvian rate.