Efficient Environmental Standards with Imperfect Completion

Economists have been concerned that sovereign communities may distort environmental policies to attract mobile capital. This paper provides something of a challenge to this idea. It does so by extending the model of Oates and Schwab (1988) to allow the supply of capital to a state, whether acting independently or strategically as part of a federation, to be less than perfectly elastic due to capital market imperfections. This gives the state an incentive to distort its policies in order to manipulate its domestic capital price relative to the given world return for capital. The key result is to show that the state always prefers to use a dedicated capital tax to achieve its desired domestic price, leaving environmental standards at efficient levels. Only when the state is denied access to a capital tax will it resort to distorting environmental standards. Thus, distortions to environmental standards arise from restrictions on the set of policy instruments rather than non-cooperative behavior or capital mobility per se, at least when the incentive to distort policy arises from capital market imperfections