Policy Reform and Optimal Policy Mix in a Polluted Small Open Economy with Tourism

• DOI: http://doi.org/10.1111/roie.12276
• Published date: 01 August 2017
• Author: Akihiko Yanase
• Date: 01 August 2017

Policy Reform and Optimal Policy Mix in a

Polluted Small Open Economy with Tourism

Akihiko Yanase*

Abstract

Effects of trade and environmental policies on a small open economy, with pollution generated in a sector

producing nontradable services consumed by foreign tourists, are examined. The nontradable good is

exported via tourism and the induced tourism terms-of-trade (TOT) effect becomes an additional source of

distortion. An increase in tariffs can cause a TOT improvement andan increase in pollution simultaneously,

affecting the condition for a welfare-enhancing tariff policy.In addition, the welfare effect of a pollution tax

reform is strongly linked to whether the reform improves the tourism TOT. The interactions between tou-

rists’ spending anddomestic welfare are also examined.

1. Introduction

The globalization of economic activities is noteworthy, not only in commodity trade

but also in services. Among others, international tourism has grown rapidly in past few

decades. According to an estimate by the World Tourism Organization (UNWTO,

2015), international tourist arrivals have grown from 25 million in 1950 to 1133 million

in 2014. It is also documented in UNWTO (2015) that international tourism receipts

reached US$1245 billion in 2014; tourism is now a trillion-dollar industry. The growing

importance of the tourism sector implies that policies affecting tourism are worth con-

sidering. For example, if an expansion of a tourism sector enhances welfare, national

and local governments will implement policies to attract foreign tourists.

Expansion of a nation’s tourism sector, however, may have negative effects on the

economy. Environmental degradation is one of such negative effects; an increase in

tourists will cause increased littering in tourist spots and can seriously damage the local

ecosystem.

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There will also be an increase in traffic, which may cause more emissions

from vehicles.

2

In order to mitigate such impacts on the environment, a national gov-

ernment may implement environmental regulations or policies.

3

While there are a

great number of studies on international trade and the environment and effects of

environmental policy in open economies have been extensively examined by many

authors,

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there are relatively a small number of studies on inbound tourism and the

environment. Taking into account the characteristics of tourism, which will be dis-

cussed below, this study carries out a theoretical analysis of the effects of trade and

* Yanase: Graduate School of Economics, Nagoya University, Furo-cho, Chikusa-ku, Nagoya, 464-8601,

Japan. E-mail: yanase@soec.nagoya-u.ac.jp. This study was launched as a joint research project with Xue-

lian Lee. She contributed at the early stage of this research, but is not responsible for the current version

of the paper. The author would like to thank Yasuhiro Takarada, Yoshihiro Tomaru, participants at the

Nagoya International Economics Study Group and two anonymous referees for their helpful comments

and suggestions on earlier versions of the paper. The author also gratefully acknowledges the Japan Soci-

ety for the Promotion of Science (JSPS) for its financial support of this research under the Grant-in-Aid

for Challenging Exploratory Research No. 15K13015.

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C2016 John Wiley & Sons Ltd

Review of International Economics, 25(3), 607–625, 2017

DOI:10.1111/roie.12276

environmental policies in the presence of environmental pollution generated in a tour-

ism sector.

In economic analyses, tourism is characterized as “a temporary movement of con-

sumers from one country to another to consume non traded goods and services”

(Hazari and Sgro, 2004, p. 2). This means that an analysis of an economy with tourism

can be conducted by applying the trade model with nontradable goods of McDougall

(1965), Komiya (1967) and Kemp (1969). A particular feature of inbound tourism is

that because the nontradable goods are consumed by foreign tourists as well as domes-

tic consumers, the home country exports the nontradable goods via tourism. This

means that even a small country, which cannot affect the world price of traded goods,

can improve its national welfare by changing the price of nontraded goods in the tour-

ism sector.

Copeland (1991) is a pioneering work that shed light on the above-mentioned effect,

called the “tourism terms-of-trade effect.” By developing a general equilibrium model

of a small open economy with tourism, Copeland (1991) shows that a tourism boom,

defined as an increase in foreign tourists’ demand for the nontradable good during

their visit, raises the price of that good. Thus, the domestic country becomes better off

if there are no distortions because of an improvement in the economy’s terms of

trade.

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This tourism terms-of-trade effect also implies that, unlike in conventional

small open-economy models, free trade is not optimal for an economy that takes the

prices of tradables as given (Hazari and Sgro, 2004, ch. 3).

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This issue is considered by

Chao et al. (2010), who develop a three-goods (two traded and one nontraded) model

and derive the optimal import quota in the presence of inbound tourism.

In the presence of pollution problems, the tourism terms-of-trade effect also affects

the design of an optimal environmental policy. If the terms-of-trade manipulation by

trade policy is possible, the optimal environmental policy is characterized by the stand-

ard Pigouvian tax, i.e. levying taxes on polluting activities equal to the marginal social

damage (Krutilla, 1991). However, Chao et al. (2008) and Beladi et al. (2009) show

that, in the presence of inbound tourism and the induced tourism terms-of-trade effect,

the optimal pollution taxes are distorted from the standard Pigouvian level. Chao

et al. (2008) develop a three-goods model similar to Chao et al. (2010) and, assuming

that the production of one of the traded goods generates pollution, examine the effects

of trade and environmental policies. The authors also derive the optimal policy mix,

which consists of positive tariffs and pollution taxes that may be higher or lower than

the Pigouvian level. Beladi et al. (2009) develop a two-goods (one traded and one non-

traded) model in which pollution is emitted from the nontraded good sector. Assum-

ing free trade, the authors examine the effects of pollution taxes on the environment

and national welfare, and derive the optimal pollution taxes under endogenous tour-

ism, where foreign tourists determine their spending based on their willingness to

travel, as well as under exogenous tourism.

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In this study, we extend the models analyzed by Chao et al. (2008) and Beladi et al.

(2009) to address the effects of trade and environmental policies on the environment

and national welfare. As in Chao et al. (2008), we consider a small open economy with

two traded goods and one nontraded good and, as in Beladi et al. (2009), we assume

that pollution is emitted in the nontraded rather than the traded good sector. More-

over, we assume that tourists consume one of the traded goods as well as the non-

traded good. Although the primary purpose of foreign tourists visiting a country is to

consume local and nontradable service goods, the tourists can also buy foods or manu-

facturing goods for their own consumption or as souvenirs. Such purchasing behavior

of tourists, which has been ignored in the previous studies, is observed in reality.

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608 Akihiko Yanase

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C2016 John Wiley & Sons Ltd