Trade costs and the choice of international commodity tax base revisited: The role of transboundary pollution

• Author: Tsaur‐Chin Wu
• Published date: 01 December 2019
• Date: 01 December 2019
• DOI: http://doi.org/10.1111/ijet.12187

Trade costs and the choice of international commodity tax

base revisited: The role of transboundary pollution

Tsaur-Chin Wu



It is generally believed that when trade costs fall, the origin-based production taxes are superior

to the destination-based consumption taxes under imperfect competition. This result can be

justified from a perspective of purely local pollution when considering a production-type

externality. However, we show that with smaller trade costs, the destination-based consumption

taxes tend to generate greater welfare levels than the origin-based production taxes when the

degree of a production-type transboundary externality is high enough, contrary to general belief.

Key words imperfect competition, transboundary pollution, commodity tax

JEL classification F12, L13, H20

Accepted 22 August 2017

1 Introduction

In recent years, trade liberalization has become an important trend globally.

1

As we show later, the

existing literature shows that increasing trade liberalization affects not only the choice of commodity

tax base but also the environment, especially within the European Union. However, these two policy

issues seem to be discussed separately in the existing literature, despite the fact that trade

liberalization may affect the choice of commodity tax base through altering environmental pollution.

Seeking to fill this gap in the literature, this paper revisits the impact of trade cost on the choice of the

destination and origin regimes when pollution is transboundary.

The effect of trade costs on the choice of destination and origin tax principles in open economies is

traced to Haufler et al. (2005), who find that when demand is linear, the origin principle is welfare-superior

to the destination principle for any level of trade costs. In addition, when demand is nonlinear, for high

trade costs the destination principle dominates, while for low trade costs the origin principle dominates.

2



Department of Public Finance, Feng Chia University, Taichung, Taiwan. Email: wutcya@gmail.com

I would like to thank Kazuo Nishimura (managing editor), and an anonymous referee for their helpful comments and

suggestions. All remaining errors are my own.

1

As shown later, we take transport costs or import tariffs as a proxy for trade liberalization.

2

The two effects have to be taken into account to explain the result shown in Haufler et al. (2005): first, the underproduction

arising from the market power of firms (the underproduction effect);and second, the rent-shifting effect, which shifts rents

to the home economy and leads to lower production taxes, but higher consumption taxes. When there are no trade costs,

these two effects add up to the Pareto-efficient tax rate under the origin principle, but not under the destination regime.

When demand is nonlinear, with positive trade costs, however, the trade-off for nationaltax policy changes qualitatively as

the resource costs of trade also enter theanalysis. For sufficiently high trade costs the rent-shifting effect becomes negligible

and the task for tax policy is to weigh domestic underproduction from imperfect competition against international

inefficiencies that arise from wasteful trade costs. This trade-off is optimally solved by the destination principle, but not by

the origin principle.

doi: 10.1111/ijet.12187

International Journal of Economic Theory xxx (2018) 1–23 ©IAET 1

International Journal of Economic Theory

International Journal of Economic Theory 15 (2019) 361–383 © IAET 361

The economic literature has re-examined the argument of Haufler et al. (2005) under different

scenarios. Hashimzade et al. (2005) show that the results of Haufler et al. (2005) are robust to some

degree of product differentiation, and also to differentiated Bertrand competition. McCracken and

St€

ahler (2010) extend the model of Haufler et al. (2005) to merge free entry. They show that the

destination principle dominates the origin principle when trade costs are high or demand is linear.

For lower levels of trade costs and nonlinear demand, the welfare ranking of the two tax bases is

uncertain. Hashimzade et al. (2011) show that small countries and efficient countries can have a

preference for the destination principle. In contrast, large countries and inefficient countries are

shown to prefer the origin principle. McCracken (2015) extends the model of Haufler et al. (2005) to

allow for horizontal foreign direct investment. McCracken (2015) shows that when integration is

complete, the destination principle is superior to the origin principle for all levels of plant fixed costs

below which foreign direct investment occurs under the origin principle. Fujiwara (2016) finds that

if the reforming country imposes an import tax, its reduction and an increase in the consumption tax

(a decrease in the production tax) that leave the world price constant attain a strict Pareto

deterioration (improvement).

3

Apart from the above papers, another policy issue is the effect of trade liberalization on the

environment. It is often argued that trade liberalization leads to moreenvironmenta ldegradation via

an increase in production and consumption. In such a situation, there are several papers exploring

whether trade liberalization worsens welfare in the presence of pollution. Walz and Wellisch (1997)

and Burguet and Sempere (2003) show that trade liberalization always raises the welfare of each

country in the presence of local pollution. In contrast, Baksi and Ray Chaudhuri (2009) demonstrate

that the above result may not remain valid when considering transboundary pollution. Fujiwara

(2010a, 2012) attempts to compare the welfare of free trade versus autarky when pollution is

transboundary.

Combining the above two streams of l iterature, this paper attempts to in vestigate whether

environmental polluti on changes the effect of trade cost on the choice of co mmodity tax base. The

reason for considerin g this problem is that trad e liberalization will af fect not only the distor tions

caused by trade but also the e xtent of pollution damage. In s uch a situation, trade libe ralization

influences the choice of comm odity tax base by changes in env ironmental pollution an d, in this

sense, the choice of comm odity tax base and enviro nmental pollution shoul d not be dealt with

separately. As we show la ter, overlooking such an environmental effe ct may mislead policy-

makers.

Building on the model that has become a workhorse in this field, Haufler et al. (2005), this paper

shows that, in the case of a production-type transboundary externality, even when the cost of trade is

low, if the degree of transboundary pollution is high enough, the welfare effect of the destination

principle is greater than the origin principle, which contrasts with the general belief as shown by

Haufler et al. (2005).

We extend the model to check the robustness of results. First, we suppose that a transboundary

externality arises from consumption. We find that welfare may be higher under the destination

principle than under the origin principle, regardless of the degree of transboundary pollution.

Next, we suppose that trade costs are an import tariff, rather than transport costs. We find that if

trade costs are small enough, the origin principle may be dominated by the destination principle.

Finally, we employ the level of pollution as an alternative criterion. We find that if the degree of

3

Keen and Lahiri (1993) and Keen et al. (2002) show the superiority of consumption taxes under tax harmonization. In

addition, Haufler and Pfl€

uger (2004) and Behrens et al. (2007, 2009) investigate the welfare implications of the two tax

principles in a model of monopolistic competition.

International commodity tax and transboundary pollution Tsaur-Chin Wu

2International Journal of Economic Theory xxx (2018) 1–23 ©IAET

International Journal of Economic Theory 15 (2019) 361–383 © IAET

362