Should Environmental Innovation Policy Be Internationally Coordinated?

Abstract

This paper analyzes and compares the effects of emission taxation on firms’ innovation activity under two institutional regimes: one in which environmental taxation is internationally coordinated, and one in which, according to the subsidiarity principle, governments are free to set the domestic tax rate. Two countries are therefore assumed to agree on the introduction of an environmental taxation scheme; however, they can determine the domestic tax rate either cooperatively or non-cooperatively. In each country, firms may react both by changing output, and by adopting a new, environment-friendly technology. Conditions under which the latter option is firms’ optimal choice are provided. It is shown that, under both regimes, firms’ innovation decisions are not simultaneous, even when firms are identical (there exists diffusion). Moreover, firms have an incentive to delay the time of innovation, because the new technology can only be achieved through costly R&D. Hence, there exists room for incentives (subsidies) that move firms to the socially-optimal timing of innovation. The paper compares the equilibrium tax rate, total welfare, and private and social innovation dates in the two regimes. It is shown that cooperation leads to a more effective emission control, and to higher total welfare; moreover, in the non-cooperative regime, firms react to the lower tax rate by further delaying innovation dates.