Can Small Economies Act Strategically? The Case of Consumption Pollution and Non‐Tradable Goods

ABSTRACT We adopt an analytical framework of a Federation consisting of asymmetric jurisdictions with capital mobility between them and cross‐border pollution due to the consumption of tradable or of non‐tradable goods. We show that the Nash equilibrium calls for a consumption tax and capital tax or subsidy. The consumption tax causes a pollution leakage between the jurisdictions, which is partly offset by the capital tax or subsidy. Thus, the presence of non‐tradable goods and interjurisdictional capital mobility prompt small open economies to act strategically. In the absence of capital taxes, consumption taxes are lower to the case where both instruments are available, since they are used strategically to mitigate the pollution leakage.