Environmental regulation and eco-industry trade: Theory and evidence from the European Union

In this paper, we theoretically and empirically study the impact of environmental taxation on trade in environmental goods (EGs). Using a trade model in which the demand for and supply of EGs are endogenous, we show that the relationship between environmental taxation and demand for EGs follows a bell-shaped curve. Above a cutoff tax rate, a higher pollution tax rate can reduce the bilateral trade of EGs because there are too many low-productivity suppliers of EGs. Our empirical results confirm our main findings using data regarding the EU-27 countries. We also theoretically and empirically show that environmental taxation has a monotonically positive impact on the extensive margin of trade. Furthermore, we show that if countries apply an environmental tax rate equals to the “optimal” tax rate, 4.03% (e.g., the tax rate maximizing international trade of EGs), then trade in EGs would experience an increase of 22 percentage points.