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

Summary

This paper builds an analytical model of a federation of asymmetric, small jurisdictions with internationally mobile capital and cross-border pollution generated by consumption of either tradable or non-tradable goods. Governments use two instruments — a consumption tax on the polluting good and a specific capital tax (or subsidy) — and each jurisdiction chooses policy non-cooperatively (Nash equilibrium).

The main findings are: the Nash equilibrium always includes a consumption tax and generally a non-zero capital tax or subsidy. Consumption taxes create pollution leakage between jurisdictions; capital taxes/subsidies are used strategically to offset that leakage. Consumption taxes set non-cooperatively are lower than cooperative (socially optimal) levels, while Nash capital taxes/subsidies turn out to be efficient. When only one instrument is available, its Nash rate adjusts to handle both local pollution and leakage (e.g. consumption taxes are driven lower when capital taxes aren’t available). The presence of non-tradable goods is crucial: it is the price effects on local non-tradables and the resulting capital flows that generate strategic behaviour even for small open economies.

Key Points

Model: two asymmetric small jurisdictions, capital mobility, tradable and non-tradable goods, consumption-generated transboundary pollution.
Nash equilibrium typically requires a consumption tax equal to marginal pollution damage and a non-zero capital tax or subsidy to mitigate cross-border leakage.
Consumption taxes induce price changes in non-tradables that trigger capital flows and alter foreign consumption — the mechanism behind leakage and strategic capital policy.
Non-cooperative consumption taxes are inefficiently low relative to cooperative (joint-welfare) rates; Nash capital taxes/subsidies are efficient.
If only one instrument is available, its Nash level shifts to address both local pollution and leakage (e.g. consumption taxes fall when capital taxes can’t be used).
Non-tradable goods matter: without them, small economies cannot act strategically and Nash capital taxes would be zero.

Why should I read this?

Because it upends a neat rule-of-thumb: even tiny, price-taking economies can act strategically when non-tradable goods and mobile capital are in the mix. If you care about carbon taxes, leakage, border adjustments or small-state policy choices, this paper saves you several weeks of digging — it shows why consumption taxes alone can backfire and why pairing them with capital tax/subsidy tools matters. Punchy policy take: don’t rely on consumption taxes by themselves if you want to avoid leakage.

Context and relevance

This work speaks directly to current debates on carbon policy design, border carbon adjustments and how small countries (think Malta, Luxembourg, Cyprus) should respond to international climate commitments. It highlights a transmission channel often overlooked in trade-and-environment studies: tax-driven price effects on non-tradables that move capital and so reshape foreign consumption and emissions.

Practically, the study implies that policymakers should consider coordinated use of consumption taxes and capital taxes/subsidies to avoid strategic spillovers and inefficient outcomes. It also underlines the limits of treating non-tradable sectors as irrelevant in international environmental policy models — they can be a decisive channel for leakage and for strategic responses even among small economies.