Pollution externalities and corrective taxes in a dynamic small open economy

This study examines the effects of tax policies in a dynamic model of a polluted small open economy with two sources of flow pollution—consumption and production—controlled by consumption and income taxes. In this setting, accumulated pollution negatively impacts households’ utility. We show that in a decentralized dynamic competitive equilibrium under exogenous tax rates, whereas a permanent increase in consumption and income taxes unambiguously reduces the steady-state pollution stock, a temporary increase in these taxes may lead to more pollution in the long run. This outcome suggests that more stringent environmental policies might be ineffective if the regulation is only temporary. We also derive the socially optimal solution and examine the optimal tax paths to achieve the social optimum. If distaste and leisure effects are sufficiently strong, tax rates decrease along the optimal path as pollution increases over time, and vice versa.