Environmental Regulation, Pollution Emissions and the Current Account

Abstract

Abstract We develop a dynamic general equilibrium model to explain the impact of environmental regulation, in a form of pollution tax, on the current account. The model predicts that lower pollution tax will increase the output and consumption of tradable goods and the total output, and appreciate the real exchange rate, but have no impact on the output and consumption of nontradable goods. Although the impact of pollution tax on the level of the current account is uncertain, we find that its impact on the current account-total output ratio depends on net foreign asset in the last period. If net foreign asset in the last period is positive, lower pollution tax and consequently more pollution emissions tend to decrease the current account-total output ratio. Otherwise, it will increase the ratio. Empirical evidence from 156 economies (1980–2018) shows a statistically and economically significant negative impact of pollution emissions on the current account-total output ratio when the last period’s net foreign asset is positive. This is especially true for higher-income economies. However, the positive impact is statistically insignificant when the last period’s net foreign asset is negative. In general, empirical evidence is consistent with the model’s prediction. In addition, we also find that the negative impact of pollution emissions on the current account-total output ratio is channeled by the real exchange rate appreciation caused by lower pollution tax. JEL Classification: F18, F32, Q28