Environmental Regulations, Transfers, and Trade: Theory and Evidence

This paper develops a theory of compensation of producers for the costs associated with environmental regulations. We show that the existence of transfers can give counter-intuitive effects of environmental policy on both output and trade flows. In particular, the compensation obtained by producers neutralizes the effect of environmental policy on output, and consequently on trade flows. This may help explain why previous empirical research has found weak evidence that environmental regulations affect trade patterns. The theory is tested using agricultural sector data. The evidence supports the hypothesis that environmental regulations and transfers are positively correlated.