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This paper contributes to the theoretical understanding of strategic interactions of governments on global factor markets. We analyze carbon taxes and subsidies and their impact on national welfare in a two country model with markets for capital and fossil resources, and asymmetric resource en- dowments. We have four contributions. First, we show that resource poor countries have an incentive to tax the use of fossil fuels to appropriate the resource rent. Resource rich countries subsidize fossil fuel use to attract production factors in order to increase national income. Second, we demonstrate that capital mobility has a taming effect on the incentives to tax and to subsidize resources. When taxing resources not only affects the international resource market, but also the international capital market, taxation is more distortionary and is thus more costly to governments. Third, while early studies of asymmetric tax competition found that small countries in terms of population are winners of tax competition, we show that with asymmetric resource endowments but a symmetric population size, there are no winners. Then, the Nash equilibrium of carbon tax competition is the least desirable outcome in terms of social welfare. A game structure similar to a Prisoner’s Dilemma emerges and cooperation makes Pareto improvements over the Nash equilibrium possible. Fourth, we explore the distinction of strategic policy interaction in tax competition and tariff war.

Tax Competition With Asymmetric Endowments in Fossil Resources