NBER WORKING PAPER SERIES UNMASKING THE POLLUTION HAVEN EFFECT. Arik Levinson M. Scott Taylor. Working Paper

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1 NBER WORKING PAPER SERIES UNMASKING THE POLLUTION HAVEN EFFECT Ark Levnson M. Scott Taylor Workng Paper NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambrdge, MA July 2004 Ths research s part of a project funded by the Natonal Scence Foundaton grant # The authors are grateful to Wolfgang Keller, John Lst, Rod Ludema, Dan Mllmet and Mchael Rauscher for comments, and to Akto Matsumoto and Sjamsu Rahardja for research assstance. Taylor thanks the Prnceton Economcs department for ts hosptalty durng the tme he worked on ths paper, and the Vlas Trust at UW for fundng. The vews expressed heren are those of the author(s) and not necessarly those of the Natonal Bureau of Economc Research by Ark Levnson and M. Scott Taylor. All rghts reserved. Short sectons of text, not to exceed two paragraphs, may be quoted wthout explct permsson provded that full credt, ncludng notce, s gven to the source.

2 Unmaskng the Polluton Haven Effect Ark Levnson and M. Scott Taylor NBER Workng Paper No July 2004 JEL No. F18, Q38, H73 ABSTRACT Ths paper uses both theory and emprcal work to examne the effect of envronmental regulatons on trade flows. We develop a smple economc model to demonstrate how unobserved heterogenety, endogenety and aggregaton ssues bas measurements of the relatonshp between regulatory costs and trade. We apply an estmatng equaton derved from the model to data on U.S. regulatons and net trade flows among the U.S., Canada, and Mexco, for 130 manufacturng ndustres from 1977 to Our results ndcate that ndustres whose abatement costs ncreased most experenced the largest ncreases n net mports. For the 20 ndustres hardest ht by regulaton, the change n net mports we ascrbe to the ncrease n regulatory costs amounts to more than half of the total ncrease n trade volume over the perod. Ark Levnson Department of Economcs Georgetown Unversty Washngton, DC and NBER aml6@georgetown.edu M. Scott Taylor Department of Economcs Unversty of Wsconsn Madson, WI and NBER staylor@ssc.wsc.edu

3 Unmaskng the Polluton Haven Effect 1. Introducton All sdes n recent trade and envronmental polcy debates seem to share the vew that regulatory strngency n developed countres shfts pollutng ndustres to the developng world. Whle wdely beleved, ths "polluton haven effect" has proven dffcult to demonstrate emprcally. Some studes examne ndvdual plant locaton decsons, whle others study nternatonal trade. Untl recently, nether approach found sgnfcant evdence of a polluton haven effect. But most of these used cross-sectons of data, makng t dffcult to control for unobserved characterstcs of countres or ndustres that may be correlated wth both envronmental regulatons and economc actvty. A few recent studes have used panels of data and ndustry or country fxed effects, and have demonstrated small but statstcally sgnfcant polluton haven effects. 1 Ths paper employs both theoretcal and emprcal methods to uncover and estmate the magntude of the polluton haven effect whle smultaneously argung that prevous efforts suffer from both nadequate accountng for unobserved heterogenety and from the endogenety of polluton abatement cost measures. Explanatons for the falure to fnd a polluton haven effect often pont to the small fracton of costs represented by polluton abatement. Whle t s possble that more strngent envronmental regulatons have a small effect on frms' costs and nternatonal compettveness, t seems unlkely that more strngent regulatons would have no effect whatsoever. Ths explanaton s further undermned by frequent counter-ntutve emprcal results. Some researchers fnd larger and more sgnfcant polluton haven effects for less polluton-ntensve ndustres. A few even fnd evdence that ndustres wth relatvely hgh polluton abatement costs are leadng exporters. 2 In these cases, the Porter hypothess that regulaton brngs cost- 1 See, for example, Lst (2003), Becker and Henderson (2000), and Greenstone (2002) for recent papers on plant locatons, and Ederngton and Mner (2003) on nternatonal trade. Jaffe et al. (1995) survey the earler lterature, and Copeland and Taylor (2004) and Brunnermer and Levnson (2004) revew the newer studes. 2 See for example Kalt (1988), Grossman and Krueger (1993), or Osang and Nandy (2000). 1

4 reducng nnovaton s often nvoked as the explanaton for fndng a postve lnk between regulatory strngency and exports. 3 The current state of emprcal work leaves mportant questons unanswered. Many trade polcy analysts express concern that countres may undercut nternatonal tarff agreements by weakenng envronmental regulatons to placate domestc protectonst nterests. If ths s true, nternatonal trade negotators may need to close ths loophole by placng explct restrctons on the use of domestc envronmental polcy. Ths concern, however, rests on the assumpton that envronmental regulatons have sgnfcant cost and compettveness consequences a dsputed emprcal pont. In ths paper we re-examne the lnk between abatement costs and trade flows usng both theory and emprcs, n the hope of dentfyng and accountng for several mportant econometrc and data ssues. We beleve that these ssues and not the relatvely small costs of polluton abatement nor the Porter hypothess are responsble for the mxed results produced thus far. To do so we develop a smple, mult-sector, partal-equlbrum model where each manufacturng sector (.e. a 3-dgt SIC ndustry) s composed of many heterogeneous (4-dgt) ndustres. Sectors can dffer n ther use of prmary factors and n ther average polluton ntensty; one sector s producton could be captal ntensve and relatvely drty, whle another's s labor ntensve and relatvely clean. Industres wthn a sector dffer only n ther polluton ntensty, and two-way trade wthn each 3-dgt sector occurs because of these dfferences. We take factor prces and natonal ncomes as exogenous, and make no attempt to make envronmental polcy endogenous. We use ths smple model for three purposes. Frst, we derve an analytcal expresson for measured polluton abatement costs as a fracton of value-added. Ths statstc s wdely used as a measure of regulatory strngency n emprcal work estmatng the polluton haven effect. We show how ths measure s smultaneously determned wth trade flows, and demonstrate how unobserved changes n foregn costs, regulatons, or domestc ndustry attrbutes can produce a spurous negatve correlaton between the sector-wde polluton abatement costs and net mports. Ths correlaton s of course opposte to the drect effect predcted by the polluton haven hypothess, and suggests an explanaton for the dffcultes encountered by earler studes. 3 Porter (1995). 2

5 Second, we use the model to derve an estmatng equaton lnkng ndustry net mports to domestc and foregn measures of regulatons, factor costs and tarffs. We then estmate the polluton haven effect, takng account of the unavalablty of many control varables and the mplcatons of employng polluton abatement costs as a proxy for drect measures of regulaton. Thrd, our use of a theoretcal model forces us to be explct regardng our estmatng equaton s error term. We detal the set of condtons a successful nstrument must exhbt and then construct nstrumental varables relyng on the geographc dstrbuton of drty ndustres around the U.S. Geographc locaton has of course been used before as a source of exogenous varaton (see Frankel and Romer (1999) n partcular), but here t poses some new challenges because of the moblty of ndustres wthn the U.S. We then estmate the effect of regulatons on trade flows usng data on U.S. mports n 133 three-dgt manufacturng ndustres from Mexco and Canada over the perod. We are lmted n coverage by changes n SIC codes after 1987 and by the dscontnuaton of the polluton abatement cost data. Our emprcal results consstently show a postve, statstcally sgnfcant, and emprcally plausble relatonshp between ndustry polluton abatement costs and net mports nto the U.S. Ths s true for mports from both Mexco and Canada. In our fxed-effects estmatons we fnd that a 1 percent ncrease n polluton abatement costs s assocated wth a 0.2 percent ncrease n net mports from Mexco (or decrease n net exports), and a 0.4 percent ncrease n net mports from Canada. Our theoretcal model suggests several reasons why these fxed-effects estmates msmeasure the polluton haven effect, and n our nstrumental varables estmaton we fnd larger effects. The same 1 percent ncrease n polluton abatement costs predcts a 0.4 percent ncrease n net mports from Mexco and a 0.6 percent ncrease from Canada. To prevew the magntudes of the effects we are fndng, consder that the 20 three-dgt ndustres whose costs rose most from 1977 to 1986 experenced a 2.7 percentage pont ncrease n polluton abatement costs as a share of value added. Accordng to our fxed-effects results, ncreased envronmental costs, on average among these 20 hghly affected ndustres, were assocated wth a $38 mllon ncrease n net mports from Mexco. The nstrumental varables 3

6 results suggest an $85 mllon ncrease. For comparson, two-way trade wth Mexco n these same hardest-ht ndustres rose by an average of $143 mllon over the perod. Before descrbng the detals of these estmates, we need to outlne a model of trade and derve the estmatng equaton. Along the way, we wll pont out bases that may have affected prevous work usng smlar data. 2. A Model of Polluton Costs and Trade Consder two countres, "Home" and "Foregn," wth foregn attrbutes denoted by a star (*). Each country has dentcal technologes. The model s partal equlbrum, n the sense that factor prces and envronmental polces n the form of polluton taxes (τ,τ*) are exogenous. To generate a bass for trade arsng from dfferences n regulaton, we assume Home has more strngent regulatons: τ > τ*. In each country there are N sectors, ndexed by, and wthn each sector are many ndustres. Emprcally, "sectors" correspond to 3-dgt SIC codes and "ndustres" correspond to 4-dgt SIC codes. 4 We denote output avalable for sale or consumpton n the -th sector by x, and snce each sector contans numerous ndustres we denote ndustry output by x (η), where η s an ndex runnng from zero to one. We assume consumers spend a constant fracton of ther ncome on goods from each sector wth spendng shares gven by b. Consumers spread ths fracton of spendng across all ndustres wthn the x sector unformly. 2.1 Technologes and Abatement Producton s CRS and uses both labor L, and an ndustry-specfc factor K. Producton of output creates polluton as a byproduct, but frms have access to an abatement technology that can be used to reduce emssons. We assume frms can allocate part of ther factor use to abatement, and denote ths fracton by θ(η). Producton for sale n a typcal ndustry n the x sector s then (droppng the subscrpts for clarty) 4 Techncally, 3-dgt SIC codes are referred to as "ndustry groups." We use the term "sector" for convenence. 4

7 [ ] ( ) x( η) = 1 θη ( ) F K ( η), L ( η) (2.1) X X where F s ncreasng, strctly concave, and CRS, and η [0,1] labels ndustres wthn the x sector. Gven CRS and free entry, total revenue equals total costs, and snce there are no ntermedate goods, value added equals total revenues. Ths mples θ(η) s the share of polluton abatement costs n value added n ndustry η -- a commonly used emprcal measure of regulatory costs. Polluton emtted s a functon of total output and the abatement ntensty θ, ( ) ( ) z( η) = φθη ( ) F K ( η), L ( η) (2.2) X X where φ s a decreasng functon of θ. Wth no abatement, θ = 0, φ(0)=1, and by choce of unts, polluton emtted equals output : z = x =F(K,L). When abatement s actve, θ > 0 and polluton s reduced. 5 Followng Copeland and Taylor (2003) we adopt a specfc formulaton for φ( ) lettng ( θ) 1 α φ( θ) = 1, where 0<α<1. Then, assumng abatement s undertaken, we can employ equatons (2.1) and (2.2) to wrte output as f t were produced va a Cobb-Douglas functon of polluton emtted and tradtonal factors. [ ] 1 αη ( ) x = z F K L (2.3) αη ( ) ( η) ( η) ( X( η), X( η)). Fnally, t wll be helpful to rank the ndustres wthn each sector n terms of ther polluton ntensty, α(η), so that hgh-η ndustres are the most polluton-ntensve: α ( η) > See Copeland and Taylor (2003) chapter 2 for a smlar model and further detals on abatement. 6 When polluton taxes are costly relatve to abatement nputs, we can both (1) ensure that actve abatement occurs and (2) extend the rankng on the prmtve α(η) to ensure that polluton abatement costs as a fracton of valueadded and emssons per unt of output rse wth η. Snce these rankngs are mportant to our emprcal work we wll assume that ths s true throughout. 5

8 2.2 Wthn and Across-Sector Trade Patterns To determne whch set of ndustres s produced at home and abroad, we compare ther unt costs. From equaton (2.3), the unt cost functon for good x s αη ( ) c( η) k( η) τ c ( ) 1 α F ( η ) = (2.4) where k( η) α α (1 α) (1 α ) s an ndustry-specfc constant, and c F = c F (w,r ) s the unt cost of producng one unt of F, assumng the two factors of producton (K, L) sell at prces (w,r ). 7 A smlar unt cost functon descrbes foregn costs; hence, f good η s produced at home, free entry mples t must sell at prce (2.4). If t s produced abroad, t must sell at α η * F* ( ) ( ) c*( η) = k( η) τ c ( ) 1 α ( η ) (2.5) The Home country produces and exports all ndustres η such that c(η) c*(η). Industres η are produced domestcally f αη ( ) F c * 1 αη τ ( ) F* c τ Γ( η; ττ, *) Note by constructon the left sde of (2.6) s ndependent of η and only vares across sectors. The rght sde s fallng n η because we have assumed τ > τ* and ordered the ndustres such that α(η) s ncreasng n η. 8 Fgure 1a depcts the basc setup. The x 1 sector faces factor costs c 1 F at home and c 1 F* abroad, and polluton taxes τ and τ*. The functon Γ determnes the threshold ndustry η 1, defned by takng (2.6) wth equalty and solvng to fnd: (2.6) 7 Snce every sector has ts own specfc factor K we can be assured that both countres wll be actvely producng at least some ndustres n every sector. 8 To see ths, take the log of the rght sde and dfferentate. 6

9 F * * (, F c, ττ, ) η g c (2.7) Snce τ > τ*, Γ s declnng and ndustres to the left of η 1 have c(η) < c*(η). These ndustres are produced at home and exported. Industres to the rght of η 1 have c(η)* < c(η) and are produced abroad and mported. There s two-way trade wthn ths 3-dgt sector because of dfferences n comparatve advantage at the 4-dgt ndustry level. Havng solved for the margnal ndustry, η, we can now wrte Home net mports (mports mnus exports) n the x sector. Let b denote the fracton of ncome spent on x, and I and I* represent home and foregn aggregate ncomes respectvely. Home has ncome I, spends the fracton b on x, and of ths expendture the fracton 1 s spent on mported foregn goods. The foregn country lkewse spends the fracton b of ncome on x, has ncome I*, and of ths expendture the fracton η s used to purchase Home exports. Home net mports are thus: _ η _ Net Imports = bi[1 η ] bi* η (2.8) Equatons (2.7) and (2.8) gve us a relatonshp between trade flows and polluton regulatons by sector. By constructon the model allows trade flows to reflect both dfferences n factor endowments and regulatons. Dfferences across countres n ther abundance of prmary factors, captal, land or sklled human captal, wll be reflected n the relevant rato of home to foregn costs, (c F /c F* ), and hence trade patterns. Sectors may also dffer n ther polluton ntensty so that a very drty sector, J, wll have Γ J > Γ I for all η, even f frms n both I and J face the same polluton taxes. Despte ths, a country wth hgh polluton taxes may stll produce and export a large fracton of the world s drty J goods, and mport a large fracton of ts I goods, f the prmary factors used n J are relatvely cheap n the tghtly regulated country. By allowng sectors to dffer n ther use of prmary factors, we allow for the possblty that tght regulaton countres produce and export drty goods. But to capture the effect of regulaton on trade flows cleanly, we have assumed that wthn-sector trade s determned solely by relatve polluton taxes. Ths ensures that wthn each sector the drtest ndustres are located n the low regulaton country, and changes n polluton taxes alter the composton of the ndustres remanng at home 7

10 n a clear way. An ncrease n home polluton taxes decreases Γ() and moves η to the left n fgure 1a, ncreasng net mports. To examne ths relatonshp emprcally, we need to derve an estmatng equaton and dscuss several data-related complcatons. 3. From Theory to Estmaton Snce sectors dffer greatly n sze, emprcal work typcally scales net mports by domestc producton or value shpped. 9 In our model these are the same, and notng the value of domestc producton must be b η (I+I*), net mports n the x ndustral sector, scaled by domestc producton, s smply N I η ( I + I*) s = = 1 η( I + I*) η (3.1) where N s net mports over the value of producton, and s s Home s share of world ncome. Net mports n sector are postve so long as s > η ;.e. Home s a net mporter f ts share of world ncome exceeds ts share of world producton n x. Equaton (3.1) can be rewrtten as a lnear regresson, addng tme subscrpts, as t Nt β0 β1 η t where β 0 = -1 and β 1 =1. Then we can use (2.7) to rewrte (3.2) as s = + (3.2) N = β + β g c t t 0 1 F F* * Take a lnear approxmaton of (3.3), rewrtng t as: s ( t, ct, τt, τt ) (3.3) N = β + β s + β c + β c + β τ + β τ +ε (3.4) F F* * t 0 1 t 2 t 3 t 4 t 5 t t 9 Ths s to ensure that any excluded rght-hand-sde varable that s correlated wth ndustry sze does not automatcally contamnate the error. See Leamer and Levnsohn (1996) on ths pont. 8

11 where we have ntroduced the error ε t to reflect both approxmaton error n lnearzng (3.3) and standard measurement error n obtanng data on net mports, N t. The only component of foregn costs (c F *) that we observe emprcally s tarffs on foregn products, so we nclude those at the ndustry level and denote them by (T t ). We do not observe other components of (c F *) or foregn polluton taxes (τ*). To capture changes n Home s share of world ncome s t, and any other economy-wde change n the U.S. propensty to mport, we nclude a set of unrestrcted tme dummes (D t ) n our estmaton. In addton, we add sector dummes (D ) to control for sector-specfc but tme-nvarant dfferences n foregn and domestc unt costs. Snce we have a relatvely short panel, and the stocks of prmary factors such as physcal and human captal that determne (c F ) and (c F *) are only slowly movng, ndustry fxed effects may capture most f not all unobserved dfferences n the rato of home to foregn costs. Whle the typcal sources of comparatve advantage adjust slowly over tme, U.S. envronmental regulatons changed dramatcally over our sample perod, and dramatcally relatve to most tradng partners. Importantly, we do not observe domestc polluton taxes or other measures of envronmental regulaton to represent (τ t ). We do however observe polluton abatement costs as a fracton of value added (θ t ). Makng ths substtuton yelds our estmatng equaton: N N = aθ + bt + cd + d D + e t t t t t t = 1 t= 1 T (3.5) where we note the error term e t contans our orgnal measurement and approxmaton error reported n (3.4), plus any ndustry-specfc tme varyng elements of the rato c F * t /c F t not captured by our ndustry dummes, foregn polluton taxes τ t, and measurement error ntroduced by employng θ t rather than τ t. Ths observaton rases several econometrc ssues. 9

12 3.1 Econometrc Issues Because gettng drect measures of polluton taxes or ndustry-specfc polluton quotas for a broad spectrum of ndustres s nfeasble, researchers have reled on ndrect measures of strngency such as polluton abatement costs. To see one major problem wth ths approach, note that total revenues (at producer prces) for any ndustry n the x sector are gven by p(1-α )x. Total polluton abatement costs (PACs) are just a fracton of ths gven by p(1-α )x θ. 10 To fnd the sector-wde measure of PACs, ntegrate over all the ndustres n the x sector that are actve n the Home country: η 0 ( ) p( η) x( η) 1 α( η) θ( η) dη Total PACs as a share of value added (agan measured at producer prces) s η 0 ( ) p( η) x( η) 1 α( η) θ( η) dη η 0 ( ) p( η) x( η) 1 α( η) dη Snce spendng (p(η)x(η)) s a constant fracton (b ), of world ncome (I+I*), we can smplfy the above and wrte polluton abatement costs as a share of value added for the x sector as PAC θ( η) = VA η 0 (1 α( η)) θ( η) dη η 0 (1 α( η)) dη (3.6) _ where θ ( η ) s the fracton of value added n sector x that s spent on polluton abatement when the Home country produces goods n the range [0, η ]. 10 Producers pay the fracton α of revenues as polluton taxes (recall (2.4)) hence the producer prce, net of tax payments, s p(1-α). From (2.3) we have p(1-α)x=c F F. Polluton abatement costs are θc F F ; hence, polluton abatement costs can be wrtten θp(1-α)x. Polluton abatement costs as a fracton of value added are then just θ. 10

13 Once we ntroduce tme subscrpts, (3.6) s our proxy for τ t n (3.5). Because ths measure s readly avalable n the U.S. from the md-1970s untl 1996 t s also the measure of regulatory strngency used by numerous studes examnng the effect of polluton regulaton. Unfortunately the measure ntroduces several sgnfcant problems. To see why, t s useful to totally dfferentate (3.6) wth respect to a generc parameter y. Ths generc parameter could be anythng that affects trade flows across ndustres: transportaton costs, non-tarff barrers, factor costs, etc. Wth some rearrangement we fnd varaton n measured polluton costs comes from two sources. dθ = dy + η 0 0 η (1 αη ( )) ( dθη ( ) dy) dη η (1 αη ( )) dη 0 _ (1 αη ( ))[ θη ( ) θη ( )] dη (1 αη ( )) dη dy η 0 (1 αη ( )) dη 2 (3.7) The frst source of varaton s created by the change n abatement costs of exstng domestc ndustres (ths s the dθ/dy term ntegrated over [0, η ]). If the change n y rases polluton abatement costs at the ndustry level, then all the elements n ths frst ntegral are postve and our sector-wde measure rses. For example, f y represents the cost of factors used to abate polluton, the polluton abatement costs ncurred by those ndustres wthn sector ncrease, and our sector-wde measure of polluton costs ncreases. The second source of varaton s created by the change n the composton of domestc ndustres (ths s the term nvolvng dη /dy). The change n y wll lkely alter the threshold ndustry η. Snce θ(η) s ncreasng n η the ntegral n ths second term s postve and hence the sgn of ths term hnges on dη /dy. Measured polluton abatement costs rse when η rses because n ths case relatvely more pollutng ndustres are beng produced at home, rather than mported. Ths rases average polluton ntensty and polluton abatement costs at the sector 11

14 level. It s ths second term, the effect of changes n the composton of the sector, that causes econometrc problems. Loosely, the problems can be labeled "unobserved heterogenety," "unobserved foregn regulatons," and "aggregaton bas." 3.2 Unobserved Heterogenety One obvous problem confrontng emprcal work n ths lterature s the lkelhood of unobserved but fxed characterstcs of states/ndustres/countres that are correlated wth both the propensty to export and to pollute. As our dervaton of (3.5) makes clear, researchers typcally have only a subset of the potentally relevant covarates, and ths makes unobserved heterogenety a key problem. The bases nvolved n the effect of unobserved factors on measured polluton costs θ, calculated n (3.7), exacerbate ths problem. To demonstrate, suppose we compare two sectors, x 1 and x 2, depcted n fgure 1a. Assume that they face the same polluton taxes, are equally drty, and have dentcal costs at F home gven by c 1 = c F 2. They are observably equvalent to the econometrcan, but assume producton of x 2 n the foregn country s relatvely cheaper than x 1. That s, c F* 1 > c F* 2. Agan use (3.7) but now let dy be replaced by the change n foregn costs across sectors at a pont n tme. Foregn polluton taxes have no drect effect on home polluton abatement costs, and hence dθ(η)/dτ* = 0 for all η and the frst term n (3.7) s zero. From (3.7) we fnd: _ η F (1 αη ( ))[ θη ( ) θη ( )] dη (1 αη ( )) dη dc * dθ 0 = > 0 F 2 dc * η (1 αη ( )) dη 0 (3.8) measured polluton abatement costs wll be hgher n sector 1 than n sector 2 because _ η > _ η. 1 2 Ths s because sector 2 has hgher net mports, and the drtest ndustres n sector 2 are mported, and not counted n domestc polluton costs. Snce foregn costs are unknown, we only observe that sector x 1 has hgher polluton abatement costs and lower net mports than x 2 a seemng contradcton of a negatve lnk between envronmental control costs and compettveness. 12

15 Note that (3.8) establshes a theoretcal ratonale for a postve covarance between foregn costs of producton and home polluton abatement costs, and ths suggests the coeffcent on the polluton cost coeffcent s downwardly based. In fact, there s some evdence of ths symptom n exstng work. Grossman and Krueger s (1993) orgnal study of NAFTA found a negatve and sgnfcant relatonshp between polluton abatement costs and mports n some of ther cross-secton regressons. And several studes have reported a smaller coeffcent on polluton cost varables n resource-ntensve or drty ndustres than n other ndustres;.e. coeffcents are smaller n just those ndustres where unmeasured ndustry-specfc factors may loom large n determnng producton costs. To show that ths s a real concern n our data, consder Canada and Mexco (snce t s clear that these countres dffer n comparatve advantage vs-à-vs the U.S.). In table 1 we descrbe polluton abatement costs and net mports from Canada and Mexco for varous groups of U.S. ndustres, for the perod In the top panel of the table we report that the 20 sectors (3-dgt SIC codes) wth the lowest polluton abatement operatng costs (PAOC) spent 0.12 percent of ther value added on abatement. By contrast, the 20 sectors wth the hghest PAOC spent 4.8 percent. But column 2 of the table clearly shows that net mports from Mexco are hgher n those ndustres wth lower abatement costs, although ths dfference s not statstcally sgnfcant. For Canada, the pattern s reversed. Column 3 shows that the U.S. mports from Canada sgnfcantly more goods wth hgh polluton abatement costs. The top panel of table 1 thus seems to mply that the U.S. mports polluton-ntensve goods from a rch country (wth ostensbly tght regulaton) and clean goods from a poor developng country (wth presumably lax regulaton), belyng a lnk between envronmental control costs and nternatonal compettveness. Most lkely, these correlatons reflect the fact that Canada has an unobserved comparatve advantage n natural resource ndustres that are relatvely polluton ntensve, whle Mexco has an unobserved comparatve advantage n laborntensve and relatvely clean ndustres. 11 But ths trade pattern predcton s not nconsstent wth the result that ncreases n U.S. polluton abatement costs, ceters parbus, rase net mports from both countres at the margn: a polluton haven effect. 11 If true, ths would ft the results of Antweler et al. (2001) who argue that other motves for trade, n partcular captal abundance, more than offset the effect of polluton regulatons, leadng rch developed countres to have a comparatve advantage n many drty-good ndustres. 13

16 To confrm ths, n the bottom panel of table 2 we present the change n net mports for the 20 sectors whose polluton abatement costs ncreased least from 1977 to 1986, compared wth those whose polluton costs ncreased most. In contrast to the top panel, the sectors whose polluton costs ncreased most saw the largest ncrease n net mports from both Canada and Mexco. Though statstcally sgnfcant only for Canada, these results suggest a lnk between hgher envronmental control costs and ncreased net mports, whereas the top panel suggested the opposte. Table 1 only confrms that unobserved heterogenety drves much of the dfferences n trade patterns across ndustres. The problem hghlghted by equaton (3.8) and fgure 1a s that those unobserved ndustry dfferences wll bas emprcal fndngs aganst fndng a polluton haven effect. 3.3 Unobserved Foregn Envronmental Regulaton Next consder the emprcal consequences of not observng foregn polluton taxes. Equaton (3.6) demonstrated that θ t s functon of the threshold η. Meanwhle, the threshold s a functon of unobserved foregn polluton taxes, τ t * (recall (2.7)). Consequently, the error e t n (3.5) s almost surely correlated wth the rght-hand-sde varable θ t makng estmaton by OLS based and nconsstent. To nvestgate the drecton of the bas, consder (3.7). Agan, foregn polluton taxes have no drect effect on home polluton abatement costs and dθ(η)/dτ* = 0. The frst term n (3.7) s zero. But when foregn polluton taxes rse, the home country begns producng ndustres that were prevously mported, and dη /dτ > 0. Ths mples _ η (1 αη ( ))[ θη ( ) θη ( )] dη (1 αη ( )) dη dτ* dθ 0 = > 0 2 dτ * η (1 αη ( )) dη 0 (3.9) Measured sector-wde polluton abatement costs rse when foregn polluton taxes rse. 12 But from (3.1), we can conclude that when η rses net mports fall. Unobserved foregn polluton 12 In a full general equlbrum settng wth endogenous polcy settng, both Home factor costs and polluton taxes may vary, whch would add addtonal terms to consder. These complcatons would not, however, elmnate the term dscussed here. 14

17 taxes ntroduce a negatve correlaton between polluton abatement costs and net mports. More concretely, f home and foregn polluton taxes were the only tme-varyng determnants of net mports we could then use the standard omtted varable formula to conclude that β 4 n (3.4) s based downward, because β 5 s negatve and (3.9) establshes a postve covarance between the measure of home strngency and unobserved foregn polluton taxes. Whether ths covarance s postve n the data s unknown; nevertheless, our dscusson provdes a suggestve explanaton for the small or even counterntutve sgns found on polluton costs n prevous research. 3.4 Aggregaton bas A thrd problem wth estmatng (3.5) arses from the fact that the unt of observaton (3- dgt sectors) s a heterogeneous mx of 4-dgt ndustres. 13 Ths heterogenety means that when polluton taxes rse at home and rase producton costs, some of the ndustres lose out to foregn competton and shut down. If the ndustres most senstve to polluton taxes are n fact the drtest, then measured sector-wde polluton abatement costs fall from ths change n the composton of the ndustry. To demonstrate, replace y n (3.7) wth τ, to fnd: η (1 αη ( )) ( dθη ( ) dτ) dη dθ 0 = η dτ (1 αη ( )) dη 0 + η 0 _ (1 α( η))[ θ( η) θ( η)] dη (1 α( η)) dη dτ η 0 (1 αη ( )) dη 2 (3.10) The drect effect of an ncrease n the polluton tax s that ndustres at home respond by abatng more polluton, devotng a larger share of output to abatement, and ncreasng θ(η) for each ndustry η wthn sector x. Ths cost ncrease then drves up prces whch n turn lowers the 13 We recognze, of course, that 3-dgt SIC codes aggregate 4-dgt ndustres that are heterogeneous n many ways, not only polluton ntenstes. The econometrc ssues we descrbe here would apply equally f we were tryng to estmate, say, the effect of labor standards or captal costs on trade, and aggregatng across ndustry groups wth dfferent levels of labor and captal ntenstes. We can only hope that dfferences n these other characterstcs are of second order, relatve to the changes n polluton regulatons that occurred from 1977 to 1986, and that they can be absorbed by the ndustry fxed effects. 15

18 quantty demanded by foregners. Ths s the frst element n (3.10) and t rases θ n equaton (3.6). Ths frst (postve) element tells us what the measured change n sector-wde polluton abatement costs would be f we held constant the composton of ndustres. There s, however, a second effect, whch s depcted n fgure 1b. The ncrease n the polluton tax lowers the functon Γ, and as a consequence there s a new lower threshold ndustry η%. Industres between η% and η are now mported rather than beng produced domestcally. Snce these ndustres were the drtest produced n the x sector, ths second effect s negatve and t works to lower θ n equaton (3.6). 14 Polluton abatement costs n x have fallen, and net mports have rsen, another seemng volaton of the polluton haven hypothess. Ths second effect s essentally a form of endogenety. Studes seekng to measure the effect of polluton costs on trade nadvertently also capture the effect of trade on measured polluton costs. 15 To demonstrate ths aggregaton bas, n fgure 2 we plot polluton abatement operatng costs per dollar of value added n the U.S. manufacturng sector over These plots _ compare θ ( η ) from (3.6) where we allow ndustry composton wthn the -th sector to vary, _ t t wth θ ( η ) where ndustry composton s fxed wthn the -th sector. Our analyss of (3.10) t 1974 tells us that rsng home polluton taxes lower measured sector-wde costs by alterng the composton of the remanng ndustry (.e. the second term s strctly negatve). By fxng the composton of ndustry we should observe hgher sector-wde polluton abatement costs, as we are then only measurng the frst term. The bottom lne n fgure 2 shows the aggregate value for the entre manufacturng sector. It rses sharply through the late 1970s, and then remans relatvely flat. Note, however, that f the composton of U.S. manufacturng shfted away from pollutng ndustres, ths bottom lne understates what polluton abatement costs would have been had all ndustres remaned as they were n To see ths, the second lne n fgure 2 plots polluton abatement operatng costs, 14 There may be condtons under whch the second term s suffcently negatve as to make the overall dervatve negatve. We have not pursued ths possblty, because the exstence of the second negatve term s suffcent to generate an aggregaton bas. 15 In general though, the drecton of ths bas s unclear. In our model, an ncrease n polluton costs causes the most polluton-ntensve ndustres to move abroad, reducng the average polluton costs of the ndustres remanng at home, but t s unclear whether ths s true n the data. For example, some very drty natural resource ndustres may have lttle or no nternatonal moblty whereas relatvely clean assemblng operatons may move qute easly. 16

19 dvded by value added, where the composton of U.S. ndustres by 2-dgt SIC code s held constant as of Ths lne s hgher because U.S. manufacturng has shfted towards less pollutng 2-dgt ndustres. Smlarly, the thrd lne holds the ndustral composton constant at the 3-dgt SIC code level. It s hgher stll because wthn each 2-dgt ndustry, the composton has shfted towards less-pollutng three-dgt ndustres. We strongly suspect, but cannot prove because of data lmtatons, that a smlar process s at work at the 4-dgt level makng our 3- dgt sector-wde measures smlarly suspect. Furthermore, the problem cannot be solved by dsaggregatng, because any practcal ndustry defnton wll nclude heterogeneous subndustres that dffer n ther polluton ntenstes and ther propensty to be mported. Fgure 2 shows why polluton haven effects are so dffcult to observe. Aggregate measures of polluton abatement costs per dollar of value added understate the rse n regulatory strngency n the U.S., because the composton of output has become relatvely cleaner over tme. Whle we cannot say that ths change n composton s due solely to rsng U.S. polluton control costs, the change n composton alone poses a major problem for research on the effect of envronmental costs on trade: ndustres whose regulatons ncreased most are ncreasngly lkely to be mported, whch then lowers measured ncreases n polluton costs. Researchers tryng to estmate the effect of costs on trade can be msled by the effect of trade on measured costs. 4. Instruments The precedng secton has detaled the problems nvolved n estmatng (3.5): unobserved heterogenety, unobserved foregn polluton taxes, and aggregaton bas. Unobserved heterogenety s a well-recognzed ptfall, and s typcally solved by ncludng ndustry or country fxed effects, dependng on the unt of analyss. 16 Gven our panel, we nclude tme and ndustry fxed effects to soak up unobserved ndustry-specfc or tme-specfc excluded varables. Many of the unobservable ndustry characterstcs are very slow movng, 16 Of course, that mples that researchers have access to a panel of data over many years, somethng that s not always true. Several researchers have taken ths approach, and the results often do support a modest polluton haven effect. See, for example, Ederngton and Mner (2003), Ederngton et al. (2004). 17

20 ncludng sources of comparatve advantage that attract polluton-ntensve ndustres: geographc proxmty to markets, sources of raw materals, etc. By lookng at changes n net mports as a functon of changes n polluton abatement costs, we can dfference out the unobservable effects of ndustry characterstcs that reman constant. To address the other two problems, we adopt an nstrumental varables approach. 17 It s clear that our nstrument must have both tme and ndustry varaton; t must be correlated wth sector-wde polluton abatement cost measures; and t must be uncorrelated wth the ndustryspecfc tme varyng elements left n e t.. Usng (3.6) and (2.7) we can wrte sector-wde polluton abatement costs more generally as: F * * (, F c c,, ) θ =Ω τ τ t t t t t Snce domestc cost, foregn costs, and foregn taxes are unobserved, any tme and ndustryspecfc component of these s left n our error. Therefore, our nstrument must create ndependent varaton n abatement costs by alterng the home country's polluton regulaton. To fnd nstruments we proceed n several steps. Frst, we note that standard theores of regulaton relate the strngency of regulaton to the ncome levels of affected partes, the current level of polluton, and tastes. Hence, varaton n ncome levels, pollutant emssons or tastes are possble canddates. 18 However, these characterstcs are not ndustry-specfc. The second step then s to transform these aggregate characterstcs nto useful nstruments wth tme and ndustry varaton. To do so we employ two facts and make one assumpton. The frst fact s that much of U.S. envronmental polcy s set by states. As a result, varaton n state-level regulaton wll affect polluton abatement costs. The second fact s that the dstrbuton of ndustres across states s not unform: dfferent ndustres are concentrated n dfferent parts of the country. A consequence of these two facts s that some ndustres are predomnantly located n strngent states and face hgh polluton abatement costs; other ndustres are located n lax states and face low abatement costs. 17 Ederngton and Mner (2003) also nstrument for envronmental regulatory strngency n a paper that focuses on envronmental regulatons as a strategc substtute for trade restrctons. 18 See for example, Copeland and Taylor (2003, chapter 2). 18

21 To construct our nstruments, for each ndustry we take a weghted average of state characterstcs (q s ), where the weghts are the ndustry's value added n the varous states (v s ) at the begnnng of the sample perod. By usng begnnng-of-perod weghts, all varaton over tme comes from changes n state characterstcs. More concretely, for the 48 contguous U.S. states, our nstrument for the polluton costs faced by ndustry based on characterstc q, s 48 I = qv v (4.1) t st s,77,77 s= 1 where q st s the characterstc of state s n year t, v s,77 s the value added by ndustry n state s n , and v,77 = vs,77 s the sum of the value added of ndustry across all 48 contguous s= 1 states n To be a good nstrument I must be correlated wth the polluton abatement costs facng the x sector, whle smultaneously beng uncorrelated wth the error e t n (3.5). Take as gven that the state characterstc q st s strongly related to state-level regulatons and hence polluton abatement costs. And now recall that the error term n (3.5) contans measurement and approxmaton errors reported n (3.4), tme varyng sources of comparatve advantage c F * t /c F t, foregn polluton taxes τ t, and measurement error ntroduced by employng θ t rather than τ t. Snce we have ncluded both tme and ndustry dummes, only the tme-varyng and ndustryspecfc elements of these unobserved varables reman n our error term. Therefore, whether our nstruments are vald reles on there beng zero covarance between the remanng ndustryspecfc and tme varyng elements of e t and I t. Snce I t s just a (fxed) lnear functon of state characterstcs, ths smplfes to requrng that at each t we have cov(e t, q st ) = 0 for all s. In turn ths requres an assumpton: Assumpton 1. Industry-specfc shocks to costs, tarffs, foregn polluton taxes etc. that alter home ndustry producton are not large enough to nduce a change n the strngency of envronmental polcy n the states n whch ths ndustry resdes. Assumpton 1 s bascally a small ndustry assumpton. If t holds, then ndustry-specfc and tme-varyng shocks n each ndustry alter net mports n that ndustry, but do not affect envronmental strngency. We assume that states set the strngency of ther regulatons weghng 19

22 the margnal benefts and costs of tghter regulaton. A benefcal shock to ndustry wll rase the demand for ts output and ts derved demand for polluton; but f ths ndustry s share of emssons s small n ths state then the aggregate demand for polluton s vrtually unchanged. Industry-specfc shocks then have no effect on polluton demand. If ths ndustry s also small n provdng ncome to state resdents, then the shock wll have a neglgble effect on state ncomes as well and hence no mpact on margnal damage. Polluton supply s then unaffected by ndustry-specfc shocks. If the ndustry s small n both of these senses, then envronmental strngency can be thought of as beng ndependent of ndustry-specfc shocks. What are good canddates for the exogenous varaton we need to alter polluton abatement costs? We explot two basc sources of exogenous varaton. The frst arses when a set of ndustres (other than the -th) experences a shock. For example, suppose foregn costs rse n some set of ndustres we denote by J, and ths stmulates output n those sectors. Ths shock rases the compettve margn n the set of J ndustres, shfts polluton demand to the rght and rases polluton taxes for the -th sector. Abatement costs n the -th ndustry rse because of the shock n the j-th. To construct ths nstrument we need to construct measures of pollutants emtted n each state by all ndustres. The World Bank has estmated the polluton emssons per dollar of value added for each SIC code n the U.S. manufacturng sector, for 14 dfferent ar, water, and sold waste pollutants (Hettge et al., 1994). We use these fgures to estmate the total emssons of each of the 14 pollutants n each state, based on each ndustry's value added n each state n each year. Ths gves us 14 nstruments, where we are careful to exclude ndustry s contrbuton n ts own nstrument. Industres wth a hgh value of ths nstrument for a gven pollutant are located n states wth a large amount of that pollutant beng generated by other 3-dgt ndustres. Formally, the nstrument works as follows. For a gven pollutant E, say arborne partculates, we take the total amount predcted to be emtted n state s by all ndustres except ndustry. That gves us the amount of polluton n state s at tme t due to other ndustres. (Ths s the term n brackets n (4.2) below.) Then we take a weghted average of all 48 contguous states, where the weghts are ndustry 's value added n each state n That gves us our 20

23 nstrument, a measure of the amount of pollutant E contrbuted by other ndustres n the states n whch ndustry tends to locate. I E t = 48 Ejst V s= 1 j,77 ( Vs,77 ) (4.2) Industres that locate n states wth lots of polluton caused by other ndustres wll have hgh values of ths nstrument, and vce versa. Snce the World Bank cover 14 pollutants, we calculate a verson of (4.2) for each. Our second nstrument s based on polluton supply rather than polluton demand. State ncomes vary over tme because of ongong technologcal progress and factor accumulaton whch we take as exogenous to developments n ndustry. These gans may occur n servces, real estate, transportaton, mnng, agrculture or n other manufacturng ndustres. To the extent that these changes rase state ncomes they wll affect the demand for a clean envronment (polluton supply). Formally, we take a weghted average of the ncomes per capta n the states, where the weghts are ndustry 's value added n each state n I = 50 2 s= 1 t ( Income per captast ) ( Vs,77 ) V,77 (4.3) Industres located n states whose ncomes are growng faster wll have values of ths nstrument that ncrease over tme. 4.1 When mght the nstruments fal? Ths dscusson suggests our nstruments can fal n a couple of ways. Frst, our "small ndustry" assumpton may be untrue f any sngle ndustry can have a sgnfcant effect on the aggregate demand or supply of polluton. If changes n the ndustry's sze affect state envronmental polcy, then the nstrument fals. To nvestgate ths possblty, as a robustness test of our nstruments we dentfy those ndustres that represent more than 3 percent of gross 21

24 state product n any state, and elmnate those states from the constructon of the nstruments for those ndustres. Second, the geographc dsperson of ndustres among U.S. states may not be exogenous wth respect to trade. Trade agreements and fallng transportaton costs may make locatons closer to borders more attractve over tme, and ndustres may move to border states n order to trade wth Mexco and Canada. If drty and clean ndustres dffer n ther moblty, then there may be a drty-ndustry specfc but tme-varyng element to our error term. Snce the nstruments are constructed usng 1977 weghts, the movement of ndustry to take advantage of proxmty s not n tself a problem for our nstruments. The problem arses f the movement of ndustres s large so that states respond by changng envronmental polces. In that case, the ncrease n strngency n border states would be correlated wth the mproved compettveness of ndustres located there. To lessen ths concern, when studyng trade wth Mexco, we calculate the nstrument usng states that do not border Mexco. Smlarly, when studyng trade wth Canada, we calculate the nstrument usng only states that do not border Canada. 5. Data Data on mports and exports to and from the U.S. come from the Center for Internatonal Data (CID) mantaned by Feenstra (1996, 1997) at UC Davs. 19 These data are collected by the U.S. Bureau of the Census, and are organzed by ndustry accordng to the nternatonal Harmonzed Commodty and Codng System. The CID has matched these data wth the approprate SIC codes. Thus for each ndustry and for each country wth whch the U.S. trades we know the value of exports, the customs value of mports, and the total dutes pad. Data on polluton abatement costs come from the U.S. Census Bureau's Polluton Abatement Costs and Expendtures survey (PACE). The PACE data report the annual polluton abatement operatng costs, ncludng payments to governments, by ndustry. These data are publshed n Current Industral Reports: Polluton Abatement Costs and Expendtures, MA The CID can be found at 22

25 In constructng the data set for ths analyss, we confronted two sgnfcant obstacles. The frst nvolves the breakdown of publshed polluton abatement costs nto captal costs and operatng costs. The Census Bureau publshed both, but the captal cost data pose numerous problems. The PACE captal data are for new nvestment, not annualzed costs. Puzzlngly, abatement captal expendtures declned sgnfcantly as a share of value added, from around 0.8 percent n 1975 to 0.2 percent n There are several potental explanatons. One s, of course, the aggregaton bas dscussed above. If envronmental regulatons cause pollutng ndustres to relocate overseas, then nvestment n polluton control equpment could easly declne n the U.S. A second explanaton nvolves the type of captal. In the early years of polluton laws, most abatement captal conssted of "end-of-ppe" technologes. Over tme, however, abatement nvestment becomes ncreasngly dffcult to dsentangle from producton process changes that have lttle to do wth polluton abatement. Fnally, many envronmental regulatons grandfather exstng sources of polluton, and ths has the effect of stflng new abatement expendtures n exactly those ndustres most strctly regulated. For all these reasons, we focus on PACE operatng costs, whle notng that ths s only an mperfect proxy for the full costs of regulaton. The second sgnfcant data problem nvolves the defnton of an ndustry. In 1987 the SIC codes were substantally changed, makng tme-seres comparsons dffcult. Sx of the 3- dgt codes defned as of 1972 were elmnated, and 3 new codes added. The total number of 3- dgt SIC codes declned from 143 to 140. Of the 3-dgt codes that remaned, 37 were altered by changng the defnton of manufacturng ndustres wthn them. Some papers attempt to span the change n SIC codes n 1987 by applyng publshed concordances, so that the pre-1987 data are lsted accordng to post-1987 SIC codes, or vce versa. 20 These are typcally based on total output as of 1987, when the Census Bureau collected the data usng both SIC categorzatons. Two major problems arse under ths methodology. Frst, whle one may be able to attrbute x percent of the output of ndustry to ndustry j usng such a concordance, that percentage wll not lkely apply to polluton abatement expendtures. So convertng the post-1987 polluton abatement data to the pre-1987 SIC codes wll nevtably 20 For example, Bartelsman, Becker, and Gray (1996) mantan such a concordance at 23

26 attrbute some polluton expendtures to the wrong ndustres. Second, the 1987 concordance becomes ncreasngly rrelevant as ndustres change over tme. So whle x percent of ndustry 's output may be attrbutable to ndustry j n 1987, that wll not lkely be true by Consequently, we have lmted our study to the perod. Ths s the perod of fastest growth n polluton abatement operatng costs. 6. Emprcal Results The frst, and smplest, mplcaton of our dscusson so far s that cross-secton regressons of net mports on polluton abatement costs may be based by unobserved heterogenety. Fxed effects easly solve ths. 6.1 Fxed Effects In table 3 we present versons of equaton (3.5), the regresson analog to the dfferences of means at the top of table 1. In column (1) the dependent varable s net mports from Mexco dvded by valued shpped n the U.S. The polluton costs coeffcent s large and statstcally sgnfcant, suggestng that those ndustres n whch polluton abatement costs ncreased also saw ncreased mports from Mexco. Column (2) of table 4 presents the same specfcaton except that the dependent varable s net mports from Canada. In both cases we fnd a postve relatonshp between polluton abatement costs and net mports. In addton, mport tarffs lower net mports, although the coeffcents are not statstcally sgnfcant. Overall these results are sensble ncreases n abatement costs rase net mports and tarffs reduce them. Ths s a departure from much of the lterature that uses cross-sectons of data and fnds no evdence of a polluton haven effect. 21 To get a feel for the magntudes nvolved note that a one percentage-pont ncrease n the share of polluton abatement costs n an ndustry leads to a percentage-pont ncrease n net mports from Mexco and a 0.53 percentage-pont ncrease from Canada. Although the Canada coeffcent s eght tmes as large as that for Mexco, mports from Canada were seven tmes 21 We have also run cross-secton versons of table 3 wthout ndustry fxed effects and reproduced the lack of evdence for a polluton haven effect. Coeffcents on polluton costs are ether small and statstcally nsgnfcant, or are negatve. 24