DDP 763. Maurizio Bussolo, Clifford Zinnes, and Sébastien Dessus. "Economic Instruments, the Environment, and Regional Trade Agreements: A CGE Analysis of El Salvador in the First Decade of the 21^st Century." June 2000. 49 pp. Central America Project Series

We consider the challenge facing countries today to be how to design an environmental regulatory regime that supports sustainable yet competitive trade-driven growth, given the trend toward regional trade agreements. Using a computable general equilibrium (CGE) approach for the case of El Salvador we examine the long-term effects of "command-and-control" environmental policy under hemispheric trade integration scenarios including (i) a "slow improvement" in trade volumes, (ii) a "NAFTA diversion" scenario, and (iii) a regional "Trade integration" scenario. These scenarios yield very different patterns of manufactures and primary goods production and therefore sectoral emissions. We take as our indicators 13 types of air, water, and soil discharge streams and compare simulations for the period 1996-2010 where an emission charge is set so that in the final year a 25-percent reduction of the relevant emission is achieved with respect to the scenario without the charge.

Under status quo policies, resources are excessively drawn into the dirtier sectors, with emissions growth rates often exceeding production growth rates by 30 percent. We find that economic instruments-based policies actually reduce emissions growth to rates below that of production and consumption growth. The tax effects were most pronounced under the "Trade integration" case. We also show that the cost in terms of output foregone is rather small with the worst cases yielding a 0.4-percentage point loss in the annual rate of growth. In a number of experiments the pro-environment policies actually promoted GDP growth, raising the rate by 0.3 percentage points. This is due to the stimulation of savings – and therefore investment – from the lump-sum transfers we use to recycle tax revenue and due to strong composition effects of trade led-growth. We also found that pollution charges on one emission type had strong complementary reduction effects across other emission streams. These results clearly justify both the CGE approach as well as the use of environmental charges as a critical part of El Salvador’s policy agenda for the 21^st Century.

Keywords: El Salvador, NAFTA, computable general equilibrium models, economic instruments, regional integration, trade and environment linkages.

JEL Codes: F1, H2, O2, O5, Q0

Please send all correspondence to C. Zinnes at czinnes@hiid.harvard.edu or at HIID, 14 Story Street, Cambridge, MA. The authors wish to express their appreciation to Theodore Panayotou for suggesting the topic, to Francisco Acosta for research assistance, and to Jose Tavares for comments on the trade scenario. All errors and omissions are those of the authors. The results and opinions expressed herein do not necessarily reflect those of the authors’ host institutions.

* Overseas Development Institute, London, England

**Harvard Institute for International Development, Cambridge, MA

***OECD Development Centre, Paris, France