Natural resources, federal tax changes, and environmental regulation: Can contractionary fiscal policies increase air pollution?

We find that, in environmentally regulated yet natural resource rich economies, in which polluting capital is immobile, the answer to the above question is in the affirmative, contrasting a widely held view. We construct a federalism model of heterogeneous vertical tax externalities and horizontal tax competition, with asymmetries in resource richness, and a polluting and immobile extracting sector. The model shows that a federal tax hike redistributes clean capital towards environmentally regulated resource rich economies, as they are able to better absorb this hike due to their (resource-driven) fiscal advantage, raising air pollution by complementing production in the immobile extractive sector. We test the model’s predictions using a panel of U.S. non-attainment counties, regulated under the 1970 Clean Air Act, over the period 1981-2007. Our identification strategy rests on geologically-based differences in natural endowments, and narrative-based measures of federal tax changes. We find that federal tax hikes increase air pollution in non-attainment counties within resource-rich states, although these fiscal policies are contractionary and environmental regulation is at place. Our results shed light on the externalities of natural resource abundance, and the efficacy of existing environmental regulation.