The purpose of this paper is to explore automobile fuel efficiency policies in the presence of two externalities: a global environmental problem and international innovation spillovers.
Using a simple model with two regions, the authors show that both a fuel tax and a tax on vehicles based on their fuel economy rating are needed to decentralize the first best.
If standards are used instead of taxes, the authors find that spillovers may alleviate free-riding. Under some conditions, a strict standard in one region may favor the adoption of a strict standard in the other one.
The authors also show that if policies are not coordinated between regions, the resulting gas taxes will be set too low and each region will use the tax on fuel rating to reduce the damage caused by foreign drivers.
