# **I. Introduction**

The seminal work of Grossman and Krueger (1992) ignited a debate on the impact of international trade on the environment. Originally fueled by negotiations over the North American Free Trade Agreement (NAFTA), the debate remains relevant as new bilateral and multilateral agreements are formed and environmental concerns continue to rise. This paper contributes to this recent literature by assessing the environmental implications of trade, specifically the pollution effects of the changes in production and trading patterns that followed the Dominican Republic–Central American Free Trade Agreement with the United States (DR-CAFTA).

The DR-CAFTA promotes commercial and financial integration among member countries. The agreement, passed by the US Congress on July 28, 2005, encompasses the United States and the Central American countries of Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua, and the Dominican Republic. DR-CAFTA’s main goal is to create a free-trade and investment zone for economic development, and includes several measures to regulate investment activities and to facilitate the exchange of goods and services. The Agreement has a complementary policy agenda addressing local competitiveness, property rights, labor, and environmental issues. On the environmental side, the Agreement emphasizes the monitoring and implementation of current environmental laws, but unlike NAFTA it pays less attention to the strengthening and harmonizing of unequal environmental standards among member countries.

The literature on trade and the environment discusses various channels through which trade liberalization (and trade agreements) can affect pollution emissions. On the one hand, empirical evidence indicates that trade liberalization can stimulate economic growth. Scaling up (holding constant the mix of goods produced and production techniques) leads to an increase in pollution (scale effects). On the other hand, trade liberalization changes relative prices by intensifying foreign competition. As a result, the structure of production is expected to change according to relative comparative advantages—defined by both factors of production and institutional arrangements. This effect can either increase or decrease relative output in pollution-intensive sectors (composition effects). Finally, changes in production technologies (including pollution intensity by unit of output) tend to follow trade liberalization (technique effects). Technique effects can result from different forces: while trade facilitates the access to more efficient (and cleaner) technologies, stronger competition can trigger a race to the bottom of environmental standards, favoring the adoption of cheaper and dirtier technology in the short run. Nevertheless, as income grows, the demand for environmental quality tends to increase. By adopting both tighter environment policies and more advanced, cleaner technologies, countries can afford to reduce emissions after reaching a certain level of income. This inverted-U relationship between per capita income and pollution is known as the environmental Kuznets curve<sup>2</sup> .

Previous empirical studies on the relationship between trade and the environment have found varying results. For example, Dean (2002) uses province-level data on water pollution from China and finds support for the idea that trade liberalization has both a direct and an indirect effect on emissions growth

> 2 Its proponents argue that environmental degradation is just a matter of ―growing pains‖ that will disappear with prosperity.

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