Pareto Improving Reforms in the Presence of Spillovers and Spillbacks

In this paper, we contribute to the topical debate on the welfare effects of a centralised policy setting within the federal union in the presence of transboundary externalities that affect production possibilities. It is shown that when the production of federal jurisdictions generates spillover effects, which in turn result in spillback effects, then harmonisation of their public policies towards the uniform optimal cooperative level does not ensure welfare improvement for the federation. We analyse and identify federal policies harmonising reforms that deliver Pareto improvement in the presence of spillback in addition to spillover effects. These reforms are designed to neutralise all the spillback effects by maintaining the aggregate level of spillover effects constant, while increase the welfare of the federation. This result holds irrespective of the nature and sign of the spillover and spillback effects as well as for both small and large open economies, where cross-border externalities coexist with terms of trade externalities that arise through market power in international commodity markets.