We analyze the formation of environmental policy to regulate
transboundary pollution if governments are self-interested. In a common agency
framework, we portray the environmental policy calculus of two political support-
maximizing governments that are in a situation of strategic interaction with
respect to their environmental policies, but too small to affect world market
prices. We show how governments systematically deviate from socially optimal
environmental policies. Taxes may be too high if environmental interests and
pollution-intensity of production are very strong; under different constellations
they may be too low. Governments may actually subsidize the production of a
polluting good. Politically motivated environmental policy thus may be more
harmful to the environment as compared to the benevolent dictators’ solution. In
other cases it may enhance environmental quality and welfare beyond what a
benevolent government would achieve.