We present a three-sector general equilibrium model with an informal sector, which produces an intermediate input for the formal sector, and analyze the effects of different policies on the environmental standard and welfare of the economy. Since the informal manufacturing sector creates pollution, higher the use of the informal sector's
product, higher is the pollution created and higher the discrepancy between the actual and the permissible levels of pollution, so that the emission tax payable by the formal sector is also higher. The efficiency of a representative worker is inversely related to the level of pollution. In this setup, we show that even if the permissible level of pollution is reduced, the polluting sector may expand and worsen the environmental standard. However, this policy may be welfare improving. On the other hand, an inflow of foreign capital may reduce the pollution level but affect welfare adversely. The paper finds that there might exist a trade-off between the economy's twin objectives of lowering the level of pollution and improving national welfare. These results are new in the trade and environment literature.