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Seminar: Optimal Dynamic Carbon Taxes in a Climate-Economy Model with Distortionary Fiscal Policy

Date(s): April 30, 2015, 1:30-3:00 PM

Location: Room 4128, William Jefferson Clinton West Building, 1301 Constitution Ave., NW, Washington, DC

Contact: Carl Pasurka, 202-566-2275

Presenter(s): Lint Barrage (Department of Agricultural & Resource Economics, Univ. of Maryland)

Description: How should carbon be taxed as a part of fiscal policy? The literature on optimal carbon taxes often abstracts from other taxes. However, when governments raise revenues with distortionary taxes, carbon levies have fiscal impacts. While they raise revenues directly, they may shrink the bases of other taxes (e.g., by decreasing employment). This paper theoretically characterizes and then quantifies optimal carbon tax schedules in a climate-economy model with distortionary fiscal policy. The macroeconomic setup is a dynamic general equilibrium model with linear taxation. The environmental setup uses the state-of-the-art representation of the carbon cycle and climate-economy feedbacks based on the DICE framework. First, this paper establishes a novel theoretical relationship between the optimal taxation of carbon and of capital income. This link arises because carbon emissions destroy natural capital: They accumulate in the atmosphere and decrease future output. Consequently, this paper shows how the standard logic against capital income taxes extends to environmental capital. Quantitatively, the welfare costs of distorting investment by taxing capital income or by not taxing carbon are both large ($30 and $40 trillion, respectively, $2005 lump-sum consumption equivalent). Second, this study demonstrates that optimal carbon taxes must internalize climate change production impacts (e.g., on agriculture) and direct utility impacts (e.g., on biodiversity existence value) differently. Third, this paper compares the setting with distortionary taxes to the setting with lump-sum taxes considered in the literature. The central quantitative finding is that optimal carbon tax schedules are 8%-30% lower when there are distortionary taxes. This adjustment produces a global welfare gain of $190 billion to $2.8 trillion, depending on the structure of income taxes.

Seminar Category: Climate Economics