Association for Public Policy Analysis & Management

Though carbon dioxide emissions have implications for both national and international policy, they are by-and-large the result of decisions made at a more micro-level. Beginning from this standpoint I model the United States economy in a micro-founded dynamic stochastic general equilibrium (DSGE) framework that includes market imperfections and frictions in the form of monopolistic competition, labor income taxation, and menu-costs. Within this second-best setting the question of optimal carbon taxation and revenue recycling is addressed using a dynamic rules-based policy instrument.

Optimal environmental taxation has long been a focus of study in the economic literature. Despite the fervor surrounding major economic policies to reduce carbon dioxide there is still a lack of consensus among politicians and economists alike on the optimal path to take with regards to pollution taxation – and even less consensus on whether or not the revenues gained by such a tax should be used to reduce pre-existing distortionary taxes, i.e., the so-called double dividend. 

Because carbon dioxide emissions (CO₂) are a trans-boundary pollutant, their regulation and control tends naturally to be that of a macroeconomic problem. CO₂ emissions, however, are the result of individual firm and consumer actions and are thusly a macro-effect that is the result of micro-motives. This is one reason that DSGE modeling is a particularly robust setting to analyze optimal taxation. The DSGE framework allows the examination of policy in the context of an economy in which forward-looking consumers maximize utility, firms have market power, there are labor market frictions due to taxation, there are nominal frictions in price adjustment, and the economy fluctuates along the real business cycle. Further, by simulating exogenous shocks to productivity and the price of energy an optimal tax policy that minimizes welfare loss can be calculated. Results from this simulation can be used to inform policy makers on the possible effects of implementing a new CO₂ tax policy.

Using a micro-founded DSGE model I find that a tax on CO₂ should be dynamic and should change according to the state of the economy and the price of energy, and that revenues should be returned to consumers as a lump-sum payment. Consumers may be averse to a tax rate that changes over time, though, and they may even see the tax as capriciously changing at the policymakers’ whim. To that end I develop a rules-based tax that is simple to calculate and based on readily available macroeconomic aggregates. Bridging the gap between theory and policy is important and a contribution of this paper is to interpret the optimal dynamic tax into a form that can readily be implemented and to test the resulting welfare effects of introducing this tax. In a sense the tax proposed here is equivalent to an environmental-Taylor rule that is predictable and formulaic. Using a measure of compensating variation I find that consumers are made better off following the implementation of the rules-based dynamic tax; even when consumers are not directly affected by emissions.