Carbon Taxation When Climate Affects Productivity

Abstract

Based on a model where climate change affects productivity, the second-best optimal carbon tax is found to exceed marginal social damage by 53% and “marginal private damage” (aggregate households’ willingness to pay) by 73%. Annual welfare gains are estimated at $3.58 billion when marginal damage is $40 per ton; employment also increases. A carbon tax set at the Pigouvian rate raises welfare by only $3.17 billion. The seemingly contradictory results from the “tax interaction” literature are shown to arise only when the optimal environmental tax is compared to “marginal private damage,” and only for an amenity externality. (JEL Q4, H2)