First-best vs. Optimal Carbon Taxation

Alex Schmitt JMP: At what rate should a government tax carbon emissions? This paper analyzes optimal carbon taxation while taking into account that taxes are set by national policy makers. I add three real-world features to a standard climate-economy model, namely distortionary income taxation, lack of commitment to future policies, and no policy cooperation between regions. I find that in a calibrated two-region model, the optimal carbon tax decreases by more than half relative to the global first-best rate as a result of these features, assuming that a regional government only maximizes domestic welfare. The intuition for this result is twofold: first, under unilateral policy making, the government does not take into account climate damages to the rest of the world and therefore faces a lower welfare cost of emitting carbon. Second, resorting to distortionary income taxes reduces the optimal carbon tax further, partly because of a tax-interaction effect. This effect, which is caused by the presence of second-best costs and benefits of reducing emissions, drives a wedge between the optimal tax and the Pigouvian rate. In contrast, if the regional government maximizes global welfare, then the two distortions partially offset each other, resulting in an optimal carbon tax much closer to the global first-best rate.