Robust Dynamic Optimal Taxation and Environmental Externalities

34 Pages Posted: 28 Jan 2014

See all articles by Xin Li

Xin Li

Rice University - Department of Economics

Borghan Narajabad

Board of Governors of the Federal Reserve System

Ted P. Loch-Temzelides

Rice University

Date Written: January 27, 2014

Abstract

We study a dynamic stochastic general equilibrium model where agents are concerned about model uncertainty regarding climate change. An externality from greenhouse gas emissions adversely affects the economy’s capital stock. We assume that the mapping from climate change to damages is subject to uncertainty, and we adapt and use techniques from robust control theory in order to study efficiency and optimal policy. We obtain a sharp analytical solution for the implied environmental externality, and we characterize dynamic optimal taxation. A small increase in the concern about model uncertainty can cause a significant drop in optimal energy extraction. The optimal tax which restores the social optimal allocation is Pigouvian. Under more general assumptions, we develop a recursive method and solve the model computationally. We find that the introduction of uncertainty matters qualitatively and quantitatively. We study optimal output growth in the presence and in the absence of concerns about uncertainty and find that these can lead to substantially different conclusions.

JEL Classification: N100

Suggested Citation

Li, Xin and Narajabad, Borghan and Loch-Temzelides, Ted P., Robust Dynamic Optimal Taxation and Environmental Externalities (January 27, 2014). CESifo Working Paper Series No. 4562, Available at SSRN: https://ssrn.com/abstract=2385878

Xin Li

Rice University - Department of Economics ( email )

6100 South Main Street
Houston, TX 77005
United States

Borghan Narajabad

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Ted P. Loch-Temzelides (Contact Author)

Rice University ( email )

99 Sunset Blvd
Houston, TX Texas 77005
United States

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