Robust Dynamic Optimal Taxation and Environmental Externalities

38 Pages Posted: 17 Oct 2014

See all articles by Xin Li

Xin Li

International Monetary Fund (IMF)

Borghan Narajabad

Board of Governors of the Federal Reserve System

Ted P. Loch-Temzelides

Rice University

Multiple version iconThere are 2 versions of this paper

Date Written: May 29, 2014

Abstract

We study a dynamic stochastic general equilibrium model in which agents are concerned about model uncertainty regarding climate change. An externality from greenhouse gas emissions damages the economy's capital stock. We assume that the mapping from climate change to damages is subject to uncertainty, and we use robust control theory techniques to study efficiency and optimal policy. We obtain a sharp analytical solution for the implied environmental externality and characterize dynamic optimal taxation. A small increase in the concern about model uncertainty can cause a significant drop in optimal fossil fuel use. The optimal tax that restores the socially 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 concerns can lead to substantially different conclusions.

Keywords: Climate change, optimal dynamic taxation, uncertainty, robustness

JEL Classification: Q54, Q21, Q58, Q48, D81

Suggested Citation

Li, Xin and Narajabad, Borghan and Loch-Temzelides, Ted P., Robust Dynamic Optimal Taxation and Environmental Externalities (May 29, 2014). FEDS Working Paper No. 2014-75, Available at SSRN: https://ssrn.com/abstract=2503516 or http://dx.doi.org/10.2139/ssrn.2503516

Xin Li

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Borghan Narajabad (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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

Ted P. Loch-Temzelides

Rice University ( email )

99 Sunset Blvd
Houston, TX Texas 77005
United States

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