Green and Brown Lucas Trees

Abstract

We extend the two-tree model of Eberly and Wang (2011) to incorporate climate change disaster risk. We model disaster-risk as a Poisson shock that partially destroys both trees. The probability of a disaster occurring is an increasing function of the relative size of the brown to the green tree (i.e., the larger the fraction of the economy that is green, the less likely a climate disaster is to take place). The competitive equilibrium is not Pareto efficient. The social planner would implement a higher (lower) investment rate for the green (brown) tree than the competitive equilibrium. Optimal taxation is needed to achieve the social optimum. We propose a differential capital gains tax as a way to achieve this outcome. Brown firms would face a higher capital gains tax, thereby reducing their tobin's Q, and increasing their cost of capital. As a result, they would pay more dividends and invest less than their green counterparts. Such a policy constitutes a valid alternative to carbon-price taxing to mitigate climate change.

Keywords: Climate Finance, Cost of Capital, Optimal Taxation.