Incentivizing Investors for a Greener Economy

Abstract

We propose the use of investment income taxes to incentivize investors to reallocate capital to the eco-friendly green sector away from the non-eco-friendly brown sector to reduce the climate change disaster which obliterates a fraction of capital in the economy. Compared with a Carbon tax on firms, investment income tax directly affects investors’ net returns and their capital allocation decision. Climate change disaster follows a Poisson process with intensity increasing in the fraction of capital allocated to the brown sector. The laissez-faire equilibrium is not Pareto efficient and brown (green) firms over-invest (under-invest) relative to the social optimum. We show that investment income tax can deliver the socially optimal allocation as effectively as the carbon tax, thus offer an additional policy tool to achieve a greener economy and reduce the climate change disaster risk.

Keywords: Climate change, investment income taxes, dynamic taxation, ESG investing

JEL Classification: G00, G30, Q54