The Political Economy of Climate Policies

Abstract

This paper analyzes the distributional and generational implications of a carbon tax versus a green subsidy. We find that the policies have substantially different consequences across the different groups, giving rise to a fundamental political economy problem.  In a heterogeneous agent New Keynesian (HANK) model with brown and green energy production and endogenous green innovation, we show that poorer households prefer the tax over the subsidy in the short run. A carbon tax causes a mild contraction in output and consumption, partially offset by the redistribution of tax revenues to households. Conversely, a green subsidy leads to a significant drop in consumption due to higher tax payments needed to finance the subsidy and crowding-out effects from substantially larger green R&D investment. The top 10% wealthiest households benefit from the subsidy, primarily through higher returns from dividends. However, a generational conflict arises ("tragedy of the horizon"): in the long run, the larger green R&D investment under the subsidy leads to higher productivity in the green sector, higher overall output, consumption, and welfare for all households - regardless of their wealth.

Keywords: Climate change, Heterogeneous agents, Fiscal Policy, Carbon tax

JEL Classification: C32, E52, E47