Optimal Climate Policy, Distortionary Taxation, and Public Debt *

Rym Aloui () and Hafedh Bouakez ()
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Rym Aloui: UL2 UFR SEG - Université Lumière - Lyon 2 - UFR de Sciences économiques et de gestion - UL2 - Université Lumière - Lyon 2, GATE Lyon Saint-Étienne - Groupe d'Analyse et de Théorie Economique Lyon - Saint-Etienne - UL2 - Université Lumière - Lyon 2 - UJM - Université Jean Monnet - Saint-Étienne - EM - EMLyon Business School - CNRS - Centre National de la Recherche Scientifique
Hafedh Bouakez: HEC Montréal - HEC Montréal

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Abstract: We derive the (second-best) optimal long-run carbon tax in a polluted economy with preexisting tax distortions, where labor and capital income taxes adjust endogenously to changes in the ratio of public debt to GDP via pre-established fiscal rules, and sovereign debt carries default risk. Relative to the no-climate-policy scenario, the welfare-maximizing carbon tax lowers the debtto-GDP ratio as well as labor and capital income taxes, while raising consumption and GDP. The strength of these effects depends on the aggressiveness of the tax rules and on the initial level of public debt. When initial debt is low, the optimal carbon tax and the resulting increase in consumption, GDP, and welfare rise with the aggressiveness of the tax rules. When initial debt is high, however, this monotonic relationship breaks down, and the highest welfare gain from the optimal carbon levy is attained when the tax rules are moderately aggressive. This result hinges crucially on the convexity of the default probability with respect to the ratio of public debt to GDP.

Keywords: JEL Classification: E62 H21 Q56 Distortionary Taxes Optimal Carbon Tax Public Debt Revenue Recycling Second Best Sovereign Default; JEL Classification: E62; H21; Q56 Distortionary Taxes; Optimal Carbon Tax; Public Debt; Revenue Recycling; Second Best; Sovereign Default (search for similar items in EconPapers)
Date: 2025-09-01
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