Optimal environmental policy and distortionary fiscal policy interactions: A DSGE perspective

Mehrab Kiarsi and Nahid Masoudi

Economic Modelling, 2025, vol. 147, issue C

Abstract: This study examines the interactions between optimal environmental and distortionary fiscal policies within a dynamic stochastic general equilibrium (DSGE) framework using analytical and quantitative methods. We demonstrate that the marginal cost of public funds can exceed, be equal, or fall below one, based on utility specifications and the degree of relative risk aversion. This variation can lead to under-, over-, or optimally taxed environmental damages, with the latter two suggesting the potential for a strong double dividend. Furthermore, we challenge conventional labor tax smoothing theory, showing that a Ramsey-optimal policy allows labor tax volatility in the absence of carbon taxation. Our quantitative analysis reveals that an effective carbon policy reduces fluctuations and significantly mitigates contractions in major economic variables such as GDP, consumption, and welfare in response to environmental shocks. Increased pollution leads to higher emission costs, prompting the Ramsey planner to raise the carbon tax and increase abatement efforts. However, positive government spending or productivity shocks increase the cost of abatement, leading to lower carbon taxes.

Keywords: Optimal carbon tax; DSGE models; Integrated assessment model; Distortionary tax; Ramsey dynamics (search for similar items in EconPapers)
JEL-codes: E58 E61 E62 H21 Q54 Q58 (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:147:y:2025:i:c:s026499932500032x

DOI: 10.1016/j.econmod.2025.107037

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