Optimal Climate Policy with Incomplete Markets

Thomas Douenne, Sebastian Dyrda, Albert Jan Hummel and Marcelo Pedroni

No 20820, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: How should governments design climate policies in the presence of inequality, uninsurable risk, and fiscal constraints? To address this question, we develop a climate—economy model with incomplete markets and idiosyncratic labor-income risk, where Ricardian equivalence fails and optimal long-run capital taxes are positive. We analytically show that the optimal carbon tax equals the social cost of carbon (SCC) adjusted for fiscal distortions. Calibrating the model to the U.S., we show that these deviations are quantitatively negligible: high levels of household inequality, income risk, and fiscal distortions do not, in themselves, justify lowering climate ambitions. Welfare gains under the optimal policy come almost entirely from efficiency and environmental amenities, with almost no effect on redistribution and insurance, and are fairly evenly distributed across households.

Keywords: Climate policy; Carbon taxes; Optimal taxation; Heterogeneous agents; Incomplete markets (search for similar items in EconPapers)
JEL-codes: D52 E62 H21 H23 Q5 (search for similar items in EconPapers)
Date: 2025-11
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