Optimal Climate Policy, Distortionary Taxation, and Public Debt

Rym Aloui and Hafedh Bouakez ()
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Hafedh Bouakez: HEC Montréal, 3000 Côte-Sainte-Catherine, Montréal, Québec, Canada

No 2519, Working Papers from Groupe d'Analyse et de Théorie Economique Lyon St-Étienne (GATE Lyon St-Étienne), Université de Lyon

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 debt-to-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: Distortionary Taxes; Optimal Carbon Tax; Public Debt; Revenue Recycling; Second Best; Sovereign Default (search for similar items in EconPapers)
JEL-codes: E62 H21 Q56 (search for similar items in EconPapers)
Date: 2025
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Related works:
Working Paper: Optimal Climate Policy, Distortionary Taxation, and Public Debt (2025)
Working Paper: Optimal Climate Policy, Distortionary Taxation, and Public Debt * (2025)
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