Pushing and Pulling Environmental Innovation: R&D Subsidies and Carbon Taxes

We use a novel modeling framework that incorporates free entry into the R&D sector and uncertainty about technological opportunity to evaluate three policy regimes (relative to laissez faire) designed to address a market with negative environmental externalities: a carbon tax, an R&D subsidy, and a mix of the two instruments. We show carbon taxes on their own are sufficient to obtain most of the welfare gains achieved by an optimal policy mix, and that the optimal carbon tax level is relatively robust to changing modeling assumptions, in contrast to optimal R&D subsidies. We also show R&D subsidies tend to produce more disperse outcomes than a carbon tax: either more R&D entrants (when technological opportunity is favorable) or none at all (when technological opportunity is unfavorable).