Carbon taxes around the world: cooperation, strategic interactions, and spillovers

We examine the global implications of carbon taxation using a two-country environmental DSGE model, with a specific focus on the strategic interactions between countries, the case for cooperation, and the impact on the balance of payments. From a normative perspective, we show that, assuming a convex disutility of pollution, carbon taxes are strategic substitutes across countries: when one country increases carbon taxation, the other country finds it optimal to reduce it. From a positive perspective, a country imposing unilateral carbon taxation experiences a reduction in its production, a decrease in its interest rates, a depreciation of its currency on impact and an appreciation thereafter, higher debt, and equity outflows to the rest of the world.