Optimal Climate Policy, Distortionary Taxation, and Public Debt

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.