Pollution versus Inequality: Tradeoffs for Fiscal Policy

In this paper, we investigate the impact of redistribution and polluting commodity taxation on inequality and pollution in a dynamic setting. We build a two-sector Ramsey model with a green and a polluting good. Households are heterogeneous, which allows for income inequality, and have a level of subsistence consumption for the polluting commodity, modeled by non-homothetic preferences. Increasing the tax rate has a mixed effect depend on the level of subsistence consumption. A low level allows to tackle both the pollution and inequality issues. Under a high level of it, pollution increases: if inequality can be reduced through redistribution, taxation does not allow to solve for environmental degradation. Looking at the stability properties of the economy, we find that the level of subsistence consumption and the externality matter. A high subsistence level of polluting consumption leads to instability or indeterminacy of the steady-state, while the environmental externality plays a stabilizing role in the economy. This leaves room for taxation and redistribution: increasing the tax rate and redistributing more towards workers play a key role in the occurrence of indeterminacy and instability.