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Optimal Climate Policy with Incomplete Markets

Author

Listed:
  • Thomas Douenne
  • Sebastian Dyrda
  • Albert Jan Hummel
  • Marcelo Pedroni

Abstract

How should governments design climate policies in the presence of inequality, uninsurable risk, and fiscal constraints? To address this question, we develop a climate--economy model with incomplete markets and idiosyncratic labor-income risk, where Ricardian equivalence fails and optimal long-run capital taxes are positive, leading to important inter-temporal wedges. We analytically show that the optimal carbon tax equals the social cost of carbon (SCC) adjusted for fiscal distortions. Calibrating the model to the U.S., we show that these adjustments are quantitatively negligible: high levels of household inequality, income risk, and fiscal distortions do not, in themselves, justify lowering climate ambitions. Welfare gains under the optimal policy come almost entirely from efficiency and environmental amenities, with almost no effect on redistribution and insurance, and are fairly evenly distributed across households.

Suggested Citation

  • Thomas Douenne & Sebastian Dyrda & Albert Jan Hummel & Marcelo Pedroni, 2025. "Optimal Climate Policy with Incomplete Markets," Working Papers tecipa-807, University of Toronto, Department of Economics.
    • Handle: RePEc:tor:tecipa:tecipa-807
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    Keywords

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    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H23 - Public Economics - - Taxation, Subsidies, and Revenue - - - Externalities; Redistributive Effects; Environmental Taxes and Subsidies
    • Q5 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets

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