Beyond Pigou: Climate Change Mitigation, Policy Making and Distortions

Abstract: This thesis consists of three essays.The first essay, “Optimal Carbon and Income Taxation”, analyzes carbon taxation while taking into account that taxes are set by national policy makers. I add two features, namely distortionary income taxation and lack of commitment to future policies, to a standard climate-economy model. I show that the optimal time-consistent carbon tax is in general not at the Pigouvian level, due to the presence of costs and benefits of emitting carbon that only materialize in the presence of income taxes. Quantitatively, I find a monotonic relationship between the size of this tax-interaction effect and the cost of climate change.The second essay, “Time-Consistent Unilateral Climate Policy”, studies unilateral climate change mitigation in a two-region model with distortionary income taxation and lack of commitment. I investigate how the European Union should regulate carbon emissions under the assumption that the rest of the world does not cooperate. When introducing income taxes into the model, the unilateral carbon tax rate falls by 50 percent. At the same time, the decline in economic activity leads to a considerable decrease in cumulative global emissions and thus mitigates climate change in the long run.The third essay, “Climate Change Mitigation under Political Instability”, investigates climate policy in a setting where the policy maker is subject to probabilistic political turnover. I show that an incumbent government that takes into account the possibility of losing power has an incentive to reduce emissions and invest more in clean energy relative to a corresponding myopic policy maker, independent of whether she derives more or less disutility from emitting carbon than a possible successor. Calibrating a model of the US, I find that having a strategic government results in a reduction of cumulative carbon emissions until 2100 that is equivalent to emissions being permanently 10 percent lower than in a business-as-usual scenario.