Carbon tax for emission targets - An alternative application of the DSGE model for optimal fossil fuel taxation by Golosov, Hassler, Krusell and Tsyvinski 2014

Abstract: Economists widely agree that a Pigouvian fee on emissions is the first best option to correct for the un-priced externality of climate change. However, scientific estimates of future global costs of climate change are varying. So are estimates of future carbon uptake and climate forcing as well as the estimated probability, timing and size of tipping points. Integrated assessment models are highly sensitive to these parameters and as a result are limited in their ability to precisely derive optimal policy choice. This study discusses the impact of multiple uncertainties in policy optimisation models on climate mitigation policy choice and suggests an alternative approach to IAM policy optimization, introducing an exogenous emission target in the place of carbon uptake and damage functions. This approach shifts model dependency on unknown parameters of the climate function to a dependency on parameters that are more frequently discussed in the policy context. Drawing from the general closed economy setting of Golosov et al, a fossil energy tax formula is developed that demonstrates that the optimal tax rate given a dynamic emissions target can be expressed as a function of the target, energy intensity of the economy, technology levels of the energy sectors, and substitutability of energy inputs, among others.