Optimal Fiscal Policy in a Climate-Economy Model with Heterogeneous Households

Thu, 01 Jan 2026 00:00:00 +0000

This paper asks whether inequality and redistributive taxation should make climate policy more or less ambitious, and how optimal carbon taxes interact with optimal income taxes when households differ in productivity, wealth, and energy demand. The motivation is twofold: equity considerations belong at the center of normative climate analysis, and the distributional consequences of environmental policies are increasingly recognized as critical for their political feasibility — as illustrated by the Yellow Vests episode in France. The paper extends Barrage (2020)’s representative-agent dynamic climate-Ramsey model to a heterogeneous-agent setting, using the Werning (2007) technique to characterize the Ramsey optimum in terms of aggregate variables. The government maximizes utilitarian social welfare choosing linear taxes on labor income, capital income, energy, and pollution plus a uniform lump-sum transfer. The climate module is calibrated to DICE 2016 (Nordhaus, 2017). Household heterogeneity is calibrated to US data: ten productivity groups from SCF 2013 hourly wages ranging from $6.44 (bottom decile) to $101.35 (top decile), yielding a model consumption Gini of 0.33, very close to the empirical value of 0.32 (Heathcote et al., 2010). Tax rates are set at effective US rates from Trabandt and Uhlig (2012): capital income tax of 41.1% and labor income tax of 25.5%. The model period is five years beginning in 2015, and the discount factor follows DICE at beta = 1/(1.015) per year, with inverse IES sigma = 1.45. The main quantitative exercise compares optimal policy to a climate-skeptic planner who sets carbon taxes to zero. Key findings: (i) Tax distortions have a negligible effect on the optimal carbon tax in the heterogeneous-agent setting. The second-best carbon tax is initially only 0.5% below the social cost of carbon (SCC) and subsequently fluctuates within about 0.2% above or below it — in sharp contrast to Barrage (2020), who finds tax distortions reduce optimal carbon taxes by 8% in the representative-agent setting. The key mechanism is that, with heterogeneous agents, the government optimally levies distortionary taxes for redistributive purposes (not merely to finance public spending), so the marginal cost of public funds (MCF) averages to 1 over time and its temporal deviations are quantitatively trivial. (ii) Income inequality only slightly reduces the optimal carbon tax: residual consumption inequality after optimal income-tax redistribution lowers the SCC by 3.9% in the baseline. The mechanism is that inequality raises the average marginal utility of consumption (because the marginal utility function is convex), increasing the opportunity cost of abatement; this effect dominates when IES < 1 (sigma > 1 in the calibration). (iii) The optimal carbon tax path starts at $21.7/tCO2 in 2020 and reaches $229.2/tCO2 one century later — levels consistent with Barrage (2020) and Nordhaus (2017/2018) but insufficient to achieve the Paris +2°C target under baseline damages. (iv) Comparing optimal policy to the climate-skeptic baseline, the additional carbon tax revenue is split nearly equally: the present value of labor taxes falls by 0.7% of GDP, while transfers rise by 0.8% of GDP. This violates the weak double-dividend hypothesis, which prescribes using carbon tax revenue exclusively to cut distortionary taxes. (v) The optimal policy has progressive welfare effects in the 21st century, because increased tax progressivity benefits lower-income households. The average discounted welfare gain is 5.8% of consumption under baseline damages. In the long run, gains become regressive because richer households (with IES < 1) are willing to pay proportionally more in consumption to avoid temperature increases. By contrast, a representative-agent double-dividend policy — using all carbon revenue to cut labor taxes — is regressive from the outset, with low-income households bearing a net cost even in the short run. The 3.9% inequality effect on the SCC is robust to changes in fiscal pressure and damage calibration but is sensitive to sigma: with sigma = 2, inequality reduces optimal carbon taxes by 16.2% rather than 3.9%. Extensions with wealth heterogeneity, heterogeneous energy demand (calibrated to CEX), and heterogeneous environmental damage sensitivity confirm that the MCF remains negligible and the inequality effect on carbon taxes remains small in quantitative terms.

Thomas Douenne | Macro Paper Warehouse

Optimal Fiscal Policy in a Climate-Economy Model with Heterogeneous Households