Making Carbon Taxation a Generational Win Win

May 2, 2019

By Laurence J. Kotlikoff, Felix Kubler, Andrey Polbin, Jeffrey D. Sachs and Simon Scheidegger

Carbon taxation has been studied primarily in social planner or infinitely lived agent models, which trade off the welfare of future and current generations. Such frameworks obscure the potential for carbon taxation to produce a generational win-win. This paper develops a large-scale, dynamic 55-period, OLG model to calculate the carbon tax policy delivering the highest uniform welfare gain to all generations. The OLG framework, with its selfish generations, seems far more natural for studying climate damage. Our model features coal, oil, and gas, each extracted subject to increasing costs, a clean energy sector, technical and demographic change, and Nordhaus (2017)’s temperature/damage functions. Our model’s optimal uniform welfare increasing (UWI) carbon tax starts at $30 tax, rises annually at 1.5 percent and raises the welfare of all current and future generations by 0.73 percent on a consumption-equivalent basis. Sharing efficiency gains evenly requires, however, taxing future generations by as much as 8.1 percent and subsidizing early generations by as much as 1.2 percent of lifetime consumption. Without such redistribution (the Nordhaus “optimum”), the carbon tax constitutes a win-lose policy with current generations experiencing an up to 0.84 percent welfare loss and future generations experiencing an up to 7.54 percent welfare gain. With a six-times larger damage function, the optimal UWI initial carbon tax is $70, again rising annually at 1.5 percent. This policy raises all generations’ welfare by almost 5 percent. However, doing so requires levying taxes on and giving transfers to future and current generations ranging up to 50.1 percent and 10.3 percent of their lifetime consumption. Delaying carbon policy, for 20 years, reduces efficiency gains roughly in half.

As has been amply documented in the news during the last months, concern about climate change is to a large extend a generational issue. To win over the older generation, the deal needs to be sweetened for them. This paper shows how. An important step, though, it to get them to understand carbon pricing, which may be an even bigger challenge.


Labor Mobility in a Monetary Union

April 27, 2019

By Daniela Hauser; Martin Seneca

The optimal currency literature has stressed the importance of labor mobility as a precondition for the success of monetary unions. But only a few studies formally link labor mobility to macroeconomic adjustment and policy. In this paper, we study macroeconomic dynamics and optimal monetary policy in an economy with cyclical labor flows across two distinct regions that share trade links and a common monetary framework. In our New Keynesian dynamic, stochastic, general-equilibrium model calibrated to the United States, migration flows are driven by fluctuations in the relative labor market performance across the monetary union. While labor mobility can be an additional channel for cross-regional spillovers as well as a regional shock absorber, we find that a mobile labor force closes the efficiency gaps in the labor market and thus lessens the trade-off between inflation and labor market stabilization. As migration flows are generally inefficient, however, regionspecific disturbances introduce additional trade-offs with regional labor market conditions. Putting some weight on stabilizing fluctuations in the labor market enhances welfare when monetary policy follows a simple rule.

The US is the closest we can get to perfect labor mobility, and yet it is not sufficient for a monetary union, the central bank still needs to make adjustments for labor market frictions. How much worse is it in other monetary unions, such as Europe and the various African ones, or within some of the other large countries?

Fiscal Policy Multipliers in Small States

April 25, 2019

By Ali Alichi, Ippei Shibata and Kadir Tanyeri

Government debt in many small states has risen beyond sustainable levels and some governments are considering fiscal consolidation. This paper estimates fiscal policy multipliers for small states using two distinct models: an empirical forecast error model with data from 23 small states across the world; and a Dynamic Stochastic General Equilibrium (DSGE) model calibrated to a hypothetical small state’s economy. The results suggest that fiscal policy using government current primary spending is ineffective, but using government investment is very potent in small states in affecting the level of their GDP over the medium term. These results are robust to different model specifications and characteristics of small states. Inability to affect GDP using current primary spending could be frustrating for policymakers when an expansionary policy is needed, but encouraging at the current juncture when many governments are considering fiscal consolidation. For the short term, however, multipliers for government current primary spending are larger and affected by imports as share of GDP, level of government debt, and position of the economy in the business cycle, among other factors.

Rarely is the (fixed) exogenous assumption of the small country model more applicable than in this paper looking micro-states. Yet, I sense from the results (comparing debt and interest on debt) that the interest rate is not constant in this model. I wonder how this is motivated in the IMF’s DSGE model. Also, speaking of fiscal policy in micro-states, clearly they are also driven by fiscal haven considerations, i.e., a game with the rest of the world trying to attract mobile income and wealth. I do not think the model captures this either, and I am not expecting it to do so, but this seems to be an important consideration for this particular application.

Policy Trade-Offs in Building Resilience to Natural Disasters: The Case of St. Lucia

April 17, 2019

BY Alessandro Cantelmo; Leo Bonato; Giovanni Melina; Gonzalo Salinas

Resilience to climate change and natural disasters hinges on two fundamental elements: financial protection —insurance and self-insurance— and structural protection —investment in adaptation. Using a dynamic general equilibrium model calibrated to the St. Lucia’s economy, this paper shows that both strategies considerably reduce the output loss from natural disasters and studies the conditions under which each of the two strategies provides the best protection. While structural protection normally delivers a larger payoff because of its direct dampening effect on the cost of disasters, financial protection is superior when liquidity constraints limit the ability of the government to rebuild public capital promptly. The estimated trade-off is very sensitive to the efficiency of public investment.

This paper shows how far DGE modelling has strayed from studying business cycles in the US. This one is about studying climate change and natural disasters in a Caribbean island-state. D(S)GE is very broadly applicable and should be used more to study questions like these that have concrete policy applications.

The Intergenerational Incidence of Green Tax Reform

April 10, 2019

By Sebastian Rausch and Hidemichi Yonezawa

We examine the lifetime incidence and intergenerational distributional effects of an economywide carbon tax swap using a numerical dynamic general equilibrium model with overlapping generations of the U.S. economy. We highlight various fundamental choices in policy design including (1) the level of the initial carbon tax, (2) the growth rate of the carbon tax trajectory of over time, and (3) alternative ways for revenue recycling. Without revenue recycling, we find that generations born before the tax is introduced experience smaller welfare losses, or even gain, relative to future generations. For sufficiently low growth rates of the tax trajectory, the impacts for distant future generations decrease over time. For future generations born after the introduction of the tax, the negative welfare impacts are the smallest (largest) when revenues are recycled through lowering pre-existing capital income taxes (through per-capita lump-sum rebates). For generations born before the tax is introduced, we find that lump-sum rebates favor very old generations and labor (capital) income tax recycling favors very young generations (generations of intermediate age).

Now that carbon taxes are taking a foothold, the question arises what to do with the revenue. The politically expedient way is to provide a lump-sum rebate, which may make sense if you are trying to sell the main point of the carbon tax to politicians and the general public: pricing pollution. But one can do better and this paper shows that there are stark differences across generations on both fronts, the tax itself and its benefits. This is one of those cases where you have to choose between a complex, optimal schedule and a simple, easy-to-sell policy.

Environmental Policy Instrument Choice and International Trade

March 29, 2019

By J. Scott Holladay, Mohammed Mohsin and Shreekar Pradhan

We develop a dynamic stochastic general equilibrium model to understand how environmental policy instrument choice affects trade. We extend the existing literature by employing an open economy model to evaluate three environmental policy instruments: cap-and-trade, pollution taxes, and an emissions intensity standard in the face of two types of exogenous shocks. We calibrate the model to Canadian data and simulate productivity and import price shocks. We evaluate the evolution of key macroeconomic variables, including the trade balance in response to the shocks under each policy instrument. Our findings for the evolution of output and emissions under a productivity shock are consistent with previous closed economy models. Our open economy framework allows us to find that a cap-and-trade policy dampens the international trade effects of the business cycle relative to an emissions tax or intensity standard. Under an import shock, pollution taxes and intensity targets are as effective as cap-and-trade policies in reducing variance in consumption and employment. The cap-and-trade policy limits the intensity of the import competition shock suggesting that particular policy instrument might serve as a barrier to trade.

While it is not the principal purpose of environmental policy, it is nice to know that it does not amplify business cycles. But I suspect that it matters how pollution enters the model. In this case, it is through a production loss. What if it where through a utility loss or a death probability increase (change in discount rate)? I suspect there is a reasonable specification that could reverse the result. I want to see a paper that proves me wrong.

Behavioural economics is useful also in macroeconomics : the role of animal spirits

March 27, 2019

By Paul de Grauwe and Yuemei Ji

Dynamic stochastic general equilibrium models are still dominant in mainstream macroeconomics, but they are only able to explain business cycle fluctuations as the result of exogenous shocks. This paper uses concepts from behavioural economics and discusses a New Keynesian macroeconomic model that generates endogenous business cycle fluctuations driven by animal spirits. Our discussion includes two applications. One is on the optimal level of inflation targeting under a zero lower bound constraint. The other is on the role of animal spirits in explaining the synchronization of business cycles across countries.

I guess this is more an issue of semantics, but animal spirits still need to be triggered by something, however small that may be, and this something is still exogenous to the model, right? The dream of having a fully endogenous model is a pipe dream.