The Optimal Path of Energy and CO2 Taxes for Intertemporal Resource Allocation and Improved Energy Efficiency

The purpose of this paper is to extend the dynamic resource allocation problem by including stock externalities like accumulated CO2 emissions as well as flow externalities like waste of energy in production or in using energy consuming goods. The objective is to examine how the time profiles of energy-, CO2- or gasoline-tax rates can address these problems in an optimal way. The concern about the time profile of an energy tax arises from the fact that fossil fuels are an exhaustible resource and that global warming, being a consequence of carbon accumulation in the atmosphere, is a stock externality problem. We use a micro model of a firm, which maximizes profits, uses energy as one of its inputs and is confronted with a varying energy tax over time. It reacts by substitution, by changing its output level, by investing in energy efficient technology or by improving energy efficiency of its products. The government is well aware about firms reaction on price signals. It maximizes a stream of social welfare subject to dynamic resource constraints by choosing an optimal path of its instruments – a combination of energy taxes. Our analysis supports the idea of first rising and later falling tax rates over time. If the tax is also an incentive for investing in R&D to improve energy efficiency in production and in developing energy saving products, then the tax should be modified to favor those developments over time. JEL classification: Q 32, Q 38, Q 41, O 3