Carbon Taxation when Climate Affects Productivity

ABSTRACT. Based on a model where climate change affects productivity, the second-best opti-mal carbon tax is found to exceed marginal social damage by 53 % and ‘‘marginal private damage ’ ’ (aggregate households ’ willingness to pay) by 73%. Annual welfare gains are estimated at $3.58 billion when marginal damage is $40 per ton; em-ployment also increases. A carbon tax set at the Pigouvian rate raises welfare by only $3.17 bil-lion. The seemingly contradictory results from the ‘‘tax interaction ’ ’ literature are shown to arise only when the optimal environmental tax is com-pared to ‘‘marginal private damage, ’ ’ and only for an amenity externality. (JEL Q4, H2) I