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Pollution Taxation and Environmental Policy

Implications of a Pollution Tax in a Dynamic
Stochastic General Equilibrium Model

Brigham Young University
December 19, 2014

With a general definition of pollution, modelled after carbon emissions,
what are the policy implications of a tax on pollution? This paper looks at answering that question by presenting and solving a dynamic stochastic general
equilibrium model that includes an externality from pollution in addition to
shocks on production. The model is estimated and calibrated according to
the US economy and carbon dioxide emissions, a topic of increasing interest
in public policy.

Keywords: carbon emissions, DSGE, RBC, pollution, tax policy

The problem of pollution, although not novel, has been increasingly scrutinized
in public forums across differing fields. It seems that everyone in every degree
has an opinion and an argument for their views on both the legitimacy of the
problem itself, and viability of sollutions. In this paper, I will explore the latter
while taking the former as given.
A DSGE model is an appropriate approach to tackle the problem of pollution.
A handful of papers looking at specific topics in environmental change using
DSGE models exist (Cai, Judd et al, Heutrel, Golosev et al). After looking at these
papers, it is clear that approaches vary, specifically with regards to the punishment
function. How do we model the negative impact of pollution? Is it disutility
or decreased production? There are arguments for and against both sides, and
approaches that reflect the disparate opinions. For my model, I will choose to
simply include this punishment idea in a tax on consumption (Cai). I assume that
the decrease in consumption includes the disutility of pollution. The two main
fields addressing climate change are split between a tax and a cap (Dissou et al).
Although I would be interested in exploring a cap and trade approach in a future

using the same units of atmospheric carbon (GtC). I calibrate it to values congruent to carbon emissions.model. which we assume does not have an effect on labor. however. Finally. Yt = Akαt−1 l¯1−α A = e zt (3) (4) The households make wages wt that are paid for by firms and consume ct and rt is the interest rate. First. I look at general pollution instead of a specific type of emission because this will give me more freedom to change my parameters in a way that could mock different types of pollution. Model We begin with a simple RBC model. c t = w t + (1 + r t − δ ) k t −1 − k t (5) These households are productive according to a productivity zt that is uncertain due to a stochastic shock ez . under the inevitably false assumption that different types of pollution have the same relative emissions-to-stock ratio as carbon. a pollution shock yt . I will change my parameters to simulate the differing types. Current period’s emissions Mt are a function of output Yt . xt is the stock of pollution in any time period that is a function of the previous periods stock of pollution decaying at rate ν and current period’s emissions Mt . we will hold labor constant at l¯ = 1. Because we are more interested in the effect of pollution. Agents seek to maximize utility that takes the functional form of: u(c) = 1 ( c 1− γ − 1 ) 1−γ u0 (c ) = c−γ (1) (2) We assume that production follows an aggregate Cobb-Douglas production function where Yt is the total output of final goods. The economy is populated by many atomistic households that own capital stock k t in any given time period t. and a tax T. To make my model more realistic. the choice of tax seems like a simpler policy approach and provides room to include the punishment idea developed by earlier authors. z t = ρ z z t −1 + e z (6) However. xt = νxt−1 + Mt (7) Mt = T −λ Yt ey y t = ρ y y t −1 + e y (8) (9) 2 . we introduce new variables to include pollution emissions and abatement policy.

This model is calibrated using the carbon dioxide emissions in the US economy. Ωt+1 )} = 0 ⇒ −γ c t −1 + βE{Vkit (k t+1 . the household solves the following problem when factor markets clear: V (k t . Similarly. T also has a negative effect on consumption. k t+1 is chosen and consumption ct occurs.31 percent 3 . In the production function. All factor markets are open and clear. Ωt+1 )} kt (11) To do this.36. changing the consumption function: c t = w t + (1 + r t − δ ) k t −1 − k t − T (10) We assume that pollution was no direct effect on output Yt . so k t is loaned out to firms and rt is determined while l¯ is hired and wt is determined. From an analysis of Census Bureau data using a Hodrick-Prescott filter to detrend time series data of GDP and monthly emissions (λ = 1600). scaled by a factor of = λ. we combine the first order condition for k t+1 : u0 (ct−1 ) + βE{Vkit (k t+1 . So given the information of prices and shocks Ω = {w. the parameter 0 < α < 1 accomodates positive diminishing marginal returns. y}. Mt . At the beginning of each period t. A temporary shock zt+1 is revealed and the period ends.98627 is consistent with quarterly rate of return to capital of 1 percent. zt is known. z.The tax T decreases decreases emissions. so this is value of α used. Ωt+1 )} = 0 (12) (13) with the next period’s envelope condition: Vkt+1 (k t+1 . The US’s capital share of national income is . Ω) = max u(ct ) + βE{V (k t+1 . The production of goods occurs.025 and the discount factor β = . r. or equivalently an annual discount rate of 5 percent and annual capital depreciation rate of 9. capital depreciation δ is found to be .6 percent. we find the standard deviation of cyclical GDP to be 1. Ωt ) = u0 (ct+1 )(1 − δ + rt+1 ) (14) to get the Euler equation: −γ γ = βE{c− t+1 (1 + rt+1 − δ )} ct γ ) (1 + rt+1 − δ)} ⇒ 1 = βE{( c t +1 ct (15) (16) Calibration Calibration of the parameters comes from two main groups of 1) traditional macroeconomic parameters taken from previous RBC literature and emissions related parameters taken from economics and chemistry to estimate the cost and benefits of emission reductions. nor does it have an effect on utility.

My steady state results are: z c w r k Y y M x 0 2. Using chemistry and economics. Our equation for the stock of pollution xt = νxt−1 + Mt includes a decay parameter.93 GtC. both our production shock z and our pollution shock y are at 0.5 < γ < 5.3264 3. An estimate used in other economic papers is based on a half life of 83 years. Similarly. so we take these to be our ez . we can determine reasonable estimates for our emissions parameters. so does emissions M in a period.9979 (Heutel).5 from class discussions that revealed a reasonable 2. and many papers predict differing values based on differing half life estimates ranging from 19-92 years. I pick γ = 2. ρz while normalizing my constant labor l¯ = 1. The calibration of the scaling factor λ on my tax T was found in a similar paper as λ = . ey . ν. which can be estimated from the half life of atmospheric carbon dioxide.49495 0 3.S. With T = . respectively. I assume that the current state of the U. I begin with a tax that is an estimated 10 percent of wage and 20 pecent of emissions. as emissions are positively correlated with GDP Y. I picked ρy .04 (Golosov et al).23677 0. so does consumption c. and total pollution stock is 1774. which yields ν = . like the rest of my model. Looking at the impulse response graphs will give us insight into how differing shocks to production z and pollution y affect our other variables. It isn’t clear that a 10 percent tax on wages has a large impact on the amount of emissions.2. wage w and GDP Y. Emissions M are at 3.93 At the steady state. is increasing still. This is calibrated to quarterly data. This is pretty straightforward and intuitive. as we can see by the tapering off of x. T.while the standard deviation of cyclical carbon emissions is 2.48679 2. consumption c is 11 percent greater than wage w. This value is not perfectly known. The bulk of my analysis draws upon changing the tax T. Analysis Taking our other parameters as given. From this figure we see that as production shocks z decrease.72735 1774. The total stock of pollution x.04 percent. From this figure we see that as the shock to pollution y decreases. economy will hold as I conduct my analysis based on changing the emissions tax rate.72735 GtC.0389211 32. This makes sense as the shock to production 4 . However stock of pollution is increasing at a decreasing rate.

Emissions M also decrease as production decreases. Perhaps this is because of how little our investment has been in abatement. To examine the impact of a stronger abatement policy.38644 1612. the shape of the impulse response functions remain largely unchanged. which in turn lowers total consumption. and a decrease in output decreases the number of jobs and wages in the economy. perhaps in part because of the insignificance of the T in changing other outcomes. What would happen if all of our wages are spent on abatement? The new steady state values are: z c w r k Y y M x 0 0. it is clear that our effect on abatment is almost trivial. T. The same patterns and trends follow. To re-examine our abatement policy. captial k increases.Figure 1: Orthogonal Shock to ey adds to output. As I change the tax rate.23677 0. let us increase taxes to the extreme . 5 . Even if we increased taxes from . as the interest rate r plummets.3265 3. our initial results seem a little disappointing.0389211 32.59 These results aren’t too satisfying.2 to 2.49495 0 3. Interestingly.2.486788 2.100 percent of wages. over 98 percent of wages.

2 (half our wages).48679 2. we can see the main problem lies not with the amount of the tax T relative to our wages w.04 is very low.88 Our results are more promising. Its interpretation as a scaling on the tax makes it incredibly important to our analysis. Let’s set λ = 1 and T = 1. but the variable that is expressing the impact of the tax on emissions itself. When we set λ = 2. This number represents. an increase in our technology of abatement methods . The existing λ value of . in a sense. λ. Increasing λ represents. signalling the inefficiency of each dollar spent on abatement. and the total stock of emissions decreasing over 20 percent. our results are even more optimistic: 6 . perhaps. T = 1.0389211 scientific research and methodology used to decrease or rid emissions.23677 0.Figure 2: Orthogonal Shock to ez Emissions remain high at 3. although it seems that the stock of pollution has decreased from over 1770 to around 1612 GtC.3264 3. the effectiveness of each dollar spent on abatement.91246 1386. z c w r k Y y M x 0 1. It seems that we are doomed to fail in our quest to reduce emissions. with emissions decreasing around 13 percent.38644 GtC. Looking back at our equation for emissions M.49495 0 2.2.

42705 1155. This is an illuminating result. With my original ρy shock to pollution set high at .23677 0.49495 0 2. perhaps this is not unrealistic.48679 2.95. Figure 3: Orthogonal Shock to ey First. with other types of pollution. For example. Throwing money at pollution does not solve the problem unless abatement methods are effective. I look at the pollution shock yt = ρy yt−1 + ey .nearly a 40 percent drop from our original callibration. Although this makes less intuitive sense with carbon dioxide emissions due to a greenhouse effect that perpetuates and exacerbates the current problem. with a significant drop in the stock of pollution to 1155. I now look to assume that each year’s pollution shock has no correlation with the previous year’s.74 With this doubling of effectiveness.0389211 32. looking at the epsilon shock to y we see a sharp drop in y causes a sharp drop in current period’s emmission M to 0. random shocks due to natural disasters could be argued as more random and less autocorrelated to previous year’s shocks. and instead of the stock of pollution 7 .z c w r k Y y M x 0 1. Taking a different approach with the model.3264 3. we see that each period’s emissions decrease.74 GtC .

486788 2. it steadily decreases. most of the variables are unchanged in both shape and value. it is nonetheless an interesting finding. and around 40 percent of the pollution stock as well. Looking at the steady state results are particularly interesting: z c w r k Y y M x 0 0.483 We see a drastic decrease in current period’s emissions .02. instead of starting at . we notice a big change in M and x. and for x.0389211 32.05. For M.increasing.23677 0.49495 0 1.58861 756. However. The problem arises in the standard deviations of the shock to y. Figure 4: Orthogonal Shock to ey Looking at the impulse response function for a shock to output z. it starts at . the scale is less than half of the original. signaling a much lower growth in stock of pollution as production and current emissions decrease. This suggests that types of pollution that are not serially correlated by time are less likely to have as large of an impact both per period and in aggregate. While this anaylsis is inherently flawed because the calibration was set to US carbon emissions. 8 .around 40 percent of our original calibration.3265 3. calibrated from the standard deviation of carbon emissions per cycle. as expected.

1. as a function of each period’s emissions. Capital k after an initial spike. Cutting the relationship in half should have a drastic effect on the results. This behavior seems extremely different at first sight.Finally. the interest rate r drops and remains below steady state levels. The growth in emissions and pollution stock are almost entirely dependent on shocks to pollution y. assuming that ρz is . Although the current calibration is based on existing literature.95. As z. it can be explained by the equations of our model. as production plummets. however. I would need to run more analysis for better parameters. better calibration of my model is necessary. The stock of pollution. and specify my model to better match current observed trends. seemes to decrease at a constant rate. Changing the shock to output should have no effect on the shock to pollution. To better understand the effects of the shocks. is therefore growing at a tiny rate compared to before. Our emissions variable M follows the shape of output dropping and the pollution stock x increases at the lowest rate we’ve observed with the scale no more than . This represents the percent by which shocks to output in one period are affected by shocks in the previous period. which drop drastically. This probably happens because we are taxing at a much higher rate relative to wages w. The impulse response function of the shock to pollution remains similar.5 instead of . the shock to production decreases sharply. Figure 5: Orthogonal Shock to ey However. Consumption c begins at near zero and drops at an almost linear rate after a small increase. the impulse response function for output is very different. I change my shock on production z. 9 . Emissions drop because output drops. because of differences in model specification. as we would expect.

2. Our analysis suggests that the best way to address the problem of pollution is to begin better understanding the problem itself. I would be interested in adding a disutility variable that decreases individual utility as emissions 10 . it presents a few interesting concepts that are not entirely illogical or unintuitive.Figure 6: Orthogonal Shock to ez Conclusion Although our model is a very simplistic representation of the actual world. Perhaps initially obvious policy changes will not be as effective in long term abatement. Shocks to pollution y. Our initial callibration suggests: 1. To further explain the problem of pollution and abatement. Shocks to production z. it seems that there is an underlying underestimation of the problem of pollution and its sensitivity to outside factors. Upon further examination it seems that emissions and the stock of pollution are greatly affected by more than just taxes and efficiency. M and x are affected by: 1. Simply throwing money at the problem does not solve it . we are grossly underestimating the amount of taxes we need to truly decrease pollution.we need to be effective/efficient with our funds. Although one way to solve the problem of pollution is to emply a duel front of increasing taxes and increasing efficiency. and 2.

A better understanding of the science and economics." Heutel. Correctly identifying λ is incredibly important. Print. "Cap or Tax emissions? A Multi-sector DSGE Analysis. 82. Garth. there may be underlying factors that greatly affect pollution which are not obvious at first glance. I would want to better specify my model. 1 (2014): 41âA¸ Dissou et al. This could be seen as representative of the annoyances of changing weather patterns. My later analysis revealed that if anything. However. both on the household and on the problem of abatement itself. "OPTIMAL TAXES ON FOSSIL FUEL IN GENERAL EQUILIB˘ S88. along with stronger calibration methods would add greatly to the legitimacy of this paper. etc. as a nation. Most importantly. "DSICE ." Econometrica Vol. and finding an estimate of that would be the natural next step." Harvard Kennedy School Southern Economics Association (2008). RIUM. the stress of increased health problems. Lontzek. this model reveals that we. Census Bureau 11 . Our current trends reveal an unsustainable disinterest in the world we call home. Golosov et al.increase. References Cai. Print.Dynamic Stochastic General Equilibrium Analysis of Climate Change Policies and Discounting.No. are not spending enough time and resources investing in both understanding pollution and abatement policy. I would also want to better understand and model the impact of the tax T. "How Should Environmental Policy Respond to Business Cycles? Optimal Policy under Persistent Productivity Shocks. Judd. as it stands. unsuprisingly." US. lamentation of destroyed natural beauty.