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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

model, the choice of tax seems like a simpler policy approach and provides room
to include the punishment idea developed by earlier authors.
Finally, 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. To make my model more realistic, I calibrate it to
values congruent to carbon emissions, using the same units of atmospheric carbon
(GtC), however, under the inevitably false assumption that different types of
pollution have the same relative emissions-to-stock ratio as carbon, I will change
my parameters to simulate the differing types.

We begin with a simple RBC model. The economy is populated by many atomistic
households that own capital stock k t in any given time period t. Agents seek to
maximize utility that takes the functional form of:
u(c) =

( c 1 1 )
u0 (c ) = c


We assume that production follows an aggregate Cobb-Douglas production

function where Yt is the total output of final goods. Because we are more interested
in the effect of pollution, which we assume does not have an effect on labor, we
will hold labor constant at l = 1.
Yt = Akt1 l1
A = e zt


The households make wages wt that are paid for by firms and consume ct and
rt is the interest rate.
c t = w t + (1 + r t ) k t 1 k t


These households are productive according to a productivity zt that is uncertain due to a stochastic shock ez .
z t = z z t 1 + e z


However, we introduce new variables to include pollution emissions and

abatement policy. First, xt is the stock of pollution in any time period that is a
function of the previous periods stock of pollution decaying at rate and current
periods emissions Mt . Current periods emissions Mt are a function of output Yt ,
a pollution shock yt , and a tax T.
xt = xt1 + Mt


Mt = T Yt ey
y t = y y t 1 + e y


The tax T decreases decreases emissions, Mt , scaled by a factor of = . T also

has a negative effect on consumption, changing the consumption function:
c t = w t + (1 + r t ) k t 1 k t T


We assume that pollution was no direct effect on output Yt , nor does it have
an effect on utility.
At the beginning of each period t, zt is known. All factor markets are open and
clear, so k t is loaned out to firms and rt is determined while l is hired and wt is
determined. The production of goods occurs. k t+1 is chosen and consumption ct
occurs. A temporary shock zt+1 is revealed and the period ends.
So given the information of prices and shocks = {w, r, z, y}, the household
solves the following problem when factor markets clear:
V (k t , ) = max u(ct ) + E{V (k t+1 , t+1 )}


To do this, we combine the first order condition for k t+1 :

u0 (ct1 ) + E{Vkit (k t+1 , t+1 )} = 0

c t 1

+ E{Vkit (k t+1 , t+1 )} = 0


with the next periods envelope condition:

Vkt+1 (k t+1 , t ) = u0 (ct+1 )(1 + rt+1 )


to get the Euler equation:

= E{c
t+1 (1 + rt+1 )}
) (1 + rt+1 )}
1 = E{(
c t +1



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. This model is calibrated using the carbon dioxide
emissions in the US economy.
In the production function, the parameter 0 < < 1 accomodates positive
diminishing marginal returns. The USs capital share of national income is .36, so
this is value of used. Similarly, capital depreciation is found to be .025 and the
discount factor = .98627 is consistent with quarterly rate of return to capital of
1 percent, or equivalently an annual discount rate of 5 percent and annual capital
depreciation rate of 9.6 percent. From an analysis of Census Bureau data using a
Hodrick-Prescott filter to detrend time series data of GDP and monthly emissions
( = 1600), we find the standard deviation of cyclical GDP to be 1.31 percent

while the standard deviation of cyclical carbon emissions is 2.04 percent, so we

take these to be our ez , ey , respectively.
Using chemistry and economics, we can determine reasonable estimates for
our emissions parameters. Our equation for the stock of pollution xt = xt1 +
Mt includes a decay parameter, , which can be estimated from the half life of
atmospheric carbon dioxide. This value is not perfectly known, and many papers
predict differing values based on differing half life estimates ranging from 19-92
years. An estimate used in other economic papers is based on a half life of 83
years, which yields = .9979 (Heutel). This is calibrated to quarterly data, like
the rest of my model.
I pick = 2.5 from class discussions that revealed a reasonable 2.5 < < 5.
Similarly, I picked y , z while normalizing my constant labor l = 1.
The calibration of the scaling factor on my tax T was found in a similar paper
as = .04 (Golosov et al). The bulk of my analysis draws upon changing the tax

Taking our other parameters as given, I assume that the current state of the U.S.
economy will hold as I conduct my analysis based on changing the emissions tax
rate, T. I begin with a tax that is an estimated 10 percent of wage and 20 pecent of
emissions. My steady state results are:


At the steady state, both our production shock z and our pollution shock y are
at 0. With T = .2, consumption c is 11 percent greater than wage w. Emissions M
are at 3.72735 GtC, and total pollution stock is 1774.93 GtC. It isnt clear that a 10
percent tax on wages has a large impact on the amount of emissions.
Looking at the impulse response graphs will give us insight into how differing
shocks to production z and pollution y affect our other variables.
From this figure we see that as the shock to pollution y decreases, so does
emissions M in a period. The total stock of pollution x, is increasing still, as
emissions are positively correlated with GDP Y. However stock of pollution is
increasing at a decreasing rate, as we can see by the tapering off of x. This is pretty
straightforward and intuitive.
From this figure we see that as production shocks z decrease, so does consumption c, wage w and GDP Y. This makes sense as the shock to production

Figure 1: Orthogonal Shock to ey

adds to output, and a decrease in output decreases the number of jobs and wages
in the economy, which in turn lowers total consumption. Interestingly, captial k increases, as the interest rate r plummets. Emissions M also decrease as production
As I change the tax rate, T, the shape of the impulse response functions remain
largely unchanged. The same patterns and trends follow, perhaps in part because
of the insignificance of the T in changing other outcomes.
To re-examine our abatement policy, our initial results seem a little disappointing. Perhaps this is because of how little our investment has been in abatement.
To examine the impact of a stronger abatement policy, let us increase taxes to the
extreme - 100 percent of wages. What would happen if all of our wages are spent
on abatement?
The new steady state values are:


These results arent too satisfying. Even if we increased taxes from .2 to 2.2,
over 98 percent of wages, it is clear that our effect on abatment is almost trivial.

Figure 2: Orthogonal Shock to ez

Emissions remain high at 3.38644 GtC, although it seems that the stock of pollution
has decreased from over 1770 to around 1612 GtC. It seems that we are doomed to
fail in our quest to reduce emissions. Looking back at our equation for emissions
M, we can see the main problem lies not with the amount of the tax T relative to
our wages w, but the variable that is expressing the impact of the tax on emissions
itself, .
The existing value of .04 is very low, signalling the inefficiency of each dollar
spent on abatement. This number represents, in a sense, the effectiveness of
each dollar spent on abatement. Its interpretation as a scaling on the tax makes
it incredibly important to our analysis. Increasing represents, perhaps, an
increase in our technology of abatement methods - new scientific research and
methodology used to decrease or rid emissions. Lets set = 1 and T = 1.2 (half
our wages).


Our results are more promising, with emissions decreasing around 13 percent,
and the total stock of emissions decreasing over 20 percent. When we set =
2, T = 1.2, our results are even more optimistic:



With this doubling of effectiveness, we see that each periods emissions decrease, with a significant drop in the stock of pollution to 1155.74 GtC - nearly a 40
percent drop from our original callibration. This is an illuminating result. Throwing money at pollution does not solve the problem unless abatement methods are
Taking a different approach with the model, I look at the pollution shock
yt = y yt1 + ey . With my original y shock to pollution set high at .95, I now
look to assume that each years pollution shock has no correlation with the
previous years. Although this makes less intuitive sense with carbon dioxide
emissions due to a greenhouse effect that perpetuates and exacerbates the current
problem, with other types of pollution, perhaps this is not unrealistic. For example,
random shocks due to natural disasters could be argued as more random and less
autocorrelated to previous years shocks.

Figure 3: Orthogonal Shock to ey

First, looking at the epsilon shock to y we see a sharp drop in y causes a sharp
drop in current periods emmission M to 0, and instead of the stock of pollution

increasing, it steadily decreases. The problem arises in the standard deviations

of the shock to y, calibrated from the standard deviation of carbon emissions per

Figure 4: Orthogonal Shock to ey

Looking at the impulse response function for a shock to output z, most of
the variables are unchanged in both shape and value. However, as expected, we
notice a big change in M and x. For M, instead of starting at .05, it starts at .02,
and for x, the scale is less than half of the original, signaling a much lower growth
in stock of pollution as production and current emissions decrease.
Looking at the steady state results are particularly interesting:


We see a drastic decrease in current periods emissions - around 40 percent of

our original calibration, and around 40 percent of the pollution stock as well.
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, it is nonetheless an interesting finding.

Finally, I change my shock on production z, assuming that z is .5 instead

of .95. This represents the percent by which shocks to output in one period are
affected by shocks in the previous period. Cutting the relationship in half should
have a drastic effect on the results.
The impulse response function of the shock to pollution remains similar, as we
would expect. Changing the shock to output should have no effect on the shock
to pollution.

Figure 5: Orthogonal Shock to ey

However, the impulse response function for output is very different. As z, the
shock to production decreases sharply, the interest rate r drops and remains below
steady state levels. Consumption c begins at near zero and drops at an almost
linear rate after a small increase. This probably happens because we are taxing
at a much higher rate relative to wages w, which drop drastically. Capital k after
an initial spike, seemes to decrease at a constant rate. Our emissions variable M
follows the shape of output dropping and the pollution stock x increases at the
lowest rate weve observed with the scale no more than .1. This behavior seems
extremely different at first sight, however, it can be explained by the equations
of our model. Emissions drop because output drops. The stock of pollution, as a
function of each periods emissions, is therefore growing at a tiny rate compared to
before. The growth in emissions and pollution stock are almost entirely dependent
on shocks to pollution y, as production plummets.
To better understand the effects of the shocks, better calibration of my model is
necessary. Although the current calibration is based on existing literature, because
of differences in model specification, I would need to run more analysis for better
parameters, and specify my model to better match current observed trends.

Figure 6: Orthogonal Shock to ez

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

increase. This could be seen as representative of the annoyances of changing

weather patterns, lamentation of destroyed natural beauty, the stress of increased
health problems, etc. I would also want to better understand and model the
impact of the tax T, both on the household and on the problem of abatement itself.
Correctly identifying is incredibly important, and finding an estimate of that
would be the natural next step.
Most importantly, I would want to better specify my model. My later analysis
revealed that if anything, there may be underlying factors that greatly affect
pollution which are not obvious at first glance. A better understanding of the
science and economics, along with stronger calibration methods would add
greatly to the legitimacy of this paper.
However, as it stands, unsuprisingly, this model reveals that we, as a nation,
are not spending enough time and resources investing in both understanding
pollution and abatement policy. Our current trends reveal an unsustainable
disinterest in the world we call home.

Cai, Judd, Lontzek. "DSICE - Dynamic Stochastic General Equilibrium Analysis
of Climate Change Policies and Discounting."
Heutel, Garth. "How Should Environmental Policy Respond to Business
Cycles? Optimal Policy under Persistent Productivity Shocks." Harvard Kennedy
School Southern Economics Association (2008). Print.
RIUM." Econometrica Vol. 82.No. 1 (2014): 41A
Dissou et al, "Cap or Tax emissions? A Multi-sector DSGE Analysis."
US. Census Bureau