Optimal Climate Policy with Incomplete Markets

Abstract

How should governments design climate policies in the presence of inequality, uninsurable risk, and fiscal constraints? To address this question, we develop a climate--economy model with incomplete markets and idiosyncratic labor-income risk, where Ricardian equivalence fails and optimal long-run capital taxes are positive. We analytically show that the optimal carbon tax equals the social cost of carbon (SCC) adjusted for fiscal distortions. We calibrate the model to the U.S. and show that deviations from the SCC are quantitatively negligible: the optimal tax remains nearly Pigouvian across scenarios, even under tight fiscal constraints. Welfare gains under the optimal policy come almost entirely from efficiency and environmental amenities, with almost no effect on redistribution and insurance, and are fairly evenly distributed across households. Joint paper with Sebastian Dyrda, Albert Jan Hummel and Marcelo Pedroni.