Environmental quality, the macroeconomy, and intergenerational distribution

The paper studies the dynamic allocation effects and intergenerational welfare consequences of environmental taxes. To this end, environmental externalities are introduced in a Blanchard–Yaari overlapping generations model of a small open economy. A rise in environmental taxes – taking into account pre-existing distortionary taxes and endogenous labor supply – is shown to yield an efficiency gain if agents care enough for the environment. The benefits are unevenly distributed across generations because agents are heterogeneous in their capital ownership. An accompanying debt policy can be designed – prescribing debt accumulation at impact and debt redemption in the new steady state – to ensure everybody gains to the same extent. With lump-sum recycling of environmental tax revenue, aggregate employment is unaffected in the short run, but falls in the long run. Furthermore, it raises environmental quality more in the long run than in the short run. Recycling revenue through a cut in labor taxes, however, is shown to yield a rise in employment in the short run, which disappears during transition. In the new steady state, environmental quality is higher at the expense of a lower level of employment.