Working Paper No. 2023-26 - Sequencing decarbonization policies to manage their macroeconomic

The low 9 Jo and Miftakhova (2022) used the Revankar VES production function to analyze long-run decarbonization of an economy, albeit with the implausible implication that the elasticity of substitution between the low carbon and fossil inputs in time approaches infinity. [...] Since the given technology parameters determine the ratio of low carbon to fossil inputs, final good output simplifies a function of low carbon capital and a weighted average of the productivity of low carbon and fossil capital, ̅. [...] The reason for introducing either a low carbon investment subsidy or a carbon tax is the same: to correct the relative price of low carbon and fossil input for the latter’s climate externality and induce the substitution toward the low carbon input.13 In addition to correcting the relative input price for the climate externality, there can be positive externalities associated with early investment. [...] If the existing tax system is optimal, the second-round policy effects of low carbon subsidies and carbon pricing thus depend on their scale and the extent to which they disrupt the initial balance between marginal excess tax burdens and distributional benefits.20 Put simply, the smaller-scale policy likely has the smaller policy cost because it is less disruptive of the initial balance of efficie. [...] The second type is the second-round policy costs of the two decarbonization policies—a low carbon investment subsidy and a carbon price—and depends on the relative scale and design of these policies and the existing tax system.