Social discounting: A higher weight on future generations changes both climate and fiscal policy; absent fiscal policy adjustments, the social cost of carbon is not the optimal tax

Be careful what you calibrate for: Social discounting in general equilibrium. Lint Barrage. Journal of Public Economics, Volume 160, April 2018, Pages 33-49. https://doi.org/10.1016/j.jpubeco.2018.02.012

Highlights
•    Social discounting is assessed in a general equilibrium climate-economy model.
•    A higher weight on future generations changes both climate and fiscal policy.
•    Optimal policy includes an effective capital income subsidy.
•    Optimal policy includes labor-consumption wedge that is decreasing over time.
•    Absent fiscal policy adjustments, the social cost of carbon is not the optimal tax.

Abstract: Concerns about intergenerational equity have led to an influential practice of setting social utility discount rates based on ethical considerations rather than to match household behavior, particularly in climate change economics (e.g., Stern, 2006). This paper formalizes the broader policy implications of this approach in general equilibrium by characterizing jointly optimal environmental and fiscal policies in a climate-economy model with differential planner-household discounting. First, I show that decentralizing the optimal allocation requires not only high carbon prices but also fundamental changes to tax policy: If the government discounts the future less than households, implementing the optimal allocation requires an effective capital income subsidy (a negative intertemporal wedge), and, in a setting with distortionary taxation, an effective labor-consumption tax wedge that is decreasing over time. Second, if the government cannot subsidize capital income, the constrained-optimal carbon tax may be up to 50% below the present value of marginal damages (the social cost of carbon) due to the general equilibrium effects of climate policy on household savings. Third, given the choice to optimize either carbon, capital, or labor income taxes, the socially discounting planner's welfare ranking is ambiguous over a standard range of parameters. Overall, in general equilibrium, a policy-maker's choice to adopt differential social discounting may thus overturn conventional recommendations for both environmental and fiscal policy.