Making Carbon Taxation a Generational Win Win

Carbon taxation has been studied primarily in social planner or infinitely lived agent models, which trade off the welfare of future and current generations. Such frameworks obscure the potential for carbon taxation to produce a generational win-win. This paper develops a large-scale, dynamic 55-period, OLG model to calculate the carbon tax policy delivering the highest uniform welfare gain to all generations. The OLG framework, with its selfish generations, seems far more natural for studying climate damage. Our model features coal, oil, and gas, each extracted subject to increasing costs, a clean energy sector, technical and demographic change, and Nordhaus (2017)’s temperature/damage functions. Our model’s optimal uniform welfare increasing (UWI) carbon tax starts at $30 tax, rises annually at 1.5% and raises the welfare of all current and future generations by 0.73% on a consumption-equivalent basis. Sharing efficiency gains evenly requires, however, taxing future generations by as much as 8.1% and subsidizing early generations by as much as 1.2% of lifetime consumption. Without such redistribution (the Nordhaus “optimum”), the carbon tax constitutes a win-lose policy with current generations experiencing an up to 0.84% welfare loss and future generations experiencing an up to 7.54% welfare gain. With a six-times larger damage function, the optimal UWI initial carbon tax is $70, again rising annually at 1.5%. This policy raises all generations’ welfare by almost 5%. However, doing so requires levying lump-sum taxes on and giving lump transfers to future and current generations ranging up to 50.1% and 10.3% of their lifetime consumption.