Optimal Taxes on Fossil Fuel in General Equilibrium

We embed a simple linear model of the carbon cycle in a standard neoclassical growth model where one input to the production function, oil, is non-renewable. The use of oil generates carbon emission, the key input in the carbon cycle. Changes in the amount of carbon in the atmosphere drive the greenhouse e¤ect and thereby the climate. Climate change is modeled as a global damage to production and is a pure externality. We solve the model for both the decentralized equilibrium with taxes on oil and for the optimal allocation. The model is then used to …nd optimal tax and subsidy polices. A robust model …nding is that constant taxes on oil have no e¤ect on the allocation: only time-varying taxes do. A key …nding is that optimal ad valorem taxes on oil consumption should fall over time. In the simpli…ed version of the model, optimal taxes per unit of oil should be indexed to GDP. A calibrated, less simpli…ed model also generates declining, and initially rather substantial, taxes on oil. Golosov: MIT; Hassler: IIES; Krusell: IIES and Princeton; Tsyvinski: Yale. The paper is preliminary. Please do not distribute without author approval.