The Economic and Budgetary Impact of Climate Policy in Portugal: Carbon Taxation in a Dynamic General Equilibrium Model with Endogenous Public Sector Behavior

The objective of this paper is to study $$\hbox {CO}_{2}$$ CO 2 taxation in its dual role as a climate and fiscal policy instrument using a dynamic general equilibrium model of the Portuguese economy which highlights the mechanisms of endogenous growth and incorporates a detailed modeling of public sector behavior and accounts. In addition to the conventional marginal abatement cost curve, we present a pair of complementary marginal abatement cost curves which highlight the impact $$\hbox {CO}_{2}$$ CO 2 taxation has on economic performance and public debt and are therefore directly relevant to the terms of the policy debate. These marginal abatement cost curves provide an effective tool for understanding the rate at which the environmental effectiveness, economic costs, and budgetary effects change with the tax level. Our results indicate that $$\hbox {CO}_{2}$$ CO 2 taxes can be an important policy instrument for reducing emissions and promoting fiscal consolidation, although this will come at a cost in terms of economic performance. Simulation results suggest that a tax of 17.00 Euros per $$\hbox {tCO}_{2}$$ tCO 2 can satisfy existing climate policy targets. The tax revenue effects, together with reductions in public spending, yield a 4.8 % reduction in public debt. These desirable outcomes come at the cost of a 1.3 % reduction in GDP over the long term. Our analysis highlights that limiting public consumption expenditures can contribute to larger reductions in public debt, albeit at a marginally greater cost to economic activity. In turn, reducing public investment, although effective in reducing public debt, produces a much larger negative economic impact. This evokes an important trade-off, particularly pronounced in the present debates regarding austerity measures in the EU, between fiscal consolidation efforts and efforts to promote convergence to EU standards of living. These results further highlight that modeling assumptions with respect to public spending decision are not innocuous. An exogenous trajectory for public spending suggests substantially smaller GDP effects and substantially larger public debt effects for any given emissions target.