The Effect of Environmental Taxes on Steady-State Consumption

Abstract

This paper examines the effects of environmental taxes on the demand and supply sides of the economy and uncovers two opposite forces on long-term production. An increase in the environmental tax stimulates abatement behavior as producers lower production from the same capital stock but simultaneously lower per-unit emissions increases consumers’ demand for the cleaner goods hence increasing the capital stock. Starting from a low level of environmental taxes, my model finds that initially the demand-driven positive relationship dominates while at a higher level of environmental taxes, the production lowering negative effect dominates; the transition occurs before the economy reaches the optimal tax rate.