Fiscal Policy and Transition Risk

We study how climate policy can interact with distortionary fiscal policy and potentially lead to transition risk. Using an environmental dynamic stochastic general equilibrium model that features financial frictions and preexisting labor and capital taxes, we simulate a carbon tax and an abatement subsidy under different scenarios for returning carbon tax revenue or financing the subsidy. We find novel policy implications and important differences between the carbon tax and the subsidy. Under both policies, transition dynamics can differ sharply from long-run outcomes. For the carbon tax, transition dynamics depend on both financial frictions and the choice of revenue recycling. For the abatement subsidy, distortionary financing can generate contractionary transition dynamics, because of financial frictions. Macroprudential policy can mitigate transition risk under the carbon tax but has little effect under the subsidy.