Carbon Taxation in a Second‐Best Setting: Impacts of Sectoral Differences on Optimal Rates

ABSTRACT This paper investigates the Ramsey‐optimal fiscal and environmental policy in an economy with two differentiated final‐goods sectors: brown (pollutive) and green (zero emissions). This analysis provides new insights into the interaction between distortionary taxes and carbon taxes in both the short run and long run. Under assumptions of a homogeneous composite good and preferences that are both separable in consumption and leisure, and homogeneous in consumption, the Ramsey‐optimal carbon tax aligns with the Pigouvian tax, fully internalizing the social cost of carbon (SCC). However, relaxing any of these assumptions leads to significantly different outcomes. Our findings highlight two key points: first, in our model, the gap between the Pigouvian and Ramsey‐optimal carbon tax is driven not by climate utility damages but by the substitutability of differentiated final goods together with frictions in intersectoral labor mobility. Second, we show that the Ramsey‐optimal carbon tax can be either higher or lower than the SCC in economies with differentiated final goods, when both goods are imperfectly substitutable and labor is imperfectly mobile across sectors, depending on consumer preferences over these goods. This result contrasts with prior literature, which generally suggests that in the absence of climate‐related utility damages, the optimal carbon tax equals the SCC, while the presence of distortionary taxes causes the carbon tax to fall below the SCC when climate‐related damages are present.