Why green subsidies are preferred to carbon taxes: Climate policy with heightened carbon tax salience

Abstract

Policy makers must take account of the fact that carbon taxes are highly unpopular. Once policy makers take this into account, they should adopt a modified targeting principle by setting the optimal carbon tax below the Pigouvian tax (i.e., the social cost of carbon) and excessively subsidising products that are made with renewable energy. We numerically illustrate these behavioural biases in climate policies in the face of heightened carbon tax salience and note that this helps to explain distortions in current climate policies. We find that governments might then even take the easy option of green spending and fossil fuel subsidies rather than taxing carbon emissions. This is costly as welfare is lower than it would be without behavioural misperceptions.