A real-business-cycle model with pollution and environmental taxation: the case of Bulgaria

ABSTRACT

We introduce an environmental dimension into a real-business-cycle model augmented with a detailed government sector. We calibrate the model to Bulgarian data for the period following the introduction of the currency board arrangement (1999–2016). We investigate the quantitative importance of utility-enhancing environmental quality, and the mechanics of an ‘environmental’ output tax levied on the polluting firm's output, as well as the effect of government spending on pollution abatement over the cycle. In particular, a positive shock to pollution emission in the model works like a positive technological shock, but its effect is quantitatively very small. Overall, the model performs relatively well when evaluated against data, but less so along the environmental dimension, so more research is needed to understand the aggregate effects of pollution.

KEYWORDS:

• Business cycles
• pollution
• environmental quality
• environmental tax
• abatement spending

JEL CLASSIFICATION:

• E32
• C68
• Q2
• Q4
• Q54
• Q58

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 A currency board arrangement is an extreme form of fixed-exchange-rate regime, where all the local currency is fully backed with international reserves. In Bulgaria, the rate of Bulgarian Lev (BGN) was set in 1997 at parity with the German Mark (DM), and with the introduction of the Euro, through the conversion rate of DMs to Euros, at 1 Euro = 1.95583 BGN.

2 In this paper we will refer to ‘pollution’ as emission of carbon dioxide. As pointed in Heutel (2012), CO₂ emissions are more problematic, as SO₂ emissions have a much shorter half-life.

3 We also stay in the RBC paradigm and focus on the real side of the economy, while Annicchiarico and Di Dio (2015) utilise a New Keynesian setup; Fischer and Springborn (2011) focus on emission targets, which is not of interest in the current paper. Dissou and Karnizova (2016) discuss the relative merit of emission caps versus emission tax policies.

4 For those interested, Fischer and Springborn (2011) provide a valuable survey on the topic.

5 In the exogenous policy case, which is considered in this paper, the utility weight coefficient in front of the environmental quality term does not matter, and thus it will be set to unity.

6 This way of modelling is very close in spirit to Heutel (2012), who works with output net of pollution, or .

7 From the government constraint it is clear that carbon taxes are an additional burden on labour and capital income.

8 The size of this parameter is not crucial for the results obtained.

9 The model-predicted 95% confidence intervals are available upon request.

10 A possible extension (left for future work) is to compare the environmental fiscal policy with that from the optimal (Ramsey) case.