Environmental sustainability with a pollution tax

This paper examines the feasibility of sustainable development in a dynamic general equilibrium framework of a closed economy with two final outputs and two factors of production. This paper focuses on the consumption effects of the environment on sustainable growth in an economy that uses knowledge capital as a key engine of growth. It explicitly accounts for both pollution flow effects and the existence of irreversible thresholds affecting the stock of renewable natural resources (i.e., the stock of clean air in the atmosphere). This paper highlights the crucial importance of the intertemporal substitution of consumption (represented by the elasticity of marginal utility of consumption, EMU ) in the context of multiple consumer goods, a so far much neglected factor determining sustainability. If the EMU is greater than one, an optimal pollution tax ensures sustainable growth even if the elasticity of substitution in production between clean and dirty inputs and in consumption between clean and dirty consumer goods are well below one without requiring any further government intervention. If the EMU is less than one as often evidenced in the empirical literature, sustainable growth is still feasible but requires much more demanding conditions: either the temporal elasticity of substitution between consumer goods or between factors of production must be substantially greater than one. Furthermore, an inverted U-shaped pollution-income dynamics may emerge. This paper finds that even a suboptimal pollution tax may allow for sustainable development as long as the tax time profile meets certain plausible conditions that are developed below. Finally, numerical simulation results demonstrate that if the pollution tax used as the sole policy instrument to prevent climatic disaster is well designed, it may only modestly reduce the rate of economic growth.