This paper studies optimal fiscal policy in a climate-economy model with heterogeneous agents. When individualized lump-sum taxation is not available, distortionary taxes on labor and capital income are levied to provide redistribution. The optimal pollution tax rule is then a modified Pigouvian formula that accounts for tax distortions, where the Pigouvian level depends on the degree of inequalities and tax distortions play an ambiguous role. In a quantitative analysis where the climate model is calibrated to DICE and the fiscal system to the one of the U.S., we show that tax distortions have a negligible effect on the optimal carbon tax, but inequalities reduce it by 4% in our baseline calibration. Optimal carbon taxation generates moderately negative but progressive welfare effects in the 21st century, and large positive but regressive effects thereafter.
JEL classification: E62, H21, H23, Q5
Keywords: climate policy, carbon taxes, social cost of carbon, optimal taxation, double dividend, heterogeneous agents.