Comparing Environmental Policy Instruments for China and India – A Bayesian DSGE Approach

Abstract

This paper estimates a New Keynesian DSGE model for China and India to compare the macroeconomic and welfare implications of three environmental policy instruments: environmental tax, emission cap, and emission intensity target. From Bayesian posterior estimates and impulse responses, we find that an environmental tax rate shock is less persistent for China than it is for India but induces the least amount of macroeconomic fluctuations in both economies; that the intensity target has a magnifying effect on responses to shocks for both economies; and finally, that the cap can mitigate the macroeconomic fluctuations ensuing from shocks, but only in the Chinese economy.

We then adopt the standard RBC consumption-equivalent welfare measure to compare welfare implications of the three policies. We identify the highest welfare-yielding policy instruments to be the cap for China and the intensity target for India, while acknowledging that the welfare ranking is sensitive to the degree of nominal rigidities in the economy.

Overall, we conclude that there is no one-size-fits-all approach for emission reduction policy design. Fortunately, the DSGE approach to environmental policy research has great potential for uncovering more country-specific environmental policy implications, not just for China and India but for other emerging market economies at large.