Growth, intergenerational welfare, and environmental policies in an overlapping generations economy

• Published date: 01 May 2018
• Date: 01 May 2018
• DOI: http://doi.org/10.1111/rode.12371

REGULAR ARTICLE

Growth, intergenerational welfare, and

environmental policies in an overlapping

generations economy

Hsun Chu

1

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Chu-chuan Cheng

2

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Ching-chong Lai

3,4,5

1

Department of Economics, Tunghai

University, Taiwan

2

Department of Accounting, Feng Chia

University, Taiwan

3

Institute of Economics, Academia

Sinica, Taiwan

4

Department of Economics, National

Cheng Chi University, Taiwan

5

Institute of Economics, National Sun

Yat-Sen University, Taiwan

Correspondence

Hsun Chu, Department of Economics,

Tunghai University, No. 1727, Sec. 4,

Xitun Dist., Taiwan Boulevard, Taichung,

40704 Taiwan.

Email: hchu0824@gmail.com

Abstract

This paper examines the effects of the environmental tax

on long-run growth and intergenerational welfare in a dis-

crete-time overlapping generations (OLG) model. We

highlight that the role regarding how the environmental

tax revenues are distributed between the young or old

generations has important implications for the growth and

welfare effects. Our results indicate that raising the envi-

ronmental tax can exert different effects on the environ-

mental utility of the existing young and old generations,

implying an intergenerational welfare conflict of the envi-

ronmental policy. However, if tax revenues are distributed

appropriately, our numerical simulation shows that it is

possible for a higher environmental tax to improve the

welfare of all generations.

1

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INTRODUCTION

Externalities lie at the heart of environmental economics. These externalities are usually not only

intragenerational—polluters affect currently living humans, but also intergenerational—they impose

a cost on future generations. Environmental policies, therefore, should be responsible for internaliz-

ing both types of externalities. In this study, we examine the intertemporal welfare effects of the

environmental policies. We ask the following questions: What is the environmental policy impact

on the welfare of different generations? Does an intergenerational welfare conflict emerge from the

implementation of a tighter environmental policy? Is it possible for an environmental policy to

improve the welfare of all generations?

To address these questions, we construct a two-period overl apping generations (OLG) model 

a

la Diamond (1965) featuring endogenous growth and environmental externalities. There are

DOI: 10.1111/rode.12371

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©2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/rode Rev Dev Econ. 2018;22:844–861.

multiple externalities in this model. First, in order to introduce endogenous growth, we consider

the capital externality 

a la Romer (1986) and Lucas (1988) on the production side. Moreover, the

production process emits pollution leading to a deterioration in the environmental quality, which

consequently generates two types of environmental externalities. The first environmental externality

affects the individual’s utility. As is obvious, a worse environment reduces people’s happiness. For

instance it can negatively affect people’s health or reduce their satisfaction with outdoor leisure.

The second environmental externality influences the firm’s productivity. A worse environment

harms workers’health, and bad air quality can accelerate the depreciation of equipment. These

facts indicate that a poor environment reduces the efficiency of the production process. Our speci-

fications that pollution negatively affects both the individuals’utility and firms’productivity are in

accordance with these observations.

1

A notable feature of our analysis is that we highlight the role of how the environmental tax rev-

enues are distributed between the young or old generations. This role has important implications

both for the growth and welfare effects of the environmental tax. For the growth effect, we show

that raising the environmental tax tends to stimulate economic growth when the tax revenues are

largely transferred to the young generation. The intuition is that tax revenues transferred to the old

generation are entirely consumed, while some part of the tax revenues transferred to the young

generation is used to accumulate physical capital, which is beneficial to growth. Accordingly, the

result of the positive growth effect of the environmental tax does not necessarily rely on the pres-

ence of an environmental externality in production.

With respect to the welfare effect of the environmental tax, our results characterize the inter-

generational welfare conflicts between the elderly and young, and between existing and future

generations. When the government raises the environmental tax, the environmental quality will

be improved, and at the same time it has an ambiguous effect on economic growth. For the

existing old generation who only lives in the current period, it does not have time to wait for

the improvement of the environmental quality, neither can it have time to enjoy a higher eco-

nomic growth. Therefore, its welfare is determined primarily by the rebates of tax revenues it

can receive. Obviously, the existing old generation will experience a welfare gain if a large por-

tion of tax revenues is transferred to the old generation. By contrast, for the existing young and

future generations, both the environment and economic growth matter for their welfare. In the

case where the environmental tax enhances growth, all generations (except the existing old gen-

eration) are able to experience a better environment and higher growth, which represents a defi-

nite welfare gain. In the case where the environmental tax depresses economic growth, the

welfare effect of the environmental tax becomes uncertain, but generations born in the very dis-

tant future will definitely lose because the growth effect plays a dominant role in evaluating their

welfare.

In a counterpart of this study, Bovenberg and Heijdra (1998) investigate the intergenerational

welfare effect of an environmental tax in an OLG model 

a la Yaari (1965) and Blanchard

(1985).

2

Our results differ from theirs in several important respects. First, in their model, a wel-

fare gain from a better environment is identical among all existing generations regardless of

whether they are old or young. In our model, by contrast, raising the environmental tax bene fits

the environmental utility of existing young generations more than of existing old generations, by

virtue of the feature that existing old generations can hardly wait for the improvement of the envi-

ronment. Second, in their model, the existing (very) old generations certainly lose from raising

the environmental tax; as a consequence, a Pareto-improving environmental tax is not possible in

their model. In our model, the existing old generation may be better off if it receives adequate

rebates of tax revenues. Importantly, our result implies that a Pareto-improving environmental tax

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