Habit Formation in the Environmental Quality: Dynamic Optimal Environmental Taxation

Abstract

In this article we propose a model in which individuals experience habit formation in environmental quality. Further, a consumption good causes a negative external effect on the environment. The intertemporal utility of a benevolent social planner depends on consumption of two goods and the environment. Hence, the choice of the social planner is to maximize utility given the negative effect of the consumption good on the environment, taking into account that there is habit formation in environmental quality. Given a simple model we show that the level and time path of the optimal tax is affected by the assumption of habit formation; more specifically the stronger the habit, the higher the optimal level of environmental quality in steady state, and the faster the transition towards the steady state tax level. Furthermore the initial value of the habit stock is of crucial importance for the time path of the tax. Also, we solve for, and analyze, dynamics and the existence and characteristics of equilibria in the model and discuss how the characteristics of the habit formation affect steady state.