The paper evaluates the macroeconomic effects of increasing taxation on fossil sources of energy (carbon tax) in the euro area by simulating a New Keynesian model where the tax revenues finance higher subsidies for renewable sources and reduce labour taxes. It is assumed that the increase in the carbon tax is gradual, announced by the authorities, and therefore expected by households and firms; these features make it different from a sudden and unexpected rise in the international prices of fossil fuels.
A carbon tax increase has recessionary effects, which can be offset almost entirely by using the carbon tax revenues to increase subsidies for renewable sources and to reduce labour taxes. If the monetary policy rate is at its lower bound, then the net recessionary effects can be offset by reducing the long-term interest rates through sovereign bonds purchases by the central bank for monetary policy purposes.
