Fiscal and Environmental Sustainability: Is Public Debt Environmentally Friendly?

Abstract

This article assesses the dilemma that most governments face when seeking to ensure the sustainability of their public finances through economic growth while simultaneously protecting the environment. We propose a growth model in which the government finances abatement-spending through taxation or public debt and which follows a fiscal rule that targets the long-run debt-to-GDP ratio. We show that there is a threshold for the debt ratio below which debt and environmental sustainability are secured. In steady state, the debt ratio exerts a nonlinear effect on environmental quality in the form of an inverted U-shaped curve, and the environmental tax is good for the environment when public debt is not. A fiscal rule authorizing a small but strictly positive debt ratio could help the government to implement adaptation policies for environmental protection while supporting long-run economic growth.