The Welfare Consequences of Government Budget Closure Assumptions Under New Environmental Policies

Recent subsidy-based environmental policies directly affect the government’s budget. Computable general equilibrium (CGE) models used to assess the costs and benefits of environmental policies typically assume a fiscal closure rule that holds government consumption fixed meaning budget shortfalls or surpluses induced by a policy are reconciled through transfers or the tax system. Revised guidance for regulatory analysis in the United States suggests that this closure rule potentially be considered in sensitivity in economy-wide analysis of environmental policies. In this paper, we shed light on instances when the closure rule may or may not be an important dimension of a policy analysis by modeling the overall welfare, emissions, and distributional consequences of different closure assumptions across a range of CGE models with different dynamics and policy types. We find that the closure rule does not create significant deviations in overall welfare unless a policy induces direct budgetary imbalances (e.g., tax or subsidy). Further, the choice of the balancing instrument can lead to very different distributional impacts and for lump sum transfers, distributionally neutral closure rules come at virtually no cost. Finally, Ricardian Equivalence, or the inconsequentiality of when the budget imbalance occurs, holds for debt-financed imbalances for lump sum transfers only (e.g., not for changes to tax rates).