Abstract

How do inequality, uninsurable income risk, and fiscal constraints shape the design of optimal climate policy? To address this question, we develop a climate-economy model with incomplete markets, where heterogeneous households face idiosyncratic risk. Within this framework, we analytically characterize the optimal carbon tax and show that it follows a modified Pigouvian formula, adjusted for inequality and fiscal distortions. We then calibrate the model to key features of the U.S. economy and solve numerically for the optimal path of carbon taxes, income taxes, and public debt over the transition. Our results indicate that concerns about inequality, risk, and fiscal distortions do not justify a less ambitious climate policy: deviations from the social cost of carbon remain minimal across a wide range of scenarios, even in the presence of strong fiscal constraints. Finally, we examine the implications of climate policy for redistribution, risk-sharing, and overall welfare.