The Environment and Directed Technical Change

This paper introduces endogenous and directed technical change in a growth model with environmentalconstraints. A unique final good is produced by combining inputs from two sectors. Oneof these sectors uses “dirty” machines and thus creates environmental degradation. Research canbe directed to improving the technology of machines in either sector. We characterize dynamictax policies that achieve sustainable growth or maximize intertemporal welfare. We show that:(i) in the case where the inputs are sufficiently substitutable, sustainable long-run growth can beachieved with temporary taxation of dirty innovation and production; (ii) optimal policy involvesboth “carbon taxes” and research subsidies, so that excessive use of carbon taxes is avoided; (iii)delay in intervention is costly: the sooner and the stronger is the policy response, the shorter isthe slow growth transition phase; (iv) the use of an exhaustible resource in dirty input productionhelps the switch to clean innovation under laissez-faire when the two inputs are substitutes. Underreasonable parameter values and with sufficient substitutability between inputs, it is optimalto redirect technical change towards clean technologies immediately and optimal environmentalregulation need not reduce long-run growth.