Can public debt mitigate environmental debt? Theory and empirical evidence

Highlights

• We study the theoretical and empirical link between public and environmental debt.

• The two types of debt are complementary (usually substitutes) in the long run (short run).

• An empirical analysis confirms our theoretical findings.

• Debt-related fiscal policies can have short- and long-run conflicting environmental effects.

Abstract

This paper investigates the relationship between public debt and environmental debt—reflecting CO${}_2$ carbon concentration. First, using an endogenous growth model in which pollution abatement spending can be financed by public debt, we show that public debt and environmental debt are complementary in the long run and usually substitutes in the short run. Second, these predictions are empirically confirmed: in particular, a 1% increase in the public debt ratio leads to an increase of 0.74% in cumulative CO${}_2$ per capita in the long run. Our findings emphasize the difficulty of defining policies that jointly serve both the economic (fiscal) and the environmental goals, due to the short- and long-run conflicting environmental effects of policies that either reduce or do not constrain public debt.

Introduction

The recent history emphasizes two distinguishing features of unsustainable development, stemming from global environmental degradation and from rising sovereign indebtedness. These two features are structural and are expected to persist well past the end of the Covid-19 pandemic: between 1960 and 2015 the time-profile of the debt-to-GDP ratio and the CO${}_2$ emissions present a growing trend for OECD countries, as Fig. 1 depicts.

On the climate side, energy-related CO${}_2$ global emissions rose to a historically-high in 2018 (International Energy Agency, 2019). This reinforced the issue of the environmental or climatic debt that will be carried by future generations (Azar and Holmberg, 1995). According to the 2017 Annual report of the Global Footprint Network, over 85% of the world population lives in countries with an “ecological deficit”, due to polluting emissions above the nature’s absorptive capacity. The accumulation of such deficits gives rise to an environmental debt, defined as “the accumulation of past environmental impacts of natural resource depletion and environmental degradation, owed to future generations” (OECD definition: https://stats.oecd.org/glossary/detail.asp?ID=820) and measured by “the costs required to restore the environmental damage that is economically and technically restorable” (Jernelöv and Edenmark, 1992). On the fiscal policy side, the post-1970s oil shocks era is characterized by persistent deficits,² which fueled an increasing trend in the public debt-to-GDP ratios around the world and resulted into historically-exceptional indebtedness nowadays.

A fundamental debate concerns the environmental and climate consequences of these large indebtedness levels. One view is that high public debt may hurt economic growth (Reinhart and Rogoff, 2010, Eberhardt and Presbitero, 2015) and damage the natural environment by hindering the implementation of environmental protection programs. This could undermine the ability of indebted economies to

engage in sustainable energy transition.³ In particular, in developing countries public debt can limit the capacity to mobilize domestic resources and thus to invest in climate change adaptation (Van den Bergh, 2013, UNCTAD, 2017).⁴ In addition, the repayment of the debt burden can force highly-indebted economies to increase the pressure on the natural environment in order to raise public revenues (Combes et al., 2015). However, an alternative and more optimistic view suggests that public debt can increase the environmental quality by financing investments in low-carbon technologies, clean energy projects, or environmental R&D activities that will mainly benefit future generations (Bénassy-Quéré et al., 2010).⁵ In this case, thanks to public spending-financed investments in abatement knowledge, public debt sustainability and environmental preservation could be compatible.

The goal of this paper is to shed light on the debate regarding the relationship between public debt and environmental debt by adopting an integrated strategy combining theoretical modeling and empirical evaluation.

Theoretically, we build an endogenous growth model with an environmental good modeled as a stock in the spirit of Tahvonen and Kuuluvainen (1991), Bovenberg and Smulders (1995), Fullerton and Kim (2008) and Menuet et al. (2020).⁶ As usual, the environmental quality that can be related to CO${}_2$ concentration is a renewable resource that regenerates itself and depletes through CO${}_2$ emissions. These emissions come from economic activity relying on fossil fuel energies for production—net of abatement spending provided by the government.

In this setup, we introduce two key ingredients. First, we relax the standard balanced-budget hypothesis to account for deficits and debt in the long run, consistent with the current state of public finances in most countries in the world. Second, we define the environmental debt as the gap between the natural capital at the virgin state (i.e. the state without economic activity) and at the current state. Following Jernelöv and Edenmark (1992), the environmental debt reflects economy’s obligations towards nature, namely the price that the society must pay to restore the virgin-state environmental quality. With this definition, environmental debt can be measured by cumulative CO${}_2$ emissions.

Our findings are that public and environmental debt are complementary in the long run, and usually substitutes in the short run. The intuition is the following: an increase in public debt provides a flow of environmental-detrimental resources (the public debt burden), and a flow of environmental-improving resources (the public deficit that finances abatement expenditure). In the long run, the first effect offsets the second, so that public debt has an adverse overall effect on abatement expenditure;⁷ while in the short run the second effect outweighs the first provided that public debt is not too high.

Empirically, we test our predictions using cointegration techniques in a panel of 22 countries over 1990–2011. We define the environmental debt as cumulative CO₂ emissions.⁸ As our analysis is concerned with both short- and long-run effects, the use of the “carbon debt” as a proxy for the environmental debt is supported by the fact that CO${}_2$ emissions persistently remain in the atmosphere. To account for the individual and time dimensions of our data, combined with the presence of a unit root, we rely on panel cointegration techniques that conveniently allow capturing the common long-run trend suggested by our model. Our empirical findings are twofold. First, we reveal a robust positive long-run relationship between public debt and environmental debt, confirming the long-run complementarity suggested by the theoretical model. Second, we mostly observe a negative relation between the two debts in the short run. However, additional estimations show that the substitution effect between public debt and environmental debt can be weakened when average public debt is relatively high.

Finally, we exploit the theoretical mechanism describing the interaction between public debt and environmental debt to derive normative policies from a welfare analysis. In particular, we unveil an inverted-U relationship between public debt and long run welfare, in which environmental preferences affect the welfare-maximizing debt threshold.

Related literature. Relative to existing work, our paper provides theoretical, empirical, and policy contributions.

On the theoretical side, although many studies introduced an environmental module in endogenous growth models (see e.g. Bovenberg and Smulders, 1995, Chen et al., 2003; and the review of Xepapadeas, 2005), the papers that study the impact of fiscal policies on environmental outcomes (as, e.g., Bovenberg and Smulders, 1996, de Mooij and Bovenberg, 2007, Rosendahl, 1997, Fullerton and Kim, 2008, Karydas and Zhang, 2019, Barrage, 2020) restrict government’s abatement public spending to be financed exclusively by taxation (i.e. with zero deficit and public debt). By allowing for public debt in an environmental endogenous growth model, we are able to examine the impact of public debt on economic growth and climate debt both in the short and the long run.

Additionally, in the particular context of overlapping generations (OLG) setups, some authors (see, e.g., Rausch, 2013, Fodha and Seegmuller, 2014, Fodha et al., 2018) attempted to evaluate the consequences of environmental policies financed by public debt. In Fodha and Seegmuller (2014) and Fodha et al. (2018), there are two steady states with reverse properties: at the stable steady state, higher debt reduces capital but improves environmental quality; while opposite effects are observed at the unstable steady state. Rausch (2013) found that when a carbon tax serve to consolidate public debt, the environmental policies could generate sustained welfare gains.

Our model extends and challenges these results in three directions. First, in our endogenous growth setup, in the long run economic growth is strictly positive and public debt is endogenous, contrasting with OLG settings. Second, contrary to Fodha and Seegmuller (2014) and Fodha et al. (2018), we demonstrate the uniqueness of the steady state, and prove that the link between the debt-to-GDP ratio and the environmental quality depends on the time horizon. Third, while Rausch (2013) focused on the welfare-enhancing fiscal instrument to consolidate public debt, we focus instead on the level of public debt (as a ratio to GDP) and unveil the existence of a welfare-maximizing debt ratio.

On the empirical side, the few studies that attempt to measure the link between public debt and environmental quality concern the evaluation of debt-for-nature swaps. The consensus is that the link between public debt and environmental quality – most often measured by the amount of rainforest in the tropical zone – is unambiguously negative. For example, Kahn and McDonald (1995) or Didia (2001), using standard ordinary least squares regressions, have shown that a rise in debt leads to an increase in deforestation in tropical countries. By addressing the endogeneity problem with instrumental variable regressions, Sommer et al. (2020) confirmed that higher debt reductions are associated with lower rates of forest loss in the context of debt-for-nature swaps involving the United States. In our econometric analysis, we measure the environmental debt by the cumulative CO${}_2$ emissions, and we show, using a cointegration technique, that the link between public debt and environmental debt is significant and positive in the long run, but can be negative in the short run.

On the policy side, we contribute to the literature on the interaction between macroeconomic policies and environmental policies—see recent examples in Combes et al. (2015), Edenhofer et al. (2017), or Siegmeier et al. (2018). Importantly, in our setup abatement technologies can overcome the conflict between environment and economic growth (Van Ewijk and Van Wijnbergen, 1995): higher abatement spending can lead to higher economic growth and lower carbon concentration (i.e., “double dividends”). Nevertheless, if the abatement technology is financed by public debt, we reveal an intertemporal trade-off: policies that do not constrain the increase of public debt may reduce carbon concentration and improve environmental quality in the short run. However, such policies may have detrimental environmental consequences in the long run. Instead, policies that limit public debt, such as tight fiscal rules, may result in lower environmental debt and better environmental quality in the long run, but with detrimental consequences in the short run. In addition, both types of policies could be equally questionable from a long-run perspective if they ultimately move away long-run public debt from its environmental-contingent welfare-maximizing value.

In a nutshell, our message is that the benefits from combining environmental and debt consolidation policies are limited.⁹ The complex public-environmental debt relationship that we unveil points to the absence of always-dominant policies, and calls for a careful use of public debt for reaching climate change goals in the long run.

The remainder of the paper is organized as follows. Section 2 presents the theoretical model, and Section 3 explores the relationship between public debt and environmental debt. Section 4 details the empirical strategy, and Section 5 provides empirical support for our theoretical findings. Further estimations in Section 6 confirm the soundness of our theoretical setup, and motivate its use for the derivation of welfare-based normative policies in Section 7. Finally, Section 8 concludes the paper.