Can Capital Controls Promote Green Investments in Developing Countries?

Abstract

Climate change poses severe challenges to economic growth and financial stability, especially in developing countries with a more carbon-intensive economy and a greater exposure to climate-related damages. This paper proposes a simple model in which an emerging open economy, characterised by the presence of a carbon-intensive and green industry, imposes a tax on the interest paid by brown corporate bonds to foreign investors with the aim of redirecting capital to the green industry and reducing the negative environmental externality of brown firms. In this framework, capital controls have two opposite effects. On one hand, a higher tax rate has a direct negative impact on production, since it discourages capital inflows to carbon-intensive firms, thereby reducing their output. On the other hand, capital controls have an indirect positive effect through the reduction of the negative environmental externality of the carbon-intensive sector. Moreover, the analysis reveals that the optimal inflow tax is an increasing function of climate-related damage and a decreasing function of foreign and domestic investors’ environmental preferences.