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The econometric critique of applied General Equilibrium modeling: a comparative assessment with application to carbon taxes in Canada McKitrick, Ross Ronald


Computable General Equilibrium (CGE) models are among the most influential tools in applied economics. In the past few years, however, some serious questions have been raised about the validity of these models. The core of the critique is that the parameter selection criteria and the functional forms used are at odds with contemporary standards of practice in econometrics. After surveying the relevant literature, which I refer to as the 'econometric critique', a formal summary of the case against standard CGE modeling is presented, as is an alternative econometric-based modeling strategy which answers the critique. I then work through a comparative CGE modeling experiment designed to assess the contrasting methods. It is found that the parameter selection rule influences model predictions in individual sectors, but industry- and economy-wide aggregates do not appear to be much affected by reparameterizing a CGE model according to econometric criteria. By contrast, the choice of functional forms affects not only industry-specific results, but aggregate results as well, even for small policy shocks. However flexible functional forms are difficult to implement in CGE models because global monotonicity must be maintained. In the second and third chapters, I adapt one of the models to analyze the effects of carbon taxes in Canada. I review an approach called 'double dividend' taxation, in which the revenues from carbon taxes are used to reduce the rates of other distortionary taxes, so an overall efficiency gain can potentially be realized whether or not the reduction in pollution improves welfare. This eliminates the need to measure benefits, and in an international context, would obviate the free-rider problem. I demonstrate the existence of a double dividend strategy for carbon taxation in Canada in the short run. In chapter three, however, a long run extension of the model shows that the double dividend does not persist over time. Nevertheless, choosing an efficient revenue-recycling option can significantly reduce the implementation cost of the carbon tax.

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