Carbon Tax

Carbon Tax

Carbon Taxes

The release of greenhouse gases in the atmosphere is a clear example of a negative externality that imposes significant costs on a global scale. In the language of economic theory, the market for carbon-based fuels such as coal, oil, and natural gas takes into account only private costs and benefits, which leads to a market equilibrium that does not correspond to the social optimum.

A standard economic remedy for internalizing external costs is a per-unit tax on the pollutant. In this case, what is called for is a carbon tax, levied exclusively on carbon-based fossil fuels. Such a tax will raise the price of carbon-based energy sources, and so give consumers incentives to conserve energy and to shift demand to alternative sources. Demand may also shift from carbon-based fuels with a higher proportion of carbon, such as coal, to those with relatively lower carbon content, such as natural gas.

Carbon taxes would appear to consumers as energy price increases. But since taxes would be levied on primary energy, which represents only one part of the cost of delivered energy (such as gasoline or electricity) and more important, since one fuel can in many cases be substituted for another, overall price increases may not be jolting. Consumers can respond to new prices by reducing energy use and buying fewer carbon-intensive products (those that require great amounts of carbon-based fuels to produce). In addition, some of these savings could be used to buy other less carbon-intensive goods and services.

Clearly, a carbon tax creates an incentive for producers and consumers to avoid paying the tax by reducing their use of carbon-intensive fuels. Contrary to other taxed items and activities, this avoidance has social benefits – reduced energy use and reduced CO2 emissions. Thus, declining tax revenues over time indicate policy success – just the opposite of what happens when tax policy seeks to maintain steady or increasing revenues.

Consider Table 1 below, which shows the impact different levels of a carbon tax would have on the prices of coal, oil and gas. A $10/ton carbon tax, for example, raises the price of a barrel of oil by $1.30, which is about 3 cents a gallon. Will this affect peopleÂ’s driving or home heating habits very much? Probably not – we would not expect a high elasticity of demand for gasoline or heating oil, since these are viewed as necessities.

Most analysts conclude that a $10/ton carbon tax would be insufficient to promote a major shift away from fossil fuels. According to several studies, stabilizing global CO2 emissions would require a carbon tax in the range of $200/ton. This would approximately double the price of oil and increase the price of coal by nearly a factor of seven (see Table 1). That would certainly affect consumption patterns. In addition, the long-term elasticity of demand would be significantly greater, as higher prices for carbon-based fuels promoted development of alternative technologies.

We can use existing cross-country data on gasoline prices and consumption to gain some insight into potential impacts of carbon taxes on consumer behaviors. Figure 1 shows that as the price of gasoline goes up, consumption declines. Notice that this relationship is similar to that of a demand curve — higher prices are associated with lower consumption, lower prices with higher consumption. However, the relationship shown here is not exactly the same as a demand curve – since we are looking at data from different countries, the assumption of “other things equal”, which is needed to construct a demand curve, does not hold.

People in the United States, for example, may drive more partly because travel distances (especially in the U.S. West) are greater than in many European countries. But there does seem to be a clear price/consumption relationship. The data shown here suggest that it would take a fairly big price hike – in the range of $0.50- $1.00 per gallon or more – to affect fuel use substantially.

Would such a tax ever be politically feasible? Especially in the United States, high taxes on gasoline and other fuels would face much opposition, especially if people saw it as infringing on their freedom to drive. Note that in Figure 1 the U.S. has by far the highest consumption per person and nearly the lowest price. But letÂ’s note two things about the proposal for substantial carbon taxes:

First, revenue recycling could redirect the revenue from carbon and other environmental taxes to lower other taxes. Much of the political opposition to high energy taxes comes from the perception that they would be an extra tax – on top of the income, property, and social security taxes that people already pay. If a carbon tax was matched, for example, with a substantial cut in income and social security taxes, it might be more politically acceptable. The idea of increasing taxes on economic “bads” such as pollution and reducing taxes on things we want to encourage, such as labor and capital investment, is fully consistent with principles of economic efficiency. Rather than a net tax increase, this would be revenue-neutral tax shift – that is, the total amount which citizens pay to the government in taxes would be unchanged.

Second, if such a revenue-neutral tax shift did take place, individuals or businesses whose operations were more energy-efficient would actually save money overall. The higher cost of energy would also create a powerful incentive for energy-saving technological innovations and stimulate new markets. Economic adaptation would be easier if the higher carbon taxes (and lower income and capital taxes) were phased-in over time.

Source: Harris, J., Codur, A., & Institute, G. (2012). Policy responses to climate change

Table 1. Alternative Carbon Taxes on Fossil Fuels
Coal Oil Natural Gas
Tons of carbon
per unit of fuel
0.605/ton 0.130/barrel 0.016/ccf
(hundred cubic feet)
Average price (2003) $17.98/ton $27.56/barrel $4.98/ccf
Carbon tax amount per unit of fuel:
$10/ton of carbon $6.05/ton $1.30/barrel $0.16/ccf
$100/ton of carbon $60.50/ton $13/barrel $1.60/ccf
$200/ton of carbon $121/ton $26/barrel $3.20/ccf
Carbon tax as a percent of fuel price:
$10/ton of carbon 34% 5% 3%
$100/ton of carbon 340% 47% 32%
$200/ton of carbon 673% 94% 64%
Source: adapted from Poterba, 1993. Price data from
U.S. Department of Energy, 2003.

Other Popular Tax Definitions in the World Legal Encyclopedia

Further Reading

Dower, Roger C. and Zimmerman, Mary. The Right Climate for Carbon Taxes, Creating Economic Incentives to Protect the Atmosphere. Washington D.C.: World Resources Institute, 1992. ISBN: 0915825783
Fankhauser, Samuel. Valuing Climate Change: the Economics of the Greenhouse. London: Earthscan Publications, 1995. ISBN: 1853832375
Intergovernmental Panel on Climate Change (IPCC). Climate Change 2001, Volume 1: The Scientific Basis. Cambridge, UK: Cambridge University Press, 2001. ISBN: 0521807670
Poterba, James. 1993. “Global Warming Policy: A Public Finance Perspective,” Journal of Economic Perspectives, Vol. 7 No. 4 (Fall 1993), pp. 47-63.
Roodman, David M. Getting the Signals Right: Tax Reform to Protect the Environment and the Economy. Worldwatch Paper # 134. Washington, D.C.: Worldwatch Institute, 1997. ISBN: 187807136X

Carbon Tax and Europe

There is an entry on carbon tax in the European legal encyclopedia.


See Also

Further Reading

  • Entry “Carbon Tax” in the work “A Concise Encyclopedia of the European Union from Aachen to Zollverein”, by Rodney Leach (Profile Books; London)



, ,