Carbon Tax

Carbon Tax Economics

The topic of carbon tax economics has been circulating for decades, but several developed nations and many more developing nations have not yet implemented it, the United States being one of them. Economists feel that a carbon tax is one of the most effective ways to reduce carbon dioxide emissions because it forces producers to pay for each unit of carbon they send into the atmosphere. This adds a layer of cost that factories must incorporate into their balance sheets and could take away from their profits.

The fact that a carbon tax will make it more expensive to use fossil fuels is not debated. What is up for debate and what has slowed the widespread implementation of a carbon tax is the question of who will ultimately pay the tax. At first glance, firms producing carbon dioxide will pay the tax to the government. How much they pay is dependent on the tax rate and how much carbon dioxide is produced. Firms that produce the most carbon will end up paying the most.

However, firms will not want to accept a reduction in profits from their operating cost increasing without an increase in output. To avoid losing profits, firms will push the cost of the tax onto their customers by raising their prices. When buyers are charged a higher rate for the goods and services they consume, they will find ways to cut back on the use of these goods. This means that consumers bear the largest burden under a carbon tax, more specifically, low-income households who live on a fixed budget.⁴

Carbon Tax Rate

Each nation that has a carbon tax sets its own carbon tax rate. The carbon tax rate is the actual price that countries charge for each metric ton of CO2 they produce. The rate of the carbon tax is determined by the government implementing it. A problem that policymakers have with setting a carbon tax rate is how to decide what that rate should be since it is arbitrary. Should the price of carbon be dependent on the environmental cost? Should it depend on the social cost that climate change has brought on? Measuring these costs would also prove difficult. For the moment, each country sets its carbon taxes at the rate they see fit to deter the increased production of carbon emissions. Figure 1 below illustrates the different prices of carbon by country. (Please note that this is not a complete list.)

Fig. 1 - Carbon tax rates from around the world, 2022. Source: The World Bank⁶

There is no clear pattern to how countries decide to price carbon other than that most countries are developed or are more developed than their neighboring nations.

The result of the carbon tax is an increase in the price level that consumers pay for carbon-producing goods. As the government places the carbon tax on producers, they will offload the burden on the consumer. Have a look at Figure 2.

Fig. 2 - Effect of a carbon tax on demand

Think of Figure 2 as a story. At first, we are at the E₁ where the equilibrium price and quantity are Q₁ and P₁. Then the government adds a carbon tax the size of P₂ - P₁. This causes firms to increase their prices by the same amount, resulting in a movement along the demand curve to the left, from E₁ to E₂. At this point, the quantity demanded is less than the quantity being supplied. To avoid a surplus, the firms scale back their production until the market ends up at E₂. At E₂ the quantity demanded of carbon-intensive goods is reduced which, by default, reduces the carbon emissions produced. The finale of the story is the achievement of the government's overall goal to reduce CO2 emissions.

Carbon Tax Pros and Cons

Carbon tax pros and cons are numerous and well-established since the idea of a carbon tax has been around for many decades. A carbon tax is not a perfect solution to pollution and climate change but many politicians, climate scientists, and economists feel that a carbon tax would be helpful nonetheless. Table 2 lists some of the most prominent arguments made for and against a carbon tax.

Carbon Tax: Pros

Since the main goal of a carbon tax is reducing carbon emissions, it makes sense that this is the top argument for its implementation. Supporters of a carbon tax also argue that having polluters pay for the carbon they emit is a way to force them to pay the social and environmental costs that producing carbon creates. The proceeds of the carbon tax would also form a new source of revenue for the government. This revenue could then be put towards research and development for renewable energy sources or helping those struggling to pay for the increased energy prices. Not only would government funding for renewable energy sources increase, but more companies and private entrepreneurs would be motivated to invest if they felt like renewable energy is where the future is headed.

A carbon tax is also not the first tax of its kind. Several nations that are considering a carbon tax already have some form of tax on fossil fuels, meaning that hopefully a carbon tax policy could be more easily implemented if it can piggyback off of existing policies. This would make a carbon tax one of the cheaper methods of reducing carbon compared to those that would require the establishment of a whole new structure.

Carbon Tax: Cons

Now, let's get into why not everyone is on board with a carbon tax. The biggest issue that opponents mention is the fact that a carbon tax would raise the price of energy. Although the goal is to push people to consume less carbon-intensive energy, that is not necessarily possible. Electricity and gas are goods that would be directly impacted by a carbon tax and they are both necessities making their demand inelastic, meaning people cannot simply stop using them. They need these goods to heat their homes in the winter, cook their food, and have hot water. There is only a small margin for reduced consumption before it negatively impacts the consumer's standard of living. This margin is even smaller for low- and middle-income citizens meaning they would be disproportionately affected by the increased energy prices, whereas wealthier people will simply pay more.

For larger carbon producers, it might be cheaper to relocate their operations to a country that does not have a carbon tax than to pay the carbon tax or modify their production process to reduce emissions. Not only would the home country not gain revenue from the carbon tax but it would also lose any revenue that would have come from the firm in the form of sales and regular taxes and citizens would become unemployed.

For those companies that cannot relocate, they might be motivated to find ways around paying the carbon tax since it is still difficult to monitor the exact amount of carbon a firm produces. A carbon tax would require the government to come up with a way to verify the levels of carbon produced which is yet another expenditure that they have to cope with.

Carbon Tax Examples

Having a look at some carbon tax examples will help solidify our understanding. As of 2022, Uruguay has the highest carbon tax in the world at $137 US Dollars.⁶ Uruguay is considered a developing country but is more developed than its neighbors. The reason it has such a high carbon tax is that it is trying to turn the implicit cost of carbon into an explicit cost as a way to reflect the harm excess carbon production has had on the environment.⁷

Although Finland was the first nation to establish a carbon tax and its current carbon tax rate is up to $85, it does not hold the highest carbon tax in the EU.⁶ This place goes to Sweden, Switzerland, and Liechtenstein which all have a carbon tax rate of $130.⁶

An example of a country whose carbon tax failed, and was removed after two years, is Australia. First introduced in 2011, and effective in 2012, the Clean Energy Act saw a 1.4% greenhouse gas emissions reduction by the second year but also increased the average price of electricity for a family by 10% and businesses saw a nearly 30% increase.⁸ So although the carbon tax appeared to be doing what it was meant to be by reducing emissions, social ramifications caused the tax to eventually be repealed in 2014. Australia is an example of how the political and social implications of a carbon tax can overshadow the environmental benefit that it brings.