Carbon Tax

A Carbon tax is one of the three main ways (alongside ETS and CC) through which a government can regulate the carbon emissions of an economy. Like an ETS, a carbon tax is a market-based solution, meaning it does not set an upper limit on the pollution caused by any individual company but instead tries to provide a financial incentive for companies to pollute less.

The functioning of a carbon tax is straight-forward: for any unit (usually ton) of CO2 caused, the polluting company has to pay a certain amount of money to the government. Through its simplicity, a carbon tax is easy to implement and relatively easy to monitor. Companies can choose to maintain their current pollution levels, accepting to incur a high tax payment or to lower emissions in order to avoid taxes. Usually, companies will choose the latter option and abate part of their emissions by investing in new technology or by trying to make processes more efficient. In theory, if the tax rate is chosen correctly, this will lead to an efficient outcome as companies will decrease their emissions up to the level intended by the government.

A Carbon Tax falls into the category of a Pigovian Tax as it aims to reduce negative externalities (emissions) to the level at which the marginal cost (pollution) equals the marginal benefit (economic activity). In practice, however, it is difficult to find the ideal tax rate as it is hard to put a price tag on pollution. Surely Greenpeace would set a higher price than Shell or BP. If the wrong tax rate is chosen, it can have adverse effects on the environment or the economy, i.e. if the tax rate is set too low, it won’t lead to a substantial improvement in emissions caused, while if it is set too high, it can be detrimental to the economy.

One way to mitigate this problem is to begin by introducing a low tax rate and increase it gradually to see how the economy reacts. For example, France, in 2014, introduced a tax of 7€ per ton of CO2, which was steadily increased to its current level of 44.60€ per ton. Companies often protest the tax as unlike for CC and ETS systems, they will face an increased tax payment to the government even when reducing their emissions as a result. Especially industrial companies feel mistreated, as their operations are naturally more polluting than those of a service or software company. With consumers, too, the tax is widely unpopular as it leads to higher prices; Indeed, it was an increase in petrol taxes that sparked protests of the Gilet Jaunes.

These issues could be mitigated by giving the tax revenue back to the end consumer through subsidies or lower taxes on other products. In order to have the desired effect, however, it should encourage people to make more sustainable choices. Germany, for example, recently implemented a carbon tax, that it plans to give back to commuters that now face higher costs for driving their car to work, therefore nullifying much of the positive effect of the tax. Instead, tax revenues should be used to lower taxes on public transportation, fresh produce, green energy, etc. Another way would be to use the increased tax revenues to provide subsidies to sustainable companies and projects, leading to a gradual transition towards a greener economy.

Further Reading:

World bank report on carbon taxes

Argument that Carbon Taxes and Economic Liberalism can go hand in hand

(Definitions and content draw heavily on ECON204 thaught by Prof. Neumeyer at the London School of Economics and the corresponding textbook Environmental Economics: An Introduction by Field and Field)