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The Question of the Carbon Tax

October 27, 2015
A carbon tax has long been held up by economists as a useful policy instrument to address CO2 emissions.  The use of a carbon tax has a number of key benefits that make it preferable over most policy interventions, and though a carbon tax program has not been utilized in the US, there are a number of carbon taxes in effect across the world.  In this piece, we explore the fundamentals of a carbon tax and provide a summary of the existing carbon taxes across the world with an eye for their efficacy.

Carbon Emissions:

One of the foremost challenges confronting policymakers today is the issue of climate change.  Rising global temperatures and sea levels threaten to trigger severe weather patterns and have substantial societal impacts.  While the scale of human contributions to climate change has been the subject of substantial political debate, consensus among the scientific community has directed attention to CO2 emissions as a target for policy intervention.  CO2 emissions have risen substantially over the past three decades.  Global emissions nearly doubled from 1980 to 2012, rising from 18434.66 million metric tons CO2 to 32310.29 million metric tons. [1] While western nations have traditionally contributed a disproportionate share of the CO2 emissions, growth in Asian emissions has driven the global advance over the past 30 years as can be seen below.

Carbon Emissions by Geographic Region

Source: Energy Information Administration

Reducing CO2 emissions presents a massive challenge because rising emissions across the developing world are largely a product of economic growth and industrialization.  Even in the developed world, reducing emissions is difficult, and though the Obama Administration has spearheaded a series of executive actions intended to reduce emissions, political consensus is certainly lacking, and there are concerns that caps on emissions may be insufficient.  In considering other policy tools available to address CO2 emissions, cap-and-trade systems and carbon taxes are often held up as the gold standard by economists.[2]  A cap-and-trade system would couple broad limits on CO2 emissions with a market-based trading mechanism to minimize the impact of reductions on those who value emissions most.  A carbon tax is not quite as complicated, and it is the subject of this post.

Basics of a Carbon Tax:

From an economic perspective, the issue of CO2 emissions represents a classic case of externality.  Societal costs of climate change are not fully internalized, and this leads to excess consumption of CO2 by individual actors.  The carbon tax would effectively raise cost of CO2 and should in theory lead to reduced emissions.  In taxing carbon emissions, any carbon producing activity would face a small tax, and so a huge array of products would see their prices rise slightly for consumers.  The advantage of the tax coming across many products is that the rise of the tax would be quite small.

The revenues from the tax could be used in a number of different ways.  Revenues could be redirected towards government programs devoted to the environment.  Similarly, revenues could flow more broadly to the governmental budget.  The most interesting possible use of the revenue might the possibility of implementing a “cost-free” tax, where revenues are returned to tax-payers.  Other taxes, such as the income tax, could be reduced at a level commensurate with the revenues gained from the carbon tax.  The idea of returning money collected in taxes directly to taxpayers on the surface seems useless.  However, the incentives are actually favorable- those who reduce their CO2 emission levels could effectively “make money” on the carbon tax by receiving an income tax rebate in excess of the carbon tax paid.

Potential Downsides of a Carbon Tax:

There are a number of concerns that have been levied about a carbon tax.  The first of these is that the tax threatens to be regressive.  Low-income individuals may be at risk to pay a greater share of their income towards the tax than higher income individuals. As a result, the carbon tax in its most basic form may disproportionately affect low-income households.  

The concerns about regressivity may not be fully warranted.  There are signs that quantifying the incidence of a carbon tax is greater when lifetime income models are not used.  Hassett, Mathur, and Metcalf found evidence in a 2007 study that the regressivity of a carbon tax may be overstated depending on the income models used to assess tax incidence. [3] Moreover, the design of a carbon tax can mitigate regressivity in the carbon tax.  Income rebates can be designed to benefit low-income individuals to greater degrees, mitigating the regressive impact of the tax.

Other concerns have been levied about the impact of the carbon tax on economic growth.  There are some signs that a carbon tax would slow economic growth in the long run.  In particular, growth could decline slightly at the end of the coming century.  The effects on economic growth must be understood in the context of environmental protection and reduced impacts of climate change.

Carbon Taxes across the World:

Though the US has not embraced carbon taxes, other countries have implemented carbon taxes, and exploring the results of carbon taxes across the world may offer some insights into the real-world effects of a carbon tax.  More than 20 countries have implemented some form of a carbon tax.  National taxes have been utilized in: Chile, Costa Rica, Denmark, Finland, France, Iceland, Ireland, Japan, Mexico, Norway, South Africa, Sweden, Switzerland, and the United Kingdom. [4] Programs in these countries vary substantially in the scale of the tax and the use of the tax revenue.  Finland was the first country to implement a tax in 1990; other Scandinavian countries such as Denmark, Norway, and Sweden followed suit within the next five years.  Though it is not a national tax, British Columbia introduced a province-wide carbon tax in 2008.  British Columbia’s program offers a particularly interesting example because other provinces in Canada have not established similar programs.  Thus, while there are differences between the British Columbia and other Canadian provinces, which we cannot perfectly control for, we can track carbon emissions in British Columbia and compare to other states in Canada after 2008 to derive some evidence about the impacts of the carbon tax.  

The tax does appear to have reduced carbon emissions.  Per person fuel consumption has declined by 16% since the introduction of the tax in British Columbia, while per-person consumption has risen by 3% across the rest of Canada. [5] Promisingly, growth of British Columbia has actually been greater in British Columbia than in the rest of Canada during the same time period (1.75% vs. 1.28%).

The success of carbon taxes in international contexts suggests that the US should be more seriously considering the tax to reduce carbon emissions.

References:

  1.  “International Energy Statistics,” Energy Information Administration, accessed October 22, 2015. 

  2.  Metcalf, Gilbert E., Sergey Paltsev, John Reilly, Henry Jacoby, and Jennifer F. Holak. Analysis of US greenhouse gas tax proposals. No. w13980. National Bureau of Economic Research, 2008.

  3. Hassett, Kevin A., Aparna Mathur, and Gilbert E. Metcalf. The incidence of a US carbon tax: A lifetime and regional analysis. No. w13554. National Bureau of Economic Research, 2007.

  4.  “Putting a Price on Carbon with a Tax,” World Bank, accessed October 22, 2015.

  5.  “British Columbia’s carbon tax: the evidence mounts,” The Economist, July 31, 2014. 

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