What Is a Carbon Tax?

( Best ) Carbon Tax

What Is a Carbon Tax?

A carbon tax is paid by businesses and industries that produce carbon dioxide through their operations. The tax is designed to reduce the output of greenhouse gases and carbon dioxide, a colorless and odorless incombustible gas, into the atmosphere. The tax is imposed with the goal of environmental protection.

What Is a Carbon Tax?


  • The purpose of a carbon tax is to reflect the true cost of burning carbon. Those costs are borne by those who suffer from the effects, such as homeowners, farmers, and ultimately the government. Carbon taxes make sure companies and consumers pay for the external costs they impose on society. It is a Pigouvian tax since it returns the cost of global warming to their producers.
  • The Federal Reserve blames the lack of a national carbon tax for climate change.
  • Businesses and households are not accurately charged for using fossil fuels. The Fed calls this “a fundamental market failure.”2
  • The Fed also warns that this failure could lead to another wide-scale economic crisis. Extreme weather is forcing farms, utilities, and other companies to declare bankruptcy. As those loans go under, they will damage banks’ balance sheets just like subprime mortgages did during the 2008 financial crisis.
  • For example, the Pacific Gas and Electric Company went bankrupt in 2018.3 A federal judge found it responsible for the deadliest fire in California history, the Camp Fire..

Key Points

Scope – The scope of the carbon tax depends on substances covered. For instance, a carbon tax could be levied on the carbon dioxide content of fossil fuels.

Point of Taxation ­– A carbon tax can be levied at any point in the energy supply chain. The simplest approach, administratively, is to levy the tax “upstream,” where the fewest entities would be subject to it (for instance, suppliers of coal, natural gas processing facilities, and oil refineries). Alternatively, the tax could be levied “midstream” (electric utilities) or downstream (energy-using industries, households, or vehicles).

Tax and Escalation Rates ­– Economic theory suggests a carbon tax should be set equal to the social cost of carbon, which is the present value of estimated environmental damages over time caused by an additional ton of CO2 emitted today. The tax rate should also rise over time to reflect the growing damage expected from climate change.  An increasing price over time also provides a signal to emitters that they will need to do more and that their investments in more aggressive technologies will be economically justified. One of the challenges of a carbon tax is forecasting the resulting level of emissions reduction from a specific tax rate. Building in review and opportunity for adjustment can help, but also reduces the one of the values of a carbon price – price certainty.

Distributional Impacts ­– Lower-income households spend a larger share of their income on energy than higher-income households. As a result, a price on carbon that increases energy costs can have a greater impact on lower-income individuals. Directing a certain percentage of revenue from a carbon tax toward low-income households to compensate for increased energy costs can help ensure that the tax does not disproportionately affect the poor.

Revenues ­– A carbon tax can raise significant revenue. How that revenue is used will ultimately be a political choice. Some or all of it could be returned to consumers in the form of a dividend. Alternatively, it could be reinvested in climate purposes, such as advancing low-carbon technologies or building resilience. Economic research suggests that using the revenues to reduce existing taxes on labor and capital—also known as a tax swap—can minimize the economic costs and may result in net economic benefits.


  • The added cost reduces emissions by motivating consumers to seek cleaner energy
  • Boosts economic growth by substantially increasing government revenue
  • Funds agencies managing climate change effects

  • A carbon tax is regressive
  • A sudden increase in a carbon tax would shock the economy
  • It penalizes those who can’t switch to alternatives

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