Carbon taxes deserve to be taken seriously, but the details matter greatly, both in terms of how the tax is designed and how the revenue is used.
The theoretical argument for a carbon tax is strong, but that doesn't mean they always work in practice.
A mid bipartisan climate negotiations, Senator Mitt Romney (R., Utah) made ripples when he reiterated his support for a carbon price imposed on imports as well as domestically produced goods. Though they attract controversy, carbon taxes deserve to be taken seriously, especially when compared with other climate-policy options on the table. But the details matter greatly, both in terms of how the tax is designed and how the revenue is used.
The “Econ 101” argument for a carbon tax goes like this: Carbon emissions create problems (namely, climate change) for the rest of the economy, therefore the government should tax carbon emissions so that the market reflects their full social cost. The tax, in turn, incentivizes businesses to reduce their emissions.
The advantage that carbon taxes have over other environmental policies, such as industry-specific tax credits, is that they are technology-neutral — they are not reliant on the whims of policy-makers choosing which technologies are worth subsidizing. For example, the United States has provided generous tax benefits for solar and wind, but little for nuclear power, even though all three energy sources produce almost no carbon emissions.
Unlike the energy credits proposed in the Biden administration’s Build Back Better agenda, a carbon tax would not discriminate between industries, while also avoiding the administrative red tape to qualify for different subsidies.
The primary critique of carbon taxes is that they are regressive. That is true to some extent, when we look at them in isolation, but it is important to compare them with existing climate policies, such as top-down emissions regulations and credits for new green technology. Research from Georgetown professor Arik Levinson has found that regulations tend to hurt the poor more than taxes on energy do. Meanwhile, the benefits of green credits, particularly the credit for electric vehicles, flow disproportionately to the wealthy.
Another advantage of a carbon tax is that by generating revenue, the tax can allow for the reduction of more economically harmful taxes, thereby increasing economic growth. As Art Laffer, perhaps the patron saint of tax-cutter orthodoxy, wrote in endorsement of a carbon tax: “We need to impose a tax on the thing we want less of (carbon dioxide) and reduce taxes on the things we want more of (income and jobs).”
The case for carbon taxes is very strong, which is why economists overwhelmingly support the idea. But issues come with implementation, and it is important to steer clear of the pitfalls that can arise.
The fundamental question is: Does the tax actually cover carbon emissions? The ideal carbon tax beats other carbon policies because it disincentivizes all carbon emissions equally, unlike the existing mix of regulations. However, existing carbon taxes in Europe often target only certain sectors. As of 2021, 19 European countries have some form of a carbon tax; however, there is wide variation in the portion of a country’s emissions that actually face the tax, with the average among those countries being only 34 percent of CO2 emissions.
Carving out exemptions from a carbon tax for specific industries sacrifices a major advantage the carbon tax has over the existing regulatory framework. While some small portion of emissions might need to be excluded from a carbon-tax base because of administrative difficulties, many of the existing exemptions are not due to administrative constraints. As Tufts University economist Gilbert Metcalf and University of Chicago Law professor David Weisbach estimated a decade ago, 80 percent of U.S. carbon emissions come from only 3,000 companies. While 3,000 companies may sound like a lot, in the context of a U.S. economy with over 6 million firms, more than 20,000 of which have 500-plus employees, it’s a relatively small selection. This is consistent with the general finding that excise taxes, paid by upstream producers, tend to impose lower administrative costs than income taxes do.
The other issue is how the revenue gets used. There are two interests to balance when debating how to “recycle” the revenue from a carbon tax: growth and distribution. The most pro-growth policy available is providing full deductibility of capital investments, and after that, reductions in marginal corporate and personal income-tax rates. Meanwhile, the best choice to ameliorate the (slightly) regressive impact of the tax is simple cash transfer payments.
A carbon-tax package can balance both interests. British Columbia’s approach to the carbon tax provides successes to emulate and also failures to avoid. In 2008, the Canadian province imposed a carbon tax and paired it with several reforms, including both a credit for low-income taxpayers and slight reductions in corporate and individual tax rates. The policy has been, mostly, a hit: Carbon emissions are down 5–15 percent relative to where they would have been without the carbon tax; it has not reduced growth (there’s even some evidence the package raised growth slightly); and it has stuck around, rebuffing the idea that carbon taxes are politically untenable.
However, there were some areas where the British Columbia approach missed. Only around half the revenue went toward the marginal-rate reductions and the simpler general credit for low-income individuals. The rest went toward new government programs, as well as targeted tax breaks for specific industries (including non-climate goals such as subsidies for film production).
A perfect, textbook carbon tax may be difficult to create in the real world. But a good one — which reduces carbon emissions better than existing regulations do, ameliorates distributional problems with direct cash payments, and helps pay for pro-growth tax reform — is attainable. Speaking broadly about carbon taxes is easy. Getting the nuts and bolts of such a program right is more important.