Should we tax carbon?

On a daily basis, each of us makes choices that can have an impact on the environment’s long-term health. We can look at our consumption of carbon as a case in point: the decision to drive instead of bike, to eat any foods rather than locally grown foods or to use gas-powered sources to meet energy needs instead of energy from wind turbines or even self-installed solar panels all impact the amount of carbon the Earth is exposed to. In economics speak these daily decisions we make are called “externalities” since they have an impact on the environment, and by extension on other individuals. Aside from individuals changing long-held habits, what else can we do to protect the environment? A carbon tax is an idea that has continued to gain more and more traction within the economics community.

What is a carbon tax?

Put simply, a carbon tax serves to put a price on carbon through government legislation. When companies use carbon to produce goods, they would have to pay for their carbon emissions. As a result, companies would likely pass on these additional costs to consumers, leading to higher prices for goods necessitating large amounts of carbon in the production process and by extension goods whose production disproportionally harmed the environment. In doing so, people would be “internalizing the externality” when purchasing goods under the institution of a carbon tax. Such a tax is called a Pigovian tax because it seeks to bring back a balance to the Fundamental Welfare Theorem. The theorem only holds if there are no externalities to other actors in a business transaction, and with carbon that is patently not the case. To resolve the issue of externalities, we can impose a cost to the externalities, which is a solution that was originally devised by the British economist Arthur Pigou.

What do we stand to gain?

The aim of a carbon tax is to reduce the number of choices people make that harm the environment. By imposing higher costs, people, the theory goes, will think twice about driving to work everyday. Following this chain of effect, the decreased consumption of carbon will lead to substantial environmental benefits and mitigate the tide of global warming. Additionally, the government could raise valuable tax revenue, which could then go towards subsidizing renewable energy projects, paying for social programs or reducing income taxes. Unlike many other measures to reduce carbon consumption, a carbon tax is especially useful because it requires little government intervention in correcting market failures. As a result, the tax has been widely embraced by economists, as exemplified by a 2011 survey of 41 economists by AIG that revealed 90 percent support for a carbon tax.

What makes a carbon tax potentially problematic is pricing. Obviously, the right price is one that will equally account for the cost of the externalities to create a zero sum, but environmental externalities are notoriously hard to account for. This is because the environmental externalities caused by carbon consumption lead to pernicious harms in the future. The problem with that, however, is that it is nearly impossible to value the future in the present. One way economists try to do this is by using a discount rate, but discount rates vary among different economic models. For example, using different discount rates, the economist Bill Nordhaus suggests a $30 tax on each ton of carbon produced whereas Nicholas Stern believes the tax should actually be 300$ per ton of carbon to effectively account for externalities. Over the coming years, as we try to protect the environment, politicians, economists and individuals will need to constantly engage in balancing acts to simultaneous ensure economic and environmental health.