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# Carbon Tax

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For decades now, reducing emissions has been a hot topic in both the political and the scientific spheres. Neither side can seem to agree on a solution that is both efficient, cost-effective, and nonpartisan. One of the options to combat pollution produced by excess carbon dioxide emissions is a carbon tax. Many nations like the European Union, Canada, China, Uruguay, Argentina, Denmark, and the United Kingdom already have some form of a carbon tax in place. But what is a carbon tax, and is it the key to reducing global pollution? How about we take a closer look...

## Carbon Tax Definition

The general consensus of the carbon tax definition is that it is a fee that is charged by the government to individuals or firms that produce carbon dioxide (CO2). A carbon tax is a way for governments to set a price on carbon units that are released into the atmosphere.

A carbon tax is a fee placed on the production of carbon dioxide. It is a way for the government to place a price tag on each unit of carbon dioxide emitted.

The idea behind a carbon tax is to discourage the general production of carbon dioxide. There are two categories of carbon taxes:

 Emissions-based taxes Tax on greenhouse gas-intensive goods and services. A carbon tax based on how much emissions a firm or individual produces.Example: A per unit carbon tax on a tire factory. A carbon tax applied to the final price of a good based on how carbon intense the good or the production of the good is.Examples: Gasoline, plastic, and motor vehicles.
Table 1 - Two forms of a carbon tax.

Carbon dioxide exists naturally in the environment and is a gas vital to the proper function of the earth's atmosphere. These gasses in the atmosphere trap heat in the same way that the glass panels in a greenhouse trap heat. Without carbon dioxide, the other gasses alone are not strong enough to keep the earth at a temperature compatible with life.1 So, we need carbon dioxide, but too much of it increases the greenhouse effect, and the earth's temperature is no longer at optimal levels.1

Carbon taxes are a result of countries recognizing that the pollution created by burning fossil fuels has a disruptive effect on our earth's climate patterns.2 Some of the most notable changes in climate patterns are ocean acidification and severe weather phenomenon.1 Setting a price on carbon is one of the most effective ways for counties to rapidly reduce the level of emissions they produce. The first carbon tax was implemented in Finland in 1990, making it one of the first nations to take a step towards influencing the earth's changing climate.3

Pollution is considered a negative externality to production. But what does that mean? You can learn about externalities by checking out our explanations:

- Negative Externalities

- Positive Externalities

## Carbon Tax Economics

The topic of carbon tax economics has been circulating for decades, but several developed nations and many more developing nations have not yet implemented it, the United States being one of them. Economists feel that a carbon tax is one of the most effective ways to reduce carbon dioxide emissions because it forces producers to pay for each unit of carbon they send into the atmosphere. This adds a layer of cost that factories must incorporate into their balance sheets and could take away from their profits.

The fact that a carbon tax will make it more expensive to use fossil fuels is not debated. What is up for debate and what has slowed the widespread implementation of a carbon tax is the question of who will ultimately pay the tax. At first glance, firms producing carbon dioxide will pay the tax to the government. How much they pay is dependent on the tax rate and how much carbon dioxide is produced. Firms that produce the most carbon will end up paying the most.

However, firms will not want to accept a reduction in profits from their operating cost increasing without an increase in output. To avoid losing profits, firms will push the cost of the tax onto their customers by raising their prices. When buyers are charged a higher rate for the goods and services they consume, they will find ways to cut back on the use of these goods. This means that consumers bear the largest burden under a carbon tax, more specifically, low-income households who live on a fixed budget.4

A carbon tax is only one type of tax. There is so much more to discover about taxes and their effects, you should check out our explanation - Effects of Taxes

## Carbon Tax Rate

Each nation that has a carbon tax sets its own carbon tax rate. The carbon tax rate is the actual price that countries charge for each metric ton of CO2 they produce. The rate of the carbon tax is determined by the government implementing it. A problem that policymakers have with setting a carbon tax rate is how to decide what that rate should be since it is arbitrary. Should the price of carbon be dependent on the environmental cost? Should it depend on the social cost that climate change has brought on? Measuring these costs would also prove difficult. For the moment, each country sets its carbon taxes at the rate they see fit to deter the increased production of carbon emissions. Figure 1 below illustrates the different prices of carbon by country. (Please note that this is not a complete list.)

Fig. 1 - Carbon tax rates from around the world, 2022. Source: The World Bank6

There is no clear pattern to how countries decide to price carbon other than that most countries are developed or are more developed than their neighboring nations.

The result of the carbon tax is an increase in the price level that consumers pay for carbon-producing goods. As the government places the carbon tax on producers, they will offload the burden on the consumer. Have a look at Figure 2.

Fig. 2 - Effect of a carbon tax on demand

Think of Figure 2 as a story. At first, we are at the E1 where the equilibrium price and quantity are Q1 and P1. Then the government adds a carbon tax the size of P2 - P1. This causes firms to increase their prices by the same amount, resulting in a movement along the demand curve to the left, from E1 to E2. At this point, the quantity demanded is less than the quantity being supplied. To avoid a surplus, the firms scale back their production until the market ends up at E2. At E2 the quantity demanded of carbon-intensive goods is reduced which, by default, reduces the carbon emissions produced. The finale of the story is the achievement of the government's overall goal to reduce CO2 emissions.

Did you see what happened to the equilibrium when the carbon tax was applied?

Here is an explanation that will teach you even more about what effect taxes have on the equilibrium

- Effect of Taxation on Equilibrium

## Carbon Tax Pros and Cons

Carbon tax pros and cons are numerous and well-established since the idea of a carbon tax has been around for many decades. A carbon tax is not a perfect solution to pollution and climate change but many politicians, climate scientists, and economists feel that a carbon tax would be helpful nonetheless. Table 2 lists some of the most prominent arguments made for and against a carbon tax.

 Pros Cons Reduces carbon emissions and pollutionMakes polluters pay for the emissions they createGenerates government revenue Encourages the switch to renewable energy sourcesIs relatively simple to implement Increases costs for consumersDisproportionately affects those with a lower incomePolluters may relocate production to countries that do not have a carbon tax to avoid itDifficult to monitor and administer effectivelyNot foolproof
Table 2 - Pros and cons of a carbon tax.

### Carbon Tax: Pros

Since the main goal of a carbon tax is reducing carbon emissions, it makes sense that this is the top argument for its implementation. Supporters of a carbon tax also argue that having polluters pay for the carbon they emit is a way to force them to pay the social and environmental costs that producing carbon creates. The proceeds of the carbon tax would also form a new source of revenue for the government. This revenue could then be put towards research and development for renewable energy sources or helping those struggling to pay for the increased energy prices. Not only would government funding for renewable energy sources increase, but more companies and private entrepreneurs would be motivated to invest if they felt like renewable energy is where the future is headed.

A carbon tax is also not the first tax of its kind. Several nations that are considering a carbon tax already have some form of tax on fossil fuels, meaning that hopefully a carbon tax policy could be more easily implemented if it can piggyback off of existing policies. This would make a carbon tax one of the cheaper methods of reducing carbon compared to those that would require the establishment of a whole new structure.

### Carbon Tax: Cons

Now, let's get into why not everyone is on board with a carbon tax. The biggest issue that opponents mention is the fact that a carbon tax would raise the price of energy. Although the goal is to push people to consume less carbon-intensive energy, that is not necessarily possible. Electricity and gas are goods that would be directly impacted by a carbon tax and they are both necessities making their demand inelastic, meaning people cannot simply stop using them. They need these goods to heat their homes in the winter, cook their food, and have hot water. There is only a small margin for reduced consumption before it negatively impacts the consumer's standard of living. This margin is even smaller for low- and middle-income citizens meaning they would be disproportionately affected by the increased energy prices, whereas wealthier people will simply pay more.

For larger carbon producers, it might be cheaper to relocate their operations to a country that does not have a carbon tax than to pay the carbon tax or modify their production process to reduce emissions. Not only would the home country not gain revenue from the carbon tax but it would also lose any revenue that would have come from the firm in the form of sales and regular taxes and citizens would become unemployed.

For those companies that cannot relocate, they might be motivated to find ways around paying the carbon tax since it is still difficult to monitor the exact amount of carbon a firm produces. A carbon tax would require the government to come up with a way to verify the levels of carbon produced which is yet another expenditure that they have to cope with.

## Carbon Tax Examples

Having a look at some carbon tax examples will help solidify our understanding. As of 2022, Uruguay has the highest carbon tax in the world at $137 US Dollars.6 Uruguay is considered a developing country but is more developed than its neighbors. The reason it has such a high carbon tax is that it is trying to turn the implicit cost of carbon into an explicit cost as a way to reflect the harm excess carbon production has had on the environment.7 Although Finland was the first nation to establish a carbon tax and its current carbon tax rate is up to$85, it does not hold the highest carbon tax in the EU.6 This place goes to Sweden, Switzerland, and Liechtenstein which all have a carbon tax rate of \$130.6

An example of a country whose carbon tax failed, and was removed after two years, is Australia. First introduced in 2011, and effective in 2012, the Clean Energy Act saw a 1.4% greenhouse gas emissions reduction by the second year but also increased the average price of electricity for a family by 10% and businesses saw a nearly 30% increase.8 So although the carbon tax appeared to be doing what it was meant to be by reducing emissions, social ramifications caused the tax to eventually be repealed in 2014. Australia is an example of how the political and social implications of a carbon tax can overshadow the environmental benefit that it brings.

## Carbon Tax - Key takeaways

• A carbon tax is a fee that is placed by a government on the production of carbon dioxide, as a way to put a price on each unit of carbon.
• The two ways that a carbon tax can be implemented are as a per unit tax on each metric ton of carbon a firm or individual produces or as a tax on the final price of the good depending on how carbon-intensive its production process is.
• Carbon taxes are seen as one of the most effective ways to reduce carbon emissions because the amount of carbon a firm produces has a direct financial impact on the firm.
• The benefits of a carbon tax are that it effectively reduces pollution, generates revenue for the government, and sees polluters pay for their negative effects on the environment.
• The drawbacks to a carbon tax are that it mainly increases costs for consumers, disproportionately affects low-income families, and carbon emissions are difficult to monitor therefore the tax is difficult to implement.

## References

1. Rebecca Lindsey, Climate Change: Atmospheric Carbon Dioxide, June 2022, https://www.climate.gov/news-features/understanding-climate/climate-change-atmospheric-carbon-dioxide#:~:text=Without%20carbon%20dioxide%2C%20Earth's%20natural,causing%20global%20temperature%20to%20rise.
2. Carbon Tax Center, Why A Carbon Tax, 2022, https://www.carbontax.org/why-a-carbon-tax/
3. Michal Nachmany et al, CLIMATE CHANGE LEGISLATION IN Finland, 2015, https://www.lse.ac.uk/GranthamInstitute/wp-content/uploads/2015/05/FINLAND.pdf
4. What is a carbon tax?, Tax Policy Center, May 2020, https://www.taxpolicycenter.org/briefing-book/what-carbon-tax#:~:text=Emissions%20of%20carbon%20dioxide%20and,industries%20and%20lower%2Dincome%20households.
5. Ian Tiseo, Prices of implemented carbon taxes worldwide 2022, by country, August 2022, https://www.statista.com/statistics/483590/prices-of-implemented-carbon-pricing-instruments-worldwide-by-select-country/
6. The World Bank, Carbon Pricing Dashboard, 2022, https://carbonpricingdashboard.worldbank.org/map_data
7. Martin Rabbia, Why did Argentina and Uruguay decide to pursue a carbon tax? Fiscal reforms and explicit carbon prices, November 2022, https://onlinelibrary.wiley.com/doi/10.1111/ropr.12517
8. Centre for Public Impact, The Carbon Tax in Australia, May 2017, https://www.centreforpublicimpact.org/case-study/carbon-tax-australia

A carbon tax is a fee placed on the production of carbon dioxide. It is a way for the government to place a price tag on each unit of carbon dioxide emitted.

Carbon taxes are a result of countries recognizing that the pollution created by burning fossil fuels has a disruptive effect on our earth's climate patterns.

Low- and middle-income households and individuals are those who are most affected by a carbon tax.

The carbon tax is important because economists feel that it is one of the most effective ways to reduce carbon dioxide emissions because it forces producers to pay for each unit of carbon they send into the atmosphere.

A carbon tax will cause the price of burning fossil fuels to increase which causes the price of carbon-intensive goods to increase which reduces the amount demanded. This will help reduce the amount of pollution and emissions sent into the atmosphere.

## Carbon Tax Quiz - Teste dein Wissen

Question

What is a carbon tax?

A carbon tax is a fee placed on the production of carbon dioxide. It is a way for the government to place a price tag on each unit of carbon dioxide emitted.

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Question

Which country has the highest carbon tax rate?

Uruguay.

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Question

How might a firm avoid paying its country's carbon tax?

It might not accurately disclose its emissions or it might relocate to a county that has no carbon tax to completely get around it.

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Question

List two drawbacks of a carbon tax.

1. It increases costs for consumers.

2. Disproportionately affects those with a lower income.

3. Polluters may relocate production to countries that do not have a carbon tax to avoid it.

4. It is difficult to monitor and administer effectively.

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Question

List two benefits of a carbon tax.

1. It reduces carbon emissions and pollution.

2. Makes polluters pay for the emissions they.

3. Generates government revenue.

4. Encourages the switch to renewable energy sources.

5. It is relatively simple to implement.

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Question

Explain why even though producers pay the carbon tax, it is the consumer that bears the largest burden.

The consumer bears the largest burden because although the producer pays the tax to the government, they raise their prices so that they do not lose profits, and the consumer then has to pay these higher prices.

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Question

Which demographic is most affected by the carbon tax?

Low- and middle-income households and individuals are the most affected by a carbon tax.

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Question

Who indirectly pays the carbon tax?

The consumer.

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Question

Who directly pays the carbon tax?

The firm producing the carbon.

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Question

How would a carbon tax reduce excess carbon dioxide in the atmosphere?

The carbon tax is meant to discourage the production of carbon emissions by making it more expensive to produce carbon and consume carbon-intensive goods.

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Question

Why do some countries feel that a carbon tax is necessary?

They realize that the pollution created by burning fossil fuels has a disruptive effect on our earth's climate patterns.

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Question

When buying a new tractor, which type of carbon tax would a farmer pay?

They would pay a carbon tax when purchasing the tractor.

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Question

A steel refinery would be subject to what form of carbon tax?

A per unit tax on each metric ton of carbon the factor produces.

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Question

What are the two ways a carbon tax can be applied?

1. A per unit tax on each metric ton of carbon a firm or individual produces.

2. A tax on the final price of the good depending on how carbon-intensive its production process is or how much carbon it produces.

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Question

What is an example of a carbon-intensive good?

Gasoline.

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