Tax Policy Issues in Designing a Carbon Tax

by Makari Krause

Carbon taxes have long been thought of as the most efficient and successful way to decrease GHG emissions and thereby curb climate change. Marron and Toder (2014) examine some of the challenges associated with this approach to carbon mitigation, namely setting the tax rate, collecting the tax, and using the revenue. In order to internalize the GHG emissions externality one must tax those emissions at a rate that brings the social cost in line with the private cost. This is referred to as the social cost of carbon and is the price of carbon that would maximize social welfare. Theoretically this approach seems ideal but there are many difficulties involved with determining the social cost of carbon. Determining the true economic effects of GHG emissions is quite difficult and requires complex modeling. These models operate on a set of assumptions that are controversial in many cases. Leading to a wide range of estimates for the social cost of carbon with a mean of $196/ton and a standard deviation of $322/ton. Another important question to ask when calculating cost is whether that cost will be evaluated on a global or national scale. The costs of climate change and the benefits of mitigation are global but often US policymakers exclude global considerations.

Actually collecting the carbon tax once the rate has been decided brings its own set of challenges. Ideally one would monitor all emissions and tax them at a uniform rate. This is impossible because the cost of monitoring millions of emissions sources is prohibitively expensive. Alternatively one could tax large sources of emissions such as the power sector but this would fail to capture many other sources. The most plausible way to collect the GHG tax is to instead tax fossil fuels directly. Fossil fuels account for 90% of carbon dioxide emissions in the US and their carbon content can be easily measured and translated into emissions after combustion. These fuels can be taxed at one point along the supply chain to increase the ease of monitoring and decrease the number of taxpayers. They can also be taxed at the retail level but this doesn’t encourage increased efficiency in the refining and production processes.

For the tax to be comprehensive it would have to focus on other carbon-intensive industries such as chemicals and steel in addition to fossil fuels and on GHGs other than carbon dioxide. Taxes would also need to be rebated in the case that the fossil fuel didn’t result in emissions. This would be necessary if carbon capture and sequestration became widespread in the power production industry.

The last question that further complicates the adoption of a carbon tax is what to do with the revenues. Because lower income households spend relatively more on carbon-intensive products than do upper income households, a carbon tax would be regressive and most of the burden would fall on lower income households but carbon tax revenues could be used to provide tax relief and offset the regressive nature of the tax. Additionally carbon tax revenues could go towards research and development of clean, renewable energy sources. Some of the revenues could also be used to assist communities that rely heavily on carbon-intensive industries such as the families of coal miners. Obviously the revenue could also go towards reducing the federal deficit.

A tax on carbon, while theoretically optimal, will obviously be very hard to implement and there are many considerations that need to be addressed.

Marron, D. B., & Toder, E. T., 2014. Tax policy issues in designing a carbon tax. The American Economic Review 104(5), 563-568.

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