A carbon tax is a tax on energy sources which emit carbon dioxide. It is a pollution tax, which some economists favour because they tax a 'bad' rather than a 'good' (such as income). Carbon taxes address a negative externality. Externalities arise when an individual production or consumption activity imposes costs or benefits on others. In market transactions, these costs and benefits are not normally reflected in the prices involved in the transaction, or taken into account in the transaction decision.

Pros and Cons

Carbon taxes have been said to have the following advantages:

• They put a limit on the costs of emissions reduction.
• They can be implemented quickly.
• They are predictable in their costs. Relatively stable price signals can help business and consumers plan energy spending and provide greater certainty for investments in energy efficiency that have large initial costs.
• They are a permanent incentive to reduce emissions. The price of pollutants does not change, as with the operation of a market-based emission trading system.
• They are not susceptible to 'strategic behaviour' by firms and non-government organisations that distort any market for trading emissions—such as purchasing a large number of permits and reselling them later at a profit or viewing auction permits in a cap-and-trade system as a right to pollute.
• They are economically efficient in that they are transparent, simple and can have a wide coverage.
• They can be implemented across a wide variety of economies and therefore are a suitable instrument for coordinated international action on reducing greenhouse gas emissions.
• They are a revenue source. They could result in other taxes being reduced, or the proceeds of the carbon tax could be redirected to those most affected to ensure that the introduction of a carbon tax remains revenue neutral.

For these reasons a number of prominent economists support the introduction of such taxes. However, carbon taxes as a means of controlling greenhouse gas emissions also have some disadvantages:

• There are no guarantees that emissions will decline if consumption of the goods and services that produce carbon emissions remains unresponsive to price increases.
• The level at which the tax is set to produce the best outcomes cannot be known in advance. Thus the tax may have to go through several changes before having the desired effect. This makes it politically vulnerable.
• Where such taxes have been implemented (mainly in Europe) lobby groups have been successful in gaining exemptions for highly affected industries. This reduces the effectiveness of these taxes.
• If the tax is set at too high a level, activities that are particularly vulnerable to it may relocate to a location that does not have such imposts.
• To date it has not received much support as the internationally preferred method of controlling greenhouse gas emissions. To date the international community appears to prefer the cap-and-trade approach.
• They are potentially regressive, with the impact of a flat carbon tax potentially highest on the lowest income households. This effect is offset by the higher consumption of wealthier households, that is, as they consume relatively more energy than low income households they may be paying a higher rate of tax.
• It is a tax, and therefore politically unpopular by its very nature.

Political vulnerability

It is likely that a carbon tax that is successful in reducing emissions will be set at far too high a level to be political sustainable. This is because the activities on which a tax must be levied to reduce emissions (such as emissions from coal-fired power generation) are linked to goods and services that the consumer simply will not do without (such as electricity). The political pressure arising from higher electricity prices due to the imposition of a carbon tax could swiftly lead to the reduction or removal of that tax.

International carbon taxes

According to the Carbon Tax Centre, the first carbon tax was enacted in Finland in 1990, with a small tax on fuels (except for biofuels including peat). Norway, Sweden, and Denmark followed, implementing carbon taxes in 1991 and 1992.

Germany implemented an 'ecological tax' on heating fuel, petrol, natural gas and electricity in 1999. The tax was slowly increased from 2000 to 2003 and now remains at 2003 levels.

In 1999, Luxembourg began an electricity tax and an energy tax with breaks for businesses that undergo voluntary energy or environmental audits and demonstrate other efforts to increase efficiency.

In 2001, Japan enacted a tax on high-polluting vehicles while reducing the tax on low-pollution vehicles to encourage the development and purchase of greener vehicles. Japan also restructured its energy taxes to reflect the environmental impact of carbon dioxide emissions, including a new tax on coal.

The United Kingdom implemented a 'climate change levy' in 2001 that adds about 15 per cent to the cost of electricity. The revenues are recycled by reducing the National Insurance contributions of those who pay the levy. Part of the revenue is also used to assist businesses adopt energy efficiency measures.

Hungary has introduced a New Environmental Burden Tariff, phased in since 2004, that taxes pollution of the soil, air, and water, including carbon dioxide emissions. 

Further reading:

T. Shrum, Green house gas emissions—policy and economics, Kansas Energy Council, 3 August 2007.

Carbon Tax Centre, Why revenue-neutral carbon taxes are essential, what's happening now and how you can help, Carbon Tax Centre, 2007.