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Carbon tax

A carbon tax is an environmental tax on emissions of carbon dioxide.

Carbon dioxide is considered to be a heat-trapping "greenhouse" gas, and the purpose of a carbon tax is
to protect the environment by penalizing emissions of carbon dioxide, which may cause global warming.
Some environmental taxes include other greenhouse gases; the global warming potential is an
internationally accepted scale of equivalence for other greenhouse gases in units of tonnes of carbon
dioxide equivalent.

Carbon atoms are present in every fossil fuel (coal, petroleum, and natural gas) and are released as CO2
when they are burnt. In contrast, non-combustion energy sources—wind, sunlight, hydropower, and
nuclear—do not convert hydrocarbons to carbon dioxide. A carbon tax can be implemented by taxing
the burning of fossil fuels—coal, petroleum products such as gasoline and aviation fuel, and natural
gas—in proportion to their carbon content. If carbon dioxide emissions are not released into the
atmosphere on combustion of fossil fuels, e.g., carbon capture and storage, then a carbon tax will not
apply. Accordingly, a carbon tax increases the competitiveness of low-carbon technologies, such as
renewables, compared to the traditional burning of fossil fuels.

Economic theory

A carbon tax is an indirect tax—a tax on a transaction—as opposed to a direct tax, which taxes income.
A carbon tax is also called a price instrument, since it sets a price for carbon dioxide emissions. In
economic theory, pollution is considered a negative externality, a negative effect on a party not directly
involved in a transaction, which results in a market failure. To confront parties with the issue, the
economist Arthur Pigou proposed taxing the goods (in this case fossil fuels) which were the source of
the negative externality (carbon dioxide) so as to accurately reflect the cost of the goods' production to
society, thereby internalizing the costs associated with the goods' production. A tax on a negative
externality is called a Pigovian tax, and should equal the marginal damage costs.

Within Pigou's framework, the changes involved are marginal, and the size of the externality is assumed
to be small enough not to distort the rest of the economy. Some argue that impact of climate change
could result in catastrophe and non-marginal changes. "Non-marginal" means that the impact could, at
some time future date, significantly reduce the growth rate in income and welfare. The amount of
resources that should be devoted to avoiding low-probability, high cost climate change impacts is
controversial.[6] Policies designed to reduce carbon emissions could also have a non-marginal impact.

Prices of carbon (fossil) fuels are expected to continue increasing as more countries industrialize and
add to the demand on fuel supplies. In addition to creating incentives for energy conservation, a carbon
tax would put renewable energy sources such as wind, solar and geothermal on a more competitive
footing, stimulating their growth. Former Federal Reserve chairman Paul Volcker suggested (February 6,
2007) that "it would be wiser to impose a tax on oil, for example, than to wait for the market to drive up
oil prices."

Social cost of carbon

The social cost of carbon (SCC) is the marginal cost of emitting one extra tonne of carbon (as carbon
dioxide) at any point in time. To calculate the SCC, the atmospheric residence time of carbon dioxide
must be estimated, along with an estimate of the impacts of climate change. The impact of the extra
tonne of carbon dioxide in the atmosphere must then be converted to the equivalent impacts when the
tonne of carbon dioxide was emitted. In economics, comparing impacts over time requires a discount
rate. This rate determines the weight placed on impacts occurring at different times.

According to economic theory, if SCC estimates were complete and markets perfect, a carbon tax should
be set equal to the SCC. Emission permits would also have a value equal to the SCC. In reality, however,
markets are not perfect, and SCC estimates are not complete.

An amount of CO2 pollution is measured by the weight (mass) of the pollution. Sometimes this is
measured directly as the weight of the carbon dioxide molecules. This is called a tonne of carbon dioxide
and is abbreviated "tCO2". Alternatively, the pollution's weight can measured by adding up only the
weight of the carbon atoms in the pollution, ignoring the oxygen atoms. This is called a tonne of carbon
and is abbreviated "tC". Estimates of the dollar cost of carbon dioxide pollution is given per tonne, either
carbon, $X/tC, or carbon dioxide, $X/tCO2. One tC is roughly equivalent to 4 tCO2.

The 2007 IPCC report contains an assessment of the literature on the SCC: Peer-reviewed estimates of
the SCC for 2005 have an average value of $43/tC with a standard deviation of $83/tC. The wide range of
estimates is explained mostly by underlying uncertainties in the science of climate change (e.g., the
climate sensitivity), different choices of discount rate, different valuations of economic and non-
economic impacts, treatment of equity, and how potential catastrophic impacts are estimated. Other
estimates of the SCC span at least three orders of magnitude, from less than $1/tC to over $1,500/tC.
The true SCC is expected to increase over time, probably at a rate of 2 to 4% per year.

Carbon taxes compared to cap-and-trade

An alternative government policy to a carbon tax is a cap on greenhouse gas (GHG) emissions. Emission
levels of GHGs are capped and permits to pollute are freely allocated (called "grandfathering") or
auctioned to polluters. Auctioning permits has significant economic advantages over grandfathering. In
particular, auctioning raises revenues that can be used to reduce distortionary taxes and improve overall
efficiency. A market may be allowed for these emission permits so that polluters can trade some or all of
their permits with others (cap-and-trade). A hybrid instrument of a cap and carbon tax can be made by
creating a price-floor and price-ceiling for emission permits. A carbon tax can also be implemented
concurrently with a cap.

Both cap-and-trade and carbon taxes give polluters a financial incentive to reduce their GHG emissions.
Carbon taxes provide price certainty on emissions, while a cap provides quantity certainty on emissions.
A large body of the economics literature states that because of the uncertainty over the costs of
reducing carbon emissions, carbon taxes should be preferred over carbon trading.

According to Weitzman (1974), uncertainty over the impacts of climate change and the future costs of
reducing carbon intensity (i.e., the carbon output per unit of energy), are reasons to support price
According to the Carbon Trust (2009), a carbon tax suffers from combining a set price for carbon along
with a transfer of revenue from industry to government. This, it is argued, guarantees that the tax will
not be set at the appropriate level, but will instead be determined by the politics of large-scale revenue
transfers. With a cap, however, the revenues from emission allowances can be separately negotiated
with industry.

Unlike a cap system with grandfathered permits, a carbon tax raise revenues. If the revenues are used to
reduce other distortionary taxes, this can improve the efficiency of the tax. On the other hand, a cap
with grandfathered permits can have an efficiency advantage of being applied to all industries. This
provides an equal incentive at the margin for all polluters to reduce their emissions. This is an advantage
over a tax that exempts or has reduced rates for certain sectors.

James E. Hansen has argued in a recent book (Storms of My Grandchildren) and in an open letter to
President Obama, that policies to cap carbon emissions and trade permits for them (see cap and trade)
will only make money for banks and hedge funds and allow 'business-as-usual' for the chief carbon-
emitting industries. He advocates phasing out and protesting against coal-fired power stations that do
not have onsite carbon sequestration and imposing a progressive carbon tax.

Distributional impacts

In most instances, firms pass the costs of a carbon price onto consumers. Studies typically find that poor
consumers spend a greater proportion of their income on energy-intensive goods and fuel. Therefore
cost increases in energy tend to impact the poor worse than the rich.

Studies by Metcalf et al. (2008) and Metcalf (2009) consider the possible distributional impacts of
carbon taxes in the US. The 2008 study considers three recent tax bills introduced to the US Congress.
The taxes themselves are highly regressive, but when revenues from the tax are returned lump-sum, the
taxes become progressive. The 2009 study looks at a carbon tax combined with a reduction in payroll
taxes. It is found that this combination can be distributionally neutral. With an adjustment in Social
Security payments for the lowest-income households, the carbon tax policy can be made progressive.

A study by Ekins and Dresner (2004) considers the distributional impact in the UK of introducing a
carbon tax and increasing fuel duty. It is found that a carbon tax can be made progressive, but that the
tax would make those currently worst affected by fuel poverty more badly off. Of the policy options
looked at for transport, the most effective in compensating low-income motorists is found to be an
increase in fuel duties and the abolishment of vehicle excise duty.