Carbon Taxes Explained

Poorvi Sanath
Jun 8
3 min read

By Poorvi Sanath

In view of rising carbon emissions, over 430 parts per million (ppm) currently, carbon taxation is a policy solution that has increased in relevance. Carbon taxation is a government-imposed price mechanism that incentivizes reduced emissions by adding a fee that accounts for the external costs of pollution on the market price. Essentially, carbon taxes set a price on carbon emissions.

Carbon taxes are categorized as Pigouvian taxes; taxes on transactions that cause externalities. By increasing the marginal private cost, the total cost reflects the true social cost of production, thereby internalizing the negative externalities. This additional fee is borne by the producers and consumers; through this, governments hope to reduce demand for fossil fuels and goods that are emission intensive, while redirecting firms toward environmentally conscious production methods.

Carbon taxation has the potential to drastically mitigate emissions worldwide. According to the OECD’s 2023 report, differentiated prices by 2030 could have significant impacts. This policy solution is a market-based approach, which means that it provides price signals and allows the market to react to it in the most efficient way. Perhaps most important (to governments), carbon taxes are administratively simplistic. They involve adding onto pre-existing tax structures, so they involve little hassle in terms of collection and implementation.

The main considerations that govern the efficacy of carbon taxes are the escalation rates, distributional impacts, revenue allocation and competitiveness. Per theory, tax rates must be equivalent to social costs at present; at the same time, this tax must also reflect the escalating climate damage to be effective. Forecasting this escalation is often a challenge that determines the utility of the tax. This situation creates a trade-off between price stability and long run efficiency. Next, lower income households spend a higher proportion of their income on fuel, in comparison to higher income households. Consequently, carbon taxes disproportionately impact lower income households, which explains their regressive nature. Revenue redistribution could help offset this negative impact. In a similar vein, the revenue gained from carbon taxes can be reinvested for climate research or returned to consumers as dividends. Finally, carbon taxes in a market with few protections can put domestic production at a competitive disadvantage against international competitors who do not pay these taxes. This would increase the demand for imports from the competitors, thereby causing an ‘emissions leakage’ - from one country to another - invalidating the benefit of carbon taxes.

Around the world, carbon taxes have had differential impacts. In 2024, 37 carbon tax programs were functional around the world. Scandinavian countries were among the first to implement them in the 1990s. Current rates range from $70 to $168 per ton of CO2, and the revenue is utilized for national sustainability schemes. Singapore and South Africa were the first Southeast Asian and African countries to implement a carbon tax program in 2019, and their rates were $50 by 2030 and $8.5 rising annually per ton of CO2, respectively. In the United States, Boulder, Colorado, was the first city to authorize a voter-approved carbon tax in 2006. Elsewhere in the country, tax proposals have been presented at Congress with little success, due to political viability concerns more so than doubts over the economic efficacy. In Australia, the tax was introduced by the minority Green party in 2011 during a period of economic stagnation, but it never gained the support of either of the majority parties: the Labor nor the Liberals. It was repealed in 2014.

Carbon taxation is controversial due to unintended consequences and the factors that dictate their efficacy, like most other economic initiatives to combat climate change. Ultimately, if they are well-designed, and implemented in conjunction with green investment and other sustainability measures, carbon taxes are an economically ambitious solution to reaching carbon neutrality.