How does a carbon tax work?

How does a carbon tax work? The carbon tax is centered around addressing the problem of climate change, more specifically through greenhouse gas emissions. Greenhouse gasses include carbon dioxide, which enters the atmosphere by burning fossil fuels and by other chemical reactions involved in manufacturing.

Greenhouse gasses in the atmosphere trap heat and are a significant contributor to climate change. Carbon dioxide made up 80% of the United States’ greenhouse gas emissions in 2019. Within carbon emissions, the main contributing sectors were transportation, electricity, and industry (Environmental Protection Agency, 2019). Carbon emissions are clearly a problem, as climate change is becoming exponentially more severe and soon irreversible.

Imposing a federal carbon tax forces emitters to consider the carbon output of their operations.

The environment is not an economic entity and cannot negotiate against the negative externalities of manufacturers and producers. The government, however, can protect the environment by influencing reduced emissions through incentives of money, causing emitters to internalize their externalities. Producers and consumers are driven by economics, so modifying it will change behavior.

A tax on carbon will increase the marginal cost of production of materials with carbon output and force companies to reconsider what is economically efficient. If paying the tax on production causes a higher marginal cost than marginal benefit, companies will switch to alternative production and a long term solution will be incentivized (Bradburd, 2021). Alternative production, and therefore consumption, in the main carbon contributing sectors of transportation, electricity, and industry will provide benefits to the environment and people in generations to come.

A carbon tax will affect production.

With a tax per ton of carbon emitted, the marginal cost of production will increase, therefore causing a decrease in production on the same budget. This causes supply to decrease while demand stays constant, especially in sectors like electricity and transportation.

Companies that emit greater carbon per output will be hit harder by this tax, as it will drive up their marginal cost of production. This is the point of the tax, so that companies are incentivized to find an alternative production mechanism that reduces carbon emissions. Discouraging carbon output and rewarding alternative production is the core of this tax.

While there is no federal carbon tax in the US, many have been proposed.

They differ in the amount of tax per ton as well as the percentage of increase in future years. There are also proposals including complementary policies that reduce emissions (Gundlach, Minsk, Kaufman, 2019). Despite small differences, all carbon tax proposals have the goal of increasing over time to further incentivise alternative production and discourage high carbon emissions. The allocation of the revenue of the tax is also significant in the imposition of the tax, as it can further incentivise environmental protection.

The tax revenue may result in income tax cuts, improvement of other climate change programs, assistance to low income communities that are negatively affected by the tax, and other beneficial programs (Larsen, Kaufman, Marsters, Herndon, Kolus, King, 2020).

While the US has not imposed a federal carbon tax, other countries have. Fifteen countries in the European Union have imposed carbon taxes since 1990, so the effects can be measured. According to a report, the EU’s $40 per ton carbon tax only covers 30% of emissions and as a result, limited the reduction in emissions to 4-6%. Though this is not a drastic reduction in carbon emissions, it is still progress.

The EU’s carbon tax is limited to 30% of emissions because many industry sectors are covered by the EU Emissions Trading System. If the US were to impose a federal carbon tax, it would be imposed on more industry sectors (Metcalf and Stock, 2020). Though small, the EU carbon tax supports a decrease in emissions and a decrease in future emissions, as projected emissions are now reduced. Over time, there will be a higher incentive to switch to alternative production.

Imposing a federal carbon tax may carry undesirable side effects.

Though the main target is the emissions of industry and production sectors, consumers will be impacted by increased prices. This will negatively impact those with low incomes, as they will have to pay more of their income for necessities like electricity and gas (Amadeo, 2020). Introducing the tax gradually will allow an easier transition to alternative consumption but will also slow the major sectors’ reduction in emissions.

A carbon tax is somewhat well suited to address the over-emission of carbon by using a financial incentive for alternative production.
Global growth of installed capacity CC0

The idea is good, as economic incentives drive behavior. Though the EU did not see drastic reduction in carbon emissions, a US federal tax has the ability to reach into more sectors of production and therefore target a larger percentage of national emissions. In addition to the tax, complementary climate policies like funding low carbon technologies and low carbon public infrastructure would enhance the reduction in emissions (Gundlach, Minsk, Kaufman, 2019). Environmentally beneficial allocation of tax revenues, specifically to the low income population, is also crucial to the effectiveness of the carbon tax.

The tax will have a social impact on producers and consumers’ awareness of carbon emissions and become a factor in economic decisions, which will be a new societal way of thinking. Even if emissions reduction is less than ideal, imposition of a federal carbon tax will be beneficial to the environment in incentivizing reduction in carbon emissions.

A separate policy that centers around carbon emission reduction is a cap-and-trade program.

The program works by setting a federal cap of carbon emissions and then selling the available shares to companies, allowing them to produce a controlled amount of carbon. As time goes on, the emission cap will be reduced, and if the demand for carbon output stays constant, the price of the shares will increase. Carbon will only be increasingly more expensive, so companies are incentivized to find alternative production (Horowitz, Cronin, Hawkins, Konda, Yuskavage, 2017).

The certainty of a carbon emissions cap gives a tangible and set reduction of carbon that the carbon tax fails to do, as actually reducing emissions is decided by the company.

A cap-and-trade program has been imposed on the energy sector in the northeastern states of the US. From 2005-2018, the effects have been measured as a 50% reduction in the power sector’s carbon pollution. (The Regional Greenhouse Gas Initiative, 2020). While the carbon tax is a good idea of financial incentive, the cap-and-trade program expands this idea with a set emissions limit. And proves to be more effective in reducing carbon emissions.

In a choice between a cap-and-trade program and a carbon tax, I would prefer the cap-and-trade program. However, both programs are beneficial to the goal of reducing carbon emissions.

How does a carbon tax work? Written by Lauren Kauppila

How does a carbon tax work? Works Cited

Bradburd, Ralph. “Second Externalities Lecture.” Lecture notes, Microeconomics, Williams College, April 26, 2021.

Gundlach, Justin., Minsk, Ron., Kaufman, Noah. Interactions between a Federal Carbon Tax and Other Climate Policies. New York City: Columbia University, 2019. Accessed April 19, 2021. n-tax-and-other-climate-policies. 

Horowitz, John., Cronin, Julie-Anne,. Hawkins, Hannah., Konda, Laura., Yuskavage, Alex. Methodology for Analyzing a Carbon Tax. Washington DC: The Department of the Treasury, 2017. Accessed April 20, 2021.

“Inventory of U.S. Greenhouse Gas Emissions and Sinks,” The United States Environmental Protection Agency, accessed April 19, 2021,

Kimberly Amadeo, “Carbon Tax, Its Purpose, and How It Works,” The Balance, October 27, 2020.

Larsen, John., Kaufman, Noah., Marsters, Peter., Herndon, Whitney., Kolus, Hannah., King, Ben. Expanding the Reach of a Carbon Tax: Emissions Impacts of Pricing Combined with Additional Climate Actions. New York City: Columbia University, 2020. Accessed April 21, 2021. mpacts-pricing-combined-additional-climate-actions. 

Metcalf, Gilbert., Stock, James. The Macroeconomic Impact of Europe’s Carbon Taxes. Washington DC: Resources for the Future, 2020. Accessed April 19, 2021. 

“Overview of Greenhouse Gases,” The United States Environmental Protection Agency, accessed April 20, 2021, 

The Investment of RGGI Proceeds in 2018. Connecticut: Regional Greenhouse Gas Initiative, 2020. Accessed April 23, 2021.

“What You Need to Know About a Federal Carbon Tax in the United States,” Columbia University Center on Global Energy Policy, accessed April 21, 2021, 

How does a carbon tax work?