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Last revised 1 May 1993 by the Information Unit on Climate Change (IUCC), UNEP, P.O. Box 356,

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The economics of carbon taxes

A tax on the carbon content of oil, coal, and gas would discourage fossil-fuel use and so reduce carbon dioxide (CO2) emissions. Carbon taxes have already been introduced by a number of industrialized countries, including Finland, the Netherlands, Norway, and Sweden. Detailed proposals are also being debated in Denmark and Switzerland, and a proposal by the European Commission for a community-wide carbon tax is being considered by member states.Many economists believe that a carbon tax would achieve any given reduction in CO2 emissions at minimum cost . . . Although there are other ways to reduce carbon dioxide emissions, they can be less economically efficient than are carbon taxes. A tax just on petrol, for example, would reduce the use of oil, but much of the reduction would be negated as energy users switch over to coal and natural gas, which also emit carbon dioxide. It would also not affect the use of heating oil and other petroleum products.As for energy efficiency standards and other regulatory alternatives, because they would not raise the price of emitting carbon, they would neither discourage energy use nor provide electricity generators with incentives to move away from carbon-intensive fuels. A carbon tax, on the other hand, would give all usersof fossil fuels the same incentive to reduce carbon emissions.but the tax must be well designed and administered. Because different fossil fuels have different carbon contents and can often be substituted for one another, it is important to tax carbon content. While such a tax might seem awkward to apply, estimates of each fuel’s carbon content could easily be used to translate the carbon tax into separate taxes on coal, oil, and natural gas. Since fossil fuels are already taxed in most countries, this would make the carbon tax easy to administer. Unfortunately, many of the national carbon tax programmes already in existence are not well designed. In one nation's programme, for example, the electricity industry is exempt from paying the carbon tax, and industrial companies pay the tax on the basis of their revenues, rather than on their energy use. These exceptions and exemptions have the effect of raising the country’s overall cost of abating any given level of CO2 emissions.A carbon tax cannot guarantee how great the reduction in emissions will be . . . The effect that a tax has on emissions depends on how energy users and suppliers respond to it. Their response would be difficult to predict in advance. Economists have made a range of estimates for the effect different carbon taxes would have. The firmest conclusion that emerges from their work is that the tax would have to be high - some US$100 per ton of carbon - if it were to reduce emissions substantially in the long run. A US$100 per-ton tax would raise the current price of crude oil (US$20 per barrel) by about two thirds. The tax would have to be this high in part because economic growth will, in the absence of abatement policy, increase emissions over time. Hence, the tax would have to be raised every now and then to keep emissions levels stable. On the other hand, future technological innovations may reduce the cost of abatement in the very long run, allowing carbon taxes to be reduced.but it can guarantee that the cost of abatement will not be excessive. Faced with a carbon tax of US$100 per ton of carbon, individuals and firms would seek to avoid this penalty by spending up to - but not more than - US$100 to abate a ton of carbon emissions. Quantitative emissions limits, on the other hand, would guarantee how much CO2 is emitted, but not the price for achieving that level. Therefore, a quantitative limit on emissions could turn out to be too costly (higher, for example, than the damage avoided) or not costly enough. In many industrialized countries, CO2 emissions are no higher today than they were in 1973 due to real increases in the price of energy. If energy prices, always volatile and unpredictable, increase in the future, a given quantitative ceiling on emissions might be reachable without devoting any additional resources to abatement; if prices fall, the costs of achieving a given quantitative target could turn out to be much higher than expected. A key virtue of the carbon tax is that it fixes the incentive to abate emissions independently of energy price fluctuations (that is, a US$100 tax provides a US$100 incentive). In addition, the tax could be adjusted up or down if new scientific information becomes available about the damages caused by particular emissions levels. A supplementary benefit is that a carbon tax would allow other, more distorting, taxes to be lowered, thus improving the economy’s performance. A high carbon tax would raise substantial sums of money; one study estimates that a tax of US$100 per ton would raise revenues equal to 3.4% of GNP in the US and 1.1% of GNP in energy-efficient Japan.1 Such high sums would allow income and other taxes to be reduced, making the carbon tax revenue neutral (i.e. keeping the total tax burden unchanged). While taxes on income and savings distort economic decision-making by individuals and firms, a carbon tax actually reduces distortions in the economy. This contribution to economic performance needs to be factored in when calculating the true cost of an abatement policy based on a carbon tax.The carbon tax is regressive, but other taxes and transfers can be adjusted to offset its negativeimpact on poorer households. Poor households tend to spend a greater percentage of their total income in energy than do rich ones. But the regressive nature of the carbon tax can be neutralized by indexing transfer payments to inflation (as is already done in many countries) and by increasing the personal deductions households can take on their income taxes. At the same time, it should be recognized that other policies for abating net greenhouse gas emissions would also impact the distribution of income, even if less transparently than would a carbon tax. For example, energy efficiency standards would hit the poor hardest because the poor tend to buy cheaper, less-energy-efficient appliances than do richer households. The most cost-efficient carbon tax would be one that is comprehensive and internationally coordinated. A one-ton reduction in carbon emissions has the same benefit as a one-ton increase in the amount of carbon absorbed by trees or other "sinks". The most efficient policy, then, would be to offer a subsidy for sink enhancement that is equivalent to the tax on CO2 emissions. In addition, taxes should also be imposed on other greenhouse gases; such taxes would be calculated according to the globalwarming potential of each particular gas (fact sheet 7). The US, for example, taxes chlorofluorocarbons(CFCs), and a few other countries are considering doing the same. If such taxes were set at the same level in every country, the total cost of reducing greenhouse gas emissions would be reduced (fact sheet 228). There would be no need for such an international tax to be imposed by an international agency, an arrangement many countries would anyway not accept. Instead, as exemplified by the current proposal by the European Community, a standard carbon tax could be coordinated internationally but administered nationally. For further reading:S. Barrett, "Global Warming: Economics of a Carbon Tax," in D. Pearce (ed.), "Blueprint 2: Greening the World Economy", London: Earthscan (1991). J. M. Poterba, "Tax Policy to Combat Global Warming: On Designing a Carbon Tax," in R. Dornbusch and J.M. Poterba (eds.), "Global Warming: Economic Policy Responses", Cambridge: MIT Press (1991). D. Pearce, "The Role of Carbon Taxes in Adjusting to Global Warming," The Economic Journal, 101, pp. 938-948 (1991). Notes:1 Poterba (1991).