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What is a Carbon Tax and Will it Work?

Updated: Oct 3, 2022

Climate change is the ultimate market failure. No business or individual has any incentive to reduce their emissions on their own, but when they all continue to emit, they end up placing the entire planet in jeopardy. The solution that some policymakers have proposed is to put a price on carbon, thus using the market to incentivize businesses not to pollute. This policy, called a carbon tax, enjoys a surprising degree of support from business leaders and former Republican officials.

Holding Polluters Accountable

At its core, the carbon tax is simply what it sounds like: a tax on carbon emissions. The advantage of a carbon tax is that by putting a price on carbon, it incentivizes businesses to aggressively look for ways to reduce their carbon emissions and speeds up the transition to green energy. For a very long time, the costs of carbon emissions have been borne by everyone, but if polluters are held directly accountable for their emissions, those polluters will face immediate pressure to cut their carbon emissions. Unlike more extreme climate policies such as the Green New Deal, the carbon tax enjoys the support of countless Republican economists, oil companies, and CEOs of industrial corporations, who see the tax as a better alternative to more regulations and government subsidies, both of which distort markets rather than help them work better.

One of the biggest objections to a carbon tax is that it would raise energy prices, something that would hit working-class people the hardest. France was wracked by months of violent unrest following the imposition of a fuel tax, and policymakers in the United States rightly fear that raising energy prices would be political suicide. One work-around that supporters of a carbon tax have proposed is to make the tax revenue neutral. At the end of each year, every American would receive a carbon dividend check from the government. Another major objection is that a carbon tax would fail to meet the scale of the environmental challenges that America is facing. If the entire economy needs to be restructured, as some Democrats claim, then a carbon tax would not be enough.

A Permit to Pollute

One alternative to the carbon tax that has been proposed (and even attempted in California), is a policy called cap-and-trade. In a cap-and-trade system, the government puts a hard cap on carbon emissions, and if a business comes in under their cap, they can sell emissions permits to others who want to emit beyond their limit. In some ways, this is the inverse of a carbon tax. Both use market forces, but with a carbon tax, the government sets the price of emissions, and the market sets the level of emissions. In a cap-and-trade system, the government puts a hard cap on emissions, while the market sets the price to go over that limit. One advantage of a cap-and-trade system is that it offers more flexibility during an economic downturn. While a carbon tax would need to be lowered by an act of congress to help stimulate the economy, the market would naturally let permit prices fall under a cap-and-trade system. Unfortunately, the cap-and-trade system that California has already set up lacks the ability to hold specific polluters accountable, and large oil and gas companies have been able to get away with letting their emissions rise.

A carbon tax, especially a revenue neutral one, may be a good solution to climate change, but it isn’t politically possible. Democrats have demonstrated that they are more interested in structural changes (including addressing the eating and consumption habits of Americans) and would see the carbon tax as inadequate and at worst a distraction from their bolder plans. Meanwhile, many Republicans are hesitant to go near a carbon tax for fear of burdening their constituents with higher energy prices.

That leaves cap-and-trade. In California, the cap-and-trade system has not worked as well as politicians hoped it would, in large part because of the influence of oil and gas companies in designing the system. Those companies were allowed various carve-outs and exemptions from the cap. In Europe, the cap-and-trade system that the EU has had since 2005 has managed to reduce emissions but it has failed to impose sufficient costs on carbon emissions. In the United States, this failure may actually be a success, and too-high costs might end up making the program politically impossible.

Cleaning up the Mess

Instead of pinning their hopes on the U.S. adopting a nationwide cap-and-trade system, which will be politically impossible, those looking for sensible climate policy should instead pay attention to a new bill that passed in the House of Representatives last month, which increases federal funding for carbon capture technology. If a bill like this was to be reintroduced in 2021 alongside a similar bill in a Democratic-controlled senate, it would represent the largest federal effort to promote carbon capture to date, and it has already enjoyed greater support than any proposal for a national cap-and-trade system.

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