Any debate about global warming leads inevitably to proposals for a carbon tax as one of the most powerful tools in the arsenal to combat it. In January 2019, a bipartisan group in the US House of Representatives introduced H.R. 763, the Energy Innovation and Carbon Dividend Act of 2019, which would pave the way for a carbon tax on fuels that emit greenhouse gases into the atmosphere. But, because everybody would face the same price increase, low-income households would be hit harder than richer households, making the measure no less politically treacherous than past proposals that have come and gone. To eliminate or reduce the burden of inequality caused by the tax, governments should design compensation mechanisms to accompany it.
Alongside carbon markets, where carbon credits are traded following the establishment of a cap on greenhouse gas emissions by a government (also known as cap and trade), carbon taxes are market-driven instruments that have the potential to be more efficient at reducing emissions than the sectoral or industry-level regulations used in the past.
A carbon tax works like a classic Pigouvian tax: It is a government fee on activities that inflict external social harm not internalized by those who do these activities. (The term derives from the work of English economist Arthur Cecil Pigou.) For example, a vehicle that is noncompliant with emissions regulations causes those around it to suffer immediately from the exhaust it releases without any consequence to the driver—the driver does not internalize the cost borne by others unless penalties or fines are imposed.
Ideally, a Pigouvian tax will cost those who produce pollution—or carbon emissions—the amount equivalent to the harm that pollution causes others. Calculating precisely how much that cost should be is no simple feat. This said, given the urgency of measures to combat climate change, it could be argued that a carbon tax should be set at the maximum amount that is socially tolerable and consistent with the tradeoffs involved. One such tradeoff is the impact on consumers: While a carbon tax may reduce emissions and be socially beneficial, it will inevitably raise the price of gasoline or electricity that is dependent on fossil fuels as producers pass on the additional cost.
To address these problems, H.R. 763 proposes an economic redistribution mechanism by establishing a Carbon Dividend Trust Fund in which revenues from carbon fees would be deposited and paid out as dividends to US citizens and lawful residents.
Another problem is that carbon taxes would hamper the international competitiveness of US firms that either produce or rely on fossil fuels. Many US trading partners do not adopt carbon taxes. China, the world’s largest emitter of greenhouse gases, has no such mechanism in place, although the European Union has laid out ambitious goals on global warming that seem likely to produce a big carbon tax in the future. If US trading partners have no carbon taxes, US adoption of carbon taxes could harm US companies or even induce them to move to countries where these fees are nonexistent, causing job losses, reducing investment, and possibly lowering economic growth. To circumvent these negative effects, a carbon tax would need to be accompanied by a border adjustment tax, ensuring that carbon-intensive imports cost as much as similar domestically produced goods. H.R. 763 envisions such provisions. While border adjustment may dampen trade, those costs may ultimately be outweighed by the social benefits they create in reallocating resources to the production of less carbon-intensive goods.
If set high enough, a carbon tax may generate significant revenues that could be deployed to stimulate investments in renewable energy sources as well as innovation activities. A recent study by the Congressional Budget Office (CBO) showed that setting a carbon tax at $25 per metric ton on most emissions of greenhouse gases in the United States, while adjusting it annually by 2 percent after accounting for inflation, as much as $1.1 trillion could be generated in 10 years. H.R. 763 proposes an initial tax of $15 per metric ton of carbon emitted during the first year, with a steep increase of $10 per year in subsequent years. Applying the CBO’s calculations proportionately to the carbon tax schedule envisaged in H.R. 763 would result in revenues of some $2.5 trillion after 10 years. As revenues grow nonlinearly over time, they could potentially be used to provide both dividends to American consumers and incentives to companies to invest in innovation and alternative energy sources. It is conceivable that given sizeable revenues, using them for redistribution and investment incentives would ultimately be budget-neutral, which could help bring about bipartisan support for the bill in the future.
Carbon taxes are not a panacea, however: Alone they cannot reduce greenhouse gas emissions sufficiently to avert the consequences of climate change. But they should certainly be included in a larger toolbox of measures to achieve climate goals. H.R. 763 is, therefore, a first step in the right direction, making it a priority for any administration that is truly concerned about climate change.