Back to Basics: What Is Carbon Taxation?
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- Authors: IAN PARRY
- Published: June 1, 2019
Why carbon taxes matter
- Deterring the burning of fossil fuels is crucial to reducing the accumulation of heat-trapping greenhouse gases in the earth’s atmosphere.
- Carbon taxes could discourage the use of fossil fuels and encourage a shift to less-polluting fuels, thereby limiting carbon dioxide (CO2) emissions, which are by far the most prevalent greenhouse gas.
- According to the World Meteorological Organization, without measures to reduce greenhouse gases, global temperatures are projected to rise by about 4°C above preindustrial levels by the end of the century (temperatures have already increased by 1°C), with rising and irreversible risks of collapsing ice sheets, disruption of ocean circulatory systems, inundation of low-lying island states, and extreme weather events.
Mechanism and direct benefits
- Carbon taxes are levied on coal, oil products, and natural gas in proportion to their carbon content and can be collected from fuel suppliers.
- Fuel suppliers will pass on the tax in higher prices for electricity, gasoline, heating oil, and products and services that depend on them, creating incentives to:
- Reduce energy use;
- Shift to lower-carbon fuels or renewable energy sources through investment or behavior.
- Immediate environmental and health benefits include reductions in deaths resulting from local air pollution.
- Carbon taxes can raise significant revenue for governments that can be used to:
- Counteract economic harm from higher fuel prices (for example, by lowering personal income and payroll taxes);
- Fund productive investments to help achieve the United Nations Sustainable Development Goals, including reducing hunger, poverty, inequality, and environmental degradation.
Comparative effectiveness versus other policies
- Incentives for renewable power generation do not:
- Promote switching from coal to gas or from these fuels to nuclear;
- Reduce electricity demand;
- Promote emission reductions beyond the power-generation sector.
- Carbon taxes provide economy-wide price signals that other targeted incentives may not.
International appeal and scalability
- Carbon taxes are generally straightforward to administer because they can be piggybacked on existing fuel taxes that most countries already collect.
- They can also be integrated into royalties paid by coal mining and oil and gas drilling industries.
- The fiscal and administrative case may be especially appealing in developing economies where large informal sectors constrain revenue from broader taxes on income and profits.
- With emission-monitoring capacity, carbon-tax variants can be applied to other greenhouse gas sources such as emissions from forestry, international transportation, cement manufacturing, and mining and drilling activities.
- Carbon taxes can play a key role in achieving countries’ pledges under the 2015 Paris Agreement; these commitments must be updated every five years.
Findings from comparative price scenarios (chart summary)
- A $35 a ton carbon tax (green bars in the referenced chart) would produce reductions in emissions that would be more than sufficient to meet the total commitments of the Group of Twenty countries.
- Those commitments (black squares in the chart) represent percentage reductions in projected fossil fuel CO2 emissions in 2030 below baseline levels (levels in the absence of new mitigation measures) implied by Paris pledges.
- A $35 a ton carbon tax would be particularly effective in reducing emissions in heavy coal users such as China, India, and South Africa; the tax would roughly double coal prices but would increase pump prices for road fuels only moderately.
- Even a $70 a ton carbon tax falls short of what is needed in other cases, such as Canada and some European countries, reflecting the more stringent pledges made by these countries.
- These results suggest a possible role for international price coordination, for example:
- A group of large-emitting countries could agree to impose a minimum price on carbon (price floors) to guarantee mitigation effort and provide assurance against competitiveness losses.
- Prototype: Canada, where provinces and territories must phase in a minimum carbon price, rising to Can$50 (US$38) a metric ton by 2022.
- The regime could be designed flexibly to accommodate carbon taxes, emission trading systems, or other approaches.
- Current global statistics:
- More than 50 carbon tax and emission trading systems now operate at the regional, national, and subnational levels.
- The global average carbon price is only $2 a ton, far short of what is needed.
Domestic political economy and policy design recommendations
- Political difficulty:
- Carbon taxation can be politically very difficult; the most immediate challenge is moving mitigation policy forward at the national level.
- Design principles and complementary measures:
- Introduce carbon taxes gradually, with targeted assistance for low-income households, trade-dependent industries, and vulnerable workers.
- Clearly communicate the rationale for reform and the use of revenues to the public.
- Use revenues to offset burdens (for example, reduce personal income and payroll taxes) and to finance productive investments.
- Other instruments may be needed to reinforce carbon pricing or substitute for it in politically difficult contexts.
- A potentially promising approach is revenue-neutral tax subsidies to promote cleaner power generation, shifting to cleaner vehicles, and improvements in energy efficiency to avoid politically difficult increases in fuel prices.
- Ministries of finance will need carefully crafted policy packages that account for national efficiency, distributional, and political economy considerations to provide broader and stronger mitigation incentives.
Source: Back to Basics: What is Carbon Taxation? – IMF F&D (June 2019), Ian Parry
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