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Government Intervention - Economics of Carbon Taxes

AS, A-Level, IB
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 10 May 2022

In this short revision video, we look at the economics of carbon taxation

Economics of Carbon Taxes

A carbon tax is a type of government intervention to address market failures. Under a carbon tax, the government sets a price that emitters (polluters) must pay for each tonne of greenhouse gas emissions they emit into the atmosphere.

Carbon pricing creates signals and incentives for firms and households to reduce carbon-intensive energy use and – over time - shift to cleaner fuels thereby cutting emissions and helping to meet official climate targets.

A prominent study in the scientific journal Nature published in 2021 estimated that a price of €120 per tonne is needed by 2030 to decarbonise economies by 2050, in line with EU goals.

  • Carbon taxes are designed to change behaviour of consumers & firms
  • A carbon tax puts a price on each tonne of carbon emissions
  • This is based on the polluter-pays-principle
  • Pollution taxes first put forward by economist Pigou (Pigouvian taxes)
  • The idea is that a carbon tax helps to “internalize the externality”
  • This means that the tax raises private costs for polluters to match the external costs they are creating
  • Revenues from carbon taxes can be used to finance other projects

In 2021, the International Monetary Fund proposed an international carbon price floor (ICPF) withdifferent price points for emissions for economies at different stages of development to incentivize greater participation. In high-income countries, would be subject to a carbon price of $75 for every tonne of C02 emitted falling to $50 a tonne for polluters in middle-income countries, and $25 a tonne for low-income countries.

What are some of the main arguments in favour of a carbon tax?

  1. Important source of extra tax revenue – for example it might help fund clean energy investment and other socially beneficial projects
  2. Other taxes might be cut such as employment taxes so that a carbon tax is “revenue neutral”
  3. A carbon tax gives greater certainty to polluters such as energy plants about price of carbon contrasted with a carbon trading system where prices are more volatile
  4. Important principle of making the polluter pay
  5. If a carbon tax is set at a sufficiently high level, it creates strong incentives for clean energy investment / research and innovation to lower C02 emissions

What are some of the main arguments against a carbon tax?

  1. A tax on carbon increases variable costs, reduces business profits and might harm capital investment, jobs, exports and economic growth
  2. It is often difficult to measure carbon emissions – making it tough to set the right level for the carbon tax
  3. A tax would be likely to increase food and energy prices still further which would have a regressive impact on millions of low-income households
  4. Might encourage a shift of production towards other countries where there is either no carbon tax or a low one – global emissions don’t change
  5. Might need a very high carbon tax to make a differenceif there is low PED

Some economists argue that all revenues from a carbon tax should be returned to taxpayers for example in lower taxes or household grants so that a carbon tax is itself is revenue neutral. They believe that the main aim of a carbon tax is to increase the relative price / cost of carbon emissions rather than act as a cash-cow revenue-raiser for the government.

A growing number of countries around the world have introduced carbon taxes. Others have opted for carbon permit trading as an alternative. Be prepared to analyse and evaluate both approaches!

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