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Synoptic Revision: Micro & Macro Effects of a Carbon Tax


Last updated 11 Feb 2023

This revision video look synoptically at some possible micro and macroeconomic effects of a carbon tax.

Synoptic Revision - Micro & Macro Effects of a Carbon Tax

Under a scheme proposed by the IMF in 2022, companies with high greenhouse gas emissions, in high-income countries, would be subject to a carbon price of $75 for every tonne of carbon dioxide emitted. This would fall to $50 a tonne for polluters in middle-income countries, and $25 a tonne for low-income countries.

Microeconomic effects of a $75 per tonne carbon tax introduced in high-income countries

  • Higher supply costs for firms that emit a lot of carbon – increased VC and MC might lower profits – possible reduction in export sales for industries affected
  • Firms may pass on environmental taxes onto consumers – higher prices might then hit lower income families harder – leading to lower real incomes and less saving
  • Likely increased demand and profits for low-carbon products such as electric vehicles, off-grid renewables

Macroeconomic effects of a $75 per tonne carbon tax introduced in high-income countries

  • Short run increase in cost-push inflation as a carbon tax causes an inward shift of SRAS – a “supply-shock”
  • Might increase aggregate investment (I) in low carbon technologies although other industries might see a fall in their planned investment
  • Rise in government tax revenues from a carbon tax – improves the budget balance - might be used to fund research or invested into other areas of public spending

Here are three microeconomic and three macroeconomic effects of an increase in a carbon tax in the UK:

Microeconomic Effects:

  1. Changes in consumer behaviour: An increase in the price of carbon-intensive goods and services due to the carbon tax can lead to changes in consumer behaviour, as people shift towards more environmentally friendly alternatives such as shifting their spending towards low carbon products.
  2. Impact on firms: Firms that are heavily dependent on carbon-intensive inputs will face increased variable costs due to the tax, which could impact their competitiveness and profitability. In response, some firms may choose to pass on the increased costs to consumers in the form of higher prices, while others may choose to reduce production or invest in more environmentally friendly technologies which lowers their long-term carbon footprint. For example, an airline might bring forward research and development spending on materials science to lighten the weight of aircraft.
  3. Allocation of resources: The carbon tax can alter the allocation of resources in the economy, as firms and consumers respond to the new price signals. For example, investment in renewable energy technologies may increase, while investment in carbon-intensive industries may decrease.

Macroeconomic Effects:

  1. Impact on GDP: The carbon tax can have a direct impact on Gross Domestic Product (GDP), as the increased costs faced by firms and consumers reduce overall spending and economic activity. However, the long-term effects on GDP could be positive if the revenue generated by the tax is used to invest in low-carbon technologies.
  2. Effect on inflation: The increase in prices due to the carbon tax could lead to higher inflation, as firms pass on the increased costs to consumers.
  3. Trade implications: The carbon tax could impact international trade, as countries with a carbon tax will have a comparative advantage over those without. This could result in a shift in production towards countries with lower carbon prices, leading to a potential loss of jobs and economic activity in the UK.

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