The latest UN annual report on climate change issues the sternest warning yet that climate change due to human activity is accelerating. This series of reports has triggered two types of responses. The first type calls for government command and control measures that would phase out all fossil fuel-based energy by 2030; this has gained a great deal of attention with the introduction of the Green New Deal. The second favors the carbon tax, a pro-market approach that would use price incentives to induce market participants to reduce their greenhouse gas emissions. Both strategies will be needed, but the carbon tax is misunderstood and needs further explanation.
The atmosphere is a “common access resource.” Consequently, an unregulated “free market” does not require payment when polluters emit CO2 into the atmosphere. They have an incentive to save abatement costs by using the atmosphere as a free disposal site. The implementation of a tax per unit of carbon emitted into the atmosphere would insert the missing price per unit of CO2 emission. Profit-seeking firms would be incentivized to direct their engineers and scientists to seek emission-reducing methods that are cheaper than paying the tax.
Reducing carbon emissions costs money. In an unregulated "free" market, a firm that voluntarily incurs abatement costs places itself at a competitive disadvantage relative to competitors that do not abate their emissions. The carbon tax applied to all emitters levels the playing field by eliminating the emitters’ advantage: without the carbon tax, a firm can gain a competitive advantage by emitting more carbon; with the carbon tax, a firm can gain a competitive advantage by emitting less carbon.
As the carbon tax is passed on to consumers, they will perceive a change in the relative prices of different energy sources. For example, due to coal's relatively high carbon content per unit of energy, the carbon tax for coal would be roughly twice that for natural gas, providing coal users with a strong incentive to switch to gas. Energy buyers would perceive even lower relative prices for non-fossil energy, like wind and solar, provided they can work around natural interruptions of those sources.
The Bipartisan Approach
Recognition of the potential of this tax to curtail climate-altering CO2 emissions is growing, and support for it is gaining ground on both sides of the aisle. Recently, Senators Whitehouse (D-RI) and Schatz (D-HI) proposed charging polluters $49 per ton for their carbon emissions. Meanwhile, the Climate Leadership Council (CLC), a "conservative" organization, endorsed a fee of $40 per ton.
This measure would generate considerable revenues (e.g., the CBO estimates that the Whitehouse/Schatz proposal would generate over $2 trillion per decade). The money could be spent partially offsetting the increase in the national debt resulting from the 2017 recent debt-financed tax cut. Or, the money could be spent to beef up safety net programs for the poor, shore up the national retirement and health programs, and fix the nation’s crumbling infrastructure. Or, it could be spent on speeding up the development of alternatives to fossil fuels. After all, if the scientists are right, we need to make up for lost time. Finally, the CLC has proposed that the money could be returned to the public in the form of an equal per-person “citizen dividend.” At $40 per ton, that annual dividend is estimated at roughly $2,000 per family of four.
The Carbon Tax Complements Other Government Regulation.
Many “small government conservatives,” who recognize the need to reduce CO2 emissions, over-estimate the effectiveness of a “free-market solution” offered by the carbon tax. It has great appeal for them because, as a complement to market forces, they regard it as a substitute for the "heavy hand" of government command and control actions (quotas, bans, equipment requirements, measurement techniques, inspections, and compliance rules that restrict managerial prerogatives). However, while a carbon tax reduces the scope of the required regulatory oversight, it does not eliminate the role for regulation. The regulatory authorities still will be required to continually monitor carbon emissions to determine how high to set the tax - the higher the tax, the lower the emissions. Moreover, the government must also monitor compliance. So, while the carbon tax creates compatible incentives to reduce emissions, it is not sufficient to absolve the government of all its responsibilities.
The Carbon Tax is a Start on Net Zero CO2 Emissions by 2050
According to the CLC, such a hefty tax would induce investment in abatement methods that would keep our emissions far below the 2030 target levels agreed to in the Paris accords. That would be a good start on the "net zero" by 2050, regarded by scientists as a necessary condition to keep global temperature increase to 2°C. So the carbon tax is a good component in the large set of proposals that must work to re-organize the incentives of 340 million ideologically mixed citizens. The carbon tax gives all decision-makers an incentive to act in ways that save the planet, even if that is no part of their intent.
William L. Holahan is Emeritus Professor and former Chair of Economics at the University of Wisconsin-Milwaukee.