Carbon Tax

What is Carbon Tax?

A carbon tax is a tax levied on industries and organizations in order to limit the emission of carbon dioxide and greenhouse gases that are harmful to the environment. It is generally believed that attaching a tax to the emissions would encourage the industries to reduce the emissions of carbon dioxide. Thereby, the rate of harm caused by industries would go down.

All fossil fuels that are used by industries contain carbon which turns to carbon dioxide when burned. Carbon dioxide is a greenhouse gas which means it is a gas that affects the infrared radiation to escape the space efficiently. In other words, the burning of fossil fuels, such as coal, petroleum, and natural gas creates greenhouse gas that traps the infrared radiation in the atmosphere leading to pollution and climate change. Greenhouse gases also help the environment to get more heated for which the industries and organizations using fossil fuels have to pay a tax according to their limit of emissions.

The principle of externalities is used to describe the attachment of the carbon tax. Due to carbon dioxide emissions, a cost to society is incurred via the harm the emissions cause to the environment by the emitters. This cost is said to be negative externally. The application of carbon tax is a way to internalize the cost.

Examples of Carbon Taxes

Many countries have enacted carbon taxes to reduce the emission of greenhouse gases indirectly. The first country to implement a carbon tax was Finland. It levied a tax of $73.02 per ton of carbon as of April 2021. The tax was levied in 1990. Soon, after Finland, other countries such as Sweden and Norway implemented carbon taxes in their countries in 1991.

Countries in the European Union use a system called Union Emission Trading Scheme (ETS) where the firms are allowed to exchange emission rights. The Eastern European and Organization for Economic Co-operation and Development (OECD) countries, on the other hand, have levied taxes on energy products and motor vehicles. The Norwegian tax of $69 per ton of carbon dioxide in Gasoline is the strictest in the world now.

Key Design Elements of Carbon Taxes

To design a carbon tax scheme, policymakers may choose to focus on many aspects including the following:

  • Scope: Scope refers to the substances covered in the taxation scheme.

For example, for most carbon tax schemes the carbon dioxide emission amounts are used as the base for taxation.

  • Point of Taxation: Considering the energy supply chain, a carbon tax can be implemented at any point in the supply chain system. A tax can be implemented upstream, midstream, and downstream. In the case of an upstream tax, the lowest number of entities are affected.

Examples of upstream points of taxation would be coal suppliers, gas processing industries, and petroleum refineries. Midstream points of taxation may include electronic utilities, while the downstream points of taxation may be energy users, vehicles, and households.

  • Tax and Escalation Rates: According to economic theory, a carbon tax should be set equal or according to the social cost of the emissions. The social cost refers to the current value of the damage caused over time by an additional unit (ton) of carbon dioxide emitted today. Moreover, as the environmental damage grows over time, the tax should also go up over time.

The growing tax rate also points to the growing responsibility of emitters which means that they will need to do more and that their increasingly aggressive technologies are economically justified. However, there are troubles in calculating the exact damage caused by the emissions. One of these troubles that are related to the pricing of the emissions is known as price certainty.

  • Distributional Impacts: The impact of a carbon tax will impact lower-income households if the tax rate is not evenly designed to reduce the load of taxes from the lower-income households. Levying a low tax on the poor and directing a higher portion of the tax to reduce the workload can help the poor significantly.

  • Competitiveness: Provisions protecting local production are necessary while pricing carbon tax. Without such protection, domestic energy-intensive trade-exposed industries or EITEs could face uneven competition from international players that do not face equal or equivalent pricing. This could lead to emission leakage from one country to another which will reduce the climatic benefit of a carbon tax.

That is why all contemporary carbon tax schemes contain competition-based mechanisms. These mechanisms include output-based allocations, historical data of emissions, rebates, and exemptions to select sectors. Carbon border adjustment is a step to address this aspect where concepts such as emission leakage and incentivization emission reductions are addressed.

  • Revenues: A carbon tax can raise substantial revenues and the use of the revenue is a political matter. It can be used to further reduce the climatic burden or it can also be used to identify and use allocation points that can contribute significantly to lowering the pollution and climate change conditions. Economists have however suggested that revenues used to lower the cost of labor and capital can have great economic benefits.

How is Carbon Tax Implemented?

There are different ways to collect the carbon tax from the emitters. The most result-oriented way, however, is to levy the tax at a wholesale level at the supply channel as upstream as it can be applied.

Electricity producers will pay the tax to their gas and coal suppliers who will forward the tax to the government. The generators will pass along the tax to retail electric utilities which will thereby be passed along to the users to the market condition limits.

Similarly, the government will collect the tax from petroleum refineries or importers. These taxes will be passed on to petroleum wholesalers who will charge the customers at the end of the supply chain. This method can increase efficiency and remove paperwork.


The carbon tax is an effective measure to curtail environmental damage. However, it is challenging to exactly calculate and apply without the support of energy industries. A concerted effort is the need of the hour as the climatic conditions have been damaged beyond repair and without a strict carbon tax reducing the harmful effects of carbon dioxide emissions cannot be implemented.


Qns 1. Will a carbon tax be levied on Nuclear power?

Ans. A carbon tax won't be applicable to nuclear power directly, but the tax can be implemented on the emission of carbon dioxide used in storing and use of radioactive elements, such as Uranium.

Qns 2. What are other subjects that have an interest in Carbon tax apart from Economics?

Ans. Science and climate studies, healthcare, and energy management are some studies that have a high focus on carbon tax apart from economics.


Simply Easy Learning

Updated on: 13-Oct-2022


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