Published on 4/12/21
A Pigouvian tax on carbon emission, or a carbon tax, aims to directly correct the market inefficiencies caused by externalities in the consumption of gasoline and in the production of electricity (Pigou). For example, setting an ambitious target of reducing carbon emissions by 70% from 1990 levels by the year 2030, the Danish parliament approved a new corporate carbon tax in 2022 which is reported to be the highest in Europe, setting the CO2 levy to 1,125 Danish crowns ($159) per tonne by 2030 for companies subject to the EU Emissions Trading System (World Economic Forum; Reuters). Some may argue that corrective taxation ought to be implemented only for gasoline because of the three options, diesel cars generate the greatest total and per unit carbon emission and pollution to the environment through burning gasoline. But such taxation is suboptimal in that it fails to consider the external costs incurred in electricity generation, 60% of which came from burning fossil fuels, as reported by the U.S. Energy Information Administration in its 2022 study (EIA). While it may be generally true that the use of EVs is more environmentally friendly than that of diesel vehicles, it is imperative that we take the additional social costs from electricity production into account as well.
Benefits
1. Most direct and least invasive way to remedy the market failure
By charging individuals and companies for the costs they impose on others, a correctly implemented carbon tax pushes the marginal private cost curve up to intersect with the marginal social benefit curve at the socially optimal level (Fig. 1). In addition, unlike other forms of government intervention such as subsidies or regulations, Pigouvian taxes do not require a heavy-handed policy affecting the specific decisions made by households and firms. Instead, they allow the market to operate more efficiently by internalizing the costs of negative externalities.
A carbon tax can have profound effects on reducing carbon emissions. For Finland, a 2012 study concludes that carbon taxation led to a decrease in CO2 emissions by more than 7% between 1990 and 1998 (Sairinen); a more recent study done in 2021 finds the Finnish carbon tax lowered CO2 emissions by 16% in 1995, 25% in 2000, and 31% in 2005 compared to a no-carbon tax counterfactual (Mideksa). Furthermore, Fig. 2 shows that although China currently does not have a carbon tax, according to a recent paper published in 2022, it is estimated that implementing a 5 yuan/ton CO2 carbon tax would significantly reduce the nation’s total carbon emission by 4 to 5 percent (Wei et. al).
2. Raises revenue for the government
The imposition of a carbon tax is appropriate and expedient for the purpose of raising revenue for the government. The demand for gasoline and electricity is inelastic, and thus the Ramsey Rule, which argues that taxing commodities with a lower elasticity of demand is more economically efficient in generating revenue for the government, highlights the economic efficiency of imposing a carbon tax (Oum and Tretheway). Rising government debt has become a significant threat to economic stability and growth with dwindling resource reserves; according to the U.S. Treasury, the U.S. has accumulated a national debt of $30.93 Trillion by the fiscal year 2022, requiring $307 billion - accounting for 12% of total fiscal spending - only to maintain the debt (U.S. Treasury). As such, the revenue raised from the imposition of a carbon tax could not only mitigate the burden on the government by reducing the total debt amount, but also allows for greater public spending by reducing the monthly interest payments.
3. Promotes technological innovation
In the grand scheme of things, it is imperative that we consider not only the immediate effects of the policy but also the long-term consequences. While opponents to the corrective Pigouvian taxation argue that it increases costs and reduces the firms’ competitiveness, the Porter Hypothesis posits that polluting firms can derive strategic advantages from environmental policies, contending that carefully crafted and rigorously enforced corrective measures can serve as a catalyst for innovation, thereby enhancing the productivity of firms and the value proposition of their products for end-users (Porter). In essence, the Porter Hypothesis refutes the notion of a zero-sum game between economic growth and environmental protection, asserting that the two objectives can be mutually reinforcing. By instilling dynamic efficiency, Pigouvian taxes on gasoline can produce spillover benefits for both society and regulated firms, potentially mitigating or completely offsetting the costs associated with compliance.
Costs
1. May potentially increase emissions in the short run
Though it may appear at first glance to be a panacea for the market failure in the car industry, a closer examination reveals that there are indeed some drawbacks to the Pigouvian tax. While the policy of implementing a carbon tax aims at reducing carbon emissions, in the short run, it may potentially lead to an increase in emissions, commonly known as the Green Paradox (Sinn). This occurs because the tax increases the expected cost of emitting pollutants in the future, which can lead to a rush to extract resources before the tax takes effect.
2. Decrease in the competitiveness of domestic firms in the global market
An increase in taxation may lead to a decrease in the competitiveness of domestic firms in the global market. Pigouvian taxation, when implemented alone, can increase the production costs of domestic firms. This can put them at a competitive disadvantage, making it more difficult for them to compete with firms in countries with lower taxes. For example, a 2020 econometrics study done on the effects of carbon taxation on the cement industry in British Columbia finds a reduction in its net exports of cement between 13 and 18 percent after its implementation of carbon taxes in 2008, although the level of domestic consumption remains the same (Thivierge). Moreover, Pigouvian taxation can also lead to the phenomenon of carbon leakage, which occurs when firms subject to Pigouvian taxes move their operations to countries with lower tax rates or weaker environmental regulations. This can result in a net increase in global emissions, undermining the effectiveness of the policy in reducing negative externalities.
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