Why Tax Carbon, and How Much?

Emissions of carbon dioxide, methane, nitrous oxide, and other greenhouse gases are increasing global temperatures, raising sea levels, shifting rainfall patterns, boosting storm intensity, and harming coral reefs and other marine life. Greenhouse gas emissions thus create a host of potential economic and environmental threats, including property damage from storms, human health risks, reduced agricultural productivity, and ecosystem deterioration (Environmental Protection Agency 2023; National Aeronautics and Space Administration 2018).

Energy prices do not currently reflect these costs of greenhouse gas emissions. Those who benefit from burning fossil fuels generally do not pay for the environmental damage the emissions cause. Instead, this cost is borne by people around the world, including future generations. Imposing a carbon tax can help to correct this externality by raising the price of energy consumption to reflect its social cost.

Estimates of the environmental cost of carbon emissions are sensitive to scientific and economic assumptions and thus differ greatly. Early in the Biden Administration, the US Interagency Working Group on Social Costs of Greenhouse Gases (2021) estimated that, by one measure, the social cost of carbon was about $50 per metric ton in 2020. Under other assumptions, however, the value could be as low as $14 or more than $150. In 2022, however, the Environmental Protection Agency proposed a cost of $190 per metric ton. At the time of writing, that proposal was still subject to review.  By contrast, current US charges on fossil fuels--chiefly the federal excises on automotive fuels--amount to only about $5 per ton (IMF 2019).

How Would a Carbon Tax Affect Welfare?

A carbon tax would increase the price of burning fossil fuels and any resulting goods or services. A tax of $40 per ton would add about 36 cents to the price of a gallon of gasoline, for example, or about 2 cents to the average price of a kilowatt-hour of electricity (Marron, Toder, and Austin 2015). Higher energy prices would raise costs for industry and households, resulting in lower profits, wages, and consumption. Conversely, however, reduced carbon consumption would lower the real costs of climate change and air pollution.

The impact of a carbon tax would differ among economic groups depending on the extent of energy price changes and on regional energy production and consumption patterns. Clearly, a carbon tax would fall more heavily on workers and investors in carbon-intensive industries as well as on regions that depend heavily on carbon-intensive fuels, particularly coal.

The distributional impact of a carbon tax would depend on the extent to which businesses could pass higher energy costs to their customers. If demand for goods is less “elastic” (that is, responds less) to price changes than the supply of goods, then consumers will bear more of the carbon tax burden than investors and workers.

Because low-income households consume a more energy-intensive basket of goods than do wealthier households, a carbon tax would be regressive; it would cost poorer households a higher share of their income than wealthier households (Rosenberg, Toder, and Lu 2018). For example, one carbon tax they consider would account for about 2.1 percent of pretax income for households in the lowest income quintile, as compared to 1.1 percent for the highest income quintile.

The environmental benefits from reduced emissions would be shared by people around the world. Combatting climate change thus poses a fundamental collective action problem.  US reductions will be most valuable if they are accompanied by comparable reductions in other nations.  Nonetheless, most countries would reap substantial domestic benefits from lowering carbon emissions, which increase disease and deaths from air pollution, among other harms (IMF 2019).

Deploying the Revenue

A carbon tax could raise substantial revenue. The Joint Committee on Taxation and the Congressional Budget Office estimated, for example, that a broad-based carbon tax starting at $25 per ton in 2023 and rising at 2 percent more than inflation would have raised more than $750 billion over its first decade (Congressional Budget Office 2022). This is close to the amount that the United States currently raises with all its other excise taxes—about 0.5 percent of gross domestic product per year.

The welfare impact of a carbon tax package would depend on how those revenues are used. One option would be to rebate the revenues to households on a per capita basis (Marron and Maag 2018). Such “carbon dividends” would render the overall policy progressive, as lower-income households would be more than compensated for higher energy costs, while upper-income households would pay a net tax (Rosenberg, Toder, and Lu 2018).  Using revenues to increase transfers, reduce Social Security contributions from low-income households, or compensate workers in carbon-intensive industries would also soften the regressive impact of the carbon tax. Revenues from a carbon tax could also be used to finance cuts in existing taxes that discourage growth. Revenues could also be used to reduce personal income taxes, to reduce future deficits, or to invest in clean energy and climate adaptation. What combination to choose depends on political, social, and economic considerations (Marron and Morris 2016).

Updated January 2024