Carbon Tax, Its Purpose, and How It Works

How a Carbon Tax Can Solve Climate Change

Jet emitting CO2

 Photo by Alex Williamson/Getty Images

carbon tax is a fee that a government imposes on any company that burns coal, oil, or gas. The World Bank reports that 40 countries and 20 municipalities use either carbon taxes or carbon emissions trading. That covers 13 percent of annual global greenhouse gas emissions. 

On November 6, 2018, the state of Washington voted against a carbon tax. If it had passed, Washington would have been the first U.S. state to do so.

It would have imposed a $15-a-ton fee on carbon emissions. The estimated $2.3 billion collected would have paid for pollution reduction and forest health programs, according to the New York Times.


The purpose of a carbon tax is to reflect the actual cost of burning carbon. When carbon-rich fuels are burned for energy, they produce greenhouse gases. These gases, such as carbon dioxide and methane, create global warming by heating the atmosphere.

These taxes make sure companies and consumers pay for the external costs they impose on society. It is a Pigovian tax since it returns the cost of global warming to their producers. 


Burning oil, coal, and natural gas create 82 percent of U.S. greenhouse gas emissions. Methane generates 9 percent, nitrous oxide adds 5 percent, and refrigerants and other sources make up the rest.

The International Energy Agency recommended that no more than a third of the world's reserves of fossil fuels should be burned by 2050.

If more is burned, the CO2 will heat up the atmosphere to a dangerous level of 2 degrees Celsius above pre-industrial levels.

China emits the most greenhouse gases, followed by the United States. But Americans emit the most per person. They comprise 5 percent of the world's population but emit 20 percent of its gases.

That's five times more than a non-American. But over the last century, America emitted most of the gases that are warming the planet today. 

Scientists agree that the resultant climate change causes heat waves, floodingdroughts, and wildfires. These economic costs are paid by homeowners, farmers, and the government. The utilities and energy companies that produce the greenhouse gases don't pay any of those costs.  

How It Works

First, the government must determine the external cost for each ton of greenhouse gas emission. This is difficult because scientists and economists must first agree on which assumptions to use. 

One group, the U.S. Interagency Working Group on Social Costs of Carbon, did develop an estimate of $40 per metric ton. A tax reflecting this social cost would increase gas prices by 36 cents a gallon. It would add $0.02 average price of a kilowatt-hour of electricity. 

A United Nations report said the price should be much higher to keep temperatures from rising above 1.5 C by 2030. It recommended a carbon tax of between $135 and $5,500 per ton.

recent report from the Organization for Economic Cooperation and Development found that the average carbon price across 42 major economies was around $8 per ton in 2018.

The price differential means governments find it politically difficult to charge enough to reduce emissions significantly.


The tax reduces the emissions in two ways. First, increasing the cost of carbon-based fuels will motivate companies to switch to clean energy. These include solar, wind, and hydro-powered sources. 

The carbon tax will also increase the price of gasoline and electricity. Consumers will then become more energy efficient, further reducing greenhouse gas emissions.

Taxes allow industries to find the most cost-effective ways to reduce carbon emissions. That's a better alternative to free-market economies than government regulation. 

A carbon tax can also boost economic growth. For example, Sweden's carbon tax has reduced its emissions by 23 percent in the past 25 years.

During that same period, its economy grew 55 percent.

A carbon tax could also raise substantial revenue. The Congressional Budget Office estimated that a carbon tax starting at $20 per ton and increasing to $34.4 per ton in 10 years could have raised $1.2 trillion. That's on par with the amount raised by all other excise taxes. 

The revenue could be used to reimburse federal agencies tasked with dealing with the effects of climate change. These include:

  • The Federal Emergency Management Agency which deals with hurricane damage.
  • The U.S. Forest Service spent almost $2.5 billion in 2017. Firefighting consumed 52 percent of its budget. This leaves little to spend on forest management.
  • The National Flood Insurance Program had accumulated $39.4 billion in debt by 2018.


To meet the Intergovernmental Panel on Climate Change’s temperature-rise targets, the United States must reduce fossil-fuel-based energy demand by 85 percent. To do that, the prices of those sources should increase by 44 times. Since it is so expensive, the government should use a carbon tax along with other alternatives. 

Doubling the price would be enough to shrink energy use by 29 percent. If gas prices were $5 or $6 a gallon, 29 percent of the users would find alternatives. But quadrupling the price would not reduce usage by 58 percent, as you would guess. It would only reduce it by 50 percent. Some people don't have alternatives and others would not give up their vehicles. That's called the price elasticity. Energy is relatively inelastic

Here are five other solutions to global warming in conjunction with the carbon tax:

  1. End government subsidies to coal, oil, and gas companies. They cost the government $25 billion a year. But their elimination would only increase prices 2-3 percent. 
  2. Subsidize wind, solar, and hydropower. They have lowered the cost and attractiveness of these alternatives, but much more needs to be done. Subsidies have only increased wind and solar power to 8 percent of U.S. electricity generation. That's not enough to halt global warming.
  3. Increase energy efficiency standards. President Obama imposed standards on appliances and the U.S. auto industry. Increase auto emissions standards. Require utilities to increase their usage of renewable energy. Require improved building efficiency.
  4. Build more public transportation. Redesign cities to reduce the need to drive cars. This is also one of the four best ways to create jobs. A University of Massachusetts at Amherst study found $1 billion spent on public works created 19,975 jobs. Tax cuts created 4,600 jobs for every $1 billion in foregone tax revenue. 
  5. Implement carbon emissions trading. This policy allows companies to buy or sell government-granted allotments of carbon dioxide output. Governments distribute a finite number of CO2 “credits” to companies. That’s the “cap” part. The companies can only emit as much CO2 as they have credits for. Those below their CO2 limit can sell credits to companies that exceed the limit. That’s the “trade” part. Industries, like utilities, are the biggest traders. They burn coal and other fossil fuels that emit the most greenhouse gases.