Carbon Tax: A Unique Twist

AgMRC Renewable Energy Newsletter
February 2010

Don HofstrandDon Hofstrand
Professor Emeritus
Iowa State University

An alternative to a Cap and Trade policy to limit greenhouse gas emissions is a tax on emissions, referred to as a Carbon Tax.  A primary difference between a carbon tax and cap and trade is that cap and trade sets carbon emissions limits and then lets the marketplace determine the price of carbon.  Conversely, a carbon tax sets the price of carbon and lets the marketplace determine the level of emissions reduction. 

Although current legislation includes a cap and trade system rather than a carbon tax, many economists prefer a carbon tax.  A carbon tax would be easier to administer and may require less oversight requirements. 

Also, the concept of a tax fits with what the legislation is trying to achieve – reduce greenhouse gas emissions.  We tax items when we want less of them.  For example, we tax cigarettes to reduce the amount of cigarettes consumed which reduced the number of cigarette smokers.  If we want to reduce greenhouse gas emissions, it makes sense to tax them. 

However, the concept of “tax” is unpopular to many people.  It implies reducing an individual’s disposable income.  Although the tax would not be focused on individuals but on companies producing energy from fossil fuels, there is little doubt that the tax would be passed onto consumers through higher energy prices (an indirect tax).

A proposed solution to this is called “Carbon Tax and 100 Percent Dividend”.  Under this arrangement, all of the money raised from the tax is given back to people.  The tax can be collected anywhere along the supply chain.  It can be collected when crude oil is refined into gasoline or collected at the pump when sold to consumers.  Regardless, the tax goes into a separate fund where it is subsequently given to the public.  Each citizen of the U.S. would receive the same amount of money (there may be smaller shares for minor children or other adjustments).  For example, there are approximately 300 million people in the U. S.  If the tax generated $30 billion ($30,000 million) of revenue, each person would receive $100 ($30,000 / 300 = $100). 

Most of the cost of higher energy prices (caused by the tax) would be borne by those who consume the most fossil fuel energy.  RV drivers will pay more than Hybrid drivers.  However, the benefits will be distributed equally among all people, regardless of the amount of energy consumed.  So, RV drivers will experience a net cost while Hybrid driver will experience a net gain. 

This will create a strong incentive for individuals to reduce fossil fuel consumption in all aspects of their daily lives include transportation, home heating, energy intensive consumers products and others. 

As per capita fossil fuel consumption is reduced, overall fossil fuel consumption is reduced and greenhouse gas emissions are reduced.  Moreover, as fossil fuel consumption decreases, tax collections and the amount subsequently returned to the public also declines.  In time, tax collections and payouts may become insignificant.

In addition to efforts by consumers to reduce fossil fuel consumption, companies are stimulated to look for ways of reducing fossil energy consumption and/or substituting increased amounts of renewable energy for fossil fuels.  In addition, energy producers will be incentivized to switch from fossil fuel energy production to renewable energy production.  For example, the tax will raise the cost of coal fired electricity production which will give an incentive to implementing renewable electricity production such as wind and solar.  As renewable energy production technologies improve, energy prices will decline, resulting in lower consumer prices.  Moreover, renewable energy production will expand, resulting in less fossil fuel energy production, declining tax revenues and smaller tax payments to consumers.