Global Policy Forum

Setting the Optimal Carbon Tax Level


This graph represents the economic effect of a carbon tax and shows how the tax level might best be set. A carbon tax changes each emitter's marginal cost and marginal benefit of reducing emissions. The tax raises the cost of using traditional carbon-based surces of energy like coal and petroleum, stimulating users to turn to alternative energy like solar cells or wind power. The graph promotes the idea that the tax would be most efficient if set at a level that would reflect the marginal cost of abatement as well as the marginal damage costs of pollution. But in a vastly complex economy, a tax rate could not be calculated in this way, nor would it actually be set with such elegant simplicity. Instead, the rate would probably reflect different costs in different economic sectors, as well as political battles, interest group pressures, and other factors. Further, if high carbon emissions lead towards an uninhabitable planet due to global warming, can we responsibly place abatement into a simple cost-benefit calculus of the type this graph proposes?

Carbon Tax
Graph developed by Professor Elizabeth Bogan at the Princeton Department of Economics

When a carbon tax is introduced, emissions are reduced to the level at which the cost of abating emissions and the cost of paying the levy on emissions are at an equilibrium. This equilibrium simplifies the factors that affect marginal costs which vary between country, region, sector and access to information for the sake of modeling the effects of a carbon tax. This equilibrium point represents the amount of carbon that would be emitted according to the cost of abating emissions for each emitter. To the right of this point, along the x axis, the fee for the levy on carbon emissions is more than the cost of abating emissions. This would cause a firm to reduce emissions, moving left along the x axis. To the left of the equilibrium point, however, the marginal cost of reducing emissions is greater than paying the levy on the carbon tax. This causes an emitter to move right along the x axis until the equilibrium between paying the levy on carbon and the marginal cost of emissions reductions is reached.

For some emitters it is relatively inexpensive to reduce emissions, and for others it is very expensive. Imposing a tax allows each to reduce at a rate which is the most cost-effective for them. For example, an emitter heavily dependent on carbon emissions, such as a steel mill, would reduce as much as possible to avoid the tax, and pay a tax on their remaining emissions. Car owners and auto manufacturers would be heavily taxed because automobiles are heavily reliant on carbon in their manufacturing and use. On the other hand, a carbon emitting industry that can rely on alternative energy sources might reduce emissions completely and avoid paying the carbon tax. Household heating, for example could easily use solar technology as an alternative energy source. Though the alternative technology would have higher initial costs, it would be cheaper than paying carbon taxes over a period of a few years.

An alternative regulatory mechanism is command-and-control of the carbon emissions level. The command and control system involves goverment-set emissions levels for all carbon emissions. This approach has been widely used for abatement of air and water pollution, where toxic pollutants are involved. But for carbon emissions it seems less workable and less pol politically viable because of the enormously large number of emission sources. The command-and-control approach is inefficient, requiring that each firm reduce to the same level of carbon emissions, disregarding their particular abatement costs. The carbon tax model does not eliminate carbon emissions, of course, but rather establishes the optimal level at which they are to be emitted for each firm.

Another alternative to the carbon tax is a carbon permit trading system which has similar economic efficiency results as the tax. Under the permit trading system, firms are allowed to trade and buy permits according to their need to emit which is based on their marginal abatement costs. Among other arguments against this model, however, is the benefit that accrues to existing emitters. Some also object to the fact that the carbon trading system places a price on carbon emissions. Regulating carbon emissions with a tax incorporates the externalities of carbon emissions into the costs of emitting, while lowering the damages caused by emitting in the most cost-effective way. Furthermore, the revenues from a carbon tax have the potential to be reinvested into beneficial international political and social programs.

GPF text developed by Olivia Tecosky



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