Policy Considerations of a Carbon Tax

Proposals for a carbon tax and other new sources of revenue, raise many policy considerations beyond simply the costs of implementing and complying with new taxes.

December 11, 2007
by Annette Nellen, CPA/Esq.

Regardless of one’s view on the issue of climate change and how high priority it should be on national and international agendas, the topic, as well as ideas for reducing greenhouse gas (GHG) emissions, is getting much attention by legislators, governors, mayors and others. One idea that has been suggested for changing manufacturer’s behavior to reduce GHG emissions is a carbon tax (for more information on carbon taxes and examples of current proposals, see Warming Up to a Carbon Tax).

Energy Taxes — Not a New Idea

Taxes on energy are not new. The federal gasoline excise tax has been around since 1932. State gas taxes are older, as Oregon has had one since 1919. By 1932, every state and the District of Columbia had followed Oregon’s lead. Since 1956, the federal tax has primarily been earmarked for highways and transit (Congressional Research Service report (PDF)).

Several times over the past few decades, proposals for higher gasoline taxes or other types of energy taxes have been considered, usually as a means of reducing budget deficits. The Congressional Budget Office (CBO) and other groups have devoted much time to analyzing different types of energy taxes, their likely impact on the economy, implementation issues, and pros and cons of various tax bases for an energy tax. For example, the CBO he CBO has studied the effects of a carbon tax to address global warming since 1990 (Carbon Charges as a Response to Global Warming: The Effects of Taxing Fossil Fuels (PDF)). Additional work continues to occur as the subject of energy taxes remains pertinent to deficit reduction as well as addressing climate change concerns.

Carbon taxes are a subset of energy taxes; they focus on the goal of reducing GHG emissions. Energy taxes can also reduce GHG emissions, but could also be more broadly based, such as on the heat content of fuels (BTUs) in which case they would even apply to sources of energy, such as renewables and nuclear, that do not generate GHG emissions.

Policy Considerations

Reasons for a new tax: Typically, energy taxes have been considered as a way to generate revenue while also having a favorable impact on reducing pollution, reducing reliance on foreign oil or encouraging energy efficiency. Carbon taxes specifically are proposed to not only raise revenue, but to also reduce GHG emissions and promote energy efficiency. If the goal is solely to raise revenue, a new tax is not needed as revenue can be generated from changes to existing taxes. To warrant a new tax, policymakers should be sure that the tax is designed to meet the non-revenue goals and that a tax is a more efficient way to reach those goals compared to alternatives.

Effects: The effect of a carbon tax on prices depends on many factors including the energy “content” of the goods or services, level of foreign competition and the ability of the affected parties to change their practices to reduce the amount of tax owed.

The 1990 CBO study on carbon charges concluded that while they can be effective in reducing GHG emissions generated from the burning of fossil fuels, “rapidly imposing large charges could be hazardous for the economy.” The CBO also noted that the costs of a tax “could be held to a loss of one percent to two percent of GNP annually during the first decade by phasing in the charges and taking offsetting actions to mitigate the contractionary effects of the charges (see report (PDF) p. xvi).”

The effects of a carbon tax will vary among industries and consumers. For industries or producers most reliant on coal to generate electricity, the impact is likely to be harsher given the carbon content and energy potential of this fuel relative to the burning of other fossil fuels. The effect on the economy will also vary depending on how the revenues generated from the tax will be used. If used to remove distortions in other taxes or provide tax reductions, the adverse economic effects of the tax might be diminished.

More recent CBO information notes that any effort to reduce GHG emissions would “produce long-term economic benefits by avoiding some future climate-related damage, and it would impose immediate economic costs by reducing the use of fossil fuels. Most analyses suggest that a carefully designed program to begin lowering CO2 emissions would produce greater benefits than costs.” (CBO testimony (PDF))

Non-tax alternatives: GHG emission reductions can also occur through regulation, investment in better technologies and to some extent, through education. Economic incentives are viewed as more cost effective than command-and-control laws and can also help to encourage better use of technology.

A commonly suggested market-based approach (besides a carbon tax) is a cap-and-trade system. Under such a system, emission targets are set and businesses are given tradable certificates that allow them to emit a specified level of GHG, with the amount decreasing regularly. Revenues could be generated through auction of the certificates.

Compared to a carbon tax, a cap-and-trade system would better enable the government to hit a specified emissions target. A tax would better enable prices to reflect the cost of the emissions. Economist Dr. Greg Mankiw observes that a cap-and-trade system is basically a tax on carbon emission with the revenue benefiting the GHG-emitting businesses. There is much debate today over which economic incentive is most efficient. The answer likely lies in system design and what other countries do to reduce their GHG emissions.

Tax alternatives: Consideration of tax approaches to reducing GHG emissions should also consider changes to existing tax rules. For example, provisions in the current income tax, such as tax-free employer-provided parking and incentives for the oil industry, could be removed. An increase in the existing gasoline tax could also be considered, although this fuel is not the only GHG generator.

Principles of good tax policy: Should policymakers decide that a carbon tax is an effective approach to reduce GHG emissions, principles of good tax policy (PDF) should be considered in designing the tax. These considerations include addressing the regressive nature of the tax, the varying effects on different regions of the country and industries, and reducing opportunities for evasion. Imposing the tax on producers rather than consumers can keep costs of collection (and evasion) low, but must be weighed against visibility of the tax. Minimizing economic distortions should also be considered to improve economic efficiency of the tax. Such consideration would include border adjustments and how to use the revenue generated.


Several lawmakers have proposed carbon taxes and other alternatives for reducing GHG emissions. Interesting and complex discussion and debates will continue with the next Congress and President.

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Annette Nellen, CPA, Esq., is a tax professor and Director of the MST Program at San José State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the AICPA and ABA. She has several reports on federal and state tax reform and a blog.