Ryan Dash
Environmental Economics
Professor Hong, Jong Ho
June 17, 2016
Carbon Taxes in Practice, A Survey Paper
Introduction
Global climate change is widely regarded as the most important and far-reaching
environmental problem we face today. It has even been described as a result of “the greatest market
failure the world has seen” by a prominent economist (Stern 2007). It is no surprise, then, that there
has been a lot of attention given to potential carbon mitigation solutions in the environmental
economics literature. Among them are carbon taxes, which have been touted by environmental
economists as being among the most efficient policy instruments to reduce greenhouse gas emissions
in some cases. This survey paper first aims to explain why a carbon tax can be a good policy option.
Then, the general structure and best-practice design principles are explained. With this in mind, I will
examine real-world examples, mostly national, of carbon taxes that have been implemented.
Definition and Justification of Carbon Taxes
The economic justification for carbon taxes is well-summarized by Perman et al. (2011).
When a Pigouvian tax on pollution is introduced, companies will seek to avoid the tax by abating as
much of their emissions as is cost-effective – that is, at a cost lower than the tax. Naturally, some
companies will be able to cost-effectively abate more than others, and this is why it is efficient.
Companies can choose the combination of abatement and tax payment that is best for them, and
achieve the desired level of pollution more efficiently than a standard, where some companies will
have to abate more than is cost-efficient, and others could cheaply abate more than required.
Furthermore, a tax does not require knowledge of each firm’s marginal abatement cost to implement.
Finally, a pollution tax will provide a revenue stream to the government, which can be allocated in
various ways: to reduce other taxes, to return to firms or consumers, or to support environmental
programs, for example.
Carbon taxes may have further-reaching consequences than might be anticipated. As noted
by Porter and van der Linde (1995) carbon taxes may inspire innovation. Faced with the tax, some
firms will research and implement lower-cost abatement technologies, which could eventually
transform the industry if these technologies are cost-effective. These early adopter firms who first
adopted the innovations, and perhaps even the whole industry, may be in a superior financial position
compared to before the tax. Additionally, Helfand (1999) notes that pollution taxes raise entry barriers
for firms that would pollute more, thereby preventing new sources of pollution in the first place.
Comparison of Carbon Taxes and Emissions Trading Schemes
Carbon taxes and emissions trading schemes both enjoy broad support from environmental
economists. Theoretically, in ideal circumstances, they will both lead to identical environmental
outcomes and tax level/permit price. In the real world, where there is imperfect information,
transaction costs, and other market inconsistencies, there are advantages and disadvantages to both.
Thus far cap-and-trade or emissions trading schemes (henceforth to be called ETS) have been the
more common policy option.
There are several reasons an ETS might be superior to a carbon tax. The relative advantages
are described by Stavins (2012). First and foremost, an ETS provides a clear emissions target, one that
has a reasonable guarantee of being reached if properly implemented. Since governments are very
goal-driven, particularly in light of recent international obligations, this is important. Second, political
pressures may affect allocations of permits in an ETS, but those same political pressures may lead to
exemptions under a carbon tax, which reduces environmental effectiveness as well as costeffectiveness. Third, ETSs may be more politically feasible to pass, as people (and thus the politicians
who represent them) are usually automatically averse to new taxes. Indeed, this seems to be the case,
given that more ETSs have been passed so far. Finally, ETSs can link up with ETSs of other regions
or countries, which makes both systems more flexible and effective.
It is also instructive to review how a carbon tax might be better than an ETS. First, carbon
taxes offer predictable energy prices since the rates are publically known. Permit prices fluctuate
under an ETS, which can actually discourage investment in abatement technologies. Second, carbon
taxes are much simpler, and can utilize existing tax structures. This allows them to be implemented
more cheaply and easily than ETSs. Third, carbon taxes provide a revenue stream to the government.
Fourth, carbon taxes do not have many of the problems that ETSs have suffered from (Carbon Tax
Center 2016). Finally, it may be easier to monitor and enforce carbon taxes, particular for small
polluters (Khan 2006).
The jury is still out as to which system is superior. Carbon taxes and cap-and-trade both have
merits, and both have proponents and opponents. Public acceptance is important for the passage of
either one, and a recent study suggests that a carbon tax designed with public welfare in mind can
reach a 70% acceptance rate, compared to 80% for a cap-and-trade system (Bristow et al. 2010). In
fact, combinations of both systems may be possible and lead to superior outcomes than either alone
(EIEP 2000). Only a thorough, empirically sound review of real-world systems can settle the debate.
Carbon Tax Design Principles
The double dividend concept is important for understanding carbon taxes. The idea states
that the benefits of a carbon tax are two-fold: they reduce carbon emissions for a better environmental
outcome, and also raise government revenues which can go toward the general government budget,
earmarked to fund environmental programs, or can be distributed back to the citizens, especially those
with a low income, in an equitable manner. Perhaps most importantly, carbon tax revenue can be
allocated to decrease the income or other tax rates. This is known as a revenue-neutral tax, and could
help increase the number of jobs and thus decrease or even nullify the economic cost associated with a
carbon tax (Eurostat 2003).
Carbon taxes can have an “upstream” or “downstream” approach. Upstream indicates that
the tax is levied on the fossil fuels that are used, while a downstream tax is levied on the individual
emitters. In some cases these approaches can be combined. An upstream approach is generally easier
to implement and enforce, because there are much fewer sources to keep track of (fossil fuel
producers and coal mines only), whereas a downstream approach would require management of an
enormous number of individual firms.
A carbon tax could also offer credits for offsetting activities. For example, a company that
chooses to invest in carbon capture and sequestration (CCS) should not be charged for their fossil fuel
use since the associated emissions are not being emitted into the atmosphere. While the role of CCS in
mitigation is currently limited because it is prohibitively expensive, this could be more relevant in the
future if the technology improves.
There are significant problems that must be considered when designing a carbon tax. Since a
tax will necessarily increase production costs, at least in the short term, industrial competitiveness is
injured. In the interest of avoiding this and the associated negative effects such as job losses, some
carbon tax policies offer exemptions to certain energy-intensive industries. However, these may incur
increased deadweight losses (Bohringer and Rutherford 1997) and so a redistributed subsidy may be
preferable. Furthermore, since a carbon tax imposes a flat rate on each fossil fuel, the distributional
impacts tend to be regressive: that is, the rich will suffer about as much, in absolute terms, as the poor
(Poterba 1991). To make the tax equitable, it is essential that at least some of the revenue be
distributed to low-income households (Callan et al 2009).
A letter was circulated at COP 21, which took place in December 2015 in Paris, urging
negotiators to consider national carbon taxes as a policy to achieve mitigation targets. The letter was
signed by a number of influential academics, including Nobel Prize winners. The letter introduced
some general advice for carbon tax design (Komanoff 2015). The first principle is to tax fossil fuels in
proportion to their carbon content so that the carbon emissions decrease in the intended manner.
Taxing on the energy content is also possible, but has some negative effects. Not only does it miss the
opportunity to abate more emissions by favoring the wrong kinds of fuels and thus slowing a shift to
renewable energy sources, it might send uneven price signals, and has a limited impact on improving
energy efficiency and reducing energy use (OECD 2015). (Note: in my presentation I mistakenly
asserted that taxing based on energy content of fuels was a good design principle. This was a
transcription error, and after further reading I have corrected the error.) Second, there should be a low
initial taxation rate to allow firms time to adjust to the new policy. This should be followed by a rapid,
but predictable, increase. This way firms know in advance what they will have to adapt to, and they
can make well-reasoned decisions on how much to invest in abatement technology, and how much tax
they will have to pay. Third, some revenue should be redistributed to low-income households to
counteract possible regressive distributional effects of the tax. Finally, a concurrent elimination of
fossil fuel subsidies should accompany the tax, so that it better fulfills its intended effects.
Country Case Studies
In this section I will cover the most important aspects of the most notable carbon taxes that
have been implemented around the world. The list is not exhaustive. Where possible, I will cite ex
post studies that analyze the economic and environmental results of the taxes in these regions. Ex ante
research, while useful in some contexts and far more plentiful, does not offer any ideas as to how the
real-world taxes have actually been working. I have used them only when they are directly applicable
and when ex post studies are not available. Ex post studies are preferable because they can give us a
general sense of how carbon taxes have worked and the effects they have had.
Finland
Finland is notable for being the first country to enact a carbon tax; it was implemented in
1990. The tax rate started at €1.20/ton ($1.46/ton) and rose until it reached its current rate of €20/ton
($22.33/ton). To retain competitiveness of key industries, several sectors were exempted from paying
the tax: peat, natural gas, the wood industry, and energy-intensive firms. However, Finland has
relatively few exemptions compared to other countries with carbon taxes. The tax was revised several
times in the 1990’s. Currently, the annual revenue is around $750 million per year, which goes into the
government general fund (Sumner et al. 2009).
Despite being the first country to implement a carbon tax, surprisingly, there don’t seem to
be any ex post studies which evaluate the environmental effectiveness of the tax. Even ex ante studies
are lacking in number and in depth. The most direct assessment comes from OECD (1997) which
estimates “modest” reductions in emissions due to the low tax rate.
Norway
Norway followed soon after Finland, introducing a carbon tax in 1991. Currently, the tax ranges
from $15.93 to $61.76 per ton, depending on the industry. Some industries, including air
transportation, are exempt, and so only 60% of emissions are covered (Anderson 2004). Annual
revenues are $1.3 billion, which go toward the government budget.
Emissions have mostly risen since the introduction of the tax, from 32.4 million metric tons in
1991 to 41.1 in 2016. (IEA 2016) However, the Norwegian government has estimated 2.5% to 11%
reduction in emissions compared to a business-as-usual case with no tax (Statistics Norway 1997).
This assessment may be overly optimistic, as Bruvoll and Larsen (2004) estimated a decrease of only
1.5% to 2.3%, completely outside of the government’s figures.
Sweden
Another early adopter of carbon taxes, Sweden began its in 1991. The tax is based on carbon
content, and is currently priced at the relatively high $104.83/ton. However, there are a number of fuel
exemptions, namely for electricity, nautical, rail, and air transportation. Certain industries such as
manufacturing and mining pay only 50% of the tax. The tax draws in $3.7 billion yearly, which goes
toward the government budget (Sumner et al. 2009).
There is limited evidence to suggest that the tax was effective initially based on emissions data
(IEA 2016), as they rose from 56.5 million metric tons in 1991. They fell again in the late 2000’s and
they went below their 1990’s levels to reach 51.1 in 2012. However, the Swedish government
estimates that carbon emissions were reduced by 20 percent compared to a business-as-usual scenario
without the tax (Naturvårdsverket, 1995). Bohlin (1998) shows that Sweden cut its emissions by 0.5
to 1.5 million tons. This reduction was not uniform among sectors: transportation, in particular,
reduced emissions significantly, while for the industrial sector, which uses less carbon-intensive fossil
fuels (and therefore facing a lower tax rate), consumption did not change much. Lin and Li (2011)
claim a non-significant reduction in emissions.
Denmark
Denmark began its carbon tax in 1992. Today, the tax is set at 90 DKK per metric ton, or
$16.41. The tax is levied in three different tiers, with some energy-intensive industries paying reduced
rates under an agreement where they must agree to make steps to save energy (Anderson 2004).
Annual revenues totaling $905 million fund environmental subsidies, while some is returned to the
industries most affected by the tax (Sumner et al. 2009).
Various ex post studies have attempted to determine the effect of the carbon tax. An early
post ex study by Shopley and Brasseur (1996) interviewed five large and two small companies. They
found that the tax had no impact on employment. The effect on the environment was noticeable – 6 of
the 7 companies reduced energy consumption by over 20%, which translated into emissions
reductions. Krarup et al. (1997) on the other hand, found a minimal impact on companies in energyintensive sectors, finding that most of the cuts would have been made even without the tax.
Enevoldsen (1998) found that the steady reduction in industrial emissions from 1991 to 1997 (1
million tons total) was likely due to the carbon tax, because industry production increased by 27%
over the same period. The Danish Energy Agency (1999) evaluated carbon emissions from 1988 to
1997 and found that they fell 6% over the time period, even as the economy grew by 20%. More
recently, Lin and Li (2011) find that the carbon tax itself has had no significant effect on emissions,
suggesting that the returned carbon tax revenue to industries, some earmarked for environmental
performance improvements, may be more responsible. Overall, these studies indicate that the carbon
tax has been environmentally effective.
Ireland
In 2010, Ireland was feeling the effects of the global recession. As a way to increase
government revenues, a carbon tax was implemented instead of increasing income tax rates. The tax
rate was initially €15 per ton of carbon dioxide ($16.70/ton) and rose to €20/ton ($22.30/ton). Annual
revenues of the tax are approximately €400 million ($446 million). The carbon taxes are
supplemented by other environmental taxes, such as a tax on household trash and additional taxes
imposed on cars, especially those with relatively low kilometers driven per liter of gas consumed.
Revenues of the tax have gone to avoid an income tax increase, and to farmers, who rely on the
carbon-intensive fuel diesel for many of their machines (Convery 2012).
To my knowledge there are no ex-post academic studies that attempt to calculate the actual
effects of the Irish carbon tax. There are several ex-ante studies employing theoretical models that
estimate the effects of various tax rates in Ireland. However, there are none that take into account the
specifics of the current carbon tax, so the results are not applicable to the current situation. Instead, by
looking at current emission rates in relation to past years we can get an idea of how well it has worked.
For example, national carbon emissions decreased by 6.7% in 2011, the year after the tax was
implemented, even as the economy grew. Experts believe that the tax was primarily responsible for
the recent growth of Ireland’s wind energy industry (Rosenthal 2012). Additionally, the tax is likely to
have positive distributional effects. Though inherently regressive because lower-income households
spend more of their income on electricity and heating, the revenue recycling of the tax, much of which
goes to reducing the income tax, has made the tax more progressive (Callan et al 2009).
British Columbia
British Columbia is not a nation, but a province of Canada. Nevertheless, with a population of 4.7
million people, it is nearly as large as some of the other countries with carbon taxes, and notable for
being the largest carbon tax implemented in the Western hemisphere. The British Columbia carbon tax
was initially priced at $10 per ton in 2008, which increased to $30 per ton by 2012. The $292 million
annual revenues are completely revenue-neutral: it cut income taxes in the region (Komanoff and
Gordon 2015).
As a relatively recent tax, no empirical studies have studied its effectiveness. However, it is
perhaps more meaningful to look at emissions data because they can be compared to other Canadian
provinces, which have the same national laws and similar economic circumstances, so it is likely that
any differences in emissions changes over the post-tax time period are due to the tax. The data shows
that per capita emissions for British Columbia were an average of 12.9% less compared to 3.7% for
the rest of Canada after the tax. The reduction for the rest of Canada can be explained by the
economic recession; it is likely that the additional reductions seen in British Columbia were due to the
tax. However, emissions rose again in 2012 due to economic growth, indicating that economic forces
overpowered the effects of the carbon tax (Komanoff and Gordon 2015).
Australia
Beginning in July 2012, the carbon tax rate was set at 23 Australian dollars per ton, or $19.60
per ton. It raised $3.8 billion in six months. Two years later, after constant debate and political
maneuvering by advocates and opponents, the tax was repealed in the Australian senate (Arup 2013).
Preliminary analyses suggest that the carbon intensity of the industrial sector decreased as a
result of the tax. In fact, the tax was estimated to have cut between five and nine million tons of
carbon dioxide equivalents per year, or a decrease of 3% to 6% (O’Gorman and Jotzo 2014).
The Australian case illustrates the difficulties involved in passing and retaining a carbon tax
in countries with relatively strong conservative political forces. A carbon tax can easily be demonized
as something that stifles economic growth, job creation, and damages international industry
competitiveness. Would-be policymakers must consider the potential for this to happen if they wish to
successfully implement a carbon tax.
Review of European Carbon Taxes
Two graphs presented by Anderson (2010) can enhance our understanding of the effects of
the carbon taxes implemented in Europe. The first graph shows the effects of environmental tax
reforms on European countries. The countries shown do not all have carbon taxes; some have more
restricted energy taxes. Nevertheless, it is instructive to look at the cases of Sweden, Finland, and
Denmark, as the environmental tax reforms for these countries refer primarily to the carbon tax.
Figure 1 indicates that reductions for Finland and Sweden, in particular, have made as much of a
difference as 6% in recent years compared to a business-as-usual case. Meanwhile, Figure 2 indicates
that effects on national GDP have actually been positive, perhaps because of the way the revenue has
been recycled, or perhaps due to environmental innovation as predicted by the Porter hypothesis.
Figure 1: % difference in carbon emissions made by environmental tax reforms compared to a
business-as-usual case.
Figure 2: % difference in GDP made by environmental tax reforms compared to a business-as-usual
case.
Comments on Revenue Allocation
As mentioned earlier, there is some agreement that revenue-neutral carbon taxes are the most
equitable. This chart, by Carl and Fedor (2016) reviews exactly how revenue has been distributed for
some of the carbon tax systems.
Figure 3: Revenue allocation of carbon taxes.
Globally, 44% of revenue has gone to reduce other taxes, which is the largest of any category.
28% has been allocated to general funds, while 15% has funded environmental programs. I know of
no study that has attempted to link the revenue allocation systems of carbon taxes with environmental
or economic outcomes; this is a potential avenue for future research.
Conclusion
This paper has reviewed the general characteristics of carbon taxes, and has discussed some
of the most important carbon taxes around the world. Unfortunately, it must first be stated that this
survey paper suffers from a lack of quality post-implementation research on carbon taxes around the
world, particularly the newer ones that have been implemented in the last five years or so. More and
better research in this area is essential to determine how carbon taxes are working in these countries,
so the policies can be tweaked as necessary. Additionally, without further analysis of what few
examples we do have, the sample size is not large enough to say with much confidence exactly how a
carbon tax would work in other countries. This is especially true for countries with different contexts,
such as developing countries. With this in mind, it will be interesting to see how Chile’s proposed
carbon tax unfolds: as the least wealthy country to propose a carbon tax thus far, it will be instructive
to see the results.
With these caveats in mind, there is some evidence that carbon taxes are environmentally
effective. All studies reviewed in this paper have shown carbon dioxide emissions reductions as a
result of the taxes, though some of these reductions are small. Moreover, the revenue that carbon taxes
bring in are beneficial to the government, and thus to the society, especially if they are allocated to be
revenue-neutral.
There are several general lessons for implementation of a successful carbon tax that can be
learned from the case studies. First and foremost, if carbon emissions reductions are the goal,
exemptions must not be given. Typically the most energy-intensive industries are exempted from the
tax, which runs counter to the whole idea underlying the tax. Second, the tax rate must be set
reasonably high, if not initially then eventually. Given the emissions data, it is clear that economic
forces have been stronger than the pressure imposed by carbon taxes, indicating that they have not
been strong enough to achieve the desired reductions.
There has been no carbon tax yet implemented that would inspire the kind of emissions
reductions necessary to have a nation do their fair share to put the world on a path for a reasonably
safe level of warming: limited to 1.5° C or 2° C (IPCC 2014). Nevertheless, it is reasonable to assume
that a well-designed carbon tax set at a high enough rate could be effective at achieving these kinds of
reductions effectively and cost efficiently. Carbon taxes could play a more significant role in
minimizing damages from climate change, but it remains to be seen whether they will.
Special Thanks
This paper has benefitted from the input of Charles Komanoff, the director of the Carbon Tax
Center. He cheerfully answered questions I emailed him and the Carbon Tax Center website he curates
was a valuable source of information.
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