A carbon tax is a policy that would set a fixed price per ton of carbon or carbon dioxide emitted, with a goal of incentivizing lower carbon emissions. Because CO₂ emissions from the combustion of fossil fuels (coal, natural gas, and oil) are proportional to the carbon content of the fuel, a carbon tax is, in effect, a tax on CO₂.

How Should a Carbon Tax be Structured?

When creating a carbon tax, key considerations and variables for policymakers include the rate of the tax, which sectors of the economy would be affected by the policy, who in a given industry would be required to pay the tax, and what to do with the revenues generated.

What Should the Carbon Tax Rate Be?

The rate of the tax is a central policy choice, and can be informed by several approaches. One approach, called the social cost of carbon, would have policymakers base the tax rate on the net benefits associated with reduced emissions. A different approach would determine an emissions target and then set a carbon tax rate that is estimated to achieve that desired outcome. Alternatively, a tax rate could be set to achieve a pre-determined revenue target over a 10-year period.

Which Industries Would Be Affected?

Policymakers must also consider how broad the tax would be. A tax may be limited to sectors of the economy that produce the most greenhouse gas emissions, or policymakers could decide on a more broad-based approach. Internationally, there are examples of both methods; France’s carbon tax affects sectors that account for 35 percent of the country’s total CO₂ emissions, while Japan’s tax applies to sectors that account for 75 percent of such emissions.

Who Would Pay the Carbon Tax?

Who pays the tax within an industry also needs to be determined. One approach is to tax those who produce fossil fuels; in the case of petroleum, for example, the product would be taxed when it is extracted. Another option is to tax “mid-stream”, such as at petroleum refineries. Finally, policymakers might choose to tax “downstream”, or taxing those who consume the fuel and emit greenhouse gases. For instance, petroleum could be taxed at gas stations or coal could be taxed when used in a generator. Each approach covers different shares of gases emitted and would impose different administrative burdens.

How Much Would a Carbon Tax Raise?

A carbon tax would raise significant revenues. A $25 per metric ton tax on most CO₂ emissions, coupled with an increase at a constant real (inflation adjusted) rate of 5 percent per year could raise $1 trillion in 10 years, according to the Congressional Budget Office. However, its effect on the federal budget would be determined by how the revenues it generates are used.

The use of revenues for policies other than deficit reduction may be a consideration for policymakers who must consider tradeoffs including political popularity, the cost of the overall policy, and whether the effect of the tax on certain groups (such as low-income households) should be mitigated. Some uses of revenues from carbon taxation include rebates in the form of checks or tax credits, additional spending on climate change resilience projects or programs that reduce emissions through other methods, and deficit reduction.

Finally, policymakers may consider a number of other issues, including how a carbon price would interact with policies in other nations. A mechanism known as border carbon adjustments would address such concerns and is under consideration both in the European Union and in the United States.

The Economic Impact of a Carbon Tax

Though the economic effects of a price on carbon would depend on choices made by policymakers, a carbon tax would have wide-ranging impacts. Sectoral impacts would depend on their carbon intensity and the degree to which industries would be able to substitute lower-carbon fuels for higher-carbon ones, among other factors. Impacts on different income groups would stem from their consumption patterns and sources of income.

Generally, a carbon tax would increase the cost of burning fossil fuels, thus increasing the cost of producing goods and services that rely on those inputs, particularly for carbon-intensive things like electricity and transportation. Regions where electricity is derived from coal would see the sharpest increase, since that power source is particularly CO₂ intensive. That change in prices would alter consumption patterns as individuals and businesses shift to consuming goods and services that are less carbon intensive. The effect of a carbon tax on the economy would depend on the revenue uses of the policy; without accounting for how the revenues from a carbon tax would be used, such a tax would have a negative effect on the economy. However, evidence from European countries that have implemented carbon taxes indicate a zero or modest positive impact on GDP and total employment growth.

More specifically, impacts would be felt differently across industries and particularly in the power, transportation, and industrial sectors, which are the three largest greenhouse gas emitters. The power sector is widely expected to be most responsive to a carbon price, as it is both cheaper and more straightforward to reduce emissions there than in some other sectors. Research indicates that even a modest carbon price would lead to a substantial reduction in CO₂ emissions in the sector.