US & World Economies US Economy Carbon Tax, Its Purpose, and How It Works How a Carbon Tax Can Solve Climate Change By Kimberly Amadeo Kimberly Amadeo Kimberly Amadeo is an expert on U.S. and world economies and investing, with over 20 years of experience in economic analysis and business strategy. She is the President of the economic website World Money Watch. As a writer for The Balance, Kimberly provides insight on the state of the present-day economy, as well as past events that have had a lasting impact. learn about our editorial policies Updated on March 13, 2022 Reviewed by Erika Rasure Reviewed by Erika Rasure Erika Rasure, is the Founder of Crypto Goddess, the first learning community curated for women to learn how to invest their money—and themselves—in crypto, blockchain, and the future of finance and digital assets. She is a financial therapist and is globally-recognized as a leading personal finance and cryptocurrency subject matter expert and educator. learn about our financial review board Share Tweet Pin Email In This Article View All In This Article Purpose How It Works Advantages Disadvantages Emissions by Country Carbon Tax Plus Examples of Where Carbon Taxes Are Used in the World Frequently Asked Questions (FAQs) Photo: Alex Williamson/Getty Images A carbon tax is a fee that a government imposes on any company that burns fossil fuels. The most widely discussed are coal, oil, gasoline, and natural gas. When these carbon-rich fuels are burned, they produce greenhouse gases. These gases, such as carbon dioxide and methane, create global warming by heating the atmosphere. The resultant climate disruption causes extreme weather such as heat waves, flooding, blizzards, and droughts. Key Takeaways Carbon taxes discourage the use of fossil fuelsTo cut usage enough to make a difference, they would have to be very highThey should be combined with other measures to be most effective Purpose The purpose of a carbon tax is to reflect the true cost of burning carbon. Those costs are borne by those who suffer from the effects, such as homeowners, farmers, and ultimately the government. Carbon taxes make sure companies and consumers pay for the external costs they impose on society. It is a Pigouvian tax since it returns the cost of global warming to their producers. Note The Federal Reserve blames the lack of a national carbon tax for climate change. Businesses and households are not accurately charged for using fossil fuels. The Fed calls this "a fundamental market failure." The Fed also warns that this failure could lead to another wide-scale economic crisis. Extreme weather is forcing farms, utilities, and other companies to declare bankruptcy. As those loans go under, they will damage banks' balance sheets just like subprime mortgages did during the 2008 financial crisis. For example, the Pacific Gas and Electric Company went bankrupt in 2018. A federal judge found it responsible for the deadliest fire in California history, the Camp Fire. How It Works To implement a carbon tax, the government must determine the external cost for each ton of greenhouse gas emission. This is difficult because scientists and economists must first agree on which assumptions to use. One group, the U.S. Interagency Working Group on Social Costs of Carbon, developed an estimate of $40 per metric ton. A tax reflecting this social cost would increase gas prices by 36 cents a gallon. It would add $0.02 to the price of a kilowatt-hour of electricity. The price should be much higher to keep temperatures from rising above 1.5 C by 2030, according to a New York Times analysis of a 2018 United Nations report. Note The U.N. recommended a carbon tax of between $135 and $5,500 per ton. A recent report from the Organization for Economic Cooperation and Development found that the average carbon price across 42 major economies was around $35 per ton in 2018. The price differential means governments find it politically difficult to charge enough to reduce emissions significantly. Pros The added cost reduces emissions by motivating consumers to seek cleaner energy Boosts economic growth by substantially increasing government revenue Funds agencies managing climate change effects Cons A carbon tax is regressive A sudden increase in a carbon tax would shock the economy It penalizes those who can't switch to alternatives Advantages The tax reduces emissions in two ways. First, increasing the cost of carbon-based fuels will motivate companies to switch to clean energy. These include solar energy, wind energy, and hydro-powered sources. The carbon tax will also increase the price of gasoline and electricity. Consumers will then become more energy-efficient, further reducing greenhouse gas emissions. Taxes allow industries to find the most cost-effective ways to reduce carbon emissions. That's a better alternative to free-market economies than government regulation. For that reason, even oil companies support the tax. ExxonMobil, Shell, and BP have all called for the tax. Exxon even donated $1 million to the nonprofit that supports its preferred plan. BP’s chief executive has promised to cut emissions. A carbon tax also boosts economic growth. For example, Sweden's carbon tax has reduced its emissions by 26% in the past 27 years. During that same period, its economy grew 78%. A carbon tax raises substantial revenue. The Congressional Budget Office estimated that a carbon tax starting at $20 per ton and increasing to $34.40 per ton in 10 years could have raised $1.2 trillion. That's on par with the amount raised by all other excise taxes. The revenue can reimburse federal agencies tasked with dealing with the effects of climate change. These include: The Federal Emergency Management Agency which deals with hurricane damageThe U.S. Forest Service spent more than $2 billion in 2017. Fighting wildfires consumed 55% of its budget. This leaves little to spend on forest management.The National Flood Insurance Program had accumulated $39.4 billion in debt by 2018 Disadvantages A carbon tax is regressive. By making fossil fuels more expensive, it imposes a harsher burden on those with low incomes. They will pay a higher percentage of their income for necessities like gasoline, electricity, and food. They can't afford to switch to electric vehicles. For this reason, a carbon tax must be introduced gradually to be successful. A one cent per year guaranteed increase in gasoline taxes would give consumers time to shift to more economical vehicles. Knowing gas prices would always go higher would help them make that shift. Some of the revenues collected could go to lower-income families. But that's probably not enough of an increase to make a significant dent in CO₂ emissions. Note To meet the UN’s temperature-rise targets, the United States must reduce fossil-fuel-based energy demand by 85%. To do that, the prices of those sources should increase by 44 times. The government should use a carbon tax along with other alternatives. Doubling the price would be enough to shrink energy use by 29%. If gas prices were $5 or $6 a gallon, 29% of the users would find alternatives. But quadrupling the price would not reduce usage by 58%, as you would guess. It would only reduce it by 50%. Some people don't have alternatives and others would not give up their vehicles. That's called the price elasticity. Energy is relatively inelastic. Emissions by Country The United States has been the largest contributor of the gases that are warming the planet today. Between 1751 and 2017, U.S. CO₂ emissions totaled 400 billion tons. That's 25% of total emissions. The European Union is next, at 353 billion tons, or 22%. China is third, at 200 billion tons, while Russia emitted 100 billion tons. Note Currently, burning oil, coal, and natural gas create 82% of U.S. greenhouse gas emissions. Methane generates 9%, nitrous oxide adds 5%, and refrigerants and other sources make up the rest. While the United States. and EU have emitted the most throughout time, China became the world's largest annual emitter in 2006. The United States is second. But Americans emit the most per person. They comprise 5% of the world's population and emit 20% of its gases. That's five times more than a non-American. The map below illustrates the annual amount of CO₂ emissions by country. Carbon Tax Plus To be most effective, the carbon tax should be used in conjunction with other measures. Here are five other solutions to global warming that should be implemented. End government subsidies to coal, oil, and gas companies. They cost the government $25 billion a year. But their elimination would only increase prices by 2% to 3%. Subsidize wind, solar, and hydropower. They have lowered the cost and attractiveness of these alternatives, but much more needs to be done. Subsidies have only increased wind and solar power to 10% of U.S. electricity generation. That's not enough to halt global warming. Increase energy efficiency standards. Increase auto emissions standards. Require utilities to increase their usage of renewable energy. Require improved building efficiency. Build more public transportation. Redesign cities to reduce the need to drive cars. This is also one of the four best ways to create jobs. A University of Massachusetts at Amherst study found $1 billion spent on public works created 19,975 jobs. Tax cuts created 7,300 jobs for every $1 billion in foregone tax revenue. Implement carbon emissions trading. This policy allows companies to buy or sell government-granted allotments of carbon dioxide output. Governments distribute a finite number of CO₂ “credits” to companies. That’s the “cap” part. The companies can only emit as much CO₂ as they have credits for. Those below their CO₂ limit can sell credits to companies that exceed the limit. That’s the “trade” part. Industries, like utilities, are the biggest traders. They burn coal and other fossil fuels that emit the most greenhouse gases. Examples of Where Carbon Taxes Are Used in the World The World Bank reports that 40 countries and 20 municipalities use either carbon taxes or carbon emissions trading. That covers 13% of annual global greenhouse gas emissions. The World Bank adds that there are a total of 88 countries who intend to use a carbon tax to meet their Paris Agreement goals. This represents 56% of global emissions. In addition, there are 51 regional and local initiatives. In 2019, Canada imposed a national carbon tax of $16 a ton of CO₂. This will increase to $39 a ton by 2022. Most of the revenue will be refunded to individuals on their tax bills. Canada is warming twice as fast as the rest of the world. In 2013, Britain imposed a $25 tax per metric ton of CO₂. As a result, utilities switched from coal to natural gas. Greenhouse gas emissions fell to their lowest level since 1890. There are 10 U.S. states that have capped greenhouse gas emissions from power plants. They also require companies to buy tradable pollution permits. Frequently Asked Questions (FAQs) How can I lower my carbon tax? You can pay less in carbon tax by lessening your carbon footprint. Your carbon footprint represents the amount of greenhouse gases, such as carbon dioxide, methane, and nitrous oxide, that you produce during the course of your daily life. How can I lower my carbon footprint? There are many things you can do, including eating a plant-based diet, buying pre-owned items when possible, driving less, and supporting politicians and initiatives that support the reduction of greenhouse gasses. What should my carbon footprint be? You should eventually strive for a carbon footprint of 1.87. Right now, the per-capita carbon footprint in the U.S. is 18.3. That's the highest in the world. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. 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