Carbon pricing – the role of fiscal policies

by Professor Nathan Sussman [1]

Carbon pricing and global warming

Despite declarations made since 2015 to limit carbon emissions to avert global warming above 1.5 Celsius, the remaining carbon budget will run out in less than six years. The reason that this budget is not taken into account by most firms and individuals, despite its dire consequences, is the result of a market failure in which the users of polluting fuels do not bear the cost of air pollution and global warming and pass this cost on to all of humanity. Pricing carbon emissions allows producers and consumers to internalize the cost of carbon emissions both in consumption and in the production of goods.

Carbon taxes versus carbon markets

Economists see Carbon pricing as the most effective incentive to reduce the use of fossil fuels. About 3,600 economists (including 28 Nobel laureates) signed a statement that a carbon tax is the most cost-effective way to reduce carbon emissions and that the price of carbon must be raised every year until carbon emissions are fully offset. Research has shown that carbon taxes reduce emissions with negligible cost in terms of economic growth. [2]

Data source: Budgets from Forster et al. (2023). Current emissions data from the Global Carbon Project.

An alternative way, advocated by many in the financial sector, to price carbon is to set an annual quota for carbon emissions and distribute it with the help of vouchers to producers in the economy. The polluting producers will have to purchase vouchers from non-polluting producers; thus, a market price for carbon will be determined in the marketplace. Theoretically, this method could similarly price carbon as a carbon tax. Moreover, the vouchers given by the government reward firms with a low carbon footprint. However, this method has several disadvantages. First, it is aimed at manufacturers and, therefore, does not cover the carbon emissions associated with the consumption, for example, of fuel for private vehicles. Second, the quotas are only distributed to large companies, and it is necessary to monitor their carbon emissions. In small economies, it is hard to believe that an efficient carbon market will be created due to market concentration in the economy. Third, market prices for carbon tend to be volatile, making it difficult for firms to plan their energy transition. Finally, while necessary for creating the market, the rewards for low emissions might go mainly to firms that are inherently low-carbon emitters rather than those that actively reduce their carbon footprint.

The advantage of the carbon tax is its transparency and inclusion of the whole economy. The carbon tax does not require monitoring of carbon emissions since there is a simple equation that links the type and quantities of fossil fuel used and the amount of carbon it emits.

Implementation of Carbon taxes – fiscal considerations and political economy

The most efficient way to collect a carbon tax is by taxing energy inputs used in production and consumption. Collecting a carbon tax is simpler than other taxes because it is difficult to conceal energy used, even in economic sectors with prevalent tax evasion. The tax could vary by source of energy – taxing more heavily the most polluting energy sources such as Mazut and more lightly natural gas. Tax rates should increase over time, allowing consumers and firms to use energy efficiently and transition to cleaner energy sources efficiently.

Compared to the mechanism of carbon pricing by markets, a carbon tax generates revenues for the government. Moreover, a carbon tax is more effective in achieving the goal of reducing emissions. A carbon tax aims to eliminate an externality and should not be intended to increase fiscal revenues; its revenues should be recycled. We propose to allocate the revenues to compensate low-income households, subsidize the transition of firms to low carbon emissions, and provide retraining for workers who might lose their jobs in polluting industries.

Like any consumption tax, the carbon tax is regressive, affecting low-income populations more severely. Our preferred refund – a transparent and politically appealing method – is to reduce the value-added tax since this tax is also regressive. An alternative proposal is to refund the tax by offsetting the electricity bill of low-income households. However, such a refund does not achieve the energy efficiency goal. Reducing the cost of goods by reducing employment taxes may distort production and might not pass through to consumers.

International carbon border taxes

On October 1st, the Carbon Border Adjustment Mechanism (CBAM) entered into application in its transitional phase. CBAM is the EU’s tool to fight carbon leakage; it will equalize the price of carbon between domestic products and imports. This will prevent relocating production to countries with less ambitious green standards, mostly lower-income economies, or the replacement of EU products by more carbon-intensive imports. CBAM will force lower-income economies to impose carbon taxes or lose market share and revenues. In a similar way that domestic carbon taxes should be recycled, we argue that border carbon taxes collected by high-income economies be recycled to lower-income economies to assist in their green transitions and create stronger solidarity bonds necessary in the global effort to reduce emissions.

In summary, Carbon taxes are not only a cost-effective way to prevent global warming, but recycling them transparently and progressively could make them politically feasible and contribute to great equality and solidarity in the campaign to reduce global warming.

[1] This blog post is partially based on Carbon pricing in Israel.

[2] See Palatnik, R. R., Davidovitch, A., Krey, V., Sussman, N., Riahi, K., & Gidden, M. (2023). Accelerating emission reduction in Israel: Carbon pricing vs. policy standards. Energy Strategy Reviews45.