Carbon Taxes: What Can We Learn From International Experience?

The Issue:

Economists have argued for almost one-hundred years that carbon taxes can address the problem of pollution. And the issue has gained increasing urgency with the threat of climate change. In the last 25 years there has been a move from theory to practice. As of early 2018, more than 25 national or subnational carbon tax systems had been implemented or were scheduled to be implemented around the world. New evidence is emerging on the way they work and their effects on greenhouse emissions and on the economy in general. What can we learn from international experience?

As of early 2018, more than 25 national or subnational carbon tax systems had been implemented or were scheduled to be implemented around the world.

The Facts:

• Pollution is a textbook example of how government intervention can correct a problem of a “missing market.” Burning fossil fuels when we use gasoline to power our vehicles, coal to produce electricity, and natural gas to cook our meals and warm our homes during winter, generates pollution. While this imposes a cost on society, those who pollute do not bear that cost. Economists call this a “negative externality” because the costs are external (not borne by) those engaged in the activity. There is, from a societal viewpoint, an undesirably high level of production and consumption of goods that have negative externalities, since the prices charged for such goods do not reflect their true social cost, which is higher than the market cost. This market failure justifies government intervention. One possible intervention is a tax that raises the price of these goods and activities, and thus lowers their consumption.
• Carbon taxes are a practical way to have consumers and producers take account of the social cost of pollution that increases greenhouse gases. Carbon dioxide, CO2, is a greenhouse gas, and there is scientific consensus that greenhouse gases emitted from human activity are an important source of global warming. The amount of CO2 associated with burning a ton of coal or a gallon of gasoline, or producing a therm of energy from natural gas, is a physical constant. Carbon taxes can therefore be accurately assessed in terms of how the reduction in the use of coal, gasoline or natural gas leads to a reduction in the emission of carbon dioxide.
• The tax rate applied to activities that generate a ton of CO2 varies widely across countries. As of 2018, tax rates ranged from less than $1 per ton of carbon dioxide in Poland and Ukraine, to as much as $139 per ton in Sweden. Twelve out of the 27 national or subnational systems that are in place had a rate of at least $25 per ton. Carbon taxes have been enacted at different times and, once established, have increased at different rates. In particular, the early 1990s carbon taxes were enacted in Denmark, Finland, Norway and Sweden, among other countries, in what has been known as the “Scandinavian wave”. A second wave in the mid-2000s saw carbon taxes put in place in Switzerland, Iceland, Ireland, Japan, Mexico and Portugal as well as in the Canadian Provinces of British Columbia and Alberta. Other countries and regions have joined in more recently. For example, every Canadian province had to have a plan in place to price carbon emissions by April 1, 2019, and those four that did not  (Ontario, Manitoba, New Brunswick and Saskatchewan) had a $20 per ton tax imposed by the federal government. Once established, taxes have increased at different rates. For example, Sweden initially fixed its tax rate at $27 per ton in 1991. Since then, it has increased more than fivefold to almost $140 per ton. British Columbia (BC) and Switzerland introduced carbon taxes in 2008 at a rate of around $10 and $13 per ton, respectively. In 2018 they had increased to $27 per ton in BC, and to $99 per ton in the case of Switzerland.
• Some evidence has started to emerge pointing to a reduction in greenhouse emissions in some of the countries where carbon taxes have been enacted. By increasing the cost of the goods associated with CO2 emissions, a carbon tax reduces demand for those “dirty” goods. With carbon taxes in place, people would be expected to drive less, purchase more energy efficient vehicles and appliances, and switch to more efficient sources of energy. These shifts in demand reduce greenhouse emissions. Although the empirical evidence of the effects of carbon taxes is relatively sparse given their relatively recent imposition, it has been found that emissions have declined in Finland, Denmark, Sweden and the Netherlands relative to those in other 13 European countries in which carbon taxes are not in place. However, Finland was the only country where the decrease in emissions was statistically significant, probably because it has relatively fewer industries exempted from the tax. In British Columbia, I estimate emissions have decreased between 5-8 percent since the introduction of carbon taxes in 2008. Analysts from the U.S. Department of the Treasury estimated that if the U.S. were to implement an economy-wide carbon tax starting at $49 a ton in 2019, emissions could be reduced by as much as 21 percent over 10 years.
• Despite their potentially positive effects on emissions reductions, carbon taxes may have a negative impact on some people and businesses. Energy makes up a more significant share of the budget of low‐income families than of higher‐income households. Carbon taxes increase energy bills and there is concern about their impact on poorer households. New research shows, however, that this concern may be overstated as part of the impact of a carbon tax is shifted from price increases to wages and returns to capital with owners of capital being especially impacted. Additionally, carbon taxes can slow economic growth by raising costs for industries that face these taxes. Also, polluting businesses in countries or regions that have carbon taxes operate at a disadvantage relative to those same types of businesses in places where carbon taxes are not in place.
• As the British Columbia case shows, the additional revenues generated by a carbon tax can be used by governments to reduce their potential negative impacts. The more than $1 billion that have been collected each year by BC’s local government, have been returned to households and businesses through different mechanisms. Low-income families and small businesses are receiving tax credits, and their tax rates have been reduced. A one-time dividend was also given to every BC resident, a measure that is highly progressive since a cash rebate has a larger impact on the disposable income of lower-income families. I have also found that, thanks to these counter-measures, BC’s overall economic activity has not been adversely affected by the carbon tax. Additionally, while carbon taxes have stimulated employment (although modestly) across all industries, jobs have shifted from carbon and trade sensitive sectors, such as chemical manufacturing, to cleaner service industries, such as health care (see here).