Carbon tax – an idea whose time has come
Kingsmill Bond // 22 April 2020
I was sitting in a hot tub in Leningrad in the summer of 1990 when I realised the Soviet Union would fall.
There were five of us, in our backpacking hostel’s back room, in a makeshift tub. The hot water poured in ceaselessly and poured out over the edge. Brought up in a household where hot water was strictly rationed, I was moved to ask who paid. And the answer was that it was “free”, so you could have as much as you liked! Of course, it wasn’t really free, since there was a price to be paid elsewhere. Under the socialist economic system of the Soviet Union, there were no proper price signals to allocate resources, so the shops were empty. But at least they had “free energy”!
Until fairly recently, this is the situation in which we have found ourselves with regards to carbon dioxide. In some ways, it still is. We can fly to Spain for as little as £20. We can burn low-VAT gas in our homes and undertaxed coal in our industries, and society picks up the tab for much of the resulting pollution. There is simply no way for us to understand and make the best use of carbon. And this leads to a system which does not work to maximise the utility of our carbon usage.
The use of fossil fuels has a real cost in terms of both air pollution and global warming. The latest data from the Centre for Research on Energy and Clean Air indicates that 4.5 million people a year die as a result of the air pollution from fossil fuels, with a total cost of $2,900bn a year, 3.3% of global GDP, or $87 for each of the 33 billion tonnes of CO2 emitted by the energy sector.
Meanwhile, we are arguably already seeing the effects of global warming: longer wildfire seasons in some parts of the world (though some argue that this is due to worse forest management as an unintended consequence of encouraging biodiversity), increased flooding in others, stronger hurricanes in yet others. All of this is happening at one degree of warming; as it gets hotter, the costs will only rise, making large parts of the earth uninhabitable, and reducing GDP per capita by up to 80% in parts of South Asia, sub-Saharan Africa and Southeast Asia. The externality cost of global warming (the social cost of carbon) was calculated under Obama at $52/t for 2020, although Lord Stern argues that this estimate fails to account for many issues and that the true cost is higher.
Add up health costs and global warming costs and you have a total annual cost of nearly $5 trillion, or $140 per tonne of carbon dioxide. You might expect this cost to be taxed accordingly. But at least at the global level, fossil fuel taxes do not massively exceed fossil fuel subsidies. The world gave the fossil fuel industry $428bn in subsidy in 2018 according to the International Energy Agency (although we can, of course, argue about what precisely constitutes a “subsidy”, and what is merely favourable tax treatment). Meanwhile, taxes on energy raised a total of €517bn in 2018 according to the OECD.
The taxation of carbon is not just insufficient to cover for the social cost of carbon. What is perhaps worse is that carbon is also taxed in spectacularly inefficient and distortionary ways. The taxation of carbon varies wildly from sector to sector. 83% of all energy taxation is for the 15% of emissions that come from vehicles. But we tax the remaining 85% of energy emissions at just €3 per tonne. Flying and shipping are almost untaxed; industry and electricity pay €2 and €1 per tonne of CO2. The UK is better, but not by much. We tax our road usage (a quarter of the total) at €262/t and everything else at €10/t. There is no economic justification for this variation. A tonne of CO2 is a tonne of CO2 is a tonne of CO2, irrespective of who the emitter is. The taxation of carbon should be neutral, symmetrical, and non-discriminatory.
It is not prohibitively expensive to tax carbon. The average person in the UK emits 12 tonnes of carbon dioxide a year. Tax that at say £30 per tonne (more on price below) and you are talking about £360 a year, or just over 1% of GDP. Carbon taxation would add only pennies to the price of a coke or a sandwich. It has already been done: Sweden taxes 96% of their emissions, and it regularly ranks as one of the best places to live.
So if we accept that there is a problem, the question is how best to solve it. There are three main ways to tackle an externality – tax, subsidy and regulation. At present we have an incoherent mish-mash of all three, the result of haphazard growth of poorly thought-out environmental initiatives over the years. The solution is the same as everywhere else in life: if you want to reduce usage and maximise the utility of what you have, you put a price on it. The impact of a universal price is to encourage people to cut usage, to drive businesses to find new solutions, and to incentivise entrepreneurs like Elon Musk to come up with low carbon innovations. The IMF calculates that a tax of $75 per tonne on carbon dioxide would save 725,000 premature deaths in 2030 in the G20, curtail emissions by 35%, and be the most effective tool to achieve the goals of the Paris agreement.
The immediate and legitimate concern is that taxing carbon would be a regressive tax and that people will be out on the street to resist it. Critics often invoke the Gilets Jaunes. However, the Gilets Jaunes were protesting against increased taxes on road transport, and road transport, as mentioned above, is already highly taxed.
More importantly, carbon taxation is not about increasing the overall tax burden. It can be done in a broadly revenue-neutral way. One solution which makes this especially clear is the Baker Shultz carbon dividends plan, advanced by Ted Halstead in the US. The idea is simple – you pay the money raised in carbon tax back to everyone as carbon dividends. This encourages societal buy-in, because everyone can see the money as it hits their bank accounts; £90 per quarter cash up-front is a powerful motivator. It is also progressive because the poor emit a lot less carbon than the rich. The US Treasury Department calculates that the biggest beneficiaries would be the lowest decile of earners, with an 8% increase in income. And for the richest decile it would reduce income by around 1%. You may not agree with this particular plan, or its distributional impact. But the point is that it is possible to allay the fears of reasonable critics, who, quite understandably, worry that a carbon tax will be just another way to fleece taxpayers.
The carbon tax should be levied on every area of usage. It makes no sense to tax one area and not another when that distorts the system, sends the wrong message, and fails to provide the right economic incentives. By the same token, once a carbon tax is fully rolled out and set at an appropriate level, many other climate change measures – if not all of them – can be abolished. There is no need to penalise the same activity twice. Once you have paid the full social cost of whatever carbon-emitting activity you enjoy, you should be entitled to enjoy it. A carbon tax would, for example, make the EU Emissions Trading Scheme (EU-ETS) superfluous. You either tax carbon, or you make emitters buy a permit, but there is no reason to do both. Subsidies for low-carbon activities could also be phased out.
Some argue that carbon labelling will do the job instead. Give consumers the right information and they will make the right choices. Apart from the collective action problem, the problem with this approach is that it requires everyone to handle colossal amounts of information. Mike Berners-Lee takes a look at the issue, and what is most striking is how complex it is. According to him, a disposable nappy actually has a lower carbon footprint than a reusable nappy washed at 90 degrees. And a strawberry eaten in January has a carbon footprint 12 times higher than one eaten in July. Nobody can carry around all these numbers in their head, and they don’t need to. We have a perfectly good system, called price.
The idea of carbon taxes is not new. It has been the default solution of economists for years, and organisations such as the Carbon Pricing Leadership Coalition have done an excellent job of making the case for it. However, things have changed in the last five years. The price of the renewable alternatives has fallen dramatically. We have options that we did not have before. Emerging markets, lacking fossil fuels, swamped by pollution, and worried about energy security, have new ways to get their energy. Renewable electricity is cheaper, cleaner, faster, and local; the emerging market energy leapfrog started in China, has spread to India, and is now moving to the rest of the world. What this means is that it is now possible for politicians to have their cake and eat it. They can increase taxes on carbon and improve the health of their constituents without hugely increasing prices to the end consumer.
This brings one further advantage to those countries which seize the opportunity. They can get their societies ready for the new world of higher carbon taxes which are spreading round the globe. Inefficiencies can be reduced, and systems can be reconfigured. UK companies can find interesting new niches in the rising green economy and take advantage of them for global success.
To tax pollution is not a socialist idea. It is a very standard neoclassical tool, and one of the core functions of the state. It was Mrs Thatcher who called for an international co-operative effort to tackle climate change. It is, of course, true that many on the left are using climate change as an excuse to shoehorn in socialist measures. But this is precisely why supporters of a liberal market economy must not vacate this space, and cede the issue to the socialists. If we do not tackle this issue head-on – they will.
The Soviet Union eventually collapsed because its leaders reacted too late to solve its internal contradictions. The risk facing our own societies is that it too will come under intolerable strain from global warming, and that the reaction will be very aggressive and late. Far better to get our society and our businesses ready for a change that will inevitably come. It is better to address this problem like adults. Putting a price on carbon is far less intrusive than relying on our bureaucrats to engineer every more complex ways of discouraging carbon use. This is at heart a very simple issue: unpriced carbon will undermine the market economy upon which rest our wealth and freedom. It is time to change if we want to keep that market economy.
 Ryanair website 11 March 2020 from London to Madrid in April
 To be clear these are separate costs and are looked at separately.
 Quantifying the Economic Costs of Air Pollution from Fossil Fuels, CREA, 2020.
 CREA calculate the costs for each of the main areas of damage, from particularates to ozone and NOX.
 Burke (2018): “Large potential reduction in economic damages under UN mitigation targets”
 US Government (2016): “Technical update of the social cost of carbon for regulatory impact analysis”; at a 3% cost of capital, the cost is $42 in 2007 dollars, which is $52 in 2020 dollars.
 Stern (2019): “The missing economic risks in assessment of climate change impacts”
 International Energy Agency (2019): “Global fossil fuel subsidies”
 OECD (2019): “Taxing energy use”
 OECD (2018): “Supplement to effective carbon rates”. For emissions excluding biomass.
 IMF (2019): “How to mitigate climate change”
 Bipartisan climate roadmap (2020): The Baker Schultz carbon dividends plan
 US Treasury Department (2017). Presented by the Bipartisan climate roadmap (2020)
 Mike Berners-Lee (2010): “How bad are bananas. The carbon footprint of everything”
 Carbon Pricing Leadership coalition(2019): “The pricing advantage”
 Bank of England (2019): “Avoiding the Storm”; UNPRI (2019): “The inevitable policy response”
This article was first published on the IEA’s blog.
EPICENTER publications and contributions from our member think tanks are designed to promote the discussion of economic issues and the role of markets in solving economic and social problems. As with all EPICENTER publications, the views expressed here are those of the author and not EPICENTER or its member think tanks (which have no corporate view).