An International Carbon Tax to Combat Global Warming: An Economic and Political Analysis of the European Union Proposal

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Efficiency and Equity Effects of an International Carbon Tax

Considerable attention has been given during recent years to the possible adoption of an international carbon tax to help deter the perceived threat of global warming.(1) Such a tax is an economic-incentive, a market-based alternative to direct, command-and-control curbs on carbon emissions.(2) A carbon tax comes under the classification of a pigovian(3) tax (Pigou, 1920), that is, a tax designed to internalize negative externalities into the price system. To accomplish this end, the carbon tax places a price upon the nonmarket or social costs of environmental pollution in the form of carbon emissions as generated by the use of the fossil fuels - coal, oil, and natural gas - in the production of energy.(4)

Since fossil fuels do not emit carbon in their natural state prior to mining, a property or wealth tax on the stocks of such fuels would be meaningless. Instead, an efficient carbon tax must be levied upon the negative externalities themselves, the carbon emissions which result from the use of such fuels. Ideally, this would take the form of an excise tax imposed upon each unit of carbon emitted when fossil fuels are used to produce energy for consumption and production activities such as automobile driving and factory operations. Unfortunately, it is not administratively feasible to impose the tax at the actual time of carbon emissions.

However, feasible alternatives are available such as the imposition of an excise tax on fossil fuels either (a) when they are mined or imported into a nation (a primary carbon tax), or (b) when they are sold to businesses and households for use in energy production (a final carbon tax). In order to capture the negative externalities, the tax base should be defined in specific rather than ad valorem terms since it is the physical amount of fuel used to produce energy that is linked to carbon emissions, not the pretax price of the fuel. The destination principle of international trade may be used to help harmonize a carbon tax across nations, thus reducing the risk of trade distortions and free-rider behavior.

The maximum reduction in carbon emissions would be attained from a tax imposed solely upon fossil fuels and not upon alternative sources of energy which do not emit carbon. Energy created from geothermal, nuclear, solar, water, and wind-driven sources does not contribute to global warming and, thus, should not be included in the tax base. In fact, a pure carbon tax levied only upon fossil fuels would encourage the substitution of these noncarbon-emitting energy sources for fossil fuels by making them relatively cheaper than coal, oil, and natural gas. While it is true that a broadbased tax on all energy sources would decrease carbon emissions in accordance with the relevant price elasticities of demand for fossil fuels and the level of the tax rate, it would not maximize carbon abatement since cross-price elasticity effects between fossil and nonfossil fuels would be ignored.

Another feature of an efficiently designed international carbon tax is the requirement that differential marginal tax rates be imposed upon the various fossil fuels since coal, oil, and natural gas emit various amounts of carbon per unit of energy production. Thus, since coal emits 25.1, oil 20.3, and natural gas 14.5 grams of carbon per 1000 British Thermal Units (BTUs) of energy production, the carbon tax rate should be highest on coal, next-highest on oil, and lowest on natural gas in accordance with these carbon intensity ratios. These differential tax rates would encourage the substitution of "cleaner" for "dirtier" fossil fuels while simultaneously encouraging the substitution of nonfossil fuels for fossil fuels if the former are not included in the tax base. In addition, an efficient international carbon tax regime would assure that such differential tax rates be uniform across nations since the atmosphere is a global public good and common property resource that does not recognize the arbitrary nation-state political boundaries imposed by mankind (Herber, 1991). …