Effects of a Carbon Tax on the Economy and the Environment

May 22, 2013

Lawmakers could increase federal revenues and encourage reductions in emissions of carbon dioxide (CO2) by establishing a carbon tax, which would either tax those emissions directly or tax fuels that release CO2 when they are burned (fossil fuels, such as coal, oil, and natural gas). Emissions of CO2 and other greenhouse gases accumulate in the atmosphere and contribute to climate change—a long-term and potentially very costly global problem.

The effects of a carbon tax on the U.S. economy would depend on how the revenues from the tax were used. Options include using the revenues to reduce budget deficits, to decrease existing marginal tax rates (the rates on an additional dollar of income), or to offset the costs that a carbon tax would impose on certain groups of people. This study examines how a carbon tax, combined with those alternative uses of the revenues, might affect the economy and the environment.

How Much Revenue Could a Carbon Tax Raise?

Neither CBO nor the staff of the Joint Committee on Taxation has published an estimate of how much revenue a carbon tax might produce. However, CBO has extensively analyzed policies, known as cap-and-trade programs, that would similarly set a price on CO2 emissions. Those analyses suggest that a carbon tax that covered the bulk of CO2 emissions or the carbon content of most fossil fuel consumed in the United States could generate a substantial amount of revenue. For example, in 2011, CBO estimated that a cap-and-trade program that would have set a price of $20 in 2012 to emit a ton of CO2 (and increased that price by 5.6 percent each year thereafter) would raise a total of nearly $1.2 trillion during its first decade. In addition, total U.S. emissions of CO2 would be about 8 percent lower over that period than they would be without the policy, CBO estimated.

How Would a Carbon Tax Directly Affect the Economy?

By raising the cost of using fossil fuels, a carbon tax would tend to increase the cost of producing goods and services—especially things, such as electricity or transportation, that involve relatively large amounts of CO2 emissions. Those cost increases would provide an incentive for companies to manufacture their products in ways that resulted in fewer CO2 emissions. Higher production costs would also lead to higher prices for emission-intensive goods and services, which would encourage households to use less of them and more of other goods and services.

Without accounting for how the revenues from a carbon tax would be used, such a tax would have a negative effect on the economy. The higher prices it caused would diminish the purchasing power of people’s earnings, effectively reducing their real (inflation-adjusted) wages. Lower real wages would have the net effect of reducing the amount that people worked, thus decreasing the overall supply of labor. Investment would also decline, further reducing the economy’s total output.

The costs of a carbon tax would not be evenly distributed among U.S. households. For example, the additional costs from higher prices would consume a greater share of income for low-income households than for higher-income households, because low-income households generally spend a larger percentage of their income on emission-intensive goods. Similarly, workers and investors in emission-intensive industries, who would see the largest decrease in demand for their products, would be likely to bear relatively large burdens as the economy adjusted to the tax. Finally, areas of the country where electricity is produced from coal—the most emission-intensive fossil fuel per unit of energy generated—would tend to experience larger increases in electricity prices than other areas would.

How Would Various Uses of the Revenues From a Carbon Tax Alter Its Economic Effects?

Lawmakers’ choices about how to use the revenues from a carbon tax would help determine the tax’s ultimate impact on the economy. Some uses of those revenues could substantially offset the total economic costs resulting from the tax itself, whereas other uses would not.

Using the Revenues to Reduce Deficits Would Decrease the Tax’s Total Costs to the Economy

At least part of the negative economic effect of a carbon tax would be offset if the tax revenues were used for deficit reduction. Federal budget deficits tend to result in lower economic output over the long run than would otherwise be the case, by crowding out private-sector investment. Thus, policies that reduce deficits generally have a positive effect on the economy in the long run (although they can have a negative effect in the short term when the economy is weak).

Using the Revenues to Cut Marginal Tax Rates Would Also Decrease Total Costs

Lawmakers could also offset some of the negative economic effects of a carbon tax by using the revenues to reduce the existing marginal rates of income or payroll taxes—a policy known as a tax swap. Existing taxes on individual and corporate income decrease people’s incentives to work and invest by lowering the after-tax returns they receive from those activities. Consequently, reducing those marginal tax rates would have positive effects on the economy.

Using the Revenues to Reduce Adverse Effects on Selected Groups Would Not Decrease Total Costs

Targeting revenues toward people who would be likely to bear a disproportionate burden under a carbon tax would provide them with relief, but such a policy would tend not to reduce the total economic costs of the tax. Thus, lawmakers would face a trade-off between the goals of helping those households most hurt by the tax and helping the economy in general. Lawmakers could use the revenues in more than one way to try to balance those goals.

How Would a Carbon Tax Affect the Environment?

Climate change resulting from an increase in average temperatures is a long-term problem with global causes and consequences, including effects on humans and ecosystems. Significantly limiting the extent of future warming would require a concerted effort by countries that are major emitters of greenhouse gases. Nonetheless, U.S. efforts to decrease emissions would produce incremental benefits, in the form of incremental reductions in the expected damage from climate change.

Researchers have attempted to estimate the monetary value of the future damage from climate change associated with an increase in CO2 emissions in a given year—and thus the value of the benefits from a commensurate reduction in emissions—a measure referred to as the social cost of carbon (SCC). An interagency working group of the federal government estimated the SCC associated with a 1-ton reduction in CO2 emissions in 2010 at about $21 (in 2007 dollars). Estimates of the SCC are highly uncertain, and researchers have produced a wide range of values. Those values are highest when researchers attach significant weight to long-term outcomes and when they incorporate a small probability that damage from climate change could increase sharply in the future—causing very large, or even catastrophic, losses. Delaying efforts to reduce emissions increases the risk of such losses. Given the inherent uncertainty of predicting the effects of climate change, and the possibility that it could trigger catastrophic effects, lawmakers might view a carbon tax as a reflection of society’s willingness to pay to reduce the risk of potentially very expensive damage in the future.