The production of carbon dioxide is widely held to contribute to social / environmental problems such as global warming. This carbon pollution is a negative externality. It is a cost imposed on the whole of society and not just the individual who consumes a certain product. e.g. if you drive a car, the external costs are felt by everyone else.
Because certain carbon intensive industries create negative externalities, the social cost of production is greater than the private cost.
In a free market, these negative externalities are not included in the price leading to overconsumption and social inefficiency. We can say there is a missing market, because the external cost of carbon emission is ignored.
Diagram to show Welfare loss of Negative Externality
SMC = Social Marginal Cost (total cost to society)
PMC = Private Marginal Cost (cost to individual)
PMB = Private Marginal Benefit (benefit to individual)
The Purpose of A Carbon tax
The purpose of a carbon tax is to internalise the externality. What this means is that the final price of the good should include the external cost and not just the private cost.
In theory, the tax should equal the external cost. Therefore, the price consumers pay will be the social cost. Demand will fall and the new equilibrium will be socially efficient because at this output, the marginal social cost equals the marginal social benefit.
Diagram to Show Carbon Tax
In theory a carbon tax should be revenue neutral. This means the tax raised from taxing carbon emissions can be used to reduce other taxes. There should be no overall increase in the tax burden.
Benefits of Carbon Tax
1. Encourages Alternatives. Encourages firms and consumers to develop more efficient engines or alternatives to consuming carbon emissions.
- This might encourage more people to cycle or walk to work. This would have health benefits such as lower risk of heart attack.
- This could make it more feasible to generate electricity from green sources (e.g. solar power). If we develop more green sources it will also make us less reliant on oil.
2. Raises Revenue. The revenue raised from carbon tax could be used to subsidise alternatives such as green electricity.
3. Leads to a socially efficient outcome. It makes people pay the social cost.
Problems of Carbon Tax
- Production may shift to countries with no or lower carbon taxes.
- Cost of administrating the tax.
- Difficult to know the level of external cost and how much the tax should be.
- Possibility of tax evasion. Higher taxes may encourage firms to hide carbon emissions.
- If demand is price inelastic, the tax may have to be very high to reduce demand significantly.
- Consumers dislike new taxes and often don’t believe that they will be ‘revenue neutral’. This is not an economic argument, but it is a political reality and explains why it is often difficult to implement.
Source: Economics Help