Updated: Aug 7, 2022
A lot of industries rely on energy provided by fossil fuels, which creates important negative externalities on the rest of the world. In a previous article, we discussed Emission Trading Systems (ETS) as a tool to incentivise firms to limit their emissions and negative externalities. However, there exists another instrument that can achieve the same outcome. This carbon pricing tool is called a carbon tax and is the topic of this week’s article.
Let’s first quickly explain the main difference between ETS and carbon tax. With ETS, the quantity of emissions is known ex-ante because a cap on total emissions is set at the beginning of the period. However, the price per unit of emission remains unknown as it depends on the demand for emissions. A carbon tax works differently, as a regulatory fee is set per unit of emission. Therefore, the price is set ex-ante, and emissions are not known beforehand.
The idea of a carbon tax was first introduced by Arthur Cecil Pigou, an English economist born in 1877. In 1921, Pigou shared in his book The Economics of Welfare the thought of a marginal tax applied on polluter to encourage them to reduce emissions of greenhouse gas. Economic Nobel Prize William Nordhaus arrived at the conclusion that a 7% tax would be a good starting point.
Switzerland has adopted a carbon tax in 2008, to encourage companies and individuals to reduce their consumption of fossil energy. At the moment, this tax only concerns heating and process fuels, and covers roughly one-third of greenhouse gas emissions. In 2021, Swiss voters rejected the revised CO2 Act, which included an extension of the carbon tax to air travel.
The Swiss carbon tax started at a low initial rate but was set to gradually increase up to a maximum of CHF 120 per ton of CO2 if pre-set targets were missed. It started in 2008 at a rate of CHF 12 per ton of CO2, and by 2021, it had increased to CHF 96 per ton of CO2, as several targets were missed. In 2022, the tax increased to CHF 120 per ton of CO2, one of the highest in the world, as emissions failed to drop sufficiently. The revenues from the Swiss carbon tax are then either redistributed or earmarked. Indeed, one-third is earmarked for building programmes and low carbon technology whereas two-third is redistributed to companies and households, so that those who consume less benefit more.
Many European countries have also implemented a carbon tax. In France, the carbon tax now amounts to 40% of the gasoline price, compared to 7% in 2014. Carbon taxes can have a profound effect on the reduction of Greenhouse gas emissions, as demonstrated by Sweden. Since 1990, Sweden has managed to reduce its CO2 emissions by 26% while still being able to increase its GDP by 78%. Its growth is one of the cleanest and most sustainable in the world. This was partly due to an aggressive carbon tax policy: in 1990, the tax was around 240 SEK (24€) per ton of CO2 and increased to 1’180 SEK (114€) per ton of CO2. This was part of Sweden’s effort to create a “greener” tax system: the state compensated the green tax with a decrease of 10 billion € of the income tax and a decrease of 7.5 billion € on labour taxes.
There are numerous benefits to the implementation of environmental (green) taxes. They internalize the negative externalities of polluting firms and industries. They promote energy saving or the use of renewable sources of energy. They motivate innovation and investment in sustainable technologies. And last but not least, they create a flow of income to the government that can reinvest it in sustainable and innovative projects.
However, environmental taxes have drawbacks. An important barrier is public opinion’s acceptance. A recent example of nonadherence to an environmental tax occurred in France. When the French government decided to increase the tax on fuel, the yellow vests movement was created, and is still continuing since October 2018. The yellow vest movement emerged because the public claimed the tax reform burdened the middle class the most. Nonetheless, different steps can be taken when implementing environmental taxes to improve its acceptance. Firstly, it is important to educate the population on the importance of environmental taxes. Secondly, determining what social class and how it will be burdened by the tax is really important. If the middle class is already heavily taxed whilst polluting industries are not, the green tax will naturally be rejected by public opinion. The co-creation of subsidies on sustainable activities could also help with adherence of environmental taxes. Another shortcoming is that environmental taxes can push industries and firms to delocalize if taxes are too high compared to other countries with similar productivity levels. These firms can then negotiate exceptions and render the tax less effective.
Swissinfo (2021). New European CO2 tax law to have limited impact on Swiss companies
Economie.gouv.fr (2022). Arthur Pigou
Investopedia (2022). Energy Tax Credit
Myclimate.org (2022). What is the Swiss CO2 Act?
BAFU (2022). Climate: In brief
Government Offices of Sweden (2022). Sweden’s carbon tax