Carbon Tax: The Background

In the human economy, a transaction typically includes two parties—the seller and the buyer. The seller receives a payment in exchange for giving up a good, the buyer gives up a form of payment and receives the good in exchange. Both parties benefit, judging that what they have given up is worth less to them at that point in time than what they received.

Imagine, for example, the purchase of a piece of fruit. Alice is hungry for a snack, spots Bert’s banana stand, and exchanges money for a banana. Alice and Bert both consider themselves better off upon transacting and, assuming Alice deposits her banana peel into a waste bin, no one is negatively affected. But, if Alice decides to pitch her banana peel onto the sidewalk after eating the fruit, we have a waste problem.

This, fundamentally, is how economists view the use of fossil fuels.

Sellers and buyers of fossil fuels both benefit from the transaction, but when oil, coal, and natural gas are consumed the waste emissions into the atmosphere present a cost to society that neither the sellers nor buyers are accounting for. That cost is called an externality, for the cost is external to the parties involved in the transaction.

In the early 20th century, British economist Arthur Pigou devised a strategy to account for these sorts of waste issues. His answer was what we now call a Pigouvian tax, in which a transaction that leads to a waste problem is taxed to account for the externality. In the 21st century this style of taxation can be seen in many countries across the world on thing like tobacco products and, increasingly, on fossil fuels in what we call carbon taxes.

Carbon taxes intend to internalize the environmental cost of burning coal, oil, and natural gas by levying a set fee per unit on carbon emissions. Most commonly, the tax is assessed at an upstream point of transaction (such as upon the sale of coal or crude oil) rather than when typical consumers use the produce (as in powering a home with electricity or an automobile with diesel fuel).