From global economic powers like the United States, Japan and Russia to developing economies like Rwanda, Bangladesh and Iran, more than 190 countries convened as part of the United Nations Framework Convention on Climate Change in late 2015.
Out of the participating countries, 177 signed the Paris Agreement on Earth Day 2016, establishing a global commitment to significantly reduce carbon dioxide emissions.
With more than 85 percent of all countries signing on, the Paris Agreement marks the strongest global commitment to carbon emissions reduction to date. Countries are now turning to the question of how to keep this commitment. In the U.S., such policies are politically fraught, but among economists, the issue has a surprisingly broad consensus.
Adam Smith’s theory of the “invisible hand” says that free markets are efficient at allocating and organizing economic resources. The theory holds that markets maximize social benefits — what economists call social welfare. A powerful theory then and now, the invisible hand provides a theoretical justification for capitalism and market-based economic systems. For more than 200 years, markets have enabled tremendous improvements in the standard of living, with the worldwide poverty rate falling below 10 percent for the first time in 2015.
But there is an important caveat to this theory. Decisions made by consumers and producers are only efficient when prices reflect all costs of a good. In some cases, consumption and production create social costs not reflected in prices. Unregulated pollution like carbon emissions are a cogent example of this type of market failure known as a negative externality.
Negative externalities occur when third parties who don’t benefit from a market suffer damages for which they are not compensated. A good example is a farmer living downstream from a steel plant that produces mercury pollution, reducing the profits of the farmer by damaging his or her crops. Since the farmer is not compensated by the steelmaker or steel purchaser, the price of steel will not go up to reflect this additional external cost. Under these circumstances, the invisible hand fails to maximize social welfare.
Carbon emissions are not directly hazardous to human health. Their externality is the costs associated with global climate change. Climate change will require extensive alterations to current infrastructure, agriculture and residential systems. Further, a warmer planet will mean increased global diseases and the potential for more extreme weather patterns. This so-called social cost of carbon (SCC) varies considerably from study to study, but recent estimates suggest that every ton of CO2 creates $20 in social cost. For context, the U.S. emitted about 5.3 billion tons of CO2 in 2015, representing a SCC of more than $106 billion.
Contemporary economists agree that a relatively efficient policy to combat negative externalities is a corrective tax — in this case a carbon tax. A carbon tax is placed on goods that emit carbon and is set equal to the SCC. In this way, markets internalize the cost so that pricing signals more accurately reflect a good’s true social cost.
So, what would a carbon tax mean for the U.S. economy? Since most carbon is emitted from the energy needs of production and transportation, a carbon tax would directly impact energy markets first.
For example, gasoline, which produces about 20 pounds of carbon per gallon, would cost about 20 cents more per gallon. Energy from coal, which produces about two pounds of carbon per kilowatt hour, would be about 2 cents per kWh more expensive. Energy from natural gas would add a penny to the cost of each kWh.
Of course, these energy cost increases also will be passed down through the supply chain, increasing the cost of most goods. Estimates suggest an approximate increase in energy costs for U.S. households of 15 percent on average. This increase would vary widely among households.
Due to the nature of goods taxes, it doesn’t matter where the tax is levied. Consumers and producers will always share the tax burden. Consumers pay a higher price, and producers receive a lower price. They both seek less carbon-intensive substitutes, and producers are incentivized to innovate away from existing carbon-intensive business and manufacturing practices.
Economists favor this approach because it allows for a voluntary response to the recognition of the SCC through market innovation, unlike traditional command-and-control regulations where the government mandates potentially cost-inefficient emissions standards. Additionally, carbon tax revenues could be used to offset the price increases experienced by lower-income consumers and smaller businesses. Most proposals call for gradually increasing the tax over time. If a $20 tax were increased at 4 percent per year, it would generate $150 billion in tax revenues annually and reduce carbon emissions by as much as 30 percent over 10 years.
The political contentiousness of environmental issues is a significant barrier to finding solutions to global climate change, and the world’s increasing alarm about carbon emissions has done little to break down these barriers. The solution is to bridge the gap between environmental and business interests by moving beyond traditional methods of emissions reduction and embracing the natural economic forces that made us so successful.
Recently, several global business leaders have expressed support for a carbon tax, and the state of Washington will vote on a carbon tax this fall. With a clear consensus among economists and growing support among businesses, a carbon tax offers a cost-effective policy tool to limit the impact of global climate change.
Todd Yarbrough, Ph.D., is an assistant professor of economics at Aquinas College who specializes in public finance and environmental economics. He currently serves as the chair of the Economics Department and is director of the Aquinas College Green Revolving Fund.