What is a Carbon Tax? (2024)

A carbon tax is levied on the carbon content of fossil fuels. The term can also refer to taxing other types of greenhouse gas emissions, such as methane. A carbon tax puts a price on those emissions to encourage consumers, businesses, and governments to produce less of them.

Why a Carbon Tax?

Greenhouse gas emissions—foremost carbon dioxide (CO₂) but also methane, nitrous oxide, and F-gases—have been driving changes in global temperatures, imposing costs on economic, human, and natural systems.The main purpose of a carbon tax is to put a price on these emissions, which, in turn, increases the price of emissions-intensive goods and services relative to other goods and services. This disincentivizes the emission of greenhouse gases and thus reduces their amount in the atmosphere, mitigating the adverse effects of climate change.

A carbon tax is a form of carbon pricing and, as a market-based approach, it is generally seen as a cost-effective way to reduce greenhouse gas emissions.

Distributional and Economic Implications

Without taking into account how carbon tax revenue is used and environmental effects, the tax would be regressive, meaning that lower-income households would be affected disproportionally. This is because lower-income households spend a larger share of their income on emissions-intensive goods and services than wealthier households do.

The tax would also negatively impact GDP and employment as it reduces after-tax wages and thus the incentive to work.

That said, the economic and distributional effects of a carbon tax vary greatly depending on how the generated tax revenue is used.

Using the Tax Revenue

A carbon tax raises substantial tax revenue due to its broad tax base. The additional tax revenue can be used to lower individual or corporate taxes, reduce the federal deficit, fund public investments, or be returned to taxpayers in the form of lump-sum rebates.

Each of the revenue recycling methods faces different trade-offs. The Tax Foundation has analyzed the economic and distributional effects of a carbon tax paired with the following revenue recycling options:

• Paired with a lump-sum rebate would increase the tax code’s progressivity significantly, but impact employment and GDP negatively.
• Paired with a cut in the employee-side payroll tax increases progressivity, GDP, and employment.

A carbon tax paired with a cut in the corporate income tax, permanent 100 percent bonus depreciation, and R&D expensing boosts GDP and pretax wages while lessening progressivity and lowering employment.