Limits on the Economic Effectiveness of a Carbon Tax

Much of the discussion regarding policies to reduce the emission of carbon dioxide (CO2) and other greenhouse gases focuses on least-cost strategies. Policies that minimize costs are desirable because they are economically more efficient than policies that are based on a command and control strategy (Gasloms and Stram, 1990). Among the many least-cost policies now under consideration, a carbon tax has received the most attention. As currently envisioned, a carbon tax would be levied on users of fossil fuels according to the amount of carbon that is emitted when the fuel is burned. Because the combustion of coal emits more CO2 per heat unit than oil, which emits more CO2 per heat unit than natural gas, the tax on coal would be larger than the tax on oil, which would be larger than the tax on natural gas. The fuel specific charges that would be imposed by a carbon tax are a popular policy option because many believe that a carbon tax will reduce emissions of carbon dioxide in an economically efficient manner. That is, a carbon tax will reduce the use of fossil fuels by spurring technical change and by inducing the substitution of capital, labour, and non-energy materials. Furthermore, a carbon tax will reduce emissions of CO2 by inducing substitution of fuels that emit less CO2 per heat unit. The reduction in emissions that is achieved by interfuel substitution is caused by the differences in the size of the tax on coal, oil, and natural gas. Because the tax on coal is largest, the price of coal will rise relative to oil and natural gas and users will substitute oil or natural gas for coal.