The Economic Cost of the Carbon Tax

Abstract

The choice of the optimal environmental policy is an important question in the current climate change context. While the carbon tax was the preferred policy of economists in the 1970s and 1980s, governments have implemented both quantity-based policies, such as emissions trading schemes, and price-based policies, such as fossil fuel taxes and renewable energy subsidies. The implementation of a general carbon tax on greenhouse gas emissions is currently not very common, and a low carbon price is generally retained. However, with the development of the EU Carbon Border Adjustment Mechanism, the Fit for 55 package and the need to achieve a low-carbon economy by 2050 if we are to keep the temperature anomaly below 1.5°C, the issue of carbon taxes is back on the agenda and the old debate of price vs. quantity regulation is reopened. In this article, we extend the input-output analysis by introducing pass-through mechanisms to define a new cost-push price model that accounts for the cascading price effects of a carbon tax through the supply chain. We can then calculate the government revenue from a carbon tax, the net cost to the economy, and the impact on inflation. Implementing a global tax of $100/tCO2e generates revenue of 2.82% of world GDP, but it also implies a net cost of 2.18% and inflation of 4.08% in terms of the producer price index (PPI) and 3.53% in terms of the consumer price index (CPI). In addition to these macroeconomic effects, we also analyze the microeconomic effects of the carbon tax. In particular, we analyze the impact on issuers' earnings, distributive implications, and social issues related to the carbon tax. We find that the implementation of a carbon tax is not as efficient as economic theory tells us it should be, which justifies the reluctance of governments to implement such a regulatory policy today.

Keywords: Climate change, carbon pricing, decarbonization policy instrument, carbon tax, emissions trading scheme, net-zero emissions, negative externality, input-output analysis, social welfare

JEL Classification: Q5, H2, E3