Options and Considerations for a Federal Carbon Tax

Greenhouse gas emissions can be reduced most cost-effectively through market-based approaches that put a price on carbon. The two most commonly discussed approaches are a cap-and-trade system and a carbon tax. By establishing a price for greenhouse gas emissions, either instrument can help correct the market failure that exists when the value of environmental damages is not included in the market price of fossil fuels. A fundamental difference between the two is that a cap-and-trade system sets the maximum level of emissions so the environmental outcome is known but the resulting price is unknown, while a carbon tax sets the price and lets the market determine the environmental outcome. This brief outlines broad considerations in weighing a carbon tax, such as environmental integrity, cost-effectiveness, and distributional equity, as well as fundamental design issues, including who might pay the tax and how to set an appropriate tax rate. The brief also reviews existing carbon taxes abroad and in localities in the United States, along with several recent U.S. legislative carbon tax proposals.