Tax Policies to Reduce Greenhouse Gas Emissions

This brief outlines the motivation for and key features of a tax designed to reduce emissions of greenhouse gases (GHGs). The two most commonly discussed market-based instruments for reducing GHG emissions are a cap-andtrade system and a GHG (carbon) tax. These mechanisms function in a similar way by establishing a price for GHG emissions. They both correct the market failure that exists when the value of environmental damages is not included in the market price of fossil fuels and other activities that release GHGs. A GHG tax and cap-and-trade approach are compared, with consideration given to how effective each policy instrument may be at meeting key objectives. These objectives include environmental integrity, cost-effectiveness, and distributional equity, and will inevitably involve political considerations. Fundamental design issues of a GHG tax policy are explored, including who would pay the tax and how to set an appropriate tax rate. There are a number of options for determining the appropriate level for a tax, including setting it to equal some estimate of the social cost of carbon or pursuing the long-run goal of stabilizing the concentration of GHGs in the atmosphere. A tax can be levied at various points throughout the energy supply chain, but most proposals call for an upstream tax on fuel suppliers in order to maximize the scope of coverage, which lowers costs, and for administrative simplicity. This brief also reviews existing GHG taxes in Europe and North America, along with several recent U.S. legislative carbon tax proposals. Finally, other pricing strategies to reduce GHG emissions in the transportation and electricity sectors are examined.