Carbon atoms are present in every fossil fuel (coal, oil and gas) and are released as CO2 when they are burnt. In contrast, non-combustion energy sources — wind, sunlight, hydropower, and nuclear — do not convert hydrocarbons to carbon dioxide. Accordingly, a carbon tax is effectively a tax on the use of fossil fuels, and only fossil fuels. Some schemes also include other greenhouse gases; the global warming potential is an internationally accepted scale of equivalence for other greenhouse gases in units of tonnes of carbon dioxide equivalent.
Because of the link with global warming, a carbon tax is sometimes assumed to require an internationally administered scheme. However, that is not intrinsic to the principle. The European Union considered a carbon tax covering its member states prior to starting its emissions trading scheme in 2005. The UK has unilaterally introduced a range of carbon taxesand levies to accompany the EU ETS trading regime. Note that emissions trading systems do not constitute a Pigovian tax because it entails the creation of a property right. Nonetheless, both taxes and tradable permits put a price on emissions, and that price is equal to all parties involved. Therefore, emission reduction targets are met at minimum cost.
The intention of a carbon tax is environmental: to reduce emissions of carbon dioxide and thereby slow climate change. It can be implemented by taxing the burning of fossil fuels — coal, petroleum products such as gasoline and aviation fuel, and natural gas — in proportion to their carbon content. Unlike other approaches such as carbon cap-and-trade systems, direct taxation has the benefit of being easily understood and can be popular with the public if the revenue from the tax is returned by reducing other taxes. Alternatively, it may be used to fund environmental projects.
In economic theory, pollution is considered a negative externality because it has a negative effect on a party not directly involved in a transaction.
To confront parties with the issue, the economist Arthur Pigou proposed taxing the goods (in this case fossil fuels) which were the source of the negative externality (carbon dioxide) so as to accurately reflect the cost of the goods’ production to society, thereby internalizing the costs associated with the goods’ production. A tax on a negative externality is termed aPigovian tax, and should equal the marginal damage costs.
A carbon tax is an indirect tax — a tax on a transaction — as opposed to a direct tax, which taxes income. As a result, some American conservatives have supported such a carbon tax because it taxes at a fixed rate, independent of income, which complements their support of a flat tax.
Prices of carbon (fossil) fuels are expected to continue increasing as more countries industrialize and add to the demand on fuel supplies. In addition to creating incentives for energy conservation, a carbon tax would put renewable energy sources such as wind, solar and geothermal on a more competitive footing, stimulating their growth.