An emissions tax
The purpose of this page is to describe an emissions tax (e.g., carbon tax) using the most basic of all environmental economic models.
Consider a polluting firm that faces an increasing marginal abatement cost curve (click on the thumbnail for a larger picture). Left unregulated it will choose to abate zero units of emissions (where the horizontal and vertical axes cross) and avoid the abatement costs represented by the area underneath the marginal abatement cost curve: C + D + F + G. Suppose a benefit-cost analysis has determined that optimal abatement occurs at the blue dot where the marginal benefit and marginal cost curves intersect. The resulting level of emissions is e* (measured right to left along the horizontal axis).
One way to achieve this level of abatement is to set a tax where marginal benefit equals marginal abatement cost — represented by the horizontal “tax” line. The polluting firm will notice that it is cheaper to abate carbon emissions as long as the marginal abatement cost is lower than the tax. Since the tax bill (B + C) is greater than the marginal abatement cost bill (C) to the left of e* the firm will choose to abate. To the right of e* the marginal abatement cost bill (D + F + G) is greater than the tax bill (D + F) so the firm will choose to pay the tax and generate emissions = e’ – e*.
Results:
- The efficient abatement level is achieved: e*
- The abatement cost to the pollution firm = C + D + F
- Government revenue = D + F
Why do firms hate emissions taxes?
An emissions tax is an attractive policy because it promotes the polluter pays principle. According to Encarta:
Polluter pays principle: the principle that a company that causes pollution should pay for the cost of removing it, or provide compensation to those who have been affected by it.
However, one quirk with an emissions tax is that the polluting firm will pay a larger tax bill than the damages generated by pollution. To see this recognize that pollution damages are equivalent to the marginal benefits of abatement. The area underneath the marginal benefits curve where emissions are positive is the total damages to society.
- The polluting firm pays abatement costs of C that generates benefits of A + B + C.
- The polluting firm pays a tax bill of D + F that generates extra benefits of 0.
The emissions tax goes beyond the polluter pays principle. Business firms see it an unnecessarily punitive and will fight it vigorously. That may be why there are so few real world examples of emissions taxes.