Sunday, May 2, 2010

A short yet excellent explanation of a Carbon Tax to reduce carbon emissions. A policy alternative to Cap and Trade

A short yet excellent explanation of a Carbon Tax to reduce carbon emissions. A policy alternative to Cap and Trade...From EconomicsBlog:
"""The production of carbon dioxide is widely held to contribute to social / environmental problems such as global warming. This carbon pollution is a negative externality. It is a cost imposed on the whole of society and not just the individual who consumes a certain product. e.g. if you drive a car, the external costs are felt by everyone else.
Because certain carbon intensive industries create negative externalities, the social cost of production is greater than the private cost.
In a free market, these negative externalities are not included in the price leading to overconsumption and social inefficiency. We can say there is a missing market, because the external cost of carbon emission is ignored.
Diagram to show Welfare loss of Negative Externality
The Purpose of A Carbon tax
The purpose of a carbon tax is to internalise the externality. What this means is that the final price of the good should include the external cost and not just the private cost.
In theory, the tax should equal the external cost. Therefore, the price consumers pay will be the social cost.
Demand will fall and the new equilibrium will be socially efficient because at this output, the marginal social cost equals the marginal social benefit.

Diagram to Show Carbon Tax

Revenue Neutral
In theory a carbon tax should be revenue neutral. This means the tax raised from taxing carbon emissions can be used to reduce other taxes. There should be no overall increase in the tax burden.


Problems of Carbon Tax
Production may shift to countries with no or lower carbon taxes.
•Cost of administrating the tax.
•Difficult to know the level of external cost and how much the tax should be.
•Possibility of tax evasion. Higher taxes may encourage firms to hide carbon emissions.
•If demand is price inelastic, the tax may have to be very high to reduce demand significantly.
•Consumers dislike new taxes and often don’t believe that they will be ‘revenue neutral’. This is not an economic argument, but it is a political reality and explains why it is often difficult to implement."""
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