Pricing Carbon, Protecting Prosperity: The Economic Case for a Carbon Tax

Introduction

Climate change is not just an environmental crisis—it is a profound economic challenge. According to the World Economic Forum, climate change could lead to over $12 trillion in global economic losses by 2050, driven by rising sea levels, floods, heat waves, and other extreme weather events (World Economic Forum, 2024). These disruptions act as negative externalities, distorting the economy and imposing costs on people that are not reflected in the price of carbon-intensive activities. 

Relying on the market to self-correct in response to these crises is critically misguided. Absent intervention, the economic effects of climate change will only intensify, jeopardizing economic growth and long-term prosperity. The question is, then, how to intervene effectively and address the externality of climate change through carbon asset pricing. Enter the carbon tax: a simple, market-compatible solution designed to internalize the cost of pollution into economies and steer them towards sustainable growth.

Origins & how it can reduce emissions

Originally conceptualized by Gordon Wilson, a carbon tax is simple—rather than continually relying on a complex set of bureaucratic regulations whose requirements and jurisdiction are often clouded in legal confusion, it createswhy not just have one predictable price that applies to all carbon-based pollution (Chandler, 2013). This price acts as a continuous signal throughout the economy, creating comparative cost advantages for renewable technology and motivating efficiency improvements in clean energy for broader energy production (Francis, 2023). Unlike most other climate policies, like subsidies, that often require inflating already strained budgets, a carbon tax is completely revenue-positive, and the money gained from it could be used to reduce the deficit or boost research and development in climate technology (Lim & Prakash, 2023). This proposal is rigorously supported by evidence, with a recent analysis of over 70 carbon pricing schemes around the globe concluding that there was a causal and statistically significant reduction in emissions, even considering countries with low tax rates on carbon (Hildebrandt, 2024). Further empirical research and theoretical review of the literature base by van den Bergh & Botzen indicate that taxation is not only effective but also has a stronger impact on innovation and emission reductions than any alternative instruments like efficiency standards and subsidies (2024). Sweden, Germany, and the United Kingdom are all countries that implemented carbon pricing schemes and subsequently experienced sharp decreases in their emissions.

Regressivity

Unfortunately, the carbon tax is mired in political unpopularity—after all, why does the average person want to pay extra money for a climate threat they perceive to be distant (Meyer, 2021)? This concern has some validity, as poor people spend a higher proportion of their income on energy in order to heat their home and cook their food—both of which are essential daily activities that a carbon tax would make more expensive (Grainger & Kolstad, 2024). However, these objections fall short with the introduction of complementary carbon dividends. These dividends could rebate the revenue gained from a carbon tax and be adjusted to target low- and middle-income households, potentially rendering the tax net progressive (Metcalf & Goulder, 2021; Kaufman, 2019). One must also consider a future in which climate change intensifies—research estimates that a child born in 2024 will face at least $500,000 in climate-related costs from reduced earnings and inflated prices, with upper estimates reaching $1,000,000 (Medintz, 2024). Even ignoring the possibility of dividends, the short-term cost of the tax would create a cheaper future for families in the long term.

Economic Effects

Now, let us speak to a major objection to carbon taxation: the resulting macroeconomic effects. Critics claim that higher carbon costs will reverberate across the entire economy, given the central role fossil fuels play in powering many stages of production. There are multiple reasons why this concern is overblown.

The economic decline of fossil fuels is inevitable—whether through abrupt collapse or gradual transition, the question is not if, but how, this shift occurs. As people continue to be inundated with extreme weather events—heat waves, skyrocketing agriculture disruptions, and infrastructure failure—public and government sentiment could shift rapidly against fossil fuels, triggering sharp declines in the valuation of carbon-intensive industries. As regulatory crackdowns and market panic intensify, fossil fuel-dependent firms may struggle to adapt, forcing abrupt mass divestment before their assets become stranded (Butler, 2023). These declines will have tremendous macroeconomic shocks on the economy, culminating in a “Minsky moment.” Minsky moments occur when over-leveraged investors are forced to sell assets at low prices to cover debts, triggering cascading sell-offs and economic crises (Tooze, 2019). This happened with the subprime mortgage market in 2008, but the carbon bubble will be far worse. In the case of abrupt climate action, the economy could see trillions of dollars of fossil fuels become worthless “stranded assets,” up to 2.5 times as bad as the Great Recession, as investors seek to dump overinflated fossil fuel stocks (Comerford & Spiganti, 2019). Rather than waiting too long and undergoing an abrupt transition away from fossil fuels, we should implement a carbon tax to jumpstart a transition away from fossil fuels in an orderly manner through a consistent, predictable price signal. Giving more time to companies to discard their fossil fuel assets, the carbon tax would be a more gradual solution that has far less negative economic impact than doing nothing and facing the consequences. 

Second, financial modeling demonstrates that carbon taxation would not overwhelmingly burden the economy and may even have positive effects. Consumption, output, employment, and labor force participation would all experience mild but positive, long-term growth under a carbon tax as firms reallocate resources towards green technologies and new firms enter the market, offsetting initial costs. (Finkelstein-Shapiro & Metcalf, 2022). This outcome hinges on two phenomena: an efficiency boost after firms adopt cleaner technologies to avoid paying higher carbon costs and the absorption of any employment loss from fossil fuel jobs following the reallocation of labor and capital to greener sectors. Studies predicting negative effects of a tax only focus on the short-term effect, which would be an obvious contraction in Gross Domestic Product due to the rise in price of a core input. However, multi-sectoral analyses predict that all the money lost by the fossil fuel sector would shift to the renewable sector, spurring innovation that would further lower the cost of energy and boost long-term growth (Metcalf & Stock, 2023).

Short-term costs are inevitable, but the price of inaction is far greater. A carbon tax is not just an economic policy—it is a commitment to a future in which we do not sacrifice long-term prosperity for short-term gains. We can either take control of the crisis—or wait, and let it make the choice for us.

Edited by Will Gasaway

References

World Economic Forum. (2024). Climate Crisis May Cause 14.5 Million Deaths by 2050. World Economic Forum. www.weforum.org/press/2024/01/wef24-climate-crisis-health/.

Chandler, D. L. (2013). Emeritus: David Wilson Was an Early Proponent of the Concept of Energy-Use Fees. MIT News | Massachusetts Institute of Technology. news.mit.edu/2013/emeritus-david-wilson-was-early-proponent-concept-energy-use-fees

Francis, R. (2023). How Carbon Pricing Accelerates Innovation & Deployment. Climate Leadership Council. clcouncil.org/blog/how-carbon-pricing-accelerates-innovation-deployment/.

Lim, S. and Aseem P. (2023). “The Innovation-Inducing Effects of Carbon Pricing | the Regulatory Review.” Www.theregreview.org. www.theregreview.org/2023/07/24/lim-prakash-the-innovation-inducing-effects-of-carbon-pricing/.

Döbbeling-Hildebrandt, N., et al. (2024). “Systematic Review and Meta-Analysis of Ex-Post Evaluations on the Effectiveness of Carbon Pricing.” Nature Communications, vol. 15, no. 1. www.nature.com/articles/s41467-024-48512-w#citeas, https://doi.org/10.1038/s41467-024-48512-w.

van den B., Jeroen C.J.M., and Wouter W.J. B. (2024). “Assessing Criticisms of Carbon Pricing.” International Review of Environmental and Resource Economics, vol. 18, no. 3. https://doi.org/10.1561/101.00000172.

Meyer, R. (2021). Carbon Tax, Beloved Policy to Fix Climate Change, Is Dead at 47. The Atlantic. https://www.theatlantic.com/science/archive/2021/07/obituary-carbon-tax-beloved-climate-policy-dies-47/619507/ ‌

Grainger, C. A., and Kolstad, C. D. (2010). How Regressive Is a Price on Carbon? NBER. www.nber.org/digest/jan10/how-regressive-price-carbon.

Metcalf, G. E., and Goulder, L. (2021). Economists: A US Carbon Tax Would Be Progressive. The Hill. thehill.com/opinion/energy-environment/550691-economists-a-us-carbon-tax-would-be-progressive/.

Kaufman, N. (2019). What You Need to Know about a Federal Carbon Tax in the United States. Center on Global Energy Policy at Columbia University | SIPA. www.energypolicy.columbia.edu/publications/what-you-need-to-know-about-a-federal-carbon-tax-in-the-united-states/.

Medintz, S. (2024). Climate Change Could Cost Each American Born Today $500,000. Consumer Reports. www.consumerreports.org/home-garden/climate-change/the-per-person-financial-cost-of-climate-change-a6081217358/.

Butler, C. (2023). Climate Change Threatens to Cause the next Economic Mega-Shock. Google.com. www.chathamhouse.org/2023/07/climate-change-threatens-cause-next-economic-mega-shock.

Tooze, A. (2019). Why Central Banks Need to Step up on Global Warming. Foreign Policy. foreignpolicy.com/2019/07/20/why-central-banks-need-to-step-up-on-global-warming/.

Comerford, D. and Alessandro S. (2016). The Carbon Bubble: Climate Policy in a Fire‐Sale Model of Deleveraging. The Scandinavian Journal of Economics, vol. 125, no. 3. https://doi.org/10.1111/sjoe.12519.

Finkelstein-Shapiro, A. and Gilbert M. (2022). Working Paper Series the Macroeconomic Effects of a Carbon Tax to Meet the U.S. Paris Agreement Target: The Role of Firm Creation and Technology Adoption.

Metcalf, G. E, and James H. S. (2023). The Macroeconomic Impact of Europe’s Carbon Taxes. American Economic Journal: Macroeconomics, vol. 15, no. 3. https://doi.org/10.1257/mac.20210052.

Grist / Getty Images / Chip Somodevilla. (2022). ‘Make the clean stuff cheaper’: Did the IRA kill the carbon tax? Grist. [Illustration]. https://grist.org/politics/did-biden-inflation-reduction-act-ira-kill-the-carbon-tax/