With Democrats experimenting with reconciliation in the Senate and the COP26 summit wrapping up in Glasgow, attention has once again turned to proposals for a tax on carbon. Such a tax would make polluters pay for each ton of carbon dioxide that they release into the atmosphere.
Pollution is an example of a negative externality — a side effect of production that is not reflected in prices. The current market takes into account producers’ costs and consumers’ willingness to pay for goods and services. It does not take into account the cost to society of the pollution that results from the production of goods.
When determining the equilibrium price, a free market will use the producer’s marginal cost curve as the supply curve. But, in order for the economy to serve its purpose of optimizing production, the marginal cost curve should really be the total social cost. This is the cost to society of production — in this example, the cost to producers plus the cost of pollution. The total social cost curve will, of course, be higher than the producer’s marginal cost curve, and so will lead to lower production of polluting goods.
A carbon tax would make polluters pay for the social cost of their carbon dioxide pollution. The cost would be equal to whatever the social cost of carbon is; such a number would have to be well-researched. This tax would shift the producer’s marginal cost curve upwards, and make it equal to the total social cost curve. This would lead to optimal production.
Of course, the issue is far more complicated. A carbon tax would increase prices — it would increase producers’ costs, which would shift supply curves up and thereby cause equilibrium prices to rise — and, as discussed above, decrease production. This would mean less consumption for us consumption-loving Americans. So there is no easy solution. And today’s political climate has made carbon tax proposals even more divisive and polarizing. The debate over a carbon tax reflects the broader issue of responses to climate change.
Yes, we must save our planet, and I think we should do everything in our power to do so. But there is also a different point of view. Like a carbon tax, most proposals to combat climate change would, to varying degrees, be bad for the economy. (See section 1.8 of David Romer’s Advanced Macroeconomics for a very interesting, mathematical walkthrough of this economics issue — his math says that we are better off doing nothing about climate change. Both he and I blame this on simplifying assumptions that he makes.)
The issue is nuanced, but let’s return to a carbon tax as an example of a response to a negative externality. The current market for goods includes the costs that polluters pay — materials, labor, and so on — but not that cost of what they spew into the atmosphere. A carbon tax would transfer this cost to the ledgers of polluters. This would lead to higher prices and lower output of polluting goods. Our planet is warming fast, and a carbon tax might just help save it.