United States

Carbon tax: A primer for the middle market


As outlined in our latest edition of The Real Economy, policymakers have a little less than a decade to put into place a mix of tax and entitlement reforms to avoid demographically-induced long-term fiscal challenges. Currently 10,000 baby boomers retire per day. Within less than a decade, about 25 percent of the entire population will be 65 or older. This means there will be fewer workers to support entitlements promised to retiree so there will have to be either significant tax or entitlement reform or new revenues to put the long-term fiscal path on a sustainable footing. One option is a carbon tax.

A carbon tax is a tariff on fossil fuels, such as coal, oil, natural gas and biofuels. From an economic perspective, a carbon tax is an example of a “Pigovian tax” that addresses inefficient market outcomes derived by individuals or firms where the costs are borne by those that do not produce them. Environmental pollution or social costs of consuming tobacco and alcohol are among the most common form of socially sub-optimal outcomes that are subject to various forms of taxation.

Like a value-added tax, a carbon tax would not be evenly distributed. Producers of energy, coal, oil, transportation firms and producers of goods and services that result in the emission of large amounts of carbon dioxide would bear a disproportionate share of the burden of a carbon tax. The impact would be regressive and hit lower-income households and small and medium enterprises disproportionately to how it would affect high-wealth households or larger firms.

While most discussion of a carbon tax revolves around attempts to raise revenue to deal with the negative affects of climate change or hydraulic fracking, policymakers caught in a fiscal crisis could plausibly turn to a carbon tax to put the U.S. fiscal path on a more sustainable footing. This is due to the relative inelasticity of demand to taxes imposed on energy use that would result in lower deadweight costs on growth compared with other types of taxes. If a carbon tax is used to address longer-term fiscal challenges, it would further reduce economic losses associated with the implementation of a new tax, as higher federal deficits tend to result in lower economic growth over the medium- to longer-term.

 A simple $1 dollar per gallon tax on the consumption of gasoline would raise more than $100 billion per year, while the Congressional Budget Office estimates that a $25 dollar per ton tax on greenhouse gases would raise in excess of $100 billion per year. To be certain, this would not put the U.S. on a path to a balanced budget, it would, however, put the primary budget -- the budget excluding net interest owed on past debt -- on a path toward long term sustainability and thus avoid a debilitating fiscal crisis.  

While a carbon tax is not an optimal solution to the U.S. fiscal problems, in a pinch policymakers would most certainly look at it as a revenue enhancer. That makes this an over-the-horizon possibility that middle market firms should be aware of in order to consider what steps to take under such a scenario.

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