Carbon Tax (Theory)

Type of Measure

Main Emission Target

Policy Focus

Status of Implementation

EU Climate Relevance


The Union of Concerned Scientists (2018) suggest that “the price of carbon is artificially low because it fails to account for the cost to society of harmful emissions”. The aim of a carbon tax is to reduce carbon emissions by incorporating the cost of their environmental damage into the price of fossil fuels and other energy activities. Thus, carbon taxes are a means of financially incentivizing consumers to reduce consumption, increase energy efficiency and switch to lower carbon products and fuel types. Generally, a carbon tax will focus on activity or services that result in the generation of CO2 emissions. For example, in Ireland, the carbon tax is levied on the importer or extractor of carbon intensive goods. With this charge being incorporated into the price and passed on to consumers.

In the context of reducing greenhouse gas emissions, Carrantini et. al. (2017) describe carbon taxes as the most effective mitigation tool available to policy makers. They are by nature revenue raising, which creates the potential to take advantage of the so-called ‘double dividend’ effect. In addition to the benefits of discouraging environmentally damaging activities, the revenue generated can be used to reduce distortions elsewhere in the economy, thereby further improving performance, yielding a second or ‘double’ dividend.

As all consumers pays the same rate of carbon tax and carbon intensive goods such as heating and transport fuel have inelastic demand, they are perceived as being regressive, placing a higher percentage of the burden on those with lower income or those who have greater distances to travel. However, Sterner (2007) finds neutral to weak evidence for fuel taxes being regressive in rich countries and indicates that they are in fact progressive in developing countries. The intuition here is that in developing countries those on lower incomes cannot afford a car at all and as such fuels take on luxury good characteristics, with taxes only affecting those wealthy enough to afford fuel. In the US however, poor public transport infrastructure and high general income make private motor-cars necessary and feasible for most citizens. In this case fuel taxes are regressive. The rational for this also applies to Ireland where the limited public transport network (particularly in rural areas) necessitates that private vehicles are the modal method of commuting to work (65.6%) (DTTAS, 2018).

Where taxes are regressive, Sterner argues the revenues can be used to alleviate this using a fee and dividend approach of returning revenues to citizens. Alternatively they can be used to fund infrastructural investment or to offset tax reductions elsewhere and increasing social welfare. The method of recycling the revenue is crucial to the overall impact of a carbon tax on the economy. Political support for a carbon tax will be greatly enhanced if the revenue generated from the carbon tax is recycled in an equitable manner.

Tovar Reaños and Lynch (ESRI, 2019) estimate that a well-designed fee and divided scheme which returns the revenues to households in a way targeted at proportionately benefiting those most effected by the tax would reduce emissions by 3.94% and inequality by 2.78% (based on a rate of €100 per tonne). Other uses of the revenue can also provide this double dividend, such as the model of re-investing it into green infrastructure as employed by Alberta, Canada since 2017. This serves to positively influence the public perception of the tax and finance the economy wide investment needed for a more extensive emission reduction. The British-Columbian carbon tax system also partially applies this ring-fencing strategy however, the majority of the revenue is used to facilitate a reduction in income and corporation taxes. This has the effect of maintaining competitiveness of industry as well as taxing the bad (pollution) instead of the good (productivity), thereby incentivizing positive behaviour and dis-incentivizing negative.

Due to the economy wide use, and necessity of carbon intensive goods, impacts of a carbon tax are cross-cutting but can be captured by assessing the impact on a number of key parameters:

Activities – the degree to which the implementation of a carbon tax reduces energy consumption across the economy. One would expect that the introduction of a carbon tax will result in a reduction in energy consumption as consumers seek to improve energy efficiency and switch to lower carbon content products and services to avoid payment of the tax.

Technology Change – the degree to which a carbon tax induces technology change – notably greater use of energy efficient and lower carbon content products and investment in low-carbon durable goods such as Electric Vehicles and Air-source Heat Pumps.

Costs – there are financial and societal costs to implementation such as the direct administrative costs of levying the carbon tax and collecting the revenues as well as increases in the price of carbon related products. The extent to which these increases may disproportionately affect low income households as discussed, may also be a cost of carbon tax policy.

Benefits – with a carbon tax expected to lead to a reduction in energy consumption as people reduce their consumption or shift to consuming more carbon efficient products there will be a reduction in emission levels, the benefit of which are felt through improvements in air quality and associated health advantages as well as improvements in domestic and consumer energy efficiency a result of this.

DeBruin and Yakut (2018) estimate the impact in Ireland of various rates of carbon tax, using the ESRI’s Energy Social Accounting Matrix (ESAM) which represents all transactions and transfers between different sectors, factors of production and institutions within the economy. They estimate that the energy transformation sector and the transport sector will be most affected by carbon tax increases. Conversely, they predict the production sector to be insensitive to carbon-tax increases and as such an increase will have little impact on the competitiveness of Ireland’s exports.

In terms of emission reductions, the ESRI recommend a stringent carbon tax policy in order to provide a sustainable pathway toward a low-carbon economy. Their findings are consistent within the framework that setting a more prohibitive price signal will shift behaviour away from environmentally harmful behaviours but also that such measures disproportionately affect those on lower incomes.


Figure 1: Impact of a Carbon Tax Increase


Figure 1: Impact of Carbon Tax Increases

Source: De Bruin and Yakut (ESRI, 2018)


Sterner (2007) studied the effect of carbon taxes by estimating the impact on emissions that imposing the low US rate of fuel tax on other OECD countries would have. This study, confirmed the power of carbon taxes as an instrument to reduce consumption of carbon intensive goods and as such reduce emissions. The efficacy, in this respect,  is often weighed against the perceived regressive nature of such interventions. Our intuition tells us that price increases place a relatively greater burden on lower-income households than on higher-income households. This however is specific to developed countries. When the general income level and the proliferation of cars is low, fuel and carbon taxes are primarily levied on the rich. In Ireland however, carbon intensive products and services such as heat, energy and transport are inelastic in the short run and as such, lower income households are likely to spend a larger share of their income on these products.

As a result, it is often argued that low income families should be compensated from the carbon tax revenue pool to at least partially offset the impact of the tax. This can be achieved through some of the methods discussed above such as reductions of other taxes and fee and dividend schemes. Given that the ultimate aim of a carbon tax is to induce emissions reductions it seems appropriate to ringfence part of the tax revenue to be invested in public good activities to further reduce greenhouse gas emissions. Such activities should include investment in developing alternative energy sources, such as renewable energies, and energy efficiency schemes to reduce the burden of the carbon levy in the long run and create new industry and employment, increasing investment in energy research and development, and establishing centres of expertise on energy efficiency and other emissions mitigation and adaption activities for particular sectoral groups.


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carbon storage

Reference this (2022). Carbon Tax (Theory). Available at: Last accessed: 06-06-2022.