A carbon tax aims to make individuals and firms pay the full social cost of carbon pollution. In theory, the tax will reduce pollution and encourage more environmentally friendly alternatives. However, critics argue a tax on carbon will increase costs for business and reduce levels of investment and economic growth.

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The purpose of a carbon tax

The purpose of a carbon tax is to internalise this externality. What this means is that the final price of the good should include the external costs and not just the private cost. It is similar to the ‘polluter pays principle.‘ – which was incorporated into international law at the 1992 Rio Summit. It simply means those who cause environmental costs should be made to pay the full social cost of their actions.

Diagram to show welfare loss of a negative externality

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This diagram shows that in a free market (without any tax), we get overconsumption (Q1) of carbon, leading to a welfare loss to society.

Social efficiency with Carbon Tax

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Explanation:

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3 years ago