What is the Carbon Tax and how does it work?

The Carbon Tax is a controversial policy in Canada with ardent defenders and critics. Opinions vary on the tax as some think it is required to fight climate change and others think it is just another way for the government to tax them. What really is the point of the carbon tax and how does it work?


To understand the purpose of the carbon tax, you first need to understand economic externalities. Externalities arise when a person engages in an activity that influences the well-being of a bystander. In economics, it is a transaction between a buyer and seller that influences the well-being of a bystander. If the influence is positive, it is a positive externality. If the influence is negative. it is a negative externality. A free market often ignores externalities because a transaction between a buyer and seller will often neglect the influence they are causing to the third party and will not arrive at the optimum equilibrium of supply and demand. Pollution and Carbon emissions are one major negative externality experienced in society. How does the market balance and internalize these externalities then? Through government policy.

The three most common methods of government policy to manage negative externalities are: Regulation, Corrective Taxes, and Tradable Permits (Cap-and-trade). Regulation works by enacting strict rules that an industry must follow. On the topic of pollution and carbon, this could be something like putting limits on how much emissions a company can produce. Tradable Permits would tie directly into a system like this, allowing companies to buy and sell whatever they are limited on to other companies. For Carbon, this would mean a company could increase its emission limits by buying permits from other companies that have excess. Probably the most effective and most popular among economists, though, is the Corrective Tax. This is what the Carbon Tax is. The idea of Corrective Taxes is that the ideal tax would equal the external cost that negative externalities have on society and bring the equilibrium of supply and demand to the optimum amount. Corrective Taxes have better control over externalities because they can easily be increased or decreased to influence the externality accordingly. A main reason for advocacy of a corrective tax over regulation is that companies will always have an incentive to improve because any improvements directly lead to tax savings. With regulations, once a company is in compliance there is no more incentive to improve because there are no more cost savings. 

Knowing all this, how exactly does the Carbon Tax work in Canada? In 2018 Canada enacted the GHGPPA which calls itself a pricing or charge for carbon instead of a tax. This is likely because it is supposed to be revenue neutral with most of the generated revenue being returned to households. The end result is that it still works as a corrective tax. The goal is to be charging $50 per tonne of CO2 emitted. The amount charged for carbon started at $20/tonne CO2 in 2019 and will increase by $10 per tonne per year. The Canadian government rolled the policy out this way to avoid starting with a tax that was too big and that could break the economy but could still be dialed in over time to achieve the proper amount of taxation to equal the external cost of pollution. Overall, the carbon tax in Canada is a textbook version of a corrective tax that was rolled out in a common and responsible way. Then why is it so controversial? Politics mainly.

The Carbon Tax is only controversial because fighting climate change has become a polarized and politically charged topic. Outright denying climate change at this point is almost political suicide for most politicians (even Jason Kenney admits it is real: Example, Example) , so they do the next best thing and just criticize any policy made to do anything about it. This is why the carbon tax is heavily criticized. These criticisms often have no basis and are heavily misinformed. A common one is that the carbon tax is just a socialist wealth distribution tool under the disguise of fighting climate change. While it is true that it does redistribute wealth due to the fact lower income households receive a higher rebate, in the grand scheme of things this amount is negligible. On top of that, it is easy to see why the government went this route. Some earlier provincial carbon taxes were not revenue neutral and they received criticism that the tax was just a way to generate more profit for the government under the disguise of fighting climate change (Noticing a trend?). While criticizing where the revenue generated by the tax goes is valid, you will often hear both of the previous complaints from the same person. They would not be happy with any choice the government made on where to spend the money. Complaints about what happens with the revenue are also just not that important, because it doesn’t change the answer to the question: does the carbon tax do its job in bringing the market to the optimum equilibrium position of supply and demand? Yes it still does regardless of where the revenue goes. It would be better that the revenue is spent on something useful, but that should be more of a complain about the government and not the tax. Most people understand there is a balance between the economy and fighting climate change. People can have varying opinions on how much we should sacrifice one for the other. “The carbon tax is too much” or “The carbon tax is not enough” are legitimate complaints about the tax from an individuals point of view. But it is unlikely those are the criticisms you will hear, because the carbon tax isn’t controversial for what it does and how well it does it.

The Carbon Tax is controversial because it is more socially acceptable for people to say a solution won’t work than just admit they don’t care about the problem enough to do anything about it.

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