A carbon tax is an economic tool that would put a price on emitting carbon dioxide (CO2) into the air. “When I put a gallon of gas in my car, it's leading to 20 pounds of CO2 that go into the atmosphere that no one pays for,” says Christopher R. Knittel, George P. Schultz Professor of Applied Economics at MIT. “Part of the goal of carbon taxes is to have prices better reflect the social costs of those products.” Such a plan could charge companies a fee for every ton of CO2 they produce, which creates an incentive for them to switch to non-CO2-emitting energy sources like wind and solar.

But what’s to prevent those companies from continuing to burn fossil fuels and simply passing on the cost of the carbon tax to their customers? And if they do, then what would incentivize the polluters to use lower-carbon fuels?

In the short term, companies probably would pass on the cost of a tax, which means people would pay higher prices, says Knittel. This is especially true in places where demand is inflexible—an economist’s way of describing a situation in which people have few buying alternatives. Most people don’t have a choice about where they get the electricity for their homes, for example. Drivers have had few alternatives to pumping gasoline to power their cars, though electric vehicles are becoming a more mainstream technology.

However, Knittel says, there are ways to structure a carbon tax so that it is equitable and does not place an undue burden on consumers. One way to do this is to give the tax money back to the people through what’s called a dividend, an approach already being tested in places like British Columbia. Returning the tax revenue to consumers gives them money to pay for electricity or gasoline that the tax may have made more expensive. This strategy also gives those who can avoid emitting CO2 a financial motive to do so, Knittel says: They’re going to get the dividend from the government no matter what they do. So, if they avoid buying CO2-emitting products like gasoline, they avoid the tax. Then the dividend goes right into their pockets.

“When I go to buy a new car, because gasoline is more expensive I might buy a more efficient car so I can keep a bigger portion of that [dividend] check,” Knittel says. “I get it back as free money. When I go to replace my furnace, now an electric heat pump is going to look more attractive because I'll get to keep a bigger chunk of that dividend check each year.”

The point of a carbon price, though, is to shift the entire market away from emitting CO2. Economists predict that, over time, polluting companies will face pressure from their customers to eliminate the extra cost of their CO2 emissions, Knittel says. Companies that can offer lower-carbon products will be able to charge less because they won’t need to pay the tax, drawing customers away from their more polluting competitors. Firms would be motivated to buy materials from suppliers who can charge less because they emit less CO2. In this way, a carbon price creates economic incentives to reduce carbon emissions and embrace clean energy sources.

“What we would expect,” Knittel says, “is as you started taxing gasoline or natural gas, more and more alternatives would come around—more EVs, more heat pumps, more ways to switch from gasoline and natural gas and coal. Then that would mean that more of that burden would be felt by the firms instead of the consumers.”

Published January 11, 2022.

Thank you to Paul David Gouin of Washington for the question. You can submit your own question to Ask MIT Climate here.