Mandatory Carbon Taxes

By Kanthi Kiran Mamidanna, NALSAR University, Hyderabad

Editor’s Note: Carbon tax is a fee imposed based on the level of carbon in a particular product to discourage the release of greenhouse gases. This paper undertakes an economic analysis of carbon taxes by using the game theory to determine if developing countries like India should impose such a tax. The Coase v. Pigou debate has been used to suggest that unilateral imposition of carbon tax by one country would be ineffective and therefore a more comprehensive and inclusive approach must be used.”


The amount of Green House Gases (GHGs) has been increasing since Industrial revolution when man learned to exploit nature for his own benefits ignoring the deleterious consequences faced by his heirs. It was first in 1970s that the fury of the nature was being felt and the nations since then have been indulging in deliberations to counter the attack. The nature revolved because of the indiscriminate use of natural resources and ignoring the social costs (those costs were not taken into account and were free). Many agreements and protocols were signed such as Montreal and Kyoto protocols etc. The economists thought of imposing the cost on production, distribution or use of fossil fuels such as coal, oil and gas so as to curb the depletion of natural resources and deterioration of the environment. Since then, some of the developed countries started imposing mandatory carbon taxes in their areas and on the imports[i]. Recently, the European Union has imposed carbon taxes on Airlines (of India) and India has expressed its deep concern[ii] after which the UN has rejected the EU’s move to impose taxes[iii]. Recently, in 2010, India imposed a mandatory carbon tax of Rs. 50 per metric ton on coal production and its imports[iv]. Many nations are confused whether to implement the mandatory carbon taxes or not.

Definition of carbon tax

According to British economist Lord Nicholas Stern “Climate change” is a result of the greatest market failure that the world has seen and that it is a negative externality, a market failure, in which prices do not reflect the full costs of producing a product or service[v]. To fix negative externalities, Cambridge economist Arthur Pigou argued that the government should tax the producer of the externality at a rate equal to its social cost[vi]. A carbon tax is thus a form of Pigouvian tax. On the other hand, University of Chicago economist Ronald Coase and others have argued that creating a market for the externality, by assigning tradable property rights, could solve the problem more efficiently[vii]. Carbon tax is an environmental tax imposed by the government on the production or the use of fossil fuels such as coal, oil and gas. When industries use fossil fuels, they generate pollution, which imposes cost on the society as it affects everyone. If social costs are not included, the market price of the resources will not reflect their true costs and are rarely reflected in the end products or services.

If the market is left to operate freely, there is no stimulus for the firms to reduce the emissions. Economists suggest to apply the “polluter pays principle” either by imposing a carbon tax, which is quality based or a cap-and-trade scheme which is quantity based[viii]. Carbon tax is a fee imposed based on the level of carbon in the product to discourage the release of GHG emissions which is attached upstream (i.e at the coal mine or the oil well or the point of origin) and it increases with time[ix]. On the other hand, cap-and-trade system sets a maximum level of pollution, a limit and distributes the permits among the various industries that produce the emissions by way of allocation or auction[x].The industries may use the permits or trade with other firms. According to Economic theory, both the methods will give the same environmental results and carbon prices[xi].

How Does a Carbon Tax Help?

In case of imposition of the carbon tax, either the individual countries are left to determine their target or a common covenant would be governing them. The former is better as it would not violate the nation’s sovereignty. But the latter one involves pursuing the developing countries to sign the agreement[xii].

In order to reduce the fees, individuals are induced to use less energy derived from fossil fuels. Persons might switch over to public transportation, use CFL bulbs and install scrubbers to reduce emissions. Economic instruments such as taxation correct the market failures arising from the pollution[xiii]. Market failure arises because the supply curve does not include Social marginal Costs and the Pigou taxation internalizes this externality by imposing tax equal to marginal Social cost[xiv]. The other approach is a more fundamental approach by Coase, which focuses on property rights. For him, externalities prevailed because of non-excludability and if everything is owned, then the problem is solved[xv]. The higher the tax, the greater the incentive to reduce pollution. The successful imposition of carbon rests on the degree of certainty with which the scientists can calculate the effects of the pollution.

The Role of Game Theory

Game Theory plays a very important role in the decision making of whether to impose the tax or not of a developing country such as India. In the present case, the players are developing countries on one hand and the rest of the world on the other. A developing country has two strategies- one being to impose the mandatory carbon tax and the other being not to impose. Similarly, the rest of the world has two strategies which are to agree and impose mandatory tax or not. Here, only if the rest of the world imposes the tax, then the developing country does. So, the developing country’s strategy depends on the strategy of the rest of the world. This is rational because even if the developing country ventures to impose the mandatory tax in its own country, the global warming would not reduce as the CHG emissions from the rest of the world such as China or US continue to pollute the environment. If both the players cooperate, then the Pareto efficient solution can be reached. Dominant strategy is one optimal choice of strategy for each player no matter what the other party does. In the present case, there is no dominant strategy for the players.

Dominant strategies are fine when they take place. But, there are situations where the players do not have dominant strategy. One player’s optimal choice depends on what the other player does. This is known as Nash Equilibrium where developing country’s choice is optimal given the rest of the world’s choice and the rest of the world’s choice is optimal given developing country’s choice. Nash equilibrium is a pair of expectations about each person’s choice such that, when the other person’s choice is revealed, neither individual wants to change his behaviour. Nash equilibrium is self-enforcing and when the players are at Nash equilibrium they do not intend to change their strategies because when they do so, they would be worse off. We assume that each player has some experience in playing a particular game and each plays in isolation.

If the rest of the world does not cooperate or if the developing country does not cooperate, the result would be Pareto-inefficient. Hence, only if there is cooperation with the rest of the world, the most efficient outcome can be reached. Thus, there is no point in implementing the mandatory carbon taxation in a country unless other countries contribute for the same. The best solution is that when both the players cooperate and agree to reach a settlement on reducing the emissions in the atmosphere. At, present only Australia and EU countries impose tax of carbon emissions. There is no incentive for the counties to go for the carbon tax because if one does not pollute it the other nullifies the effect. Despite a huge Indian economic sacrifice, global emissions will remain the same. Another argument by the developing countries is that the west has been polluting the world for the past 150 years and it is unjust on the part of the developing countries to recover the taxes. Some of the advantages of imposing mandatory carbon tax are that it encourages firms to innovate and produce efficiently, provide cleaner and greener environment and the revenues raised from the mandatory tax can be used to subside the alternatives such as greener products.

Effects of imposition of carbon tax on the economy

The imposition of carbon tax on the consumption of fossil fuels indirectly affects the consumers. The producers’ only solution is to recover the costs from the consumers. For instance, an Australian Airliner, Quantas has recovered its Carbon Tax Bill of $106 million by way of ticket surcharge[xvi]. Form an economic perspective, carbon tax is sub-species of pigouvian tax; taxes which are designed to change behaviour rather than to change revenue[xvii]. The result is that prices of various commodities would be higher and everything else which people consume would cost more. The ultimate result of high prices is low standard of living, less economic opportunities and fewer jobs[xviii]. If the carbon tax is not implemented on the global level equally, the result is the shift in the production process to the nations without the tax or with the lesser tax. Imposition of taxation is in the first place a bad idea to induce the citizens to go for greener products because in the present case the producers may not be able to produce and the consumers may not be able to consume, given the taxation. Carbon pollution outcomes are uncertain as they do not guarantee that any particular outcome would be reached.

The higher prices will diminish the purchasing power of the people’s earnings thereby reducing their real wages[xix]. This in turn reduces the amount the people work which reduces supply of labour. Investment would also decline which results in the decide of the economy’s total output. Also, the costs of carbon tax would not be equally distributed among the Indian households. Low-income households would be spending more percentage of their income in incurring costs of paying carbon taxes than that of high-income people[xx]. In a similar fashion, workers and labourers in coal-based or emission causing industries would see the largest decrease in the demand of their services. So, if the mandatory carbon tax is imposed in a country, the production might shift to the other countries.

Primary costs are the costs incurred as a result of the increase in the prices of fossil fuels in proportion to the fossil content. Higher the carbons content of the product, higher the price. This type of costs has two kinds of effects- output effect and substitution effect[xxi]. The former is simply the reduction of the economy’s total output as a result of increase in the prices. This is because of the decrease in the supply of labour as a result of low wages and the lack of incentive for investment because of the increase in the cost of production. The latter effect results because of the shift in the attitude of the consumers to use greener goods rather than the goods which involve the high emissions of carbon dioxide. This effect would fall disproportionately on various sections of society[xxii].

The National Association of Manufacturers’ Report of US says that the net aggregate reports of the imposition of carbon tax in the US Economy is negative reducing the GDP growth by 3.6. per cent by 2053[xxiii]. The average consumption per household will also reduce because of the consumer behaviour in response to the changes. There is also a substantial impact on the wages and employment. In Australia, where the mandatory carbon tax is imposed, its Real GDP may decline by 0.68 per cent, consumer prices may rise by 0.75 per cent and the price of electricity may increase by about 26 per cent[xxiv]. A report by the US Congressional Budget Office said that the carbon tax would have a cascading effect on the national economic growth and that this can be countered by using the revenue to reduce fiscal deficit or to reduce the taxes to support various businesses and consumers[xxv].

The problem of spending of carbon revenue

A revenue neutral carbon tax would be beneficial to the environment as well as to the economy. Denmark’s approach of combining carbon tax with subsidies, reduced taxes or incentives to the poor and this contribute to the development in the large scale. But, it is highly impossible for the government to identify various peoples’ incomes and to decrease incomes for all income brackets[xxvi]. The government would be induced to transfer the funds to green jobs or innovation rather than to transfer to the affected individuals as a result of the tax rise. A paper by Institute for Energy Research[xxvii] says that it is impossible to create an optimal carbon tax as the planner cannot have all the necessary information that is further compounded by politics and the uncertainty of climate science. There is a strong correlation between energy use and GDP of the country and the carbon will definitely result in low economic output. Imposition of carbon taxes leads to trade protectionism. If a developing country were to impose carbon taxes, it does not allow any imports which are cheaper than the domestically produced goods and this would substantially affect the international trade. The French Government has abandoned the plan to introduce the carbon tax as it felt that its companies would be at disadvantage to their European neighbours[xxviii].

The Social Cost of Carbon is an estimate of the direct effects of carbon emissions on the economy and includes net agricultural productivity loss, human health effects, property damages from sea level rise, and changes in ecosystem [xxix]. We have to see whether imposing the taxes would harm the economy and the way forward is to compare the costs to the benefits where the benefits are measured via SCC. This approach is criticised as it disregarded various income levels between regions where the poor are expected to bear more damages when they contributed very least to the problem[xxx]. David Pearce in “The role of carbon taxes in adjusting to Global warming” said that estimation of elasticities of demand for energy varies widely and it is also important to know the standard income and price elasticities[xxxi].

The paper on “Impact of Carbon Tax on Australian Economy”[xxxii] suggests that the lump sum amount of $685 to be paid to each and every household to win public support. Recycled carbon taxes provide two types of benefits. One is the Pigouvian tax which reduces negative externality and the other is the effective utilisation of revenues to reduce marginal personal income tax rates and fiscal deficit.[xxxiii]. Lump sum recycling is giving some amount of money to offset the losses and hence does not have any effect on the taxation system. The amount can also be used to reduce the fiscal deficit and ensuring the health of the economy. By reducing the Corporate Income Tax the government is stimulating investment in greener technologies by increasing the real GDP. The effect on the economy by the introduction of the mandatory taxation finally depends on the way the revenues are used to offset the losses. They can be used to reduce budget deficits or lowering existing marginal tax rates etc.[xxxiv].

The CDM (Clean Development Mission) allows developing countries to generate Kyoto permits that can be traded in an international market for projects that otherwise would not have been undertaken and which reduce emissions below a baseline[xxxv]


In India, the mandatory carbon tax of Rs. 50 per metric ton on coal production and on imports is already in force since July 1, 2010[xxxvi], where there is no such tax even in some developed countries such as France. In 2005, European Union adopted “Emissions Trading Scheme” which is the world’s largest carbon market and covers more than 11,000 factories, power stations and other installations across all its members[xxxvii]. The alternative and best strategy for India in case of non-cooperation is to wait for the collective decision to be taken by all the countries and for the financial assistance if needed, to tackle the menace. It would be stimulating for the developed countries to impose the mandatory carbon taxes in their countries and in the rest of the world to prevent the greater harm to the mother earth.

Article 16 of the Rio Declaration[xxxviii], one of the agreements reached at the Earth Summit, urges nations: (1) to adopt the polluter pays principle; (2) to take steps to internalize the costs of industrial pollution, and (3) to promote the use of economic instruments such as pollution taxes to abate greenhouse gas emissions.

Cooperation is the only way forward. With cooperation, the losses (which can be minimised by the concept of revenue-neutrality) can be tolerated as they are for the benefit of the entire human community as a whole. So, the fundamental step for a developing country like India to reduce the emissions is to see whether the rest of the world is cooperating or not. If the rest of the world is not cooperating, the rational solution for it is not to proceed with its decision of implementing the carbon pricing. If the rest of the world is cooperating, it would be best for India to cooperate and to reach the most efficient outcome of reducing the impact of the emissions. In case of cooperation, providing a few incentives to the people to reduce the marginal personal income rate s along with giving the subsides (lowering the cost of production) of the greener goods to induce the producers to move to the greener goods is the rational and best solution. This minimises the harmful effects on the economy such as ensuring the continuous supply of labour (low wages paid by the greener industries + (additional wages= incentives given by the government)) and the stimulation of investment by way of providing the subsidies for the production of greener products.

Edited by Kudrat Agrawal

[i]Australia, for example






































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