Economic (and Market-Based) Cases for a Carbon Tax with Income Tax Credit
A post that is useful not just in the debate of carbon taxes, but also for students of Economics who are trying to understand income and substitution effects
There is a lot of debate over whether a carbon tax is the best way (or even effective) at reducing emissions, or if it is just a “tax grab”. Some people might also wonder whether carbon tax credits just cancel out the positive environmental effects of the tax so they are a waste of energy (no pun intended). Therefore, your Ride On writers want to demonstrate theoretically why economists tend to support carbon taxes with credits (like the GST credit) to ensure people will reduce pollution without undue harm on their pocketbooks.
In summary, it is our opinion that anyone who claims to support market-based solutions to problems should support a carbon tax over ham-fisted environmental regulations. Keep in mind: the reason a carbon tax works better than regulations is because people know they can reduce their tax burden by reducing pollution, so their incentives are aligned with the social optimum. Regulations, on the other hand, are not as effective at reducing pollution because even though they also lead to higher prices for consumers, the reason for these higher prices is hidden from these consumers, so their incentives to reduce pollution are reduced.
We will proceed as follows: first we will focus on the theory of externalities to show why the free market is not effective at aligning the incentives of private producers and consumers to the benefit of society as a whole, so a carbon tax can actually make society better off than under the free-market equilibrium. We will then turn to consumer theory to explain in more detail how a carbon tax will affect consumers, and also how a carbon tax credit can eliminate the negative effects of a carbon tax on effective consumer incomes while still reducing pollution overall.
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