Setting the Tax Rate: Levels and Trajectories
The tax rate is the heart of any carbon tax. Set it too low, and emissions barely budge. Set it too high, and you face economic disruption and political backlash. Getting the rate right requires balancing environmental ambition with economic and political realities.
What Does the Rate Actually Mean?
A carbon tax rate is expressed as a price per ton of CO2 (or CO2 equivalent). When you hear "a $50 carbon tax," it means:
- Emitting one ton of CO2 costs $50
- A fuel with higher carbon content costs more per unit
- Different fuels face different tax amounts per liter or kilogram, reflecting their carbon content
Example: At a $50/ton carbon tax:
- Gasoline (2.31 kg CO2/liter): $0.12 per liter
- Diesel (2.68 kg CO2/liter): $0.13 per liter
- Coal (2.42 kg CO2/kg): $121 per ton of coal
- Natural gas (2.75 kg CO2/m³): $0.14 per cubic meter
Approaches to Setting the Rate
Countries use different approaches to determine carbon tax rates:
1. Based on environmental targets
Start with the emissions reduction goal and model what price is needed to achieve it. This requires economic modeling to estimate how businesses and consumers will respond to different price levels.
2. Based on the social cost of carbon
Set the rate equal to the estimated damage that each ton of CO2 causes to society. This approach says: "If emitting CO2 costs society $50 in damages, polluters should pay $50 per ton." (We explore this in detail in the next lesson.)
3. Based on peer jurisdictions
Look at what similar countries or competitors charge and set your rate accordingly. This helps address competitiveness concerns but may not align with your specific environmental goals.
4. Based on political feasibility
Start with what is politically achievable and plan to increase over time. Many successful carbon taxes began at modest levels to build acceptance.
In practice, most carbon taxes use a combination of these approaches. Pure economics may suggest one rate, but political and competitiveness considerations often lead to starting lower and ramping up over time.
Current Carbon Tax Rates Around the World
Carbon tax rates vary enormously across jurisdictions:
| Jurisdiction | Rate (USD/tCO2e) | Notes |
|---|---|---|
| Sweden | ~$130 | Highest in the world; started at $26 in 1991 |
| Switzerland | ~$130 | Applied to heating fuels |
| Finland | ~$85 | One of the oldest carbon taxes |
| Norway | ~$80 | Varies by fuel and sector |
| France | ~$50 | After pause, now rising again |
| Canada (federal) | ~$50 | Scheduled to reach $130 by 2030 |
| UK Climate Change Levy | ~$25 | Applied to business energy |
| Singapore | ~$25 | Rising to $50-80 by 2030 |
| South Africa | ~$10 | With significant exemptions |
| Mexico | ~$3 | Well below optimal levels |
What Price Is "High Enough"?
A key question is whether carbon prices are high enough to achieve climate goals. The High-Level Commission on Carbon Prices (led by economists Joseph Stiglitz and Nicholas Stern) estimated that meeting the Paris Agreement goals requires:
- $40-80 per ton by 2020 (most jurisdictions missed this)
- $50-100 per ton by 2030
- Higher still thereafter
As of 2024, only about 5% of global emissions are covered by a carbon price in the $50-100 range recommended for 2030. Most carbon prices remain too low to drive the deep reductions needed for climate goals.
Price Trajectories: The Importance of Signals
Perhaps more important than the starting rate is the trajectory. A predictable path of rising prices gives businesses confidence to make long-term investments in low-carbon technologies.
Why trajectories matter:
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Investment decisions: A company choosing between a 30-year gas plant and a wind farm needs to know what carbon will cost over that timeframe.
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Technology development: Higher future prices justify R&D spending on clean technologies today.
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Behavior change: People adapt more effectively to gradual, predictable price increases than sudden jumps.
Canada's carbon price trajectory:
| Year | Rate (CAD/ton) | Rate (USD approx.) |
|---|---|---|
| 2019 | $20 | $15 |
| 2022 | $50 | $40 |
| 2025 | $95 | $70 |
| 2030 | $170 | $130 |
This clear trajectory allows businesses to plan. A company making investment decisions today knows exactly what carbon will cost in 2030.
Think of the price trajectory like a train schedule. If you know the train leaves at 3 PM, you can plan your day accordingly. If the departure time keeps changing randomly, planning becomes impossible. A clear carbon price trajectory lets businesses plan their transition.
Design Choices for Rate Setting
Several design choices affect how rates work in practice:
Automatic escalation vs legislative adjustment
Some carbon taxes include automatic annual increases built into the law. Others require new legislation each time the rate changes. Automatic escalation provides more certainty but less flexibility.
Fixed rates vs formula-based rates
Most carbon taxes set fixed rates by year. Some proposals link rates to environmental outcomes (if emissions are not falling fast enough, the rate increases automatically).
Uniform vs differentiated rates
Most carbon taxes apply the same rate per ton across all emissions. Some differentiate by sector, fuel, or use (though this reduces efficiency).
Carbon taxes can be set in nominal or real terms:
Nominal terms (not adjusted): A $50/ton tax stays at $50 until legislation changes. Over time, inflation erodes the real value, weakening the incentive.
Real terms (adjusted for inflation): The rate increases each year with inflation, maintaining constant purchasing power. Some jurisdictions include explicit inflation adjustments.
Best practice: Include automatic inflation adjustment to prevent the tax from becoming less effective over time. British Columbia, for example, adjusts its carbon tax for inflation annually.
This matters more than you might think. Without adjustment, a carbon tax can lose 20-30% of its real value over a decade of moderate inflation.
Starting Low: The Case for Gradual Introduction
Many successful carbon taxes started with low rates and increased over time:
Sweden started at SEK 250/ton ($26) in 1991 and increased to over SEK 1,400/ton ($130) today.
British Columbia started at CAD $10/ton in 2008 and has risen to CAD $80/ton, heading to $170 by 2030.
Singapore started at SGD $5/ton in 2019, rising to SGD $25 by 2024, with plans for $50-80 by 2030.
Why start low?
- Builds acceptance: People can adjust gradually rather than facing sudden cost increases.
- Allows course correction: You can assess impacts and adjust before rates get high.
- Develops capacity: Businesses and government learn how to comply and administer.
- Demonstrates commitment: Starting and increasing shows the policy is real and durable.
The key is credibility. Starting low only works if there is a credible commitment to increase over time. A low rate that never rises sends a weak signal and achieves little.
How Businesses Respond to Different Rate Levels
The rate level affects what kinds of emissions reductions happen:
Low rates ($5-15/ton):
- Mainly behavioral changes (turning off lights, reducing waste)
- Low-cost efficiency improvements
- Limited impact on investment decisions
Moderate rates ($30-60/ton):
- Fuel switching where alternatives exist (gas replacing coal)
- Moderate efficiency investments
- Beginning to affect some investment decisions
Higher rates ($75-150/ton):
- Significant fuel switching
- Major efficiency investments
- Strong influence on long-term investments
- Beginning to make some clean technologies competitive
Very high rates ($150+/ton):
- Deep decarbonization investments
- Electrification of transport and heating
- Industrial process changes
Example: Consider a coal power plant deciding whether to switch to natural gas.
At $20/ton, coal might still be cheaper despite the carbon tax.
At $50/ton, the economics start to favor gas.
At $80/ton, gas is clearly cheaper, and the plant has strong incentive to switch.
At $120/ton, even gas becomes expensive, and renewables become increasingly attractive.
Common Mistakes in Rate Setting
Setting rates too low to matter
A $2/ton carbon tax is essentially symbolic. It raises some revenue but does not change behavior. If the rate is invisible amid normal price fluctuations, it has no effect.
No clear trajectory
A rate without a published future path creates uncertainty. Businesses do not know whether to invest in clean technology or wait and see.
Political reversals
If rates are increased and then rolled back due to political pressure, credibility is damaged. Future rate announcements are not believed.
Ignoring existing taxes
If gasoline already has a $0.30/liter excise tax (implicitly pricing carbon at about $130/ton), adding a $5/ton carbon tax makes little difference to total price.
Looking Ahead
In the next lesson, we explore the social cost of carbon, a concept that attempts to quantify the actual damage each ton of CO2 causes to society. This provides a scientific foundation for setting carbon tax rates.