Could a Pigouvian Tax Help Solve Climate Change?

Back in 2019, an unprecedented group of thousands of economists signed a public letter in favor of a carbon tax as the best solution to climate change. 

At the same time, legislation known as the Green New Deal was gaining popularity among progressives and climate activists. The Green New Deal legislation put forward a top-down, public-sector approach to addressing climate change. While the exact parameters of the Green New Deal were vague, it emphasized massive-scale federal investment in climate-related infrastructure projects, invoking FDR’s New Deal. The climate activists downplayed or even dismissed carbon taxes—fees on greenhouse gases emitted by fossil fuel use and other economic activity—as both regressive and inadequate to achieving their goals. 

While the Green New Deal was not a serious legislative proposal, the Biden administration’s approach to addressing climate change was closer to the Green New Deal approach than it was to carbon pricing. The resulting Inflation Reduction Act (IRA) relied heavily on subsidies for green technologies, whether zero-emission electricity generation or electric vehicles. The Biden administration also pursued emissions reduction through regulation. 

The One Big Beautiful Bill Act (OBBBA), passed in July 2025, cut the IRA green energy subsidies substantially, although it stopped short of full repeal. With the IRA subsidies gutted and deficits elevated, carbon taxes may be worth another look. 

A tax on socially harmful behavior is known as a Pigouvian tax, named for the British economist Arthur Pigou, who introduced the concept in 1920. The basic case for such a tax is that some economic activity imposes costs on third parties not involved in those transactions. Those costs are also known as externalities. A Pigouvian tax forces economic actors to factor in these social costs. Taxes on cigarettes and alcohol are the two most prominent historical examples of Pigouvian taxes. The idea is to find the social cost of an activity, such as the climate impacts of carbon emissions, and impose a tax at the rate that aligns the costs from producing emissions with the benefits. 

The straightforward advantage of this policy in the context of climate change is that it leaves the decision of which emissions to reduce, and by how much, to the market. It may be cheap to reduce emissions in some sectors, but expensive in others. Under a broad carbon price, firms would undertake the least expensive approaches possible to reducing emissions. Depending on the context, that might mean more incremental changes, like improvements in energy efficiency or replacing coal-fired electricity generation with natural gas, or it might mean more radical decarbonization involving the full-scale adoption of zero-emission technology in electricity generation, passenger cars, or even other more difficult areas like industrial processes.

The U.S. has not implemented a significant carbon tax at the national level. Carbon taxes have been introduced in plenty of other developed countries, such as Sweden, Norway, France, and the United Kingdom. Carbon taxes (and cap-and-trade systems, which are similar) have expanded around the world in the past two decades. The most notable setback came in Canada this year, when new Prime Minister Mark Carney repealed the federal carbon tax that had been a signature achievement of Justin Trudeau’s premiership.  

Critiques of the simple “Econ 101” case for a carbon tax abound. They’re worth addressing, but none of them defeat the underlying logic of the basic approach. 

1. The social cost of carbon is a flawed metric.

To get to the social cost of carbon, you need to first model the damage from carbon emissions, a difficult process in itself. But then you must choose a discount rate (in short, how much to value future costs relative to present costs), and whether to consider the global costs of emissions or just the domestic costs. 

Reasonable assumptions about discount rates and global versus domestic costs can produce wildly different estimates of the social cost of carbon, from under $10 to almost $200. Because methodological differences produce dramatically different estimates of the social cost of carbon,

just about any carbon tax policy could plausibly be argued to either overprice or underprice emissions. However, this issue is not exclusive to carbon pricing. When considering a regulation on power plant emissions or the size of subsidies for green energy investment, policymakers also must make judgment calls on how to value potential future costs of climate change. 

There is no objectively correct, scientific answer to how much we should worry about climate change. However, given that we will implement climate policy in some form, and given that carbon emissions do have a social cost, a carbon tax is still the best option in the toolkit. In simple terms, we have agreed on the premise; now we’re just negotiating the price. 

2. Carbon taxes distract from pro-innovation policy that will lower the cost of green energy. 

Carbon taxes should drive clean energy innovation, and that is especially true in the United States. The pattern of “induced innovation,” where energy innovation accelerates when energy prices are higher, suggests a carbon tax would spur innovation in lower-emission technology. That’s truer in the U.S. because we are a massive market. A carbon tax in, say, Luxembourg probably won't drive emissions reduction through technological innovation because Luxembourg is not a big market for innovators to pursue. The United States is. 

A carbon tax and government support for new technological development are not mutually exclusive. Even with a carbon tax, there is a case for government support for energy research, just like there is a role for government support for basic research in other fields. 

The challenges to broader technological transformation apply regardless of a carbon price or innovation subsidy approach. If the main constraint to more transformative decarbonization is, say, permitting, then that is going to be a challenge whether the primary financial lever for supporting clean energy investments is a tax subsidy for new technology or a tax on carbon emissions. 

3. Carbon taxes don’t go far enough. 

A carbon price is not the same as a net-zero-emissions policy, and that's a good thing. Fossil fuels are tremendously useful technologies, even if they have downsides. A carbon tax would make private actors take the environmental costs of burning fossil fuels into consideration, but in many cases no viable alternatives to fossil fuels exist (and there may not be for a long time). A carbon tax lets market actors—you and me—decide if certain activities are worth their environmental costs.

4. Carbon taxes disproportionately burden low-income households. 

While there is some truth to this critique, the same can be said of other climate policies too. Green energy credits, whether consumer-facing ones for electric vehicles or business-side ones for electricity generation or other green energy tech, disproportionately flow to high-income households and big businesses and must ultimately be offset by other sources of tax revenue or spending cuts.

The economic burden of command-and-control regulation of fuel use also falls disproportionately on low-income households. Most of the economic literature shows carbon taxes are less regressive than these alternatives. 

The other factor to consider here: Carbon taxes produce revenue. Converting all, or even some, of the carbon tax revenue to universal flat cash transfer payments could more than offset the economic burden of the tax for lower- and middle-income households. 

In implementing a carbon tax, an additional consideration is the need for deficit reduction. Revenue will have to be part of the conversation. In a situation where policymakers are looking to bring deficits down, a climate policy approach like a carbon tax that reduces the deficit has a lot more appeal than an approach like green subsidies that increases it. 

Carbon taxes justifiably have their critics; translating the simple model of a Pigouvian tax to climate change involves a lot of judgment calls worthy of debate. Nonetheless, most of the objections to a carbon tax as a policy mechanism apply to other climate policies too, and the core structural advantages of a carbon tax still hold relative to the alternatives.