Cost of Energy and Energy Taxes

The price of fossil fuel based energy ($ per gallon of gasoline or Kw-hr of electricity) that we have to pay as individuals (or businesses) is basically the immediate cost to produce that energy.  There are a few cases where specific taxes are added on, such as the road tax on gasoline.  However, in general there is no attempt to include the “externality costs” the use of those fossil fuels imposes on society.  For example, burning coal to produce electricity commits us to increased health care costs associated with breathing polluted air, the costs of damage from acid rain, costs of water pollution and land recovery from coal mining, and the costs of climate disruption.  Very few economists would argue with the idea that these costs exist and that they are currently not reflected in the price of fuel.  In order for all of us to make rational decisions about energy use in our free market economy the total costs of the energy we use needs to be reflected in the price. 

The best way to have the price of energy include the external costs is to add taxes to the price of fuel to reflect the external costs.  The International Center for Technology Assessment has done a detailed analysis, entitled “The Real Price of Gasoline.”  The ICTA calculates several indirect costs, including oil industry tax breaks, oil supply protection costs, oil industry subsidies and health care costs of treating auto exhaust-related respiratory illnesses.  The total of these indirect costs is is about $9 per gallon.  Add this to the roughly $2.50 current price of gas and you get a total price of $11.50 per gallon.  There is plenty of room to argue about what should go into the external costs and how they should be calculated, but this gives some idea of the amount of tax involved.  If this tax was generalized to a “carbon tax” that would be applied to all fossil fuels the amount of the tax would be around $3,000 per ton of carbon.  This is clearly a big tax and would raise an incredible amount of revenue.

 The tax revenue raised from the carbon tax would allow major reductions in other taxes.  For example, we could remove federal income tax on all income below some level, say $100,000 per year.  Or start a Manhattan Project type effort on non-fossil energy and transportation.  We could afford to develop a system of fast electric trains for intercity travel in the US (which would be good because air travel would be rather expensive). 

 The carbon tax would need to be put into effect incrementally to avoid a big economic shock.  We could start with the equivalent of $1 per gallon of gasoline and add another $1 every other year untill we get to the right level.  That would get us to where we need to be reasonably quickly without causing a big disruption.  After all, we have had changes of that magnitude in gasoline, fuel oil and natural gas during the last year and nothing really bad has happened to the economy.

There is some evidence that the carbon tax needs to be even higher to get fossil fuel use down to the level needed to deal with global climate change, but that is the subject of another post.


6 Responses to Cost of Energy and Energy Taxes

  1. Mark says:

    I’m interested to know how you imagine the effects of such a tax filtering out if they are implemented unilaterally. What happens if, for example, I can buy a gallon of gas for $11.50 here in Michigan, but if I drive over the Ambassador bridge to Canada (which from where I work, and with the fuel economy of my current car, would require, say, two gallons of gas), and buy it for $3.00, because Canada has not implemented a similar tax? The additional cost to me is $6.00 (note I am calculating only my personal costs, and intentionally ignoring the “real” cost of that gasoline). That it only slightly more than a half a gallon of gas in Michigan, in this scenario. In exchange, I can fill up the rest of my (~13 gallon) tank for somewhere in the range of $100 less.

    Clearly, I live much closer to another country than the average American. If I lived in the middle of Kansas, this would be a very different story. Perhaps, then, we are willing to ignore these strange boundary-effects for the purposes of this discussion. Even so, my general question remains.

    How do we (do we in the first place) address issues of how this will effect businesses in the United States that must continue to compete with businesses in other nations that do not adopt a similar tax? I don’t mean to say that I think that a carbon tax, even a carbon tax high enough to adequately reflect real costs, is a bad idea. It is to say, however, that I have trouble determining the broad, international and macro-economic effects of such a policy.

    I look forward to a future post that ties in the concept of climate effects.

  2. Brando says:


    I think you can see how going to Canada is not a viable choice for nearly anyone. And, as border security gets tighter, it will become more and more inconvenient. BUT, you are totally on the mark in my view to be worried about capital flight from the U.S. to Canada or other countries (UAE -ahem-).

    I don’t think a carbon tax of this magnitude, given the current bundle of goods and services we produce would be a good thing. Given how unskilled the American labor force is compared to it’s european neighbors, we can’t expect companies to choose our unskilled labor over unskilled labor in other countries where the fuel is cheaper. Such a tax would make even worse the already disturbing trade deficit, because the U.S. economy would become, for all intents and purposes a service economy like the world has yet to see.

    To my mind, to be economically viable a carbon tax of this magnitude would require (1) International coordination (unlikely) or (2) a complete rethink of U.S. industrial policy. In short, we would need to make our economy structured more like european economies. To do that would requires serious disruption to our traditional way of life. For example, the school and university system would need to be completely refocused from providing general transportable skills to specific non-transportable skills. In order to ensure the investment in those skills by workers, a huge network of social insurance would need to be implemented. Nationalized healthcare would be an absolute must to entice and enourage large firms to move to the U.S. and grow in size. The goal would be to create an advanced infrastructure that makes it not economic for industries in the tradeables sectors to leave to other countries with cheap unskilled labor. This is how Germany, Finland, Sweden, Denmark, and Japan prevent their firms from outsourcing to the same extent as ours.

    I like the idea of a carbon tax, but I think that it will require far larger changes to the whole structure of the U.S. economy than many of its proponents expect.

  3. Sarah says:

    As the stringency and enforcement of emissions controls increases in the energy industry, extra costs are added to what the consumer pays. The companies have to spend more on monitoring and control of emissions, which the pass on to the consumer. This does not cover unregulated emissions or facilities that are “grandfathered” in, though. So some environmental costs are included.

    Another point to note is that there is a strong interest in keeping gasoline prices to below about $3-4/gallon. I don’t understand the economics of this interest, however I do know that most of the DOE funding for energy research specifies that the total cost of fuel to the consumer for the cleaner energy must be below an amount near that range. The DOE will only fund projects that have hope of producing such low-cost fuel.

    I’d also like to point out that income tax is much “fairer” than a flat tax on gasoline. If every gallon is taxed at the same level, the result is regressive tax that hits lower-income individuals (especially those that can’t afford to live where they work) harder.

  4. Dana says:


    It’s a good point that income tax is much fairer than a gasoline tax, especially since more and more people with lower incomes are having to move further away from the places they work in order to be able to afford rent. Which seems backwards.

  5. goshawk says:

    These are all good points. I certainly don’t have all of the answers about this issue. The main point I am trying to make is that our economic system is warped because we have not been including all of the costs in the price of energy. This is causing all of us make wrong decisions about nearly everything that involves energy and the only way to fix the problem is to include the missing costs in the price of energy.

    There are clearly many issues that have to be addressed to make a carbon tax (or any other method of fixing the energy price problem) possible. The border problem exists now for tobacco and alcohol. Ultimately, you would like there to be some international coordination. The unfair impact of the tax on the poor would have to be addressed in some way and the huge income from the energy tax would allow many options for doing that. I am sure there are many other major problems that we aren’t even seeing now. However, I can’t think of another way to change the way all of us think and make decisions about energy.

    I will try and post something on Global Climate Change and the carbon tax soon so we can add that issue to this discussion.

  6. Brando says:

    I don’t really think that fairness is really an issue here. The gasoline tax proposed in this post is not truely a flat tax. It is a price correction. The idea of the gas tax is not to charge people for ‘sinful’ behavior, but because the TRUE cost of gasoline fuel is not passed on to the consumer. The tax is meant to make the cost of fuel closer to what the actual cost is once external damage done by gas consumption is taking into account. What is not fair is that currently those who drive big cars are forcing me to consume more than my fair share of pollution, as I drive a little energy efficient car.

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