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What is an Energy Tax?
An energy tax refers to any tax levied on fuels, energy generation, transmission, or consumption. Due to the inelasticity of demand for energy, these taxes can be major sources of government revenue. Tax revenues so raised may or may not be directed toward spending that supports the taxed industry or activity. Other than their main purpose, energy taxes are also sometimes used to manipulate the incentives faced by consumers and businesses in order to change their energy consumption and production decisions. This may be done to manage overall energy use, promote fuel and energy conservation, or to favor or to discourage certain types of fuel or energy use over others.
Key Takeaways
- An energy tax is a tax, excise, surcharge, or royalty that the government imposes on the production, distribution, or consumption of energy, electricity, or fuels.
- Because energy is a basic need for businesses and households demand tends to be relatively price inelastic in the short run, making it an attractive target to raise substantial tax revenue.
- Energy taxes can also be used as Pigouvian taxes to discourage certain behaviors that are believed to impose costs on others, such as a carbon tax on fossil fuels to reduce carbon emissions.
Understanding Energy Taxes
Energy taxes can exist in a number of forms, from wellhead royalties on crude oil, to retail gasoline excises, to peak-hour surcharges on consumer electricity bills. Because so much economic activity by businesses and households depends on basic energy technologies and fuels in order to run, the demand for energy as an economic good is what economists call price inelastic. This means that people don’t change their energy consumption very much when the price that they pay for energy changes, at least in the short run. For example, many people will still have to drive to work and heat their homes regardless of fluctuations in the price of gasoline or home heating oil, so when prices rise people will have little choice but to pay the additional cost.
This price inelasticity makes energy goods a common target for taxes to raise government revenue. Taxes, surcharges, and excises can be levied on these goods and passed on to consumers and businesses who will have to eat the cost, since they depend on using energy to live and continue business operations. As a result, such taxes can become large and stable sources of government revenue. Oftentimes, this revenue can be directed toward specific uses, such as earmarking diesel fuel taxes for highway maintenance and construction. Or, it can simply be directed into a government’s general fund.
Other Purposes for Energy Taxes
Like other taxes, energy taxes can also be used as a policy tool to shape people’s behavior, by taxing activities that are deemed socially undesirable more than others. Economists call these types of taxes Pigouvian taxes, after Arthur Pigou who described how they can be used to discourage activities that impose costs on others. For example, state taxes on electricity may include extra surcharges to electric customers during peak usage hours during the day, in order to mitigate peak demand on electrical generation and distribution capacity by encouraging people to reduce or spread out their electricity use to avoid grid failures and blackouts.
In recent decades a popular use for Pigouvian energy taxes has been to discourage the use of fossil fuels such as oil, coal, and natural gas. The purpose of this type of tax is to give businesses and consumers an incentive to use alternative energy sources, such as solar and wind power. Some or all of the resulting revenue may also be used to help finance public spending on other energy sources such as renewable energy.
Some environmentalists believe that these taxes are necessary to reduce the greenhouse gas emissions that contribute to global warming. Opponents of energy taxes warn of their unintended consequences, such as increased prices of virtually everything, which could harm living standards for families and individuals, particularly in developing countries.
The economic challenge with these types of taxes is that the property of price inelasticity that makes energy taxes such good sources of revenue can make it difficult and costly to use such a tax to change consumer and business behavior. The switching costs to change a home or a factory over to a cleaner source of heat or electricity may be large relative to the cost of the tax in the short run. On the other hand, imposing a tax large enough to quickly outweigh switching costs can put people and businesses in a desperate situation resulting in plant closures or families faced with the possibility of going without home heating or electric service. In the long run a more moderate tax may have a better chance of achieving behavioral change at a reasonable cost, though some of the behavioral change may also include unintended consequences such as businesses and residents leaving the taxed jurisdiction or adopting energy sources and practices that circumvent the tax without actually reducing emissions.
Carbon Taxes
Another example of an energy tax is a proposed U.S. carbon tax, which proponents hope to implement on the federal or state level, or both. A carbon tax is a fee paid by businesses and industries that produce carbon dioxide through the burning of fossil fuels. Many countries that have levied an energy fee, such as a carbon tax or a cap-and-trade system, have reported a subsequent decrease in carbon emissions. Currently, the U.S. has no formal carbon tax policy.
Many opponents of a carbon tax point to the potential economic burden of such a policy. A carbon tax typically increases the prices of gasoline and oil, which could threaten businesses’ survival and consumers’ basic standard of living. Even among those who want to reduce carbon emissions, some believe that any reduction in greenhouse gas emissions as a result of a carbon tax would not be significant enough to warrant these costs. Yet others contend that the link between greenhouse gases and global warming has yet to be scientifically proven, and believe that a carbon tax would have no beneficial effect on the conditions of the future climate.
What Is an Energy Tax Credit?
The government may offer energy tax credits to the public in order to incentivize the adoption of cleaner energy sources. These energy tax credits are available through a few different programs, but they are defined by the fact that they reduce the tax obligations of eligible individuals or households on a dollar-for-dollar basis, up to certain limits.
What Energy Tax Credits Exist in the U.S.?
Currently, there are a number of energy tax credit programs available in the U.S. The Energy Efficient Home Improvement Credit and the Residential Clean Energy Credit are two programs that allow homeowners to reduce their tax obligations if they make certain investments in home improvement or renewable energy.
Do Any Countries Have a Carbon Tax?
While the U.S. does not currently impose a formal carbon tax, there are many countries that do. Finland was the first country to begin levying carbon taxes back in 1990. Today, Switzerland and Liechtenstein have the highest carbon taxes, levying a tax at the rate of 120.16 euro per ton of carbon emissions, as of September 2023.
The Bottom Line
An energy tax refers to any tax levied by the government on energy generation, transmission, or consumption. This can be done to raise revenue for specific programs in the energy sector, or simply for a government’s general fund. Unlike taxes on income or sales, energy taxes can be a stable revenue source due to the inelasticity of demand for energy. Governments may also elect to levy taxes on energy generation and use in order to incentivize changes in behavior among consumers and businesses. For instance, energy tax policy may be used to encourage energy conservation or to promote the adoption of certain sources over others.