Analyzing the Benefits and Drawbacks of Two Structures of a Potential Carbon Tax in the United States

Ryan Kenny, Associate Member, University of Cincinnati Law Review

Imagine two people riding on a bus, Jim and Jane. Jim is enjoying a bag of potato chips during his commute. However, the loud crunching of the chips annoys Jane, who just wants to enjoy her book. The question is: did the monetary cost of the potato chips to Jim accurately reflect the additional, negative cost of annoying Jane? Economists refer to this as a negative externality; the cost suffered by a third party in a transaction between two other parties.[1] One proposed solution to capturing this additional cost is a Pigovian tax, applied to the transaction to accurately capture the actual cost of the transaction.[2] One type of a Pigovian tax is a carbon tax, applied to carbon-emitting transactions and industries to reflect environmental costs that are not typically represented in the cost to producers and consumers of products. Recently, some respected members and former civil servants in the Republican party have suggested replacing the Obama administration’s environmental regulations with a carbon tax.[3] The Department of the Treasury’s Office of Tax Analysis (OTA) wrote a working paper (Paper) on how such a tax could be implemented: using either an upstream or midstream approach, or a combination of both.[4] 

I. The Different Approaches Explain the Points in the Fossil Fuel Supply Chain Where the Tax Would Be Levied.

The important policy consideration for a carbon tax is determining the point at which fossil fuels would be taxed. Essentially, the question is which party(s) in the supply chain (producer, distributor, consumer, etc.) would be subject to the tax. Under the upstream approach, the tax could be levied “on (i) crude oil as it reaches the refinery, (ii) natural gas as it leaves the processor to enter a pipeline or . . . arrives at the end user, and (iii) coal as it leaves the mine.”[5] The Paper describes this tax as an excise tax, a tax on certain specified activities and on certain purchases.[6] Therefore, the tax would be levied against companies that process oil, natural gas, and coal for energy production and other uses. The proposed carbon tax on coal is similar to the current tax on domestic coal producers in Code §4121 that levies a tax per ton of coal sold.[7] The “producer” of coal is the person “in whom vested ownership of the coal under state law immediately after the coal is severed from the ground . . . .”[8] One could deduce that a similar producer standard could apply to extractors of crude oil and natural gas, and that the statements in the Paper regarding oil “as it reaches the refinery”, and natural gas “as it leaves the processor” or “arrives at the end user” could serve as a catch-all for imported oil and gas.[9] Currently, crude oil and natural gas are not taxed based at the point of production.[10] Even if the tax were levied at the points explicitly mentioned in the Paper, the tax is applied on raw nonrenewable resources before they enter the market for consumption.

The midstream approach would levy the tax on “(i) petroleum-based fuels as they leave the refinery or are . . . sold for use . . . (ii) natural gas as it leaves local distribution centers, and (iii) fuels used by electric generating facilities . . . that have not been previously taxed.”[11] Unlike the upstream approach, the midstream approach would not levy the tax against the production or import of crude oil, natural gas, or coal. The IRS would levy the tax at the point when the refined product is distributed to the market.[12] Currently, neither oil nor coal is taxed under environmental regulations using this market-entry system.[13]

A. A Pure Upstream Approach Would Impose the Least Administrative Costs, but Would Place a Huge Tax Burden on a Small Group of Taxpayers.

The upstream approach would concentrate the carbon tax to a select group of taxpayers: carbon fuel producers and importers. The upstream approach would apply to fewer than three thousand taxpayers, and would cover eighty percent of the current greenhouse gas emissions in the United States.[14] The Paper estimated that in the first year of such a tax, the revenues to the government would be $194 million.[15] This burden would not be equally distributed among the taxpayers in the upstream tax base. The tax is levied upon different fossil fuels based upon the carbon dioxide concentration per ton of that fuel source.[16] Not all forms of fossil fuels contain the same concentration of carbon dioxide.[17] Under the upstream approach, natural gas would be taxed at $2.60 per thousand cubic feet (mcf), whereas coal’s tax burden is between $62.05 and $126.36 per short ton.[18] Crude oil would be taxed at $21.17 per barrel.[19]

This data shows the downside to the upstream approach: different industries share different proportions of the carbon tax. Even though oil production and imports are greater than coal production, coal may still bear more of a tax burden than the oil industry.[20] This could be particularly problematic given the economic hardships that have fallen upon the coal communities in the United States as coal production has decreased.[21] Moreover, this may not encourage fossil fuel companies to switch to green alternatives, but rather could increase the market share for oil and natural gas as they fill the void that being left by coal.

Conversely, the upstream approach could have a lower administrative burden. Monitoring and enforcing compliance amongst a select number of large fossil fuel companies may be easier than expanding the tax base to smaller consumers.[22] As a tax base increases, the total compliance costs to the economy increases,[23] and maintaining a cost-effective administrative burden is necessary to make the implementation of a carbon tax cost-effective as a whole. Moreover, there is already a framework currently being used which taxes imported crude oil as it arrives at the refinery, and a tax on the removal of coal from its natural location.[24] The framework for coal could easily be extended to oil, and there would be little confusion about how the tax would apply to the removal of oil from its natural location. This decreases the work that the IRS would need to perform in implementing a carbon tax, and would increase compliance among fossil fuel producers and importers, and there would be predictability for taxpayers regarding how the tax would be applied.

B. The Midstream Approach

Many of the benefits and drawbacks of the midstream approach are mirror reflections of the benefits and drawbacks of the upstream approach. The effects of the midstream approach are more pronounced with oil than with natural gas or coal. Essentially, the coal and natural gas at the production end and the consumption end are the same material: the coal taken from the mine is generally not altered in a significant way before it reaches the power plant.[25] However, a midstream approach would not directly tax crude oil, but rather would levy a tax on the refined products of oil, depending on those products’ carbon dioxide concentration.[26] Therefore, distinct tax rates would apply to gasoline, jet fuel, and diesel or home heating oil when those products are entered into the marketplace for consumption.[27] The focus of the tax would be applied to petroleum products that cause greenhouse gas emissions, and would exempt those that do not contain carbon dioxide, or at least do not contain a significant concentration of carbon dioxide.[28]

One example is the Leaking Underground Storage Tank (LUST).[29] LUST “covers all carbon-emitting motor fuels and further includes home heating oil and other refined products []. In addition, LUST exempts fuel destined for export of for use by the purchaser as supplies for vessels employed in foreign trade . . . .”[30] LUST specifically applies to refined petroleum products, and only those products that are going to be consumed in the United States.[31] This is the same goal that the midstream approach takes. For coal and natural gas, the tax would be levied at the “electric utility or other point-source emitter rather than at the first point of sale.”[32] Therefore the tax on those fossil fuels would be directed at the point of emission as well.

Arguably, the midstream approach represents a more equitable distribution of the tax burden. Rather than placing the tax burden on the small group of taxpayers who are simply sourcing the fossil fuels, the tax is applied against the actual polluters. Furthermore, by placing the tax on the polluters, it may provide greater incentives for them to reduce their carbon dioxide emissions by using new technologies or alternate fuel sources in order to reduce their tax liability.

However, the midstream approach is undeniably more convoluted than the upstream approach. For the taxation of coal and natural gas at the electric utility or point-source emitter, there are currently no federal excise taxes applied at those point.[33] This means that the IRS and the Treasury would have to develop new rules and regulations, and consumers would not have the predictability associated with the upstream method. Furthermore, the tax base under the midstream approach has the potential to be much larger. If the purpose of the midstream approach is to tax the actual polluters, this could include power plants as well as consumers who drive cars. This is evidenced by the proposed tax on gasoline under the midstream approach.[34] While it is understood that the midstream approach would apply to the entry of refined oil products into the market, this tax could theoretically be levied against the refinery or the end consumer.[35] Under the upstream approach, the tax would be levied on crude oil, the extraction of coal, and the entry of natural gas into the pipeline, concentrating the tax at the top of the vertical supply chain. This broadened tax base would increase the administrative costs of the tax, and would also provide more opportunities for noncompliance, especially in regards to smaller, less sophisticated taxpayers down the line.


Both the upstream and midstream approaches in the OTA’s Paper have drawbacks and benefits. The upstream approach is undeniably more simple, and therefore may reduce administrative costs and increase compliance. However, it also places a large tax burden on a small group of taxpayers, which could be damaging to the coal industry. Furthermore, as coal consumption contracts under market forces and a carbon tax, the financial gain from increased market share for oil and natural gas may offset the costs of the tax, thereby diminishing the carbon tax’s purpose of reducing fossil fuel consumption.

The midstream approach is arguably more equitable in applying the tax at the actual points where the carbon dioxide is released. This could provide greater incentives for actual polluters to switch to less carbon-concentrated fuels or to implement carbon capture technology.[36] However, the potential for a great broadening of the tax base would increase the IRS’s and the Treasury’s administrative costs, and would increase the overall national compliance costs of the carbon tax on taxpayers, thereby reducing the tax’s overall cost-effectiveness. Furthermore, the broader the tax base, the more instances of noncompliance are likely to occur.


[1] Negative Externalities, Economics Online;

[2] Pigovian Tax, Policonomics: Economics Made Simple;

[3] Chris Mooney and Juliet Eilperin, Senior Republican Statesmen Propose Replacing Obama’s Climate Policies with a Carbon Tax, The Washington Post, (Feb. 8, 2017);

[4] John Horowitz, Julie-Anne Cronin, Hannah Hawkins, Laura Konda, and Alex Yuskavage, Methodology for Analyzing a Carbon Tax, The Department of the Treasury: Office of Tax Analysis, Working Paper 115 (Jan. 2017).

[5] Working Paper at 4.

[6] Id.; Excise Tax, Internal Revenue Service;

[7] I.R.C. §4121(a)(1). This tax was created as part of the Black Lung Benefits Revenue Act, which provides benefits to coal miners who develop lung diseases from working in mines, see 30 U.S.C.A. §901(a).

[8] 26 C.F.R. §48.4121-1(a)(1); Treas. Reg. §48-4121-1(a)(1).

[9] There is already an environment tax levied on imported oil under the Oil Spill Liability Trust Fund in I.R.C. §4611(a)(2), which taxes the person who is importing the crude oil for consumption, use, or warehousing.

[10] I.R.C. §4611(b)(2); currently, no federal taxes are levied against natural gas, Working Paper at 8.

[11] Working Paper at 4.

[12] Working Paper at 7; the tax would be on refined fuels, which suggest the tax would be levied once the crude oil is refined and ready for shipment out of the refinery.

[13] Certain other chemicals are taxed using this method, I.R.C. §§4661, 4671, 4681.

[14] Gilbert E. Metcalf and David A. Weisbach, The Design of a Carbon Tax, University of Chicago Law School, Public Law and Legal Theory Working Papers at 5 (Jan. 2009);

[15] Working Paper at 3.

[16] Id. at 5.

[17] Table 1 in the Paper demonstrates the amount of tax that would be levied against different fossil fuels under both the upstream and midstream approaches, Id. at 7; all calculations are based upon a tax rate of $49 per metric ton of carbon dioxide equivalent.

[18] Id., the different types of coal, in order from lowest tax burden per ton to highest, are lignite, sub-bituminous, bituminous, and anthracite.

[19] Id.

[20] Fossil Fuels Still Dominate U.S. Energy Consumption Despite Recent Market Share Decline, U.S. Energy Information Administration (July 1, 2016);

[21] Id.

[22] Bill Chameides, Upstream, Downstream, or Midstream – Where to Place the Cap?, The Green Grok, Duke Nicholas School of the Environment (Mar. 4, 2009);

[23] Joshua D. McCaherty, The Cost of Tax Compliance, The Tax Foundation (Sept. 11, 2014);

[24] Supra Notes 7 – 9.

[25] This is evidenced by Table 1, where the midstream and upstream approaches for coal and natural gas have the same tax rate on the same amount of material.

[26] Working Paper at 7.

[27] Id. at Table 1.

[28] Id. at 8.

[29] 42 U.S.C.A. §6991.

[30] Working Paper at 7 – 8.

[31] Id.

[32] Id.

[33] Id.

[34] Supra Note 24.

[35] Excise Taxes, Internal Revenue Service Pub. 510 at 6 (Jan. 2016), provides guidance on how an excise tax on fuel could be levied at any point from leaving the refinery to the sale of the gasoline, and therefore could theoretically be applied to the sale at the gas station.

[36] “A cost-effective tax system would also provide a credit for carbon dioxide capture and permanent sequestration.”, Working Paper at 8.


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