Carbon Taxes: A Libertarian's Secret Love

Libertarianism has been almost entirely absent from India’s political imagination. The one serious flirtation with it came back in 1959 with the Swatantra Party. Crucially though, the party found few takers in India and yes, classically liberal it was, but only on economic issues; on social issues, it towed the societally acceptable conservative line. 

For most of independent India’s history, the left has owned the political space: from central planning and subalternism to the various hues of socialism, Marxism, and their local avatars - Lohiite, JP, and others. Dash these with some masala of regionalism, linguistic politics, anti-caste struggles, pro- and anti-tribal movements, women’s rights movements, successionist movements, sectarianism and you have a picture of the complex philosophical landscape India’s politics operates in. Yes, I am salivating.

Anyways, slurping back - markets have been viewed with suspicion in my homeland, and redistribution of capital (and one might say poverty) has been the chief obsession of my dear country’s political elite. One of the country’s foremost journalists, who I often disagree with, coined the quintessential term that summarises the phenomenon - povertarianism: poverty is my birthright and I will ensure that you have it. At last, an idea that rallies all Indians. Alas.

Amidst this rich medley of all things ‘left’, a silent smoldering fire for the cause of the classical liberals has been nurtured by the many failures of India’s heavy-handed state.  Providing intellectual succor to these festering wounds have been many reading clubs, including those romancing Ayn Rand’s books, that have blossomed across India’s cities. In fact, more than a decade ago, The Economist reported that in India Ayn Rand outsold Marx 16-to-1!

Meet Lucifer

One of my best friends growing up, who sadly continues to occupy the same space in my life, is a living, breathing Randian. He believes in rational self-interest, holds the right to property and individual freedom dearer than life itself, and most importantly, hawkishly views any form of coercion. Most obviously, he rails against any form of taxation as ‘protection money’ from the violence of the state. It does not help that political scientists, famously Max Weber himself, define the state as “a human community that (successfully) claims the monopoly of the legitimate use of physical force within a given territory.” 

To this friend - let us now call him Lucifer - it naturally follows that the more successful you are, the greater the protection you need from the state, and therefore, greater the bucks to be paid. Obviously, this is how he views progressive taxation - a fee on success.

The other day, during one of our usual chats, the conversation pivoted to my new employer, a multilateral organisation. Lucifer asserted, with all sincerity in his heart, that this organisation had joined the government protection ring by arming them with more data and information to harass citizens and push the modern nation-building project that is underwritten by hardworking innovators such as himself.

Sidestepping this colourful characterization of taxation that I very much disagree with (for I am the chosen one - a (fake) economist!) - the Pigouvian taxation model was pitched and a reluctant libertarian found his first love: the carbon tax. 

Allow me to recount the crux of the steamiest evening of my life.

Factory Next Door: How Economics Makes the Case

Imagine, dear reader, a factory next door. It burns coal to make some widgets. Its private cost curve consists of coal, labor, and machinery. But outside this private ledger lies a hidden social cost: the soot coating your balcony, the smog in your lungs (Delhiites, catch my drift), the (not so) subtle acceleration of climate change. These are negative externalities (NEs) - the classic market failure economists wax poetic about. 

To wit, here is Sahir Ludhianvi (and yours truly in red) with a sher (couplet) on NEs:

“Main zindagi ka saath nibhata chala gaya, 

Har fikr ko dhuen mein udaata chala gaya, 

Fikr toh meri thi magar, dhuan doosre ke aangan mein udaata chala gaya.”

Translation:

“Whatever life offered me I willingly embraced,

Every worry that came by was smoked out in a blaze,

The worry was mine, but the smoke in others' gaze.” 

Sorry, Sahir Sahib - forgive me for I have sinned.

ANYWAYS

In a purely private market, the factory produces widgets at a quantity where its marginal private cost (MPC, or the cost of producing one more unit) equals its marginal private benefit (MPB, or the price it gets for selling that unit), all while ignoring the social damage (that is, the NE) its smoke imposes.

The result? Overproduction, overpollution, and steadily worse air quality for you and your future generations because in this setup, the cost of smoke is effectively zero for the factory.

Economists call this missing piece behind the overproduction the marginal external damage (MED). Add MPC and MED, and you get the marginal social cost (MSC):

MSC = MPC + MED.

Without intervention, the factory produces where MPB = MPC, leading to overproduction relative to the socially optimal level where marginal social benefit (MSB) equals marginal social cost (MSC). MSB reflects the total benefit to society from one more unit, which in this case is just the private benefit because there are no positive externalities.

Suddenly, the private cost curve rises to match the social cost, and voilà: the factory internalizes the NEs. Production declines, emissions fall, and society gains. The deadweight loss from unpriced pollution evaporates like soot in a Delhi monsoon… sort of… temporarily… for a few days… what happened to you, my beloved city… *tears*... moving on.

Pigouvian Tax vs Ordinary Tax

But here comes Lucifer’s perennial gripe: “Taxes punish success!” While this may be true to some extent for ordinary income or corporate taxes, Pigouvian taxes, by contrast, do not punish productive activity! 

In fact, they correct a pre-existing distortion. An example of what economists call a ‘market failure’. The factory is no longer ‘successful’ at harming others for free; it is paying the true cost of its actions. A Pigouvian tax, such as a carbon tax, restores market efficiency, if you will. I can picture all of you Lucifers out there shuddering. Well, wait…

In fact, a carbon tax goes much further - it protects private property and stops the coercion of polluters from socialising the cost of their private pollution. Carbon pricing internalizes costs while preserving choice: the factory can pollute less, innovate, or pay - all free choices in an (un)free world. Here’s a HELL YEAH to Rand.

There are many amazing corollaries that follow from this set up, including an expansion of clean innovation vis-à-vis dirty innovation. Do remember to check out my archnemesis’s amazing piece on the subject that will come out on 20th January, 2026.

Revenue Recycling: The Double Dividend

Moreover, a carbon tax can achieve the fabled double dividend (one stone, two birds you know):

1. Environmental dividend: Pollution is priced and reduced; society’s welfare rises.
   
2. Fiscal dividend: Revenue can reduce distortionary taxes elsewhere, be returned (recycled) to citizens as a dividend, or be spent on other services.

Two concrete schemes illustrate the latter:

1. Per-capita dividend: Every citizen receives an equal share of the carbon tax revenue. Transparent and simple, but not progressive enough.
2. Targeted transfers: Low-income households or vulnerable groups receive additional support to offset regressivity. More just, requires greater administration, but potentially more politically palatable.

Both these schemes preserve the polluter-pays principle and maintain market incentives for emission reduction and optimal quantity production per the Pigouvian mechanism described above.

In fact, carbon taxes flip the conventional libertarian critique on its head. Firms that reduce emissions innovate, increase efficiency, and as a result, pay less tax. Success is rewarded and  punishment - in the form of declining revenues due to a higher relative price -  is meted out through market mechanisms. Lucifer reluctantly admits: incentives are aligned with rational self-interest. I am gleeful. 

Competitiveness and Leakage

Lucifer sharpens his knife and bounces back with a googly: firms could simply relocate to a different jurisdiction without such taxes, and we would continue to have many of the same non-local externalities from this pollution (e.g., climate change). 

This is a common problem formally known as carbon leakage, Lucifer. And don’t you worry because economics has solutions for it:

1. Border carbon adjustments (BCA) coupled with targeted relief: Imported goods face equivalent carbon pricing; domestic firms stay competitive; global emissions fall. The EU, for instance, has done exactly this.

However, it is worth pointing out that this works best for inwardly-oriented domestic firms. For exporters, a carbon tax could make them uncompetitive in the global market, unless a dividend of some sort helps them out to restore competitiveness. 

But even then, there’s another kerfuffle: if BCAs only apply to a narrow set of sectors, emissions may simply shift to downstream industries that use the taxed inputs but are themselves exempt. In other words, unless the BCA’s coverage is broad enough to include major downstream users, the pollution doesn’t disappear but just moves along the value chain. So yes, we need more sectors to be covered under the BCA and the problem solves itself. More government to enable lesser market distortion, if you will. Stop sniffing back those tears, Lucifer.

For the nerds amongst us, here is a paper that shall satiate you.

2. Phase-in schedules: High-emission industries adjust gradually; innovation is rewarded; employment shocks minimized. 

In all cases, the market signal (the price of carbon) remains clear. Pollution is costly, innovation is incentivized, and overall efficiency rises. Seems like God’s hands at work; OR did someone whisper “the invisible hand”.

Yes, Lucifer is just bawling now.

Political Acceptability

Let us return to reality. Even the most cerebral Pigou-inspired policy must survive the political economy. Carbon taxes pass with flying colors IN THEORY but remain somewhat politically fragile across a couple of the following dimensions (they have been dropped in Canada, for example):

1. Transparency: The price of carbon is visible and predictable. It is derived through exhaustive scientific and economic analysis. Yet, political (read: ideological) choices in a few technical ‘assumptions’ that feed into Integrated Assessment Models (IAMs) can yield a price that fluctuates from USD 1,367 per ton to USD 0 per ton. My dear friend Charlie explained some of these mechanics in his brilliant piece.
2. Revenue neutrality: Dividends or tax reductions, IF correctly designed, reduce perceived coercion and any implied regressivity. But that is as big an IF as any…see what the DC nerds have to say about this. 
3. Simplicity: One price signal beats sector-specific (over)regulation. You need little else if the price of carbon is endogenized across supply chains and consumption baskets.
4. Efficiency: It measurably reduces emissions and affects the direction of innovation, as described above.

In short: a carbon tax is one of the few taxes that should have a theoretical appeal to both libertarians and social democrats alike. After all, it is like capitalism cleaning up after itself. 

But challenges (read: opportunities) related to political communication and technical chops to reduce regressivity and target transfers/dividends appropriately remain. Maybe a libertarian-green-socialist combine is in the offing???

Conclusion: A Libertarian First Love

A bit of life returned to Lucifer as I uttered words in praise of capitalism and acknowledged the everyday failures of the political process. Though, he was ill-at-ease, for I had made him fall in love with a tax. With much effort, he enunciated the following in appreciation of a Pigouvian carbon tax:

• Prices harm rather than seize wealth
  
• Rewards low-carbon/clean innovation appropriately
  
• Restores market efficiency and prevents coercion by polluters
  
• Returns money transparently in the hands of consumers when designed right.

I was in shock. Still am. Perhaps, all is not lost after all. A Green Party in India could finally unite the left and the right. What a day that would be!