A carbon tax is a tax on emissions of greenhouse gases, usually carbon dioxide. The tax is designed as a financial means of controlling and limiting such emissions. It is based on the scientific theory that excess levels of such gases are trapped in the Earth's atmosphere, which can lead to an unwanted temperature rise.
From a purely economic basis, a carbon tax is designed to account for the social cost of such emissions. This social cost is an attempt to set a financial figure to reflect the damage borne by society which is not accounted for when companies set the prices of their goods and services. In practice, such a figure can only be an estimate, while setting tax levels also has to incorporate political concerns.
In some cases, a carbon tax is applied on all emissions. In others, companies are given a limit and then pay a tax on all emissions above this level. Such limits can be gradually reduced each year so that companies have more time to change their production techniques.
As with other taxes designed to influence behavior, a carbon tax cannot be relied on as a revenue raising measure. At first glance it may seem logical to argue that a carbon tax is doubly effective, as it can cut emissions while raising money for spending on environmental projects. In practice, this can't work both ways: if the tax achieves its stated goal of reducing emissions, the amount of revenue raised will fall or even reach zero.
One of the main drawbacks of a carbon tax system is that it is imposed as a national measure attempting to solve an international problem. There is a risk that firms which run the risk of paying higher taxes will relocate to other countries which have lower taxes or even no environmentally-related taxes at all. In this situation, a national government may impose duties on imports from that country to make up the shortfall.
The most common alternative to a carbon tax is a cap and trade scheme. Under this system, companies are given a designated level of emissions which they can produce each year. Those which have emission levels lower than their target earn credits. They can then sell these credits to other firms, which is the only way those firms are legally allowed to exceed their own target levels. The idea is that the system forces the "cost" of emissions to be built into the production process.