India has set ambitious climate targets, including a 45% reduction in the emissions intensity of its gross domestic product (GDP) by 2030 (from 2005 levels) and achieving net-zero emissions by 2070. Achieving these targets will require policy intervention, including the introduction of carbon pricing mechanisms to incentivize businesses and households to reduce their emissions. This study evaluates the introduction of a theoretical carbon tax in India and assesses how to balance economic growth, equity considerations and emissions reductions. The carbon tax framework proposed in this study is a potential alternative to the Carbon Credit Trading Scheme (CCTS) that will soon be implemented in India. This study uses the CSEP Environmentally Extended Social Accounting Matrix (ESAM) for India 2019-2020 to assess the impacts of the proposed carbon tax on the economy, consumption inequality and the role of revenue recycling in facilitating a just transition.
Carbon pricing is a key policy tool to reduce greenhouse gas (GHG) emissions. The three main approaches – CCTS, Emissions Trading Scheme (ETS), and carbon tax – differ in their mechanisms, coverage, impact on emissions reduction, and other parameters. India has opted to implement CCTS, a carbon pricing mechanism based on emissions intensity. On the other hand, the ETS sets a fixed limit on total emissions and distributes or sells allowances accordingly. The carbon tax, which is the focus of this study, imposes a fixed fee per unit of emissions.
Each of these mechanisms has different characteristics that may make it more suitable for a given context. A carbon tax provides price certainty in emissions, but not the quantity of emissions reductions and revenue generation, which can, in turn, be used to address the distributional effects of climate-financing requirements and achieve explicit compatibility with international carbon markets. While the CCTS may not necessarily be able to provide revenue and, as an emissions-intensity-based mechanism, does not align well with international markets, it brings several advantages to the Indian context. It syncs better with existing domestic plans, provides greater flexibility to industries that need to grow to meet demand, and can be adjusted to meet the needs of a particular sector. The ETS has a well-established history in the European Union (EU) context and has also been proven to generate revenue when permits are auctioned; However, it took almost a decade for the European Union Emissions Trading System (EU-ETS) to mature and generate these revenues. If the ETS is adopted, it will be compatible with the European Union Carbon Border Adjustment Mechanism (EU-CBAM) framework.
CSEP ESAM is a macroeconomic framework of the Indian economy (Chadha, Shivamani, and Verma, 2023). It includes 45 production sectors, 80 household categories and 318 categories of labour, as well as other economic agents (government, institutions, capital account and rest of the world account) to meet the circular flow of the economy. It includes environmental (pollution) accounts with data on GHG emissions by sector and households, allowing the impact of a carbon tax on emissions to be assessed. The model captures inter-industry relationships (input-output relationships) and income flows, making it possible to analyze how the carbon tax is spread through output, income/employment, expenditure and emissions. A limitation of the study is that it is based on the Leontief assumption of fixed cost structures, which also does not take into account behavioral responses to price changes.
For this study, a carbon tax is applied to eight emissions-intensive (EI) sectors selected corresponding to the sectors covered by the CCTS. These eight major emitting industrial sectors in CSEP ESAM – aluminum, cement, fertilizer, iron and steel, paper and pulp, textiles, combustible petroleum products, and non-combustible petroleum products – account for about 27% of manufacturing output, 22% of manufacturing gross value added (GVA), 19% of industrial employment, and about 80% of direct manufacturing carbon dioxide (CO₂) emissions. The hypothetical carbon tax is imposed at three rates ( 1,700, 2,150, and 2,600 per tonne of CO₂ emissions), reflecting a low to medium carbon price level for emerging market economies (EMEs) in line with the International Monetary Fund (IMF) suggestion. The tax also applies to emissions from the production and use of coal-fired electricity in these sectors, ensuring that downstream industries face higher costs commensurate with the carbon content of their inputs.
In this study, two scenarios are examined: (1) carbon tax alone, where all new carbon tax revenue accrues to the government and is used to reduce the fiscal deficit, and (2) carbon tax with revenue recycling, where a portion of the revenue is recycled back to households through direct benefit transfers (DBT). Revenue recycling is designed through DBT for households in the bottom 50% of the consumption expenditure distribution in both rural and urban areas and across all social groups. The volume of transfers to each household group is equal to the reduction in their consumption due to the carbon tax, effectively compensating poor households for the carbon tax-induced higher prices in the economy. This design ensures that approximately 57% of India’s population, including the most vulnerable groups, receives compensation. India’s existing DBT infrastructure facilitated and delivered 182 crore transactions 2.23 lakh crore in 2024-2025, indicating that such large-scale targeted transfers are administratively feasible.
Implications of carbon tax
- Emissions and Climate Targets:
Even a moderate carbon tax implemented on selected sectors contributes to emissions reductions. The reduction in total CO2 emissions from the economy relative to the baseline ranges from 1.02%–1.55%, with higher tax rates achieving larger reductions. Emissions from targeted EI sectors declined by an even larger margin (1.49%–2.27%), reflecting the direct impact of the tax. These are notable effects, given that the tax only covers part of industrial sectors and uses nominal rates for emerging market economies. In the context of India’s climate pledges, a carbon tax could reduce GDP emissions intensity by 0.8%-1.2%, in addition to the approximately 37% reduction already achieved since 2005. - Gross Domestic Product and Growth:
A carbon tax has a modest impact on economic output. Due to the tax, GDP is estimated to be about 0.22%-0.33% below the baseline. This marginal contraction reflects a slight reduction in production and consumption due to higher costs. The impact is relatively small in magnitude, suggesting that gradually phasing out a carefully designed carbon tax need not derail India’s economic trajectory. - Fiscal Results:
One of the major benefits of introducing a carbon tax is the generation of government revenue. But 2,150/tCO2 rate, the carbon tax yields roughly Rs 1.27 lakh crore in the first year, thereby significantly improving India’s fiscal position. In the carbon tax only scenario, the fiscal deficit-to-GDP ratio decreases from the baseline of 5.01% to about 4.40%. With the revenue recycling case, the deficit still improved, albeit to a lesser extent (about 4.57%). The revenue thus creates much-needed fiscal space that can help finance climate action and other development activities. - Area-Specific Effects:
A carbon tax increases production costs for carbon-intensive industries, leading to modest reductions in their production and emissions. Notably, the mining sector is witnessing lower activity due to lower demand for coal and minerals from taxed industries such as steel and cement. However, services and low-emission manufacturing sectors remain largely unaffected in the short term. - Employment and Income:
Across all sectors of the economy, total employment is projected to decline by 0.95%–1.44% in the carbon tax scenario, with the largest losses occurring in secondary (manufacturing) sectors. Rural employment has been more adversely affected than urban, reflecting the concentration of industrial and mining jobs in rural areas. However, revenue recycling through DBT helps offset these job losses, especially in the primary sector (for example, agriculture), as the transfers increase rural household consumption. With DBT, total job loss reduces to 0.67%-1.01%. - Household Consumption and Inequality:
The carbon tax alone slightly increases consumption inequality, as poor households spend a larger share of their income on primary and secondary sector goods. The national Gini coefficient increases modestly in the case of a carbon tax, with rural areas being more affected due to higher consumption of energy-intensive goods. However, with revenue recycling, inequality falls below baseline levels, especially in rural areas, thus demonstrating that targeted transfers can protect vulnerable groups and stimulate the economy without undermining the environmental goals of the tax.
International experiences reinforce that well-designed environmental taxes can be conducive to equity and growth. Brazil invested oil royalty revenues in health and education, which helped reduce regional disparities. Ireland and Canada have implemented carbon taxes with revenue recycled to support vulnerable households. India’s reforms in removing fuel subsidies between 2010 and 2017 demonstrate that environmentally harmful subsidies can be phased out and redirected toward cleaner alternatives with public health and financial benefits. These experiences underline the need for transparent, equitable use of environmental revenues.
Based on this study, the following policy changes are proposed to help India meet its climate, development and equity goals.
- Adopt a moderate, phased-in carbon tax: Introduce carbon pricing at modest starting rates in key emissions sectors, while balancing climate goals with economic growth needs. This could start in line with the CCTS framework and gradually expand over time.
- Apply revenue recycling for equity: A significant portion of carbon tax revenues could be used to fund DBT to vulnerable households, reducing regressiveness and promoting inclusive consumption. A carbon price coupled with job security will help achieve a more just transition, especially in fossil fuel-dependent sectors.
- Join the broader EFR strategy: rationalize fossil-fuel subsidies, strengthen monitoring, reporting, and verification (MRV) systems, and integrate environmental targets into fiscal policy at the national and subnational level.
India’s climate response can be fiscally prudent and socially equitable if it combines moderate carbon pricing with redistribution and reinvestment of revenues. This integrated approach is in line with India’s twin imperatives of growth and decarbonization.
This paper can be accessed Here,
This paper is written by Rajesh Chaddha, Senior Fellow, Ganesh Shivmani, Associate Fellow and Rajat Verma, CSEP, New Delhi.
