Does a Carbon Tax need a “Border Tax Adjustment”?

Posted by Kathy Baylis on Dec 4, 2009

Filed Under (Environmental Policy)

When our colleague Don Fullerton was in Brussels this week speaking at a conference on climate change, he voiced support for border adjustments for carbon policies. This idea was promptly rebuffed with cries of ‘protectionism’, particularly from the business participants. Now, a border adjustment is just a friendly way of saying ‘an import tariff,’ so it’s understandable that people might see them as a harbinger of protectionism. Like most trade economists, I’ve seen many examples of trade policies that were reputedly intended to ‘level the playing field’, e.g. countervailing duties and anti-dumping tariffs, promptly get co-opted and used as a means to protect the loudest domestic industries, so I am sympathetic to this concern. That said, I think there are a number of compelling arguments for introducing some border controls along with a stringent domestic carbon policy.

Think of a carbon tax or cap-and trade system like a Value-Added Tax (or VAT), where border-adjustments are common. Most countries that tax the value-added in production of each good also tax imported goods at the same rate. They do this to ensure that imported goods aren’t given an unfair advantage over the taxed goods produced domestically. The same logic applies to a carbon tax, or a cap-and-trade system on emissions. The idea is that we would like to tax imports at an equivalent rate as domestic production. Thus, we would impose a tax based on the average carbon content of the equivalent domestic product. This approach conforms with the WTO rule of equivalence – that a country doesn’t favor its own producers over producers in another country.

Is designing a border adjustment going to be harder to do for carbon than for a VAT? Definitely, because carbon content is harder to measure than value-added, which is just a price. It also means using domestic carbon content as a proxy for the carbon content in imported goods, which is not going to be accurate. The problem is that the alternative is trying to estimate specific carbon content for all imports, which is not only impossible, but also generates the potential for problems with the WTO.

Now you might well be thinking, you’re suggesting imposing an imperfect, potentially arbitrary tariff on billions of dollars of imports. How can this be a good thing? Let me walk through a few arguments.

1) If you don’t have a border adjustment, other countries have an incentive not to sign on to an international carbon agreement. By imposing a carbon policy domestically, we are raising the marginal cost of production inside the United States, so it gives firms the incentive to move to a lower-cost location as long as they continue to have access to the US domestic market. From the perspective of, say, Indonesia, a US carbon policy might make the US look quite tempting as a potential market. And the last thing they want to do is to get rid of this advantage by imposing a carbon policy themselves.

2) In contrast, a border adjustment means that a country like the US or Europe does not have to wait for an international climate agreement before implementing a carbon policy. In short, because it neutralizes the potential negative trade effects of a carbon policy, it becomes easier for a country to ‘go it alone’ and not have to wait for other developed and developing countries to sign on to a Kyoto-like agreement.

3) Similarly, if you do have a border adjustment, it can be used as an incentive to get other nations to implement a carbon policy, particularly developing countries with a large export base. Only those countries without a carbon policy would be subject to a border adjustment, and the revenue from the border adjustment accrues to the importing country. So an exporting country faces the choice of letting their firms pay the tariff to someone else, or collecting that revenue themselves in the form of a carbon tax or (auctioned) cap and trade permits. So even if the border adjustment is imperfect, one can hope it’s temporary.

I can see my trade colleagues wincing at their computer screens while they read this. Yes, we have had loads of trade measures that were supposed to be temporary that ended up becoming enshrined by the interests that they benefit. So my last argument is for them.

4) Without a border adjustment, import-competing industries will demand special treatment in the form of free permits, or, of more concern, outright exemptions from the carbon policy. Why do I claim this? We’ve seen it in Europe. Under the European Trading System for carbon, each country was allowed to exempt certain industries from the cap-and-trade system, and they particularly targeted those firms in ‘trade-sensitive’ industries. Along with generating concerns about environmental efficiency, such exemptions generate potentially large economic inefficiencies domestically and are incredibly arbitrary. Thus we tend to see the most politically-sensitive industries often identified as the most ‘trade-sensitive’. At least a border adjustment could be designed to be neutral across domestic industries, reducing the potential gains for firms in politically-powerful positions. As an aside, note that industry-specific subsidies could include exemptions to costly general environmental regulations and are subject to countervailing duties (CVD). Thus, I wonder if we might see such exemptions generating a cascade of CVD cases.

OK, I always find it frustrating when people from other disciplines pretend to be economists, so let me be clear that I’m not in any way a trade lawyer, so I can’t speak convincingly on the trade legality of these ideas. That said, we know that border adjustments for VATs are allowed under the WTO. You might also be concerned, however, that any border adjustment policy might spark a trade war, which our anemic global economy certainly does not need. In response, let me note that when the Uruguay round of the GATT was concluded, countries signed on to a ‘peace clause,’ where they agreed not to take trade actions against their fellow countries on agricultural subsidies as long as those subsidies conformed to the Agreement on Agriculture. To facilitate carbon policy, I wonder if there might be the potential to negotiate a similar peace clause for environmental subsidies and/or border adjustments as long as those border adjustments conform to some internationally-agreed upon rules. For example, these rules might try to ensure that countries treat importers no differently than they treat their domestic industries, and that the border adjustments be transparent and apply equally across industries.

In conclusion, border adjustments might help make domestic carbon policy both more palatable and more efficient, and could, in fact, be less harmful to free trade than allowing one-off industry exemptions.

One Response to “Does a Carbon Tax need a “Border Tax Adjustment”?”

  • Jem Cooper says:

    I have a simpler, better way of maintaining a level playing field while reducing emissions cost effectively.

    In essence fuel producers would be obliged to contract for the capture of a quantity of carbon dioxide equal to a proportion of that produced when their fuel is burnt. The proportion would start at a few percent and build up over the years. Naturally this would raise the price of fuel encouraging energy saving, nuclear, renewables etc.

    For details on how it works, what it costs and why all nations would join in see my blog.