WEEKEND READ: Carbon neutral borders

The European Union is leading the effort to tackle climate change. The European Commission has committed to cutting carbon emissions by 20 per cent by 2020 and by 30 per cent if other regions match their commitment. European business, however, is worried that leading on climate change means lagging on competitiveness, unless other nations follow suit.

These concerns have led to calls for tariffs and export subsidies to offset any competitive disadvantage. The proposed border tax adjustments would involve tariffs and subsidies based on the carbon content of products. Carbon-motivated adjustment could be an integral part of a multilaterally negotiated climate change regime, unilaterally declared commitments, or simply follow on after an initial negotiation.

Current thinking in global environmental policy circles suggests that border tax adjustments would likely form part of a new environmental regime. They might emerge from Copenhagen in 2009 as part of the post-Kyoto world/UNFCCC post-Bali process, and are also currently under discussion in the European Union and United States.

But would the offsetting tariffs and subsidies change nations' competitiveness? Simple economic logic – logic that has been accepted by US and EU policymakers in the past – suggests that the answer is "No”.

While the carbon motive is new, calls for competitiveness-linked border tax adjustments are not. The present debate has overlooked older analytical literature that is highly relevant to today – and it suggests that border tax adjustments may have little effect on trade and related economic activity.

The issues last arose following the EU-wide adoption of the Value Added Tax (VAT) in the early 1960s. The VAT system adopted the so-called destination principle, which allowed nations to set different VAT rates, but implemented offsets at the border to level the playing field for producers. When a EU-made product is exported from a EU nation, the VAT paid by the producer is rebated; the importing nation's VAT rate is imposed as the goods enter the country.

US business initially viewed this approach as giving EU business an advantage. The argument was that both EU and US exports to the EU had to pay the importing nation's VAT, but the Americans did not enjoy the VAT rebate that EU producers did.

This line of argument from the policy community was, however, countered by academic literature at the time. The basic idea is that a broadly based tax is offset by general equilibrium adjustments of wages, prices, and/or exchange rates, so national differences in broadly based taxes do not affect businesses competitiveness. In the VAT literature, this is called the "equivalence theorem”, that shows VAT based on the "origin principle” (where nations do not offset VAT differences at the border) and the "destination principle” (where they do) lead to the same equilibrium outcome.

This analytical argument caused a shift in US policy, which had previously been pushing for a negotiation on border tax adjustments as part of the then-emerging Tokyo Round in the GATT. Since those days, the border tax adjustment issue has not been forcefully raised in any policy debate.

Essentially the same arguments apply to today's carbon-motivated border tax adjustments. The impact of border tax adjustments on trade and competitiveness does not depend on the motivation for the adjustment. The same equivalence logic applies to differential labour standards, government-provided health care, or climate change policies. If the taxes accompanying carbon emissions reductions are broadly based, the discussion of earlier years still applies. There will be a price level effect as well as a relative price effect, and the price level effect will have no real effects on trade flows or domestic industry.

Of course, a carbon-motivated tax adjustment will also create variance in tax rates across industries, which may not be neutral like the price level effect that occurs across all industries. However, even in cases involving product- or sector-specific tax adjustments, one can again produce neutrality propositions for the tax basis change if there is sufficient sector-specificity in inputs. Rediscovering the older literature on border tax adjustment would aid in clearly articulating their likely effects.

Recent discussions of carbon-motivated border tax adjustments have largely neglected the impacts of these measures. Instead, they have focused on:

– Whether such measures are WTO compatible.

– Whether countries embarking on stricter climate policies will shift from consumption of domestically produced carbon-containing goods to cheaper carbon-intensive imports from regions without comparable climate change policies (so-called "leakage”).

– Whether they would spur the offshoring of carbon-intensive production to such regions.

Border tax adjustments are seen as creating certainty in a world of unequal cross-country carbon prices for those investing in emissions reduction initiatives.

There is much discussion of the need to offset the competitive disadvantages that would be associated with commitments on carbon emissions reductions – legislation is pending in both Europe and the United States. Those discussions have neglected the lessons of the older literature on border tax adjustments. Such measures may be neutral, so it is crucial to separate the price level and relative price effects when assessing their impacts. Their potential price level effects may have little to no impact on trade flows and not offset any leakage.

Tax adjustments that appear to offset the competitiveness effects of environmental policies may not. Indeed, the seeming relative price effects themselves may not even have an impact on trading patterns if there is sufficient specificity in the production technology. If there are rents present, either in sector-specific wage rates or through specific factors that would absorb the effects of the tax change, there would be no effect on trade. Those working to formulate trade-sensitive climate change policies should heed the lessons learned decades ago by those formulating tax policies in a globalised world.

Ben Lockwood is Professor of Economics at Warwick University. John Whalley is Professor and William G. Davis Chair in International Trade, Department of Economics, University of Western Ontario

Originally published on www.VoxEU.org. Reproduced with permission.