Experts agree that carbon taxes intended to combat global warming could most efficiently be imposed upstream or midstream in the production-distribu- tion process for fossil fuels. In the case of domestically pro- duced fuels this would be at the mine mouth for coal, at the refinery for petroleum, and at processing plants or pipelines for natural gas. (To simplify exposition, this is hereafter called upstream taxation of fuel.) If fuel imports were taxed, but fuel exports were not, upstream taxation of fuel would produce the same economic effects as taxation of emissions of carbon dioxide (CO2) or a cap-and-trade system, but it would be much simpler. By comparison, Thomas Courchene and John Allan, in the March 2008 issue of Policy Options, have suggested instead the use of a downstream ”œcarbon-added tax” (CAT) patterned after the value-added tax (VAT, known as the goods and services tax or GST in Canada). This apparent anomaly is explained by two words, ”œborder adjustments.”
Under upstream taxation of fossil fuels, taxation of emissions or a cap-and-trade system, non-fuel products would bear the ”œcarbon price” " the carbon tax or the cost of emissions permits " of the nation where they are pro- duced, not that of the nation where they are consumed. (The remainder of this article generally omits references to the economic effects of cap-and-trade systems, which are broadly similar to those of a tax on emissions.) Such ori- gin-based (or production-based) car- bon pricing creates two related risks. First, it places the energy-intensive industries of the nation pricing car- bon at a competitive disadvantage, relative to those of nations lacking policies to reduce emissions. Second, it may encourage ”œcarbon leakage” (exit of energy-intensive activities to such countries), reducing the effec- tiveness of efforts to limit global CO2 emissions.
Border adjustments (BAs) " pric- ing carbon embedded in non-fuel imports and rebating carbon prices embedded in non-fuel exports " have been suggested as a means of overcoming these problems. BAs would convert origin-based carbon prices to destination- or consump- tion-based prices. All nations that employ the VAT provide BAs for their VATs, creating destination-based taxa- tion. In that context BAs are called border tax adjustments (BTAs). In what follows, the term BA refers generically to border adjustments for any form of carbon price; BTAs is reserved for BAs for taxes.
The design and imple- mentation of BAs for car- bon prices is extremely complicated. This is espe- cially true if an effort is made to reflect the carbon content of inputs to exports, as well as carbon added at the export stage. For imports the problem is simply that the carbon content of products cannot be observed from their physical appear- ance and cannot easily be estimated. Whereas most advocates of BAs for car- bon prices probably assume, perhaps implicitly, that ad hoc methods would be used to calculate BAs, Courchene and Allan suggest that a CAT with BTAs on carbon embedded in traded products resembling those for the VAT would offer an attractive alternative.
It is also unclear whether the World Trade Organization (WTO) would find BAs for carbon prices are consistent with the rules that govern international trade, primarily the General Agreement on Tariffs and Trade (GATT) and the Agreement on Subsidies and Countervailing Measures (ASCM). A ruling that they are not would eliminate the case for the CAT. Courchene and Allan suggest, with no supporting analysis, that the BTAs associated with the CAT would be ”œGATT-legal” " shorthand used here to describe compatibility with the GATT and the ASCM. Also, they do not consider limitations that the WTO might place on the methodologies used to calculate BAs for carbon prices, even if it did not declare them illegal.
This article questions the case for the CAT. First, at the most basic level, it argues that because the carbon con- tent of products cannot be observed, the CAT could not truly function like the VAT and it therefore could not be employed to implement BTAs for imports.
Second, BAs should not be applied to trade with other countries that limit carbon emissions; they should be lim- ited to trade with countries that do not limit emissions. Thus limited, BAs " especially those for exports " may not be GATT-legal.
Third, even if the WTO were to find BAs for carbon prices GATT-legal, it might limit them to carbon content calculated using best available technol- ogy or (in the case of imports) the pre- dominant method of production in the importing country. Such a limita- tion would further undermine the case for the CAT and complicate the calcu- lation of BTAs for the CAT.
Finally, it is generally agreed that, for administrative reasons, BAs for car- bon prices should be limited to a rela- tively small number of carbon-intensive basic products.
Because of all these limitations, it would not be cost-effective, even if feasible, to require firms in all sectors to comply with the CAT " or for a government to administer it. In short, the CAT ”œwon’t hunt.” (In the 1960s US President Lyndon Johnson popu- larized the old southern saying ”œThat dog won’t hunt,” meaning that an idea is not a good one and will not work.) Upstream taxation of carbon is preferable, despite requiring the use of ad hoc methods to calculate and administer BTAs.
It must be admitted at the outset that ad hoc methods would share some (but not all) of the problems identified here. The point is simply that the CAT is not a ”œsilver bullet” that can slay the BA dragon.
It may be useful to note before continuing that, in my correspon- dence with him, Courchene says that the CAT ”œis a conceptual frame- work” that I ignore. But the exam- ples he gives (trade neutrality and avoidance of competitive risk, pref- erence for assignment of emissions to the consuming country instead of the country of origin, taxation of emissions from shipping and prefer- ence for destination-based treat- ment of carbon embedded in interprovincial trade in Canada) are arguments for BAs for carbon prices, not for the CAT, per se. Moreover, Courchene and Allan’s statement that ”œthe devil clearly is in the implementation details (and in par- ticular the details relating to the carbon tariff)” makes it clear that these authors do not intend that the CAT be merely a conceptual exer- cise; they intend the CAT to be implemented. Implementation is the topic of this article.
BTAs for the CAT cannot be imple- mented in the same way as those for the VAT.
The CAT’s fatal flaw. In calculating liability of the VAT, a trader multiplies sales times the tax rate to arrive at gross tax liability. Net liability is calcu- lated by subtracting (taking input cred- it for) VAT paid on purchased inputs other than labour, as shown on invoic- es. Courchene and Allan suggest that liability for the CAT could be calculat- ed in the same way, by multiplying the carbon content of sales times the tax rate and allowing credit for CAT paid on purchases (see table 1). The trouble with this methodology is that, unlike the value of sales used to calculate VAT, the carbon content of products cannot be observed, by either the taxpayer or the fiscal authorities. It would be nec- essary either to utilize calculations of the carbon content of sales made out- side the tax system for other reasons (e.g., to help consumers make informed decisions regarding the envi- ronmental impact of their choices) or to specify in the tax system the rules for making such calculations, some- thing that would be far from simple. Neither of these options is attractive, especially given the availability of superior upstream methods of taxing carbon and the limited scope of cost- effective BAs for carbon prices, dis- cussed further below.
Simpler alternatives: domestic car- bon added. Except in the case of process-related emissions, such as those from the production of cement, discussed in the next para- graph, the only way to add carbon is to combust fossil fuels. It would thus be much simpler just to tax purchas- es (or sales) of fossil fuels (including imported fuels) than to implement the CAT. But it would be even sim- pler to adopt an upstream tax (sup- plemented with taxation of fuel imports and exemption from, and rebate of, tax on fuel exports), as such a tax would cover all possible purchases of fuel for domestic use. In either case, ad hoc measures would be needed to provide BTAs for non- fuel imports and exports.
Qualifications: where carbon in does not equal CO2 out. Although it is gen- erally satisfactory to assume a close relationship between the amount of carbon purchased and the amount CO2 emitted, this is not always the case. Certain processes can emit CO2 not related to combustion of fuels. It would thus be necessary to supple- ment an upstream tax on fossil fuels with a tax on process-related emis- sions. But it would not be necessary or cost-effective to utilize the full CAT methodology for this purpose or to extend it to other sectors.
Moreover, that fossil fuel is pur- chased does not necessarily mean that CO2 is emitted. Some carbon is physi- cally incorporated in products such as asphalt, steel and tires, and some CO2 may be captured and stored. In theory the CAT could reflect this, whereas simply taxing fuel would not. But off- sets could be provided, without adopt- ing the CAT methodology. Carbon capture and storage (CCS), empha- sized in Courchene’s correspondence with the author, is likely to make a real difference only in electric genera- tion, plus a few energy-intensive basic industries that combust fuel, rather than relying on electric power, as the production of aluminum does " pre- cisely the same sectors for which ad hoc BAs would be most cost-effective. It would not be cost-effective to impose an economy-wide CAT, merely to reflect the relatively limited effects of CCS; more targeted methods of reflecting CCS would be appropriate.
BTAs for non-fuel exports: the best- case scenario. Under the VAT it is simple to eliminate tax on exports. Exports are ”œzero-rated” (taxed, but at a zero rate) and, as in the case of taxed domestic sales, credit is allowed for tax paid on pur- chased inputs, and refund- ed, if net liability is negative. The same tech- nique could, in principle, be used to implement export BTAs for a CAT. This is the
CAT’s primary administrative advan- tage. But, as explained in the next sec- tion, this theoretical advantage may be more apparent than real.
The unknown carbon content of non- fuel imports: Even if the CAT could be used to implement BTAs for exports, the same is not true for import BTAs, which would ideally be based on the carbon added in the foreign countries where imports originate. It is true that the VAT on imports is also levied on something that occurs abroad: the cre- ation of value. But the value of imports is observable, whereas their carbon content is not. (Ad hoc methods share this problem.)
In the case of the VAT it does not ultimately matter whether imports by VAT-registered traders are valued accu- rately and fully taxed at the border; failure to tax them fully will subse- quently be reflected in concomitantly lower input credits. While the same is true in a formal sense in the case of the CAT, the practical difference is strik- ing. Whereas the value of post-import sales is observable, their carbon con- tent is not. If imports are undertaxed at the border because their carbon con- tent is understated and that under- statement is reflected in the calculation of post-import carbon foot- prints, the undertaxation of imports would not wash out, as it does in the case of the VAT. As a result, CAT paid on imports will not equal the CAT levied on local products (assuming, of ourse, that their carbon content can be accurately determined). Avoiding this would require that calculations of post-import carbon content not be based on the carbon content taxed at the border, something that is possible, but not inevitable.
It is quite possible that the WTO would not approve of any BAs for carbon prices. (Courchene and Allan state that, because the CAT functions like the VAT, it should be GATT-legal. This opinion appears to be based on economic reasoning, rather than a careful reading of the GATT, the ASCM, cases interpreting them or liter- ature commenting thereon.) If BAs for carbon prices were found not to be GATT-legal, the case for the CAT would evaporate, as it relies entirely on the suggestion that it would facilitate BTAs. (See the previous discussion of simpler alternatives.)
The key issue is whether domestic carbon prices and BAs on imports are imposed on ”œlike products.” If carbon prices are found not to be imposed on products, BAs for them are not GATT- legal. Beyond that, if carbon-intensive imports and physically identical ”œclean” domestic products are deemed to be ”œlike,” BAs that reflect the carbon intensity of the former would not be allowed. (The question is whether dif- ferences in ”œprocessing and produc- tion methods,” as manifested in differences in carbon intensity, make products unlike.) These are complicat- ed issues on which experts do not agree and that cannot be reviewed here; they will not be settled until the WTO decides a concrete case, if then.
BAs based on BAT or PMP: general. The WTO might rule that BAs for car- bon prices can be based only on best available technology (BAT) or (in the case of imports) the predominant method of production (PMP). There is no analogous limitation on BTAs for the VAT. Of course, with this limita- tion, if the actual carbon content of a traded product exceeds that under BAT or (for imports) PMP, the CAT embedded in exports would not be eliminated, and imports would not be taxed as heavily as domestic produc- tion. (This is also true of BAs calculat- ed using ad hoc methods.) Contrary to what Courchene and Allan say, destination-based taxation would not be fully achieved.
Implementing export BTAs based on BAT. Implementing export BTAs based on BAT would not be simple. As noted above, zero-rating exports would elim- inate CAT, in effect producing BTAs based on the actual carbon content of exports, not on BAT. It would be neces- sary to modify zero-rating to comply with a BAT limitation on export BAs.
How to do that is not obvious; it prob- ably would not be simple " certainly not as simple as zero-rating and per- haps not as simple as using ad hoc methods to calculate BAs for a limited number of sectors.
Implementing import BTAs based on BAT or PMP: If import BAs were to be limited to BAT or PMP, it would not be satisfactory simply to use one of these methodologies to calculate the amount of CAT to impose at the bor- der and then calculate post-import car- bon footprints based on the actual carbon content of imports (however that might be done), as that would have the effect of negating the reduction in import BTAs implied by BAT or PMP. Because of the way gross liabilities for the CAT are calculated, it would be necessary to utilize the carbon content of imports calculated under the chosen method (BAT or PMP) in calculating post-import carbon footprints for pur- poses of the CAT all the way to the retail level. (In this case the kind of undertaxation described above would be consistent with a BAT or PMP limit on import BAs.) Carbon footprints cal- culated for non-tax reasons are unlike- ly to be based on BAT or PMP.
A mixed system for pricing carbon. Whether one of a nation’s trading partners employs an origin-principle VAT a destination-based VAT, or no VAT at all does not affect the choice of whether to make BTAs for the VAT on trade with that country. (As a practical matter, virtually all VATs are destination-based.) The same is not true of the CAT. It would be inappropriate " and probably not GATT-legal " to apply BTAs to trade with countries that price carbon on an origin basis (or that utilize simi- larly effective origin-based non-price means of reducing emissions), as that would result in no carbon pric- ing of exports and double carbon pricing of imports (or their econom- ic equivalents), a highly distor- tionary result that could not be justified by the raison d’é‚tre of car- bon prices. (Origin-based systems are the only ones currently in use and the only ones likely to be used, aside from mixed systems. The Euro- pean Emission Trading System is the best extant example of an origin- based system.) BAs for carbon prices should be applied only to trade with countries that do not price carbon (or otherwise reduce emissions), pro- ducing a mixed system. That is, only exports to such countries should be zero-rated and only the carbon con- tent of imports from them should be priced. There is nothing analogous under the VAT.
The GATT-legality of export BTAs in a mixed system. However the general issue of GATT-legality is resolved, BTAs for a CAT " or indeed BAs for any car- bon price " levied in the context of a mixed system might not pass muster under the GATT. A mixed system would clearly violate the most- favoured-nation provision, which pro- hibits differential treatment of trade with different members of the WTO. It would be necessary to seek an excep- tion under article XX of the GATT. It is unknown whether, but perhaps not unlikely that, import BAs would be allowed under paragraph (g) of that article, which allows exceptions for measures ”œrelating to the conservation of exhaustible natural resources if such measures are made effective in con- junction with restrictions on domestic production or consumption.” But it is difficult to argue that export BAs fur- ther this objective, as they allow domestic producers to avoid the car- bon price intended to reduce CO2 emissions by exporting. Since, as argued above, the CAT does not facili- tate import BTAs, this more limited decision would, by itself, eliminate the case for the CAT.
R esearch suggests that a carbon price would increase production costs significantly for only about 1 per- cent of economic activity, including aluminum, iron and steel, wood and paper, cement and lime, and chemi- cals, in addition to petroleum prod- ucts. (The list may include more or fewer industries in some countries.) It is thus generally agreed that, for administrative reasons, BAs should be limited to a few carbon- and trade- intensive basic industries, as these are the ones where potential loss of com- petitiveness and carbon leakage are greatest. Under a mixed system BAs should be even more limited " to trade of those sectors with countries that do not have equivalent measures to reduce CO2 emissions. Table 2 sum- marizes these limits. It would not make sense to create a complex econo- my-wide CAT system simply to pro- vide BTAs for this limited portion of international trade. This conclusion is enforced by the fact that embedded carbon does not constitute much of the value of most finished products " and, of course, by the availability of the much simpler system for taxing carbon described in this article.
The CAT would entail high costs of compliance and administration and might produce little benefit. It would not be cost-effective to intro- duce it simply to implement BTAs, even if it were GATT-legal and could achieve that objective, which is not the case for imports. The most efficient way to implement a carbon tax is to impose it upstream. It is true that an upstream carbon tax would not pro- vide the information required to calcu- late BTAs; it should be necessary to calculate BTAs in some other ad hoc way. But that is also true of BTAs on imports under the CAT. Fortunately, BAs would be needed for trade only in a limited number of carbon-intensive basic products that are traded heavily with countries that do not limit CO2 emissions.