We welcome the opportunity to reply to “The Carbon-Added Tax: A CAT That Won’t Hunt,” Charles E. McLure Jr.’s Policy Options October 2010 critique of our March 2008 Policy Options article (“Climate Change: The Case for a Carbon Tariff/Tax”). While McLure objects to many aspects of our analysis, his principal objections would appear to be that the quantification of carbon footprints necessary for the successful implementation of a carbon-added tax (“CAT”) — indeed, of any carbon tax other than the “upstream” tax he proposes — is virtually impossible, and that the border adjustments necessary to achieve the destination basis of taxation we propose would almost certainly be unacceptable to the World Trade Organisation and the General Agreement on Trade and Tariffs. With the alternative of an administratively simple upstream tax on fossil fuels available, McLure concludes that, even if a CAT were feasible, which he doubts — “this CAT won’t hunt,” — there is no reason to pursue what he considers an impractical approach to combatting climate changing greenhouse gas (GHG) emissions.
Our response to McLure proceeds along three principal lines. First, we reassert the heuristic virtue of a CAT as an ideal conceptual yardstick or standard against which all approaches to carbon pricing may be assessed. Measured against such a standard, for example, it is evident that the conceptual underpinnings of the Kyoto Protocol were seriously flawed. Similarly, Stephane Dion’s “Green Shift” deserved its eventual fate because it ignored the level-playing-field characteristics that are central to a CAT. Thus, while we acknowledge McLure’s witty adaptation of President Lyndon Johnson’s “that dog won’t hunt,” we believe that, in his rush to dismiss the CAT as an operational device, he fails to appreciate its theoretical value as an exemplar of what a carbon-pricing or carbon-taxing system should be. We return to this argument below.
The second thrust of our response has to do with the CAT’s potential as an operational approach to carbon pricing. Clearly, the present state of knowledge concerning the carbon footprints of most commodities is sadly lacking, and so constitutes an unsatisfactory foundation for a broad-based system of carbon taxes. This is certainly true at the national level and, a fortiori, internationally. As McLure rightly points out, a prerequisite of any effective tax system is a determinable and measurable tax base. We do not accept, however, his implicit assumption that the present lack of knowledge of carbon footprints will persist, particularly if, as we believe the seriousness of the climate-change threat warrants, the vast majority of trading nations are forced to adopt effective carbon pricing schemes. Even now, without such international pressure, substantial progress is being made. For example, the voluntary Carbon Disclosure Project, launched in 2000, has enlisted some 2,500 organizations — including many of the largest corporations — in some 60 countries around the globe to measure and disclose their GHG emissions and climate-change strategies in order that they can set reduction targets and make performance improvements. The imputation of such emissions to individual products will never be easy, and carbon values are unlikely ever to be as readily observable as monetary values. Nonetheless, we are optimistic that substantial progress is possible, even if the best that may be accomplished for some time will be will be a system of carbon taxation that assigns taxable goods and services into a limited number of tax categories depending on their approximate carbon footprints. As McLure concedes, some such ad hoc approach would be necessary even if relief were provided for the carbon tax that would be embedded in exports under his upstream fuel tax. For example, energy-intensive products would embody not only the energy required for their production, but also the associated upstream tax. If exporters of such products are not to be placed at a competitive disadvantage, some means would have to be found to rebate or credit this tax. Without the CAT’s apparatus for requiring the identification of carbon footprints, the adjustment to provide relief for the upstream tax would necessarily be ad hoc.
The third and final line of defence we would offer is somewhat related to the second. In our original article, we argued that carbon taxation should be levied on a destination basis, which is the international norm for value added taxation (VAT). This would result in the carbon tax — CAT or otherwise — being imposed on imports at the point of entry, with tax credits provided for exports, to relieve them of their domestic carbon levy. The result would thus be to tax carbon where the related products are consumed, rather than where they originate; i.e., to tax them on a destination basis. McLure makes much of the difficulties that the “border adjustments” (to impose a carbon levy on imports and relieve exports) are likely to encounter under the WTO and GATT. In particular, he suggests that border adjustments for imports are likely to be either inadmissible or permitted only if applied assuming either the best available technology or the predominant method of production in the importing country, both of which would weaken the importing country’s ability to impose a suitable carbon levy on imports from carbon-intensive sources.
We acknowledge the considerable uncertainty beclouding the likely disposition under the WTO and the GATT of the border adjustments necessary to make carbon taxation effective — indeed, even politically possible — in a world in which many trading countries may choose not to adopt carbon levies or carbon pricing. After all, the problems associated with combatting global warming were virtually unknown when the GATT and WTO institutions and practices were established.
First, we reassert the heuristic virtue of a CAT as an ideal conceptual yardstick or standard against which all approaches to carbon pricing may be assessed. Measured against such a standard, for example, it is evident that the conceptual underpinnings of the Kyoto Protocol were seriously flawed.
Similarly, Stephane Dion’s “Green Shift” deserved its eventual fate because it ignored the level-playing-field characteristics that are central to a CAT.
We are not, however, as pessimistic as McLure’s concerning the likely disposition of the border adjustments on which destination-based carbon taxation would depend. Indeed, we are of the view that, should the WTO rule against such adjustments, it would find itself under considerable pressure to adapt to the new reality in which global warming is the major international problem to be resolved, even if this requires sacrificing some of the trading practices that have served us well in the postwar period. It would, for example, be patently absurd and perverse in a world concerned over global warming to shelter the carbon intensive exports of countries doing nothing about the problem by requiring that the border tax adjustments of importing nations be applied as if the carbon-laden imports had been produced by the best available (carbon-reducing) technology or their own preponderant (low-carbon) method of production. In such circumstances, the choice facing the WTO and the GATT will be to adapt to this new imperative of combating climate change or risk becoming irrelevant. Any effective action to combat global climate change will require concerted action on the part of many nations, and this must be accompanied by the border adjustments essential to prevent “carbon leakage”; i.e., the loss of carbon-intensive production or processes to states not participating in the efforts to combat climate change, with the result that global emissions are merely relocated, rather than reduced. This, we would suggest, is the “bigger picture” that McLure is missing.
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Before closing, we would note that it was the defects of the Kyoto framework that served to highlight for us the virtues of the CAT. While far from exhaustive, these defects included the following:
- Of the 175 countries that ratified Kyoto, only 37 developed countries were assigned emissions targets, the remaining countries having no obligation save that of monitoring and reporting their emissions. Hence these 37 countries were required to put their economies at a competitive disadvantage vis-à-vis the rest of the world.
- With the BRIC countries (Brazil, Russia, India and China) effectively exempt from commitments, it would be only a matter of time before the carbon tipping point would be reached. In other words, Kyoto did not, and could not, guarantee success in controlling emissions.
- Kyoto built in incentives for countries controlling their emissions to shift carbon-intensive production elsewhere in order to avoid the carbon price/tax. In the environmental vocabular. Not only could Kyoto not prevent “carbon leakage,” it positively encouraged it.
- Kyoto assigns the carbon footprints of resources primarily to where they are extracted, rather than to where they are utilized or consumed. This is inappropriate, since it means that countries like Japan and the United Kingdom, that are heavily dependent on imported resources appear to be environmentally benign, while in fact their economic activity has a very substantial carbon footprint.
- Since the Kyoto Protocol focuses on countries and not on carbon footprints, it ignores many forms of carbon emissions because they are not easily attributable to countries. The best example is transportation, in particular bunker-fuel-polluting ocean shipping. This means that under Kyoto, Middle-East oil is, in terms of shipping footprints, as close to the US as is Alberta!
Of the 175 countries that ratified Kyoto, only 37 developed countries were assigned emissions targets, the remaining countries having no obligation save that of monitoring and reporting their emissions. Hence these 37 countries were required to put their economies at a competitive disadvantage vis-à-vis the rest of the world.
At the conceptual level, a CAT correctly addresses all of these challenges. Because a CAT operates like a VAT, at each stage the carbon footprint embodied in the product is taxed and the carbon tax on all inputs is rebated so that only the carbon added at each stage is carried forward. These carbon-added taxes cumulate either 1) until the final stage where the total carbon-added tax is paid by the final purchaser or 2) until the point of export where the cumulated value of the CAT is rebated to the exporter. Given that the CAT is also applied to the carbon footprint on imports at their point of entry, the CAT would be export-import neutral. Not only would this address the Kyoto competitiveness issue, but it would also allow one or more countries to go it alone in terms of carbon pricing. For example, Canada could contemplate going it alone under a CAT, since export rebates and taxing imports would ensure that the CAT would be competitively neutral. Indeed, we now operate a VAT with the US, even though the US does not have a VAT. Analogously, we could operate CAT with the Americans, even if they do not follow suit. Moreover, because a CAT focuses on taxing carbon footprints, it follows naturally that CO2 emissions from shipping, trucking, airline transportation, etc., would be subject to the CAT. Similarly, under a CAT there would no incentive to transfer production elsewhere; i.e., for engaging in activities leading to carbon leakage. Because the CAT is destination based, it is the ultimate consumer who bears the burden of the tax. It would thus appropriately assign the carbon footprints arising from resource extraction and consumption. Given these considerable virtues, it is our view that the CAT can play the same benchmark role in terms of carbon-reduction models as perfect competition does in terms of assessing the role of industrial production models.
We do not for a moment minimize the practical difficulties associated with trying to implement a carbon-added tax or, for that matter, any carbon tax, including the upstream tax that McLure advocates (which, as noted, would have difficulties with the tax embedded in nonfuel exports). These difficulties are formidable. We would hope, however, that they are not insurmountable, particularly if the major developed nations of the world commit to actually doing something effective to combat greenhouse gas emissions.