The Problem of Carbon Tax Border Adjustments

One of the obvious problems with implementing a carbon tax is that there would be “leakage”—meaning that CO₂-intensive industries would have an incentive to migrate out of taxed jurisdictions into untaxed ones. In a previous post I discussed the issue of leakage directly, but in this post I want to highlight a new Resources for the Future (RFF) study that shows the problems with an alleged solution to leakage—namely, taxing goods at the border coming from unregulated jurisdictions. The RFF authors are not opposed to carbon taxes in principle, or even to the use of “border adjustments” to combat leakage, but they demonstrate that economists have not yet made a convincing case that this is indeed a solution.

Border Adjustments Aren’t a Magic Bullet

Specifically, the RFF study by Kortum and Weisbach analyzes the concept of “border adjustments,” which means a country would place an extra tax on goods coming in from jurisdictions that do not have their own carbon tax, and also which would exempt a country’s own exports from a domestic carbon tax as they left the country. In this way, even if just some governments around the world implement a carbon tax, then they won’t be placing their own industries at a competitive disadvantage vis-à-vis unregulated firms around the world.

However, things are not so easy to fix. Here is the abstract of Kortum and Weisbach’s study:

We consider the economics and the design of border adjustments (BAs) under a carbon tax. BAs are taxes on imports and rebates on exports on the emissions from the production of a good. They are thought to be a method of reducing inefficiencies from a unilateral carbon price, such as shifts in the location of production, known as leakage. After examining the basic economics of BAs, we examine three design issues: which goods BAs should apply to, which emissions from the production of those goods should be taxed, and from and to which countries BAs should apply. We conclude that BAs will impose high administrative costs and need strong welfare justifications. [Emphasis added.]

In the jargon of academic economists, to say that border adjustments “need strong welfare justifications” means that there is a prima facie cast against them, and that the burden of proof is on the proponent of border adjustment taxes to show that their benefits (in terms of reduced leakage) outweigh the high hurdle of administrative costs.

Once again, we see that reality is far messier than the simple picture often pushed by advocates of a carbon tax. For example, remember that they are fond of saying a “carbon tax swap deal” would make the economy more efficient, even though the peer-reviewed research says the opposite. We see here a similar pattern: The immediate response to the problem of leakage is to recommend border adjustments, as if that solves everything. But the in-depth researchers are telling us that this might be a cure worse than the disease, putting us right back where we started.

Why Are Border Adjustments So Costly?

Although in principle it sounds easy to “adjust” things at the border to correct for countries having different levels of carbon taxes, in reality it’s messy. As the authors explain:

Perfect BAs [border adjustments] are not feasible because of the costs of gathering the necessary information. The costs of administering and complying with the system would far exceed the benefits. A wide variety of different goods are imported from many different countries. Supply chains can be complex. A single import may have parts produced in many different countries, using different production methods and fuel sources. Imagine, for example, a customs agent in Los Angeles faced with a cargo boat filled with automobiles of different makes and models. For a given vehicle, the chassis may have been produced in one country, the glass in another, the engine in a fourth, the tires in a fifth, and so forth, and then all of the parts assembled in a final country before export to the United States. Each make and model may have a different supply chain, and the supply chain for a given make and model may vary by year. Determining the embedded emissions would be a massive task.

The design of BAs therefore is about deciding on the compromises necessary to balance the costs of administering the system with the benefits. There are three broad sets of trade-offs: which goods, which emissions, and from which countries. [Emphasis added.]

Much of the RFF study is then devoted to analyzing these three tradeoffs. But the important takeaway for our purposes is the recognition that determining “embedded emissions” will at best be a crude approximation.

Counterintuitive Results

The RFF study does not so much come down against the use of border adjustments to mitigate the problem of “leakage,” but rather the authors are pointing out that economists have not yet fully recognized just how complicated the problems are. “Intuitive” results may in fact be wrong.

It would take too much space to fully summarize their various arguments, but let me at least give a flavor. In the first place, it makes a difference whether the underlying carbon tax (which is only imposed by some governments) is levied on extraction, production, or consumption. If some governments impose a tax on the extraction of carbon-intensive fuels, then the global (pre-tax) price of energy rises. This causes fossil fuel production to increase in non-carbon-taxing jurisdictions, which is a form of leakage on the supply side.

On the other hand, if a carbon tax is imposed by some governments on consumption, then the global (pre-tax) price of energy falls, which induces more consumption of fossil fuels in the non-carbon-taxing jurisdictions, which is a form of leakage on the demand side.

Already we can see that different governments would collect different amounts of revenue based on the form of a carbon tax, and that these different forms would induce different worldwide effects. In principle, border adjustments could help offset this leakage.

However, once you begin formally modeling these processes, you see that all kinds of outcomes are possible. For example, the authors can construct a scenario in which a country with large oil and gas resources and a domestic carbon tax on production would hurt the welfare of its people if it then added border adjustments, even though one might have originally thought that such an adjustment could only make things better.

(To give some of the details: This outcome could occur because initially, before the border adjustments, the government is implicitly getting foreigners to shoulder some of the cost of its domestic tax, due to the higher world price of energy that even foreign consumers must pay. But with border adjustments, energy can continue to flow to consumers in non-taxed jurisdictions with no impediment, and so there is no reason for their price of energy to rise. Therefore, once the border adjustments have been added, the taxing government is concentrating the brunt of its tax on its own people. Given that the government is going to levy a domestic carbon tax, then, in this scenario we can see that adding border adjustments makes its own citizens poorer.)

Conclusion

After exhaustively considering the various categories of tradeoffs, the RFF authors conclude:

Each of the design issues—which goods, which emissions, and which countries—raises significant problems. In combination, implementing BAs will be complex. The best that can be done is crude BAs that roughly estimate emissions for broad categories of goods from a select group of countries. Even imposing such a system would be difficult.

Because of these problems, we should demand strong justifications before imposing BAs. Our review of the economics of unilateral carbon taxes, however, does not find strong justifications for BAs. We do not know whether BAs improve welfare, either of the taxing country or globally. Leakage measures are not directly related to welfare, so they are not reliable indicators of the need for BAs. Even if they were, whether BAs increase or reduce leakage depends on a number of parameters, and extraction taxes may in fact have lower leakage than the production or consumption taxes resulting from the use of BAs. Similarly, notions of competitiveness are poorly defined or even incoherent and do not provide a justification for BAs. [Emphasis added.]

To paraphrase, the RFF authors are not saying, “Border adjustments are a bad idea.” Rather, they are pointing out just how complicated things will get in the real world, and they are noting that other economists have yet to make a convincing case that border adjustments would in fact improve things.

The case for a carbon tax—especially one imposed unilaterally by a few governments—continues to weaken.

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