Calculating a fair tax on carbon

American President Donald Trump’s commerce secretary, Wilbur Ross, fears the European Union’s (EU) proposed higher carbon price will be protectionist and warns of punitive counter measures. Brazil’s president Jair Bolzano and Malaysia’s Mahathir Mohamad are calling it a new form of “colonialism”.

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Yet, for Prime Minister Scott Morrison, Europe’s proposed step in the direction of a consumption-based carbon tax may prove to be as much an opportunity as a challenge.

"Like the politicians of other advanced economies, Europe's leaders are under pressure to make bigger cuts in greenhouse gas emissions.”

So what are the Europeans up to? And why is it so threatening to leaders like Bolzano and Mahathir?

Carbon leakage

The proposal from EU president Ursula von der Leben is for Europe to impose its own carbon tax on imports that have not already been subjected to a similar carbon price in their country of origin: a “border tax adjustment”, the politicians like to call it.

Like the politicians of other advanced economies, Europe's leaders are under pressure to make bigger cuts in greenhouse gas emissions. But, to do so, they need to deal with the issue of “carbon leakage”. 

Europe's production-based emissions trading scheme imposes a carbon price on emissions produced in Europe - but not on emissions embodied in the imported production of foreign goods and services.

Without modification, production-based taxation puts European exporters and import-competing industries at a competitive disadvantage against producers in countries with little or no tax on carbon emissions.

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The result is likely to be a shift of emissions-intensive production to low and zero-tax countries which costs European jobs and undermines the global emissions reduction effort.

Carbon tax

You can see why the Brazilians and Malaysians are crying foul: their exports will lose an important competitive advantage in the huge European market.

You also can see why the proposed border tax is attractive to Europe’s environmentalists. Not only would it give the Europeans more room to increase their carbon price, it would also “encourage” Europe’s trading partners to impose their own carbon prices. After all, if they must pay a carbon tax, it makes more sense to pay it to themselves.

Perhaps not surprisingly, a similar carbon-pricing model has gained influential support in the United States.

The founders of the US Climate Leadership Council include some of the largest companies and most prominent economists in the US.

According to the council "a well-designed system of border carbon adjustments will enhance the competitiveness of American-based firms that are more energy-efficient than their foreign competitors, while preventing carbon leakage and free-riding by other nations”.

“This will put America in the driver’s seat of global climate policy and encourage other large emitters – such as China and India – to follow America’s lead and adopt carbon pricing of their own."

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Climate policy

It is possible an American carbon tax is closer than generally assumed. The economist Jeffrey Frankel believes that if Americans aged 18-24 voted in the same proportions as older age groups in the coming presidential election, Trump probably would not be re-elected.

But even if Trump is re-elected in November, the approaching end of his administration and the pressure for more and higher carbon taxes emanating from Europe is likely to affect Australia’s climate politics.

The Malaysians and Brazilians think the European move has the potential to be a game changer. It is hard to argue with their conclusion. The circumstances in which deposed former Australian prime minister and climate-change sceptic Tony Abbott once said he would re-consider his opposition to Labor’s carbon price appear to be moving into place.

The opportunity for the current Morrison government, despite internal divisions, is to prepare public opinion for an optimal Australian response to a more concerted emissions reduction effort by one, or possibly both, of the world’s mega economies.

As a small economy, Australia cannot make a significant direct impact on the global climate but it can play a role in the development of a more efficient global carbon price.

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Even with the proposed modifications, the production-based carbon pricing model still appears problematic. First, there is the potential for challenges under the unclear rules of the World Trade Organisation (WTO). It has also proved very difficult for production-based carbon price systems to fully insulate trade-exposed producers – especially small and medium-sized exporters and importers - from carbon leakage. And carbon border taxes geared to the climate policies of trading partners are vulnerable to foreign government cheating and corruption.

The Australian government may conclude a more reliable route to an effective global carbon price would be via value-added style carbon consumption taxes, as advocated by the Australian economist, Geoff Carmody. In that model, all exports are exempt, and all imports are taxed on the assumption they have the same emissions intensity as the importing country’s products.

That, Carmody says, makes the tax both trade-neutral and WTO compliant. It is neutral in the sense that the relative prices of the domestic and imported products are not altered and WTO-compliant because it is built on the template accepted by the WTO for consumption taxes in general. And it minimises the incentive and opportunity for cheating and corruption, since it does not affect   competitiveness, with the import tax based on the border price and domestic emissions data.

Alan Mitchell is a former economics editor of the Australian Financial Review.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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