Do border adjustment taxes work?

If the Gillard/Garnaut plan for a carbon tax is implemented would border-adjustment taxes (BAT) help to offset the trade impacts including loss of export competitiveness and “carbon-leakage”?

It turns out BATs might notl have any impact, good or bad, on trade. In the late 1960s, adisagreement between Europe and the USA over the protectionist impact of border tax adjustments started to shape up as the first (of many) trans-Atlantic struggles over the external impact of Europe’s market integration. But, to everyone’s surprise, the issue fizzled out before the launch of the 1973 Tokyo Round of GATT negotiations.

A group of academic analysts including the legendary Harry Johnson, using simple models of production, demand and trade showed that remitting a uniform, economy-wide product tax on exports (to preserve competitiveness) and imposing the tax on imports (to create a ‘level playing field’) had no impact on demand, on the relative prices of imports or on local production in the importing country and no export subsidising effect.

The theoretical analysis showed that it didn’t really matter whether governments taxed production (an ‘origin-based’ tax) or consumption (a ‘destination-based’ tax system, such as Europe had adopted for VAT); relative prices would not be affected. Ultimately, the economists said, consumers’ budget constraint in the taxing country would be unchanged. Import demand, too, would be the same after adjustment in the relative exchange rate (and presumably, real wages). Nor would there be any change in the opportunity cost of exports, even with a remission of the tax; because there would be no change in relative prices in the taxing country, there would be no export subsidy.

“Don’t worry about BATs”, was the economists’ message. GATT Parties let the matter drop; by the mid-1970s a Working Party on the issue had decided that border adjustments were compatible with the GATT Subsidy rules, the rules on Schedules and on National Treatment

But would this slightly counter-intuitive result hold for similar border adjustments hold for the proposed Gillard/Garnaut carbon tax? If the proposed carbon tax were offset for exporters and imposed on imports would it really make no difference to relative prices and demand in Australia? More important, perhaps, would the problem of “carbon-leakage” disappear? Would the intended compensation to producers—to “level the playing field” against imports and to protect the competitiveness of exports— be needed at all?

If the market models used by the economists advising GATT applied accurately to the proposed Gillard/Garnaut carbon tax, there would probably be no further grounds for concern about “carbon-leakage” and no concerns about taxing imports (assuming the right rate of tax can be struck) or remitting the tax on exports.

But are these simple models accurate in the case of a tax that is not uniform but applies only to energy use and is compensated, probably via social-payments to consumers but never fully compensated (otherwise it would have no carbon-abatement effect)?

Because the tax increases the prices paid by consumers relative to the prices received by producers, a carbon tax should affect the supply of real money balances, in addition to reducing expenditures. This looks like a recipe for economic contraction, to me.

Of course, the price of imports from all sources (in fact all tradables) will go up, thanks to the border adjustment tax, by the same amount as the price of non-traded goods and services. So, although our preferences won’t change between domestic or imported goods as the GATT economists noted, our real effective exchange rate (the price of goods in Australia compated to the average price of those same goods in our trading parters’ markets) will fall.

The remission of the full tax burden on exports of energy resources, manufactures etc will help maintain export competitiveness and, in principle, the fall in the real exchange rate should even assist exporters. But given that the import tax matches a tax on consumption pushing up input prices for producers, the net impact of the tax remission on exports, as the GATT economists noted won’t make any change in the propensity to export.

Carbon-leakage would still be likely, if only because (absent a sudden, miraculous appearance of a nuclear power industry) Australia will be a less rewarding place to produce energy or energy-intensive goods. It will be a slower-growing economy.

As the price of all goods produced with taxable energy rises, real wages will fall and there will be pressure for an increase in real wages that the Labor government will find hard to combat, despite the compensation package. I assume that inflation pressures will rise, too.

I’m not much of a macro-economist, but if this analysis is right I expect the impact of even the compensated, export-remitted tax to be a blow to our current prosperity.

Note: Economist John Whalley has written a short paper on the history of the BAT issue.

3 Comments

  • duncan wrote:

    Hi Peter,

    As an retired primary producer now environmentalist and social ecologist I have no doubt that early transition to carbon stability is vital if we are to mitigate the unmeasurable suffering our generation will inflict on future generations by our greed.

    Prima facie, it seem central that import BATs be applied in any successful carbon tax system .

    -So domestic producers stay competitive. All domestic producers paying the carbon carbon tax on their energy inputs.
    -Excepting those export trade exposed for whom adjustment grants be made over a twenty year period for structural adjustment (Whilst in business).These industries must have incentive to change.
    -Equally lower income member of society be given a proportional compensatory adjustment lift to pensions, social payments and income tax thresholds to cover increased energy costs.
    -Households above the threshold be given a 20 year capital structural adjustment grant to reduce energy consumption.
    -Numerous studies have shown increase in totoal demand for labour with transition loss to GDP have been due to leakage of unsupported energy intensive industries.(Spain)

    Whilst this may mean a contraction in the formal GDP ; Real GDP,(GDP minus “bads”) should eventually grow again after transition costs are absorbed; especially in an expected world of skyrocketing energy costs.

    Levying a carbon tax credited tax on imports would send powerful signals to the international community to get their house in order; ie to bring their tax to parity.

    Not being an economist or having found relevant models or having the time to study the Garnaut report, expect I have missed salient point.

    Your comment would be welcome.

    cheers Duncan

  • duncan wrote:

    You make no comment on massive reduction in externalities (pollution, road transport) and personal costs (commuting) inherent in a no carbon tax economy.
    Sure GDP per capita may decline but what is the likely situation in nett personal income?

  • Hi Duncan,

    I apologise for not responding to your comments. We may have to agree to disagree on the need for any action to reduce carbon emissions: I cannot see any certain value in it (or, at most, if you’re highly risk-averse, a tiny value that does not warrant any expensive action).

    As to the impact of the Labor/Greens tax on carbon dioxide: Treasury’s modelling of the economic impact on aggregate demand (i.e. GDP) of the former ETS plan showed a 1- 2% cut to GDP which SOUNDS small but is, in fact, a huge amount of money. Roughly ten billion dollars every year.

    If the Carbon Tax has anything like that impact (it’s designed to) it will certainly cut net personal incomes! We cannot, as a nation, “compensate” ourselves for a loss in our national income: so someone has to pay and that “someone” is, inevitably, households like yours and mine.

    As for the estimate from Treasury: it is very likely an underestimate of the costs because it seems that their model assumes (it’s a massve, unrealistic, assumption) that labour markets in Australia would instantly adjust to the new prices of carbon-intensive production. In other words; they assumed away a big chunk of the real-world costs of this wretched experiment.

    Thanks for your interest.

    Peter

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