WTO treatment of a carbon tax

In which I try briefly to describe the practical impact of WTO rules on the administration of a compensated carbon tax that is not levied on exports.

The huge volumes of recent commentary on the interaction of WTO rules and carbon emission taxes or administered markets (“emission trading schemes”, ETS) contain a bewildering diversity of analysis. The matter is so contentious that the 2010 Copenhagen Accord of the UN Kyoto Protocol omitted any mention of trade measures that might be used to shore up domestic tax/ETS schemes if some large emitters (China, India, Japan) declined to make proportionate (or any) emission cuts.

In the present state of WTO jurisprudence the only thing we can say for sure is that any laws to levy a carbon tax on imports or to remit a domestic carbon tax on exports are likely to provoke nasty trade disputes; which is why the then-EC-Trade-Commissioner, Peter Mandelson, advised against putting any such border taxes on imports or tax-remissions on exports in place when the EU adopted its own ETS in 2005.

Mandleson’s advice has intuitive appeal but it is little better than the advice of The Great Oz (“Ignore that man behind the curtain!”). Governments are bound to use these contentious trade measures to deal with two fundamental problems of either a carbon tax or an ETS that they adopt unilaterally or, under any international agreement that attracts less than universal compliance:

  • First, a unilateral tax that is not remitted on exports will hurt the export competitiveness of an economy—its capacity to exploit its comparative advantage in the production or exploitation of carbon-based energy, for example
  • Second, an uncompensated tax will lead to carbon leakage and possibly an increase in the global amount of carbon emissions as emission-intensive industries move offshore to locations where there are weaker or no abatement measures in place.

If the Gillard government succeeds with its carbon tax+ETS proposals, it will not be able to avoid remission of the tax on exports because coal is our biggest export and because every extractive (iron ore), manufactured and farm product we export uses (taxable) energy input. The government must offset the impact on export competitiveness or risk choking the economic prosperity that allows it even to consider this luxury-good (a “carbon-conscience” to which few countries aspire).

As for compensation, the government has already made that commitment to energy producers and I expect it will be forced by the same logic to offer compensation to manufactures and farmers: although the “compensation” across such a broad spectrum of production might be easiest managed through a subsidy to consumers rather than to producers.

What then, are the WTO challenges? WTO subsidy rules permit remission of the tax on exports and on the taxable (i.e. carbon) inputs wholly incorporated into manufactures or farm products. This is a long-standing rule applying to indirect/product taxes such as value-added taxes. It was adopted as an interpretation of the GATT subsidy rules in the mid-1970s in settlement of a trans-Atlantic dispute over the EC’s “destination-based” VAT rules and has since been incorporated explicitly in the WTO’s 1994 Agreement on Subsidies and Countervailing Measures. But note, that the remission on exports of the tax on the taxable carbon incorporated in either primary or processed products must be no greater than the actual tax that would have been due on the incorporated carbon on the domestic market. Any excess is an ‘actionable’ export subsidy that would attract either a WTO dispute or a “countervailing” import duty in an export market.

The imposition of taxes on the carbon component of imports from places where the equivalent carbon tax has not been paid will be urged by businesses demanding “fairness” on the domestic market. In this light, the import duty is akin to an anti-dumping duty; good for import competing industries but bad for everyone else, especially consumers and, consquently, for economic growth. But there is an economically plausible rationale, too; without some equivalent taxation, emitters will have a strong reason to relocate production to markets where the emission limits are weak or non-existent. In other words, the import duties will be a defence against carbon-leakage. Since a reduction in global emissions is the ultimate motive for the carbon tax, any Gillard/Garnaut carbon tax that has a meaningful impact on emissions will have to be buttressed by these additional import duties (in WTO jargon, “border adjustment taxes”, BAT) on the products of all non-extractive industries that can switch to foreign sources of supply. This includes all manufacturing and most farm products.

“Compensation” for the new tax will be a horrible tax-administration tangle, but it is less of a problem from a WTO perspective. The logic of “compensation” is the same as the logic of border-adjustment taxes. Producers who will find it difficult to pass-on the full burden of the tax to consumers and who are worried that, even so, consumer demand will slump if they do pass on the tax—at a guess, this group includes producers in every sector other than electricity production, fuel and services—will demand full compensation for reasons of “fairness”. Again, the government will be motivated to compensate if it wants to ensure that the Australian tax leads to a reduction in global emissions and not just to carbon-leakage. But, from a WTO perspective compensation is problematic only if it overshoots; in which case it is an actionable subsidy to domestic production and countervailable in export markets. But the Gillard/Garnaut proposals would fail if the compensation overshot because people would have little reason to switch to non-emission-intensive goods (assuming there are any such alternatives available).

For more reading (but not too much) I recommend two overview papers by Horn and Mavroidis and by Low, Marceau and Reineau.

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