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Wonking Out: Two Cheers for Carbon Tariffs

Summary:
This time it really is Infrastructure Week. Democrats have agreed on the broad outline of a big public investment program, to be passed through reconciliation on top of a much smaller bipartisan “hard” infrastructure program. As I noted in my column Friday, big spending has gotten its groove back. But there has been another major policy development: It’s Infrastructure Week, but it’s also Carbon Tariff Week. The Democratic proposal says in general terms, although without specifics, that we should levy tariffs on imports from countries that don’t take sufficient steps to limit greenhouse gas emissions. On the same day, the European Union laid out, in much greater detail, plans to impose a carbon border adjustment mechanism — which I’m afraid everyone will call a carbon tariff, even though

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This time it really is Infrastructure Week. Democrats have agreed on the broad outline of a big public investment program, to be passed through reconciliation on top of a much smaller bipartisan “hard” infrastructure program. As I noted in my column Friday, big spending has gotten its groove back.

But there has been another major policy development: It’s Infrastructure Week, but it’s also Carbon Tariff Week. The Democratic proposal says in general terms, although without specifics, that we should levy tariffs on imports from countries that don’t take sufficient steps to limit greenhouse gas emissions. On the same day, the European Union laid out, in much greater detail, plans to impose a carbon border adjustment mechanism — which I’m afraid everyone will call a carbon tariff, even though CBAM is a great acronym. (See? Bam!)

So how should we think about carbon tariffs? From past experience, I know that we’ll hear a number of voices denouncing them as a new form of protectionism and/or asserting that they’re illegal under international trade law. These voices should be ignored.

First, let’s talk about priorities, people. Yes, protectionism has costs, but these costs are often exaggerated, and they’re trivial compared with the risks of runaway climate change. I mean, the Pacific Northwest — the Pacific Northwest! — has been baking under triple-digit temperatures, and we’re going to worry about the interpretation of Article III of the General Agreement on Tariffs and Trade?

And some form of international sanctions against countries that don’t take steps to limit emissions is essential if we’re going to do anything about an existential environmental threat. Developing countries, especially but not only China, are already responsible for most carbon dioxide emissions; even a big effort to decarbonize on the part of the United States and Europe will accomplish little unless it’s matched by efforts in other nations. Furthermore, “industry will just move to China” is a favorite argument of domestic opponents of climate action, so the politics of such action depend crucially on having an answer to that claim.

Given these considerations, it seems almost trivial to point out that carbon tariffs aren’t actually protectionist and should be considered legal under international trade law. But I do think those are points worth making, if only because this happens to be a topic I’ve thought about and worked on for many years.

To understand the law and economics of carbon tariffs, it’s helpful to consider the economics and legality of value-added taxes (VATs), a major revenue source in many countries (although not the United States). Trust me, it’s a highly relevant comparison.

A VAT is, on paper, a tax paid by producers: If a country has a 15 percent VAT, a company that produces, say, furniture must pay a tax equal to 15 percent of its sales — minus the taxes it can show were paid by the companies selling it wood, fabric and so on. The advantage of such a system is that the private sector does a lot of the work of enforcement, since each company has an incentive to make sure that its suppliers pay their fair share.

But who pays the tax in the end? Normally, all those taxes on producers end up being passed on in higher prices, so that a 15 percent VAT is, in effect, a 15 percent national sales tax.

Now, VATs are always accompanied by “border adjustments”: Importers must pay the tax on the goods they import, while exporters get a rebate equal to the tax paid on what they export. This makes perfect sense when you think of a VAT as a sales tax. You wouldn’t want a situation where shoppers at Walmart pay sales tax only on American-made goods, while Chinese products are exempt. And you also wouldn’t want to charge sales tax on U.S. goods being sold to other countries.

This point is widely misunderstood. U.S. businesses, in particular, often look at the border adjustments imposed by countries with VATs and see them as tariffs and export subsidies that give their competitors an unfair advantage. They are, however, wrong on the economics. And the World Trade Organization considers VAT-related border adjustments legal, because they are necessary to carry out a domestic policy that, in principle at least, doesn’t distort international trade. That is, border adjustments don’t tilt the playing field; they actually level it.

So what does all this have to do with carbon tariffs? You can think of national policies designed to limit greenhouse gas emissions as ways to induce a country’s residents to take into account the emissions resulting from the production of the goods they consume. This is obviously true if a nation imposes a carbon tax, or a cap-and-trade system, in which businesses must purchase licenses to pollute. It’s also true, although in a harder-to-measure sense, when countries impose regulations like mileage and clean-energy standards.

The point is that many climate-change policies can be seen as a form of tax on domestic consumers. And as with a VAT, both the economics and, I believe, the law (I’m not a trade lawyer, although I think I understand this issue) say that border adjustments, in this case a carbon tariff, are appropriate parts of a climate strategy. That is, if a country lacks an adequate climate policy, the price of goods imported from that country should reflect an estimate of the greenhouse gases emitted during their production.

What might make carbon tariffs slightly trickier than VAT border adjustments is the likelihood that an important part of climate policy will involve regulations rather than a straight carbon tax. In that case, while a carbon tariff remains clearly justifiable as a way to level the playing field for domestic and foreign producers, setting the appropriate level of the tariff won’t be easy — it won’t be as simple as charging the same VAT rate on imports as that imposed on domestic products. A fair bit of estimation and imputation will be involved, and there will no doubt be arguments about the numbers.

But while getting border adjustments right will be tricky, this trickiness isn’t a reason to do nothing. Carbon border adjustments are clearly the right thing to do, and better to do them imperfectly than not at all.

So two cheers for carbon tariffs.

Wait — why only two cheers? Because carbon tariffs affect only goods that are exported and hence are only a partial solution to the problem of countries that don’t do their part in reducing greenhouse gas emissions.

Consider the case of China, which says that it plans to reduce emissions but is still building a large number of coal-fired power plants. If advanced countries impose carbon tariffs, this will give China an incentive to reduce the carbon dioxide emitted in producing its steel exports. But it won’t impose any penalty for carbon emissions from the power plants that supply China’s cities with electricity. And those emissions, which aren’t related to international trade, are almost surely a bigger threat to the environment than emissions associated with exports.

To fully address the problem of international cooperation, then, carbon tariffs that level the playing field wouldn’t be enough. We’d have to go beyond that to the threat of sanctions against nations behaving irresponsibly.

And that would, I’m afraid, be illegal under current trade law, because it would mean intervening in policies that have traditionally been considered purely domestic. Now, given the threat of climate change, our response should be to revise or ignore trade law. But that would be a big step and won’t happen right away.

For now, carbon tariffs are what we can reasonably expect to happen. And they should happen as soon as possible.

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Paul Krugman
Paul Robin Krugman (born February 28, 1953) is an American economist, Distinguished Professor of Economics at the Graduate Center of the City University of New York, and an op-ed columnist for The New York Times. In 2008, Krugman won the Nobel Memorial Prize in Economic Sciences for his contributions to New Trade Theory and New Economic Geography.

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