David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: the carbon cycle, part two.
We're continuing our discussion from last week on the pros and cons of taxing carbon emissions. The first part of this series, which you can find linked to in the show notes, focuses on the opposition to a carbon tax with David Kreutzer, an economist with the Institute for Energy Research.
This episode, part two, will highlight the arguments in support of such a tax with Shuting Pomerleau, a climate policy analyst at the Niskanen Center.
For those interested in the background and basics of a carbon tax, check out part one of this series.
I'm joined again by Tax Notes contributing editor Marie Sapirie. Marie, welcome back to the podcast.
Marie Sapirie: Thank you. I'm glad to be here again.
David D. Stewart: Now, before we get to this week's interview, could you give listeners a brief recap of your interview with David Kreutzer on the cons of a carbon tax?
Marie Sapirie: David and I spoke about why he thinks the carbon tax wouldn't be an ideal climate policy. He said that the economic theory behind the carbon tax is compelling, but the reality of implementing the tax isn't.
David D. Stewart: All right, now you recently spoke with someone with a significantly different view on a carbon tax. Could you tell us about your guest and what you talked about?
Marie Sapirie: Shuting was previously at the Cato Institute and the American Council on Renewable Energy. I spoke with her about her research on why a border adjustment is a necessary component of instituting a carbon tax in the United States and how one should be designed. She also discussed some of the administrative issues that would be critical to implementing a border-adjusted carbon tax.
David D. Stewart: All right, let's go to that interview.
Marie Sapirie: Thank you, Shuting, for joining me today to talk about the considerations for designing and implementing a border-adjusted tax on carbon dioxide and other greenhouse gas emissions.
Shuting Pomerleau: Thank you, Marie, for having me.
Marie Sapirie: There are many facets to the discussions about whether and how Congress might decide to implement a carbon tax. In this discussion we'll go over some of the design choices that legislators might make in drafting the carbon tax, as well as some of the administrative considerations involved in implementing a new tax. And then we'll look at some of the recent carbon tax proposals.
You've written extensively about a feature of the carbon taxes that many economists have identified as an important component of a carbon tax regime, a border adjustment. So, to get started, I'd like to have you give us an overview of how a border adjustment works generally and what its role is in implementing a carbon tax.
Shuting Pomerleau: The way I think about a border adjustment is that it's a pretty critical component of a well-designed carbon tax. So, while there are policymakers, economists, or lawmakers on the Hill disagree on how exactly a border adjustment should be designed, most of the policy experts agree that a border adjustment is a very critical component and should go with a domestic carbon tax. Now, a border adjustment works by imposing an import tax on imported goods and then giving a rebate on exported goods.
The concept of a border adjustment is really trying to tax all the consumption of goods and services within the jurisdiction based on where they're consumed rather than where they're produced. So, if you think of imported goods, therefore domestic consumption, domestic production that sell to domestic consumers they're also for domestic consumption. So, they should be taxed. On the other hand, domestic production of goods sold to foreign countries in terms of exports, therefore foreign consumption, so they should be exempted from a carbon tax. So, the critical components of border adjustment is that it should always have an import tax and an export rebate at the same rate as a domestic carbon tax.
Marie Sapirie: Turning to the design question, there are several foundational issues that legislators would need to consider in setting up a carbon tax in the United States. And one of those is which goods and services to cover. How should the parameters for designating covered goods and services be defined? And is there a trade-off between precision and identifying the carbon content of goods and services and administrability?
Shuting Pomerleau: Yes, that's an excellent question, Marie. So, in an ideal world, right? We would like to enact a border adjustment on all goods and services based on their associated carbon emissions. However, it's actually quite complex and difficult to determine a given product. Say like the cell phone you're using, the computer you're working on right now, what are the actual carbon emissions associated with a specific product? So, to work around those, some policymakers have actually proposed narrowing down a certain list of goods and services to be eligible under the border adjustment. There's actually a kind of a challenge with those. I think you brought up a really good point. There's always a trade-off between an ideal policy design, which have a broad-based carbon tax with the border adjustment, versus making sure the administrative burden of the border adjustment mechanism is feasible, not too heavy for the government. So there's always a trade-off there.
So, I think with the pending carbon tax border adjustment proposals, policymakers tend to either name a certain list of products that would go into the border adjustments. So they're either very energy intensive products or carbon intensive products like steel or aluminum, or they will determine a certain threshold. So, like any products in a certain industry, if their emissions are above a certain threshold, they would be considered as eligible products under such an eligibility criteria. Now, the challenges with that is if the government were to only border adjust a select list of primary goods like steel, aluminum, cement, but not really covering more downstream consumer goods like cars, laptops, cell phones, there might actually be some incentives for corporations to go around the policies and avoid paying for the taxes. I'll give you a quick example. So, say if the United States were to implement a carbon tax right now with a border adjustment that only covered certain primary goods, but not any of the final consumer goods.
In such a scenario, I see a manufacturer that would likely try to export the primary goods, say for example steel, get the export rebate and then try to produce a car using the steel in the foreign country where there's no carbon price, either cap-and-trade system or carbon tax. And then try to import back that car produced with the steel into the States. But because the border adjustment is narrow-based not really covering any final goods, including a cars. So when that company tried to sell back to domestic consumers in the U.S., that car would not be subject to the import tax under the border adjustments. So, I think this is an example of what are some key considerations when policymakers, when they look to, OK, how should we balance between the administrative burden and the good design of a policy they need to keep in mind that there might be some challenges.
Marie Sapirie: Is a phased approach possible, perhaps one that starts with a smaller number of covered goods with high emissions and then transitions into a more inclusive framework over time?
Shuting Pomerleau: Yeah, I think from the perspective of administration of a border adjustment, this is definitely one of the options to roll out a policy. I think starting with a smaller number of goods in certain industries allows the government and relevant agencies to accumulate experience in terms of putting in a reporting system, collecting information and data from importers and exporters just kind of have a pilot phase, and then expand from there. But I think in order for a border adjustment to work well with a domestic carbon tax, it's important for the policymakers to make it clear to the business community industries, that over time we will expand to include other industries and goods.
Marie Sapirie: In addition to defining which goods and services are covered, a method for calculating the tax would also need to be established. And that raises the question of how to determine and track the carbon emissions and products. What are the options for doing that? And what are the different considerations for exports and imports?
Shuting Pomerleau: Yeah, I think that's also another great question. So, when we think of border adjustment, I like to always point it out to my fellow colleagues and external colleagues that is actually not a entirely new concept for the tax policy. As a matter of fact, border adjustment is widely used in other types of taxes around the world. The most common example would be a value-added tax (VAT). So, there are more than 150 countries around the world that have a domestic value-added tax and they're typically border adjusted. With a VAT, it's actually quite straightforward to border adjust imported goods and exported goods because all you need is a look at a certain product's sales price, and then use that sales price times the VAT rate minus any VAT previously paid on the inputs that go into the production of such a product.
Now what makes border adjustment under a carbon tax actually more complicated, in terms of measuring the tax liability for a certain product, is the tax base here is actually the emissions associated with a certain product. So, different from the sales price of a product. You can't just look at a computer or a cell phone and say, "Oh, I know what the emissions associated with it." It's actually much more complicated than that. So, very smart people. For example, Brian Flannery, a border adjustment expert with the Resources for the Future organization, and his colleagues have actually proposed a tracking framework. That's kind of like the credit invoice VAT method to actually track cumulative carbon emissions along supply chains. And I think that is a wonderful proposal and method that we could actually use to look at how different producers along the supply chains add to the carbon emissions of a certain product.
And to your question, Marie just now, the considerations of exports and imports, there are actually a couple things I like to unpack here. So let's first look at exports. In order to know the carbon emissions associated with a certain product, we would need to know the journey, sort of like the product takes through the complicated supply chain domestically, and then how each producer along the supply chain can add to the carbon emissions of the product. So Flannery's proposal is really proposing a certain producer or manufacturer along the supply chain. The first step is they can add up to all the previous carbon emissions associated with producing all the inputs into a product and then add to the producer's current facilities, all the carbon emissions. So kind of combine a product's life cycle emissions, including all the emissions with the inputs and the current production stage emissions.
And then the second step he proposed was actually when you have the entire life cycle emissions with a facility under a manufacturer, you look at all your products under a portfolio. So, maybe as a manufacturer, I produce 50 different types of products and then 100 units of products each. How do I actually apportion the entire life cycle emissions I just talked about to specific type of product and down to the unit? And we're actually talking about product level emissions here. And with this framework, Flannery and his colleagues believe that there is actually a feasible way for the government and companies in the United States to really track a specific product's carbon emissions. And then so when an exporter try to ship a certain product at the border, when they leave the United States, the government would know, "OK, so these are so many emissions associated with the product and here is the rebate."
So that's kind of on the export side. Now, it's a little bit more complicated on the import side. And there have been several different proposals on how we can track and measure the carbon emission with imported products. I think some experts have proposed that we should just require foreign governments and companies to really comply with this border adjustment, report a specific company's products emissions, and then the U.S. government can go ahead and validate emissions. This is one of the proposals. Another proposal is instead of really looking at all the different imported products' actual emissions, put such a burden on foreign producers or governments to have them really report emissions. Let's actually use a like product approach to really link an imported product to a domestically produced product, to tax the imported product as if that product was produced in the United States. And there are several benefits and some challenges with that as well.
Marie Sapirie: With regard to a tracking system like the credit invoice method, what are the benefits and burdens of that type of approach?
Shuting Pomerleau: So, I think the benefits are very obvious. If such a system were put in place and operated really nicely, is that it allows the government and all the companies to really know the emissions associated with producing a product. It allows the nice operation and good implementation of border adjustment under carbon tax. It also provides great visibility into how each industry is doing in terms of decarbonization. What are some of the great opportunities that companies can take to decarbonize certain sections of their supply chains or even work with their suppliers and distributors to decarbonize upstream and downstream supply chains? I think the burdens of this approach, it's actually quite complicated. I don't believe there is actually such a system in place currently in the world tracking a specific product's cumulative carbon emissions along the supply chain throughout the whole economy.
And I think there's a reason why there hasn't been such a system in place yet. I think it takes a lot of resources on both the government and the company side. But I think it's an inevitable trend going forward to decarbonize industries and now economy. So maybe at some point in the future, we'll have the system in place.
Marie Sapirie: On the like product approach for imports, would you help us to understand what kind of regulations would be necessary to implement that?
Shuting Pomerleau: I think a helpful way to think about a like product approach is there are two likely scenarios for an imported product. So, if we treat it as a domestically produced product, one scenario, the imported products, carbon emissions would be higher than the emissions with a domestically produced product. So, in that case, with a like product approach, it is not able to capture that difference of the emissions. But again, like I said earlier, there's always a trade-off between precision and administrative burden. If we're talking about thousands and thousands of products from hundreds of countries, it might be just administratively impossible to get down to the actual emissions of each product.
Another scenario is the imported product's associated emissions are actually lower than those of a domestically produced product. So in this case, I think it will be really helpful for a government agency to really step in and investigate and rule on the petitions from a certain foreign company. So they can submit a petition and then try to demonstrate, "OK, so with our technologies and production processes, we're actually able to have a very low carbon intensity product. And we don't think we should be paying for this much of import tax." I think Department of Commerce, they have experience in dealing with this kind of petitions or complaints in terms of like anti-dumping and countervailing duties. So maybe they are a good candidate for being a designated agency in dealing with the positions.
Marie Sapirie: Over the past few years, carbon tax proposals have split over whether to include a credit for foreign carbon prices. But more recently in the European Union and in the U.S. there have been proposals that include a credit. What are the arguments for and against providing a credit?
Shuting Pomerleau: Some policymakers, they are really supportive for providing a credit for importers to account for the carbon policies in the countries of origins. They propose this because of two reasons. First, they think that to account for the carbon policies or other climate policies in the countries of origin to fully or partially exempt an importers' imported goods. That might actually incentivize other countries to up their climate policy game and to enact more ambitious climate policies. And the second reason that they're thinking about is if say a manufacturer is already subject to a carbon tax or cap-and-trade in their home country, it doesn't make sense for them to pay for another carbon tax when they're trying to sell to domestic consumers in the United States.
So, I think those are the two key considerations of why some policymakers or policy experts are supporting the credit approach. Now there's also another side like policy experts and policymakers, they think we should not provide a credit for any importers. Actually, we are not going to account for any climate policies or carbon price policies in the countries of origin. And based on my research, I am actually against providing a credit for foreign carbon prices. And here are several reasons. The first one is having a differential treatment approach, so fully or partially exempting some countries' imported products, but not the other countries would really risk violating the WTO's most-favored-nation rules. It would be perceived as a discriminatory policy. So from a legal perspective, this might be really challenging to provide credits for foreign carbon prices.
From an administrative perspective, it's also challenging to do so. We're looking at a lot of products from many different countries. It would be a very heavy administrative burden for the U.S. government to determine what a specific product, what kind of a carbon price, or how much of a carbon price it is subject to in their home country. And even if they can easily find a way to determine that, it would still take a lot of resources to monitor and keep track of the updated carbon prices, and then keep validating it. Especially for some countries, they're not having an economy-wide carbon price. They might give some exemptions to certain producers in certain industries, or they have other policies like regulations, tax incentives, clean energy subsidies. It's actually really difficult to look at a product and say, "OK, how much is the production of this product is subject to in terms of a carbon price?" Another key consideration under administrative perspective is transshipping would be a huge problem if such a foreign credit approach is adopted in border adjustment.
So for example, if say the United States were to implement a carbon tax with border adjustment and determine, say, "These are the 20 countries that would be fully exempted from the border adjustment mechanism." I actually see a scenario in which foreign producers, they will try to ship their products to those 20 fully exempted countries, and then try to ship the products to the U.S. from those 20 countries. So, we call it transshipping. It's not directly shipping the production country to the consumption country, but through several transshipping points. That's actually a behavior that will be really difficult for the government to prevent or even deter from happening. And another important reason why a foreign credit approach might not be a really good design is from an economic approach. If the United States were to just refund any carbon prices already paid in the home country for any importer, foreign countries might have an incentive to max out their carbon tax rate so that it can just collect the revenue.
So, the revenue that would have gone to the IRS in the United States would just go to foreign governments. I think from a tax collection standpoint or tax policy design perspective, this is also another challenge.
Marie Sapirie: What other considerations are there for designing a border-adjusted carbon tax?
Shuting Pomerleau: Yeah, so I think a great consideration that needs to be accounted for is compliance with WTO rules. And obviously border adjustment is really addressing the carbon emissions embedded in international trade. And actually countries really need to consider whether the policies or the proposals they put forward are complying with WTO rules or any other trading partners would likely bring a challenge to the WTO organizations. And I think in terms of the compliance with WTO rules, the smart people, including Jennifer Hillman and other policy experts, they believe that it is possible to design a carbon border adjustment that is compliant with WTO rules.
It generally allows border adjusting taxes in terms of import tax and export rebate. As long as the tax liability is not higher than the tax liability that domestic producers are subject to. So, there's a way to make a WTO compliant carbon border adjustment. I think another important consideration is oftentimes some people might be confused with a tariff and a border adjustment. So, there are two distinct policies. A tariff is just a stand-alone import tax. Whereas a border adjustment includes a pair of equal rate import tax and export rebate and the economic impact of the two different policies are very different. And I think that's a key consideration when policymakers, when they're trying to design border adjustment, they need to really look at the policy and think about what would be the intended and unintended consequences of their proposals.
Marie Sapirie: Well, thank you, Shuting, for joining the podcast today.
Shuting Pomerleau: Yes, of course. Thank you for having me Marie.
David D. Stewart: And now coming attractions, each week we highlight new and interesting commentary in our magazines. Joining me now is Acquisitions and Engagement Editor in Chief Paige Jones. Paige, what will you have for us?
Paige Jones: Thanks, Dave. In Tax Notes Federal, Stephen Curtis and David Chamberlain examine Apple’s cost-sharing arrangement. Lori Hellkamp and Alden Dilanni-Morton consider two provisions in U.S. income tax treaties that can cause unfavorable tax results for U.S. taxpayers trying to claim treaty benefits. In Tax Notes State, Brian Kirkell considers how P.L. 86-272 should be applied in the context of conversational commerce. Four EY practitioners examine sales tax compliance and what recent changes in that area mean for businesses. In Tax Notes International, Anne Levin-Nussbaum explains how to determine how much debt to use when capitalizing a U.S. blocker corporation. Patrick Yip examines the implications of Hong Kong’s new and innovative tax policy on private equity funds. In Featured Analysis, Joseph Thorndike looks at conservative claims that the Biden administration’s plan to raise the capital gains rate is born out of envy. On the Opinions page, Robert Goulder and Mindy Herzfeld discuss possible ways the OECD/G-20 Pillar 1 proposal could pass through the U.S. Congress.
David D. Stewart: That's it for this week. You can follow me online @TaxStew, that's S-T-E-W. And be sure to follow @TaxNotes for all things tax. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.
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