Blog Post

Solving Carbon Tax Competition Issues

Nov 4, 2013 | Gilbert E. Metcalf

Whether you’re designing a carbon tax or experimenting with a cap-and-trade policy, carbon pricing affects all participants differently. Potential inequality under a carbon tax has been a particular concern for energy-intensive, trade-exposed (EITE) sectors, whose energy-heavy processes and competitive global markets make them particularly vulnerable to carbon pricing disparities across countries. Politicians acting in the interests of EITE businesses, which produce everything from glass and steel to paper and chemicals, previously ensured that allowances were given to these sectors during the framing of the Waxman-Markey Bill.

Now, as carbon pricing garners greater attention, a method to reduce the negative impacts on these industries of a carbon tax has become an important goal for policymakers. In a recent paper, I analyze the role that tax mechanisms could play in solving possible competition and leakage problems in EITE sectors. Ultimately, I examine the feasibility of a plan for compensation under a carbon tax that could eliminate the need for EITE-specific aid. The result is a number of findings regarding the potential role of a carbon tax in broader tax reforms, as well as the possibility of striking a balance between efficiency goals and competitiveness concerns.

At $20 per ton, a carbon tax would raise about $100 billion annually—money that would allow for the flexibility to seek such a balance. My focus involves using some of this money for direct compensation in the form of corporate income tax credits, which would be given to EITE firms for carbon tax payments. Using direct compensation may be justified on a political or distributional basis, but my analysis also reveals its potential to interfere with other efficiency considerations. Any funds used for direct relief to EITE firms can’t be used to lower marginal tax rates on existing taxes, as that would reduce gains made in tax reforms that include a carbon tax.

Additionally, using corporate income tax as a route for direct compensation offers its own challenges. Because EITE sectors have a higher carbon tax liability than corporate tax liability, their existing tax appetite wouldn’t be large enough to offset the former through the latter. Though offering lump-sum relief to these firms would keep marginal emissions reduction incentives intact, competitiveness would still remain a concern. Some of these problems could be addressed by pinning tax credits to output-based allocation, or by setting a firm-level credit at a “best-practices” benchmark formed according to a sector’s emissions intensity.

As I also discuss, indirect compensation may offer some favorable benefits as well. Firms in EITE sectors disproportionately benefit from corporate income tax rate reductions on average, given their relative capital intensity.  Using carbon tax revenues in part to lower corporate income tax rates might lead to reduced political pressure to provide specific and direct relief to EITE sectors.

Economic theory predicts that it would be costly to use carbon tax revenue to compensate EITE sectors, and that policy risks should be treated as any other risk by EITE firms. But politics may be a game-changing variable here—and if it is, my analysis suggests that some approaches are better than others for creating targeted relief at minimal cost.