Human activities around the world are producing increasingly large quantities of greenhouse gases (GHGs), the most abundant of which is carbon dioxide (CO2). In recent years, concerns about the effects those emissions might have on the climate have prompted the Congress, federal regulators, and others to consider policies to reduce them. This CBO report examines the unintended effects on the competitiveness of U.S firms of an economywide policy, such as a carbon tax or a cap-and-trade program, that would reduce emissions by imposing a price on them. The report also assesses the use of border adjustments, such as import tariffs and export subsidies, and transition assistance to mitigate those unintended effects. Border adjustments could reduce the loss of competitiveness and make the costs of U.S. producers more similar to those of producers in countries that do not impose comparable policies, but such adjustments could be difficult to implement and to defend if challenged as being inconsistent with the General Agreement on Tariffs and Trade (GATT), one of the component agreements of the World Trade Organization (WTO). Transition assistance could also offset the loss of competitiveness and would probably be easier to implement but might engender difficulties under WTO agreements as well.
Under a carbon tax or cap-and-trade policy that covers all or almost all GHG emissions, industries’ or firms’ production costs would increase, causing those industries or firms to raise the prices of the goods they produce. The prices of emission-intensive goods (that is, goods whose production involves the emission of large amounts of greenhouse gases relative to their value) would increase the most. The higher prices would create incentives for other firms and consumers to purchase fewer of those goods, leading to declines in the production of those goods and the resulting emissions.
The higher prices would also make emission-intensive U.S. products less competitive relative to competing foreign products. Therefore, imports of the competing products would increase, and exports of the domestically produced products would decrease. Those changes in trade would lead to declines in the value of the dollar on foreign-exchange markets, thereby increasing the exports and reducing the imports of the products that are less emission-intensive. As a result, the policy would have little net effect on the U.S. trade balance, but it would have other unintended effects.
The displacement of domestically produced emission-intensive goods by products produced in other countries would cause some of the reduction in U.S. emissions to be offset by increases in foreign emissions. The resulting changes in trade in the products of the other industries would reduce foreign emissions, but not by as much as the changes in trade of emission-intensive products would increase them. Hence, the emission reduction achieved by the policy would be partially offset by a net increase in foreign emissions, a phenomenon known as carbon leakage. Such leakage would also occur through other mechanisms. In particular, reducing domestic demand for fossil fuels would lower the price of those fuels in other countries, thereby increasing their use in those countries.
The estimates in the literature that CBO reviewed for total leakage (through trade and other mechanisms) under an economywide carbon tax or cap-and-trade policies in the long term fall in a range from 1 percent to 23 percent of the reduction in emissions from domestic sources. Recently, a group of 12 modeling teams examined a policy consisting of a 20 percent reduction in emissions from their level in 2004. The modelers assumed that a large group of industrialized countries that includes the United States would implement the policy. The leakage rates projected by the modeling teams ranged from 5 percent to 19 percent, with a mean of 12 percent for the estimates. Leakage is likely to be lower in the shorter term, and studies of programs in Europe have found no significant leakage in the first few years of those programs.
The displacement of domestically produced emission-intensive goods would also cause losses in employment and profits in the industries that produce them, such as the chemical and primary metals industries. The resulting changes in trade in the products of other industries would cause increases in employment and profits in those other industries. The initial net effect of all of the changes in trade on employment would probably be small, but some workers in emission-intensive industries who lost their jobs would have to look for work elsewhere.
Border adjustments are one way to offset the decline in competitiveness of U.S. emission-intensive firms and thereby reduce the consequent leakage and lost profits and employment that would otherwise result from an economywide carbon tax or cap-and-trade program. Those adjustments are provisions that would impose the same costs on imports that the emission-reduction policy would impose on domestic production and that would rebate the costs the policy would impose on domestic production that is exported. In the case of a carbon tax, the adjustments might take the form of import tariffs and export subsidies in proportion to the greenhouse gases emitted in the production of traded products. In the case of a cap-and-trade program, they might take the form of a requirement that importers obtain allowances for those emissions and that domestic manufacturers receive a rebate of the allowances required for their products that are exported.
Although border adjustments would help emission-intensive firms by preventing the increases in imports and declines in exports of their products that the policy would otherwise cause, they would harm firms that are not emission-intensive by preventing the declines in imports and increases in exports of their products that would otherwise occur as a result of changes in the exchange rate. Moreover, the adjustments would not reduce leakage occurring through mechanisms other than trade—in particular, leakage that would occur through lower prices for fossil fuels. Nevertheless, the 12-model study found that applying simplified border adjustments to emission-intensive industries with significant foreign competition reduced the mean estimated amount of leakage by roughly one-third.
Implementing border adjustments for an economywide carbon tax or cap-and-trade program would require determining the GHG emissions embodied in imports (that is, the amount of greenhouse gases emitted in producing each imported good and service), which would be extremely difficult if applied to most imports (but not if applied only to imports of fossil fuels). The difficulty could be reduced, but not eliminated, in several ways:
However, such simplifications would result in adjustments that less accurately offset the effects of the emission-reduction policy on competitiveness.
The use of border adjustments might be challenged in the WTO as being inconsistent with the GATT, an agreement to which all WTO members, including the United States, are signatories. CBO has not independently analyzed the merits of such challenges but instead has reviewed several legal analyses of border adjustments in the literature. Those analyses suggest that the prospects for a successful defense of border adjustments are uncertain and would depend on the design of those adjustments. For example, an allowance requirement for imports under a cap-and-trade program might be more difficult to defend than would import tariffs and export subsidies under a carbon tax. Certain simplifications—such as assuming that the emissions embodied in products were the same for all firms in a given industry and country—might increase the difficulty of defending the adjustments in the WTO.
Transition assistance could also be used to reduce the decline in competitiveness that would result from a broad emission-reduction policy. Transition assistance would be the aid the government provided to compensate firms and their employees for some of the costs incurred while the emission-reduction policy was being phased in. If such assistance was made contingent on firms’ levels of output or employment after the policy went into effect, it could offset the decline in competitiveness—and, consequently, some of the leakage and employment losses. In principle, such assistance could be made in an amount sufficient to eliminate the decline in competitiveness. However, doing so would negate the incentive for consumers to reduce their purchases of emission-intensive products—one of the major mechanisms of emission reduction under such policies. Hence, such assistance would result in more emissions under a carbon tax and would increase the cost of meeting the emissions cap in a cap-and-trade program.
Implementing transition assistance could be a substantial undertaking, but it would probably be easier than imposing border adjustments because the necessary data regarding firms’ costs and emissions would be more readily available. However, it might engender problems under the Agreement on Subsidies and Countervailing Measures, a component agreement of the WTO.