However, as with all collective action problems, each country benefits from delaying engagement or from being one of the hold-outs to any global agreement. The transition to a carbon-free or at least a carbon-neutral economy is costly and fraught with concerns about uncertainty, risk, intergenerational and geographic equity, development rights, and liability for past pollution.
Nevertheless, a country may act unilaterally to address climate change by taxing carbon dioxide and other greenhouse gas emissions or by otherwise placing a price on those emissions. By taxing activities that cause climate change at a level that reflect their true costs to society, the costs of those activities become readily apparent in higher prices for energy and goods. The higher prices encourage consumers to seek alternative sources of energy, heat, and transportation, and goods that are less expensive (and consequently less harmful to the environment). Unfortunately, when a nation acts unilaterally to tax greenhouse gases, they put their domestic manufacturers and industries at a disadvantage. For example, if the United States were to implement a carbon tax, goods produced here would bear higher prices (as a result of the carbon tax) than goods produced in places that do not regulate carbon dioxide. Foreign goods (not subject to carbon pricing in their home jurisdiction) imported to the U.S. would be cheaper than domestic goods and enjoy a competitive advantage here. Similarly, U.S. exports would be more expensive (as a result of carbon pricing) than goods manufactured in places that do not regulate.
Unilateral regulation has two “leakage” problems. First, if the U.S. were to regulate carbon emissions by taxing energy at the time it is produced (coal-fired power plants for example) and consumed (gasoline and home fuel oil for example), domestic fossil fuel firms might respond by reducing prices on the regulated commodity (coal, oil, and gas) to maintain a steady price in the U.S. market. This reduction in price would offset all or a portion of the price increase from the carbon tax. However, given that fossil fuels are traded in a global economy, consumers in countries that do not regulate carbon will enjoy the US firms’ price reduction as well. At a lower global commodity price, overall demand will be higher and may offset reductions in the U.S. Consequently, any environmental gains in the U.S. from reduction in the use of fossil fuels may be offset by the increased fossil fuel use in other countries that don’t regulate. Since climate change is a global problem caused by the aggregate stock of greenhouse gases in the atmosphere sealing in the heat, the U.S. would not enjoy any national benefits from national climate change regulation. Second, firms are not static in response to the changing regulatory environment. They may relocate to jurisdictions that do not regulate carbon to avoid the tax and enhance the competitiveness of their goods in the global market. The relocation of U.S. businesses to other countries has a variety of effects, including increased unemployment and revenue loss.
The primary solution to this conundrum is to make border tax adjustments; the U.S. would place a tax on energy resources or goods imported from places that do not price carbon and rebate the carbon tax on domestic energy resources or goods when they are traded abroad. Applying border tax adjustments, particularly to goods, is difficult and expensive. First, the extent of the carbon dioxide emitted during the manufacture of a good (“imbedded carbon”) is not apparent in the good and not easy to measure or to mark in an effective way. Second, most goods are manufactured from parts from many places and may be routed through numerous jurisdictions before arriving at their final port. Fortunately, David A. Weisbach (Chicago), Samuel S. Kortum (Yale), Yujia Yao (IMF) and Michael Wang (Northwestern) in their recent paper, Trade, Leakage, and the Design of a Carbon Tax, have developed a model to explore alternative solutions.
First, they show that the most efficient (cheapest) policy imposes a tax on both the supply side (at fossil fuel extraction) and the demand side (at energy production and use). They clarify that when taxes imposed at extraction are matched with a border tax adjustment on those resources when they are imported from other countries, the incidence of the tax shifts downstream from extraction to energy production. If the border tax adjustment is lower than the tax on domestic extraction, a portion of the tax remains with the extractors. Their model shows that taxing the extractors is far more effective in reducing global emissions. They add one caveat. Much of this depends on the elasticity of foreign energy supply, that is, to what extent may foreign firms respond quickly and easily to the U.S. tax by increasing their own extraction and supply. If foreign elasticity of supply is low, then border tax adjustments may not even be necessary to have the desired effect. If foreign elasticity of supply is high, then border tax adjustments would need to be near the level of the tax on extractors to prevent leakage.
Second, they examine the mix of taxes on production and consumption and the accompanying border tax adjustments that would be optimal, given the administrative costs of applying border tax adjustments. They determine that if you have trade but zero administrative costs, taxes on both domestic production and domestic consumption will be the most efficient policy. While the administrative costs of applying border tax adjustments to goods may be prohibitively expensive, applying such adjustments to energy production is relatively easy. As a result, they find that if foreign elasticity of supply is low, the combination of taxes on domestic extraction and domestic production plus a border tax adjustment on imported energy resources would be optimal. On the other hand, if foreign elasticity of supply is high, a border tax adjustment on goods would also be necessary (notwithstanding the administrative cost).
Finally, they suggest that a better (cheaper) solution to imposing border tax adjustments on goods may be to bring major foreign countries with highly elastic supply into a carbon tax coalition to impose extraction taxes across their jurisidctions. They use China as an example of a potential foreign supply partner that might be brought into a carbon tax coalition. China has vast reserves of coal, relies on coal to power most of their major cities, suffers from significant smog pollution as a result, and is making significant strides to shift to renewable energy. It’s therefore plausible that the U.S. and China could form a carbon tax coalition. Oil, however, appears to be another matter altogether. OPEC’s willingness and ability to respond to adverse events and advantageous opportunities, demonstrated by their responses to the war in Ukraine and US attempts to increase supply, has demonstrated their elasticity of supply of oil. It’s difficult to imagine that OPEC countries would join a carbon tax coalition, given their deep and historic economic dependence on oil production.
According to the World Bank, as of 2021, 47 national jurisdictions and 36 subnational jurisdictions have adopted carbon taxes or other carbon pricing schemes. The US is, therefore, not the first, but one of the last, of the more developed nations to adopt a carbon tax or carbon pricing mechanism. Nevertheless, Weisbach, Kortum, Yao and Wang, with their latest efforts to model the effects of different carbon tax and border tax adjustment designs, make significant advances in addressing some of the most challenging puzzles of our global collective action problem, and in identifying pathways for the U.S. to join existing coalitions devoted to addressing the cataclysmic effects of climate change and preserving life on Earth.