Alternative Approaches to Offsetting the Competitive Burden of a Carbon/Energy Tax

J. Andrew Hoerner

1997

Executive Summary

Energy-related carbon emissions in the United States rose for the fifth straight year in 1996, according to data from the U.S. Department of Energy (DOE). Emissions from the use of fossil fuels climbed to 1,454 million metric tons of carbon equivalent in 1996, an increase of 3.3 percent relative to emissions in 1995, and 8.7 percent compared to 1990. Carbon emissions in the form of carbon dioxide are the main contributor to global warming. Limited improvement in energy efficiency was a key factor in the growth in carbon emissions since 1990. Carbon emissions in 1996 were well above the level targeted in the Clinton Administration's Climate Change Action Plan. The United States is not on track for returning its greenhouse gas emissions to 1990 levels by 2000, which is a commitment made as part of the Framework Convention on Climate Change.

Fossil fuels and fossil-derived electricity are consumed in every sector of the economy: roughly a third by manufacturing industries, slightly over a third by households, and the remainder about evenly divided between non-household transportation and non-manufacturing industry, commerce, and government. Policies need to be broad-based to properly spread the incentive for efficiency improvements across sectors.

One such broad-based approach is a carbon or carbon/energy tax. A pure carbon tax is a tax on fossil fuels proportional to their carbon content, while a carbon/energy tax is a broad-based energy tax that also applies to non-carbon energy sources such as nuclear and hydro-power, and may include tax rates on fuels that reflect additional concerns, such as national security in the case of oil). A carbon/energy tax applies to all economic sectors and fossil fuel consumers proportionally to their carbon dioxide emissions or energy use. Many economists argue that a carbon/energy tax is the most efficient instrument for promoting emissions reductions. A carbon/energy tax is a market-based approach, encouraging cuts in emissions through price incentives, and provides individuals and firms with maximum flexibility in deciding when and how to achieve reductions. Moreover, the revenue from a carbon/energy tax can be used to reduce other taxes, creating additional efficiency gains.

The prospect of a carbon/energy tax increase, however, raises potentially serious concerns about the competitiveness of U.S. energy-intensive industries. Previous proposals for such taxes have not adequately addressed these concerns from either an industry or an environmental point of view. The purpose of this study is to identify potential competitive burdens of a carbon/energy tax and to examine a range of alternative approaches to offsetting those burdens.

Several factors suggest that increased carbon/energy taxes will be under serious consideration in the coming decade. The United States is a signatory of the United Nations Framework Convention on Climate Change (FCCC), which commits nations to the "stabilization of greenhouse gas concentrations in the atmosphere at a level which will prevent dangerous anthropogenic interference with the climate system." The FCCC mandates an ongoing negotiation process to achieve this goal. As part of that process, the United States recently announced that it supports new, tighter, binding emissions reduction targets for industrial nations. It appears likely that some market incentive system, whether in the form of a carbon/energy tax or a tradable permit system, will be part of the U.S. strategy to meet these targets.

A carbon/energy tax increase combined with recycling of the revenue through the reduction of other taxes would increase the total tax burden on energy-intensive industries and decrease the burden on other industries. The paper considers three approaches to offsetting competitive burdens:

(1) Border tax adjustments (BTAs) are the most straightforward way to prevent firms in low tax jurisdictions from preying on energy-intensive industries in high tax jurisdictions. The simplest and most common border tax adjustment is the "destination system," in which traded goods are subject to the taxes of the importing ("destination") country and exempted from the taxes of the exporting ("origin") country. Current U.S. taxes with border adjustments include taxes on alcoholic beverages, tobacco products, motor and aviation fuels, hazardous substances (the Superfund tax), ozone-depleting chemicals, and many smaller taxes.

U.S. leadership in clarifying that BTAs are allowed is critical for three reasons. First, it is an essential precaution to protect American jobs and industries in case the United States should decide to adopt a carbon/energy tax. Second, U.S. opposition to BTAs on carbon/energy taxes is seen as a potential barrier to their adoption. Finally, it is important to assure that BTAs are available to other nations even if the United States chooses not to adopt a carbon/energy tax, for all nations benefit from emissions reductions directly caused by such measures.

(2) An energy efficiency credit reduces the competitive burden of fuel taxes from increased fuel bills caused by higher fuel prices. If energy consumption per unit of output can be lowered through the adoption of new and more efficient technology, the burden of these taxes is offset to that extent. A large number of engineering studies in many nations suggest that, even at current prices, national energy efficiency gains on the order of 10 to 20 percent could be achieved by adopting available best-practice technologies. Considerable evidence exists that firms generally under-invest in technology because some of the benefits of such investments are not enjoyed by the investor but flow to other firms or to society as a whole.

Thus it is desirable, both economically and environmentally, to accompany an energy tax with a package of measures that encourage adoption of energy-efficient processes. One such measure is a tax credit for investments in energy-efficient technology, which encourages adoption of energy-efficient technologies by reducing the cost of capital devoted to those investments. The most difficult part of designing a good efficiency credit is determining which investments will be eligible. Ideally the credit should be targeted to investments with high reductions in energy consumption relative to the tax revenue foregone. However, this sort of balancing would require engineering analysis which the taxing authority is not well equipped to audit. There are several possible approaches to dealing with this problem, including: developing a list of approved technologies with high expected energy saving per unit of tax revenue lost; self-certification by firms, combined with technical audits; and basing the credit on changes in a firm's aggregate energy efficiency, rather than conducting investment-specific assessments.

(3) A number of authors have proposed offsetting the burden of a carbon/energy tax through an investment tax credit (ITC). The ITC was first enacted by the Kennedy administration in 1962 and repealed by the Tax Reform Act of 1986. Under the ITC in its final form, investment in qualifying depreciable property with a useful life of at least three years resulted in a 10 percent tax credit. The most important classes of qualifying property were tangible personal property, primarily equipment, and certain structures integral to manufacturing, such as bulk storage facilities.

Prior to its repeal, the ITC went primarily (~60 percent) to non-manufacturing industries, the bulk of which are not very energy-intensive. This study suggests that, if the coverage of the ITC could be restricted to energy-intensive industries or processes, or to investments that significantly reduce energy consumption, the rate of the credit could be increased substantially, thus more effectively targeting competitive effects. For instance, we could offer a 20 percent investment credit if the credit could be limited to the fifth of all investment most directly related to energy consumption.

The paper also discusses alternative approaches to emissions reductions and competitiveness. For example, tradable permits and carbon/energy taxes result in the same level of emissions reduction and have the same impact on the price of fossil fuels and derivative energy sources. A tax sets the increase in price and allows the market to choose the quantity of fuels purchased, while a permit system sets the reduction in emissions and allows the market to set the increase in fuel price. While the paper focuses on offsetting the competitive burden of carbon/energy taxes by using the revenue to reduce other taxes, some of those revenues could be used to increase expenditures in areas that promote competitiveness, such as:

• Increased federal expenditures on research in efficiency and renewable technologies;

• Demonstration and early commercialization of new technologies;

• Public/private energy research consortia;

• A revolving loan fund for efficiency investment; and

• Increased public investment in education and training.

Much of the concern about carbon/energy taxes has focused on their impact on jobs and the competitiveness of domestic energy-intensive industries. A number of policies to offset such impacts have been adopted or proposed. However, little consensus exists regarding which offset policies are best, in part due to the failure to evaluate such policies by any consistent set of criteria. We propose a list of criteria by which competitive offset strategies can be evaluated. The measures should:

• Protect or promote the competitive position of energy-intensive industries against untaxed foreign competition in domestic and international markets;

• Maintain the tax's price incentive to reduce emissions by developing new clean technologies and processes or shifting to less carbon-intensive patterns of consumption;

• Be administered and enforced consistently and at a reasonable cost (including compliance costs accrued by the taxpayer);

• Distribute the energy tax burden fairly, and be perceived as fair by the public;

• Not be unnecessarily expensive; and

• Be consistent with U.S. treaty obligations under international environmental and trade agreements, especially the FCCC and the General Agreement on Tariffs and Trade.

Several of the measures described could be effectively combined to produce positive synergies. By integrating a range of tax and non-tax approaches, it may be possible to use climate policy to promote the overall competitiveness of U.S. industry. Any credible package of revenue recycling instruments will probably employ several approaches. For example, BTAs are approximately revenue neutral and can be combined with any of the other options discussed. Labor tax reductions are necessary to offset household burdens but need to be combined with energy efficiency credits or similar spending measures in order to provide adequate offsets to energy-intensive industries and promote the adoption of new technologies. Thus a package consisting of labor tax reductions, BTAs, and some combination of energy efficiency credits and non-tax measures to promote new technology may be appropriate. A policy package including tax-shifting with border adjustments and perhaps other energy efficiency incentives would improve the overall competitiveness of U.S. manufacturing by promoting plant modernization and technological development and lowering the average tax burden on exported goods. A well-designed system of competitive offsets can place both energy-intensive products and non energy-intensive products in an improved competitive position in international markets.

As the United States moves into the 21st Century, it faces increasing environmental challenges in an environment of tightening federal budget constraints and an increasingly competitive integrated global economy. If we are to continue to preserve and improve our standard of living, this combination of challenges requires innovative approaches to environmental problem-solving that better harmonize environmental and economic goals. This means that our efforts to reduce emissions should be structured to promote U.S. production and employment if possible, or at least to try to minimize any negative impact of climate policy on the U.S. economy.

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34 pps., 1997, $14.00, E972