Climate Change, Trade, and Competitiveness

BROOKINGS INSTITUTION PRESS

Contents

Chapter One

The Economic and Environmental Effects of Border Tax Adjustments for Climate Policy

For the foreseeable future, climate change policy will be considerably more stringent in some countries than in others. Indeed, the United Nations Framework Convention on Climate Change explicitly states that developed countries must take meaningful action before any obligations are to be placed on developing countries.

However, differences in climate policy will lead to differences in energy costs, and to concerns about competitive advantage. In high-cost countries, there will be political pressure to impose border tax adjustments (BTAs), or "green tariffs," on imports from countries with little or no climate policy and low energy costs. The BTAs would be based on the carbon emissions associated with the production of each imported product, and they would be intended to match the cost increase that would have occurred had the exporting country adopted a climate policy similar to that of the importing country.

Several justifications have been proposed for including BTAs as a key component of climate policy. Some researchers—including Stiglitz, Kopp and Pizer, and Ismer and Neuhoff—argue that BTAs are required for economic efficiency in carbon abatement. An alternative argument is that BTAs are needed to keep climate policy from being undermined by the "leakage" of emissions through migration of carbon-intensive industries to low-tax countries and, as a corollary, to protect import-competing industries in high-tax countries. There are also a number of papers that argue that the approach could be used to punish countries that did not participate in the Kyoto Protocol, or could be used as a threat to encourage recalcitrant countries to join a global regime. Finally, there is also a considerable literature debating the legality of BTAs for climate polices under World Trade Organization rules.

These arguments are reflected in the political debate in Europe and the United States. In 2006 then–French prime minister Dominique de Villepin suggested that countries that do not join a post-2012 international treaty on climate change should face additional tariffs on their industrial exports. The European Parliament's (2005/2049) resolution was focused on penalizing countries such as the United States for nonparticipation in the Kyoto Protocol. In the United States, both the Bingaman-Specter Bill (S 1766) and the Leiberman-Warner Bill (S 2191) include mechanisms that would, in effect, impose BTAs under some circumstances for imported goods from countries deemed to be making insufficient effort to reduce their greenhouse gas emissions.

Most of the arguments in the literature, however, have been theoretical. Little empirical work has been done to determine either the magnitude that BTAs would take in practice, or on the economic and environmental consequences they would cause. This gap leads to a range of important questions. Would BTAs actually improve global carbon abatement? How much would they help or hurt the economy of the country imposing them? How much would they help or hurt the global economy? Are the gains, if any, large enough to justify the administrative costs involved? In this chapter, we address several of these questions. We estimate how large such tariffs would be in practice, and then examine their economic and environmental effects using G-Cubed, a detailed multisector, multicountry model of the world economy. We find that the tariffs would be small on most traded goods, would reduce leakage of emissions reduction very modestly, and would do little to protect import-competing industries. We conclude that the benefits produced by BTAs would be too small to justify their administrative complexity or their deleterious effects on international trade and the potentially damaging consequences for the robustness of the global trading system.

In a sense, these results are not surprising, because most carbon emissions are from domestic activities, such as electricity generation and local and regional transportation, which are largely nontraded and are little affected by international trade. In practice, the most important mechanism through which leakage could occur would be world oil markets, not trade in manufactured goods. A sufficiently large carbon tax imposed in a major economy would lower global oil prices and lead to higher consumption in countries with little or no carbon tax. However, BTAs would be neither appropriate nor effective in reducing that form of leakage. We conclude that it is an unnecessary distraction for the global community to focus much attention on negotiations over BTAs as a component of climate policy; they would not matter much in practice and, as also argued by Lockwood and Whalley, they may lead to greater distortions to the global trading system.

An Overview of the G-Cubed Model

G-Cubed is an econometric intertemporal general equilibrium model of the world economy with regional disaggregation and sectoral detail. For this chapter, the world economy is divided into the ten regions shown in table 1-1. Each region is further decomposed into a household sector, a government sector, a financial sector, the twelve industrial sectors shown in table 1-2, and a capital-goods-producing sector. To facilitate the analysis of energy and environmental policy, five of the industries are used to represent segments of the energy industry: electric utilities, natural gas utilities, petroleum refining, coal mining, and crude oil and gas extraction. All regions are linked through bilateral trade in goods and financial assets. All relevant budget constraints are imposed on households, governments, and nations (the latter through accumulations of foreign debt). Households and firms have forward-looking expectations and use those projections when planning consumption and investment decisions. However, a portion of the households and firms are assumed to be liquidity constrained. G-Cubed is a very large example of the dynamic stochastic general equilibrium models used in the macroeconomics literature. It is also an intertemporal general equilibrium model from the computable general equilibrium class of models. We have described G-Cubed's theoretical and empirical structure in more detail elsewhere. In the remainder of this section, we present a brief summary of its key features.

Producer Behavior

Each producing sector in each region is modeled by a representative firm, which chooses its inputs and its level of investment to maximize its stock market value subject to a multiple-input constant elasticity of substitution production function and a vector of prices it takes to be exogenous. We assume that output is produced using inputs of capital, labor, energy, and materials. Energy and materials, in turn, are aggregates of inputs of intermediate goods and services.

We assume that all regions share production methods that differ in first-order properties but have identical second-order characteristics. This is intermediate between the extremes of assuming that the regions share common technologies and of allowing the technologies to differ across regions in arbitrary ways. Finally, the regions also differ in their endowments of primary factors and patterns of final demands.

Maximizing the firm's short-run profit subject to its capital stock and its production function gives the firm's factor demand equations. At this point, we add two further levels of detail: We assume that domestic and imported inputs of a given commodity are imperfect substitutes, and that imported products from different countries are imperfect substitutes for each other. Thus, the final decision the firm must make is the fraction of each of its inputs to buy from each region in the model (including the firm's home country). We assume that all agents in each economy have identical preferences over foreign and domestic varieties of each particular commodity. The result is a system of demand equations for domestic goods and imports from every region.

In addition to buying inputs and producing output, each sector must also choose its level of investment. We assume that capital is specific to each sector, that investment is subject to adjustment costs, and that firms choose their investment paths to maximize their market value. In addition, each industry faces the usual constraint on its accumulation of capital that the change in the capital stock is equal to gross investment less depreciation.

Following the cost of adjustment models of Lucas, Treadway, and Uzawa, we assume that the investment process is subject to rising marginal costs of installation. Setting up and solving the firm's investment problem yields an investment decision that depends on production parameters, taxes, the current capital stock, and marginal q (that is, the ratio of the marginal value of a unit of capital to its purchase price).

Following Hayashi, we modify the investment function to improve its empirical properties by writing it as a function not only of q but also of the firm's current capital income. This improves the empirical behavior of the specification and is consistent with the existence of firms that are unable to borrow and therefore invest purely out of retained earnings. The fraction of fully optimizing firms is taken to be 0.3 based on a range of empirical estimates; the fraction that are liquidity constrained is 0.7.

In addition to the twelve industries discussed above, the model also includes a special sector that produces capital goods. This sector supplies the new investment goods demanded by other industries. Like other industries, the investment sector demands labor and capital services as well as intermediate inputs. We represent its behavior using a nested constant elasticity of substitution production function with the same structure as that used for the other sectors. However, we estimate the parameters of this function from price and quantity data for the final demand column for investment.

Households and Governments

Households consume a basket of composite goods and services in every period and also demand labor and capital services. Household capital services consist of the service flows of consumer durables and residential housing. Households receive income by providing labor services to firms and the government, and from holding financial assets. In addition, they receive imputed income from ownership of durables and housing, and they also receive transfers from their region's government.

Within each region, we assume household behavior can be modeled by a representative agent who maximizes an intertemporal utility function subject to the constraint that the present value of consumption is equal to the sum of human wealth and initial financial assets. Human wealth is the present value of the future stream of after-tax labor income and transfer payments received by households. Financial wealth is the sum of real money balances, real government bonds in the hands of the public, net holdings of claims against foreign residents, and the value of capital in each sector.

There has, however, been considerable debate about whether the actual behavior of aggregate consumption is consistent with the permanent income model. On the basis of the evidence cited by Campbell and Mankiw, we modify the basic household model described above to allow a portion of household consumption to depend entirely on current after-tax income (rather than on wealth). This could be interpreted in various ways, including the presence of liquidity-constrained households or households with myopic expectations. For the purposes of this chapter, we will not adopt any particular explanation and will simply take the income-driven share of consumption to be an exogenous constant. Following McKibbin and Sachs, we take the share to be 0.7 in all regions.

Within each period, the household allocates expenditures among goods and services to maximize its intratemporal utility. In this version of the model, we assume that intratemporal utility may be represented by a Cobb-Douglas function of goods and services. Finally, the supply of household capital services is determined by consumers themselves, who invest in household capital. We assume that households choose their level of investment to maximize the present value of future household capital service flows (taken to be proportional to the household capital stock), and that investment in household capital is subject to adjustment costs. In other words, the household investment decision is symmetrical with that of the firms.

Government

We take each region's real government spending on goods and services to be exogenous and assume that it is allocated among final goods, services, and labor in fixed proportions according to the base year input/output table for each region. Total government spending includes purchases of goods and services plus interest payments on government debt, investment tax credits, and transfers to households. Government revenue comes from sales, corporate, and personal income taxes and from the issuance of government debt. In addition, there can be taxes on externalities such as carbon dioxide emissions. We assume that agents will not hold government bonds unless they expect the bonds to be serviced. Accordingly, we impose a transversality condition on the accumulation of public debt in each region that has the effect of causing the stock of debt at each point in time to be equal to the present value of all future budget surpluses from that time forward. This condition alone, however, is insufficient to determine the time path of future surpluses: The government could pay off the debt by briefly raising taxes a lot; it could permanently raise taxes a small amount; or it could use some other policy. We assume that the government levies a lump sum tax in each period equal to the value of interest payments on the outstanding debt. In effect, therefore, any increase in government debt is financed by Consols (that is, bonds without a redemption date that pay interest in perpetuity), and future taxes are raised enough to accommodate the increased interest costs. Thus, any increase in the debt will be matched by an equal present value increase in future budget surpluses.

Macroeconomic Features: Labor Market Equilibrium and Money Demand

We assume that labor is perfectly mobile among sectors within each region but is immobile between regions. Thus, within each region, wages will be equal across sectors. The nominal wage is assumed to adjust slowly according to an overlapping contracts model, where nominal wages are set based on current and expected inflation and on labor demand relative to labor supply. In the long run, labor supply is given by the exogenous rate of population growth; but in the short run, the hours worked can fluctuate depending on the demand for labor. For a given nominal wage, the demand for labor will determine short-run unemployment.

Relative to other general equilibrium models, this specification is unusual in allowing for involuntary unemployment. We adopted this approach because we are particularly interested in the transition dynamics of the world economy. The alternative of assuming that all economies are always at full employment, which might be fine for a long-run model, is clearly inappropriate during the first few years after a shock.

Finally, because our wage equation depends on the rate of expected inflation, we need to include money demand and supply in the model. We assume that money demand arises from the need to carry out transactions and depends positively on aggregate output and negatively on the interest rate. The supply of money is determined by the balance sheet of the central bank and is exogenous.

International Trade and Asset Flows

The regions in the model are linked by flows of goods and assets. Each country's exports are differentiated from those of other countries; exports of durables from Japan, for example, are not perfect substitutes for exports of durables from Europe. Each region may import each of the twelve goods from potentially all the other regions. In terms of the way international trade data are often expressed, our model endogenously generates a set of twelve bilateral trade matrices, one for each good. The values in these matrices are determined by the import demands generated within each region.

Trade imbalances are financed by flows of assets between countries. We assume that asset markets are perfectly integrated across the regions and that financial capital is freely mobile. Under this assumption, expected returns on loans denominated in the currencies of the various regions must be equalized period to period according to a set of interest arbitrage relations. In generating the baseline of the model, we allow for risk premiums on the assets of alternative currencies, although in counterfactual simulations of the model, these risk premiums are generally assumed to be constant and unaffected by the shocks we consider.

(Continues...)

Excerpted from Climate Change, Trade, and Competitiveness Copyright © 2009 by THE BROOKINGS INSTITUTION. Excerpted by permission of BROOKINGS INSTITUTION PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Lael Brainard is vice president and director of the Global Economy and Development (Global) program at the Brookings Institution. Isaac Sorkin is a research assistant with Brookings Global.