Climate Finance: Regulatory and Funding Strategies for Climate Change and Global Development

Chapter 35 Tax and Efficiency under Global Cap-and-Trade

300 Climate Finance Chapter 35 Tax and Efficiency under Global Cap-and-Trade Mitchell A. Kane Professor, NYU School of Law Key Points • Two approaches to the taxation of carbon markets and abatement opportunities can be taken to avoid distorting the market and its participants’ behavior and thereby to preserve the efficiency of trading-based climate regulatory systems: inter-firm tax neutrality and intra-firm tax neutrality. • Inter-firm tax neutrality requires that all abatement costs receive the same tax treatment and that all permits receive the same tax treatment , regardless of the firm which undertakes the abatement or acquires permits. In the context of international emissions trading, this approach requires harmonization of the respective domestic tax rates for permits and abatement. • Intra-firm tax neutrality requires that each firm face the same tax treatment of actual abatement and permits on the margin. In the context of international emissions trading, this approach requires each country to achieve this matching, but does not require harmonization of tax rates. It does not require international harmonization of tax systems. • In the real world, intra-firm tax neutrality is the preferred policy approach due to the lesser degree of required coordination among national tax systems. The key challenge in implementing intra-firm tax neutrality will be to match tax treatment of permits and abatement . Because permits are likely to receive the same tax treatment Tax and Efficiency under Global Cap-and-Trade 301 for all holders, this means the efficient tax policy will require removing national-level tax differences among different methods of abatement (except where they are justified by non-climate externalities ) or making them ineffective at the margin. Coordination of this particular tax policy goal would be best achieved under the aegis of international climate agreements rather than through tax treaties. A cap-and-trade regime relies on the price of permits to signal which abatement opportunities are cost-effective, in light of the overall cap. Just like any market where we use price signals to achieve allocative efficiency, taxation is a looming problem. To the extent that taxes distort prices, the market will not function optimally, impairing the efficiency of the regulatory system. The very fact that one requires a market to achieve efficient abatement in the first place only arises because there are firm-specific lowcost abatement opportunities. Such firm-specific opportunities can take one of two forms. First, some firms may have low-cost abatement opportunities due to the ownership of some type of proprietary technology that allows production with fewer emissions than competitors. Second, some firms may have low-cost abatement opportunities because they happen to operate in jurisdictions where there are relatively low-cost abatement opportunities . Taxation presents the same type of potential problem in each of these cases: abatement opportunities that should be favored on a pretax basis become relatively expensive on an after-tax basis due to differential tax treatment of firms operating in the market, either due to their mode of production/abatement or their territorial location of operations. (Some tax preferences might be independently justified by non-climate externalities, such as national security, and would accordingly not distort the market; these preferences are not the subject of the analysis which follows .) In a first best world there are two ways to structure tax systems in order to preserve efficient allocation of abatement. Each approach involves concepts of tax neutrality, but they operate at different levels. Thus, we can distinguish between inter-firm tax neutrality and intra-firm tax neutrality. Inter-firm Tax Neutrality Inter-firm tax neutrality is the more intuitive of the two types of tax neutrality , albeit the form that is much more difficult to achieve in a multijurisdictional cap-and-trade system. The goal is to remove tax distortions 302 Mitchell A. Kane that operate to shift abatement away from firms which have low-cost abatement opportunities and toward firms with high-cost abatement. For example, suppose that Firm A can abate a ton of carbon emissions at a cost of USD 20 and Firm B can abate a ton of carbon emissions at a cost of USD 15. If we imagine that Firm A faces a 50% marginal tax rate and Firm B faces a 10% marginal tax rate, then the after-tax cost of abatement (which should give rise to a deductible expense under standard income tax principles), will be USD 10 and USD 13.50...