Output-based rebating of carbon taxes in the neighbor’s backyard. Competitiveness, leakage and welfare

Abstract

We investigate how, in an open economy, carbon taxes combined with output-based rebating (OBR) perform in interaction with the carbon policies of a large neigh-bouring trading partner. Analytical results suggest that, whether the purpose of the OBRpolicy is to compensate firms for carbon tax burdens or to maximize welfare (accountingfor global emission reductions), the OBR rate should be positive in policy-relevant cases.Numerical simulations for Canada, with the US as the neighbouring trading partner, in-dicate that the impact of US policies on the OBR rate will depend crucially on the purposeof the Canadian OBR policies. If, for a given US carbon policy, Canada’s aim is to restorethe competitiveness of domestic emission-intensive and trade-exposed (EITE) firms to thesame level as before the introduction of its own carbon taxation, we find that the necessarydomestic OBR rates will be insensitive to the foreign carbon policies. However, if not onlythe Canadian carbon tax but also an equally high US tax is introduced, compensatoryCanadian OBR rates will be up to 50% lower, depending on the sector and on US OBRpolicy. If the policy objective is to increase economy-wide allocative efficiency (welfare)of Canadian policies by accounting for carbon leakage, the US policies will have only aminor downward pressure on desirable OBR rates in Canada. Practical choices of OBRrates hardly affect overall domestic economic performance; thus, output-based rebatingqualifies as an instrument for compensating EITE industries without a large sacrifice interms of economy-wide allocative efficiency.