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Economists often advocate taxes or cap-and-trade schemes to fight pollution, but US policy primarily subsidises clean energy alternatives. This column critiques such subsidies on four counts: they lower the cost of energy, pick favourite technologies, are often "inframarginal", and interact in unexpected ways with other policies.

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Nearly all economists agree that the most efficient way to address environmental problems is to raise the cost of the pollution-generating activity. Whether one uses a tax as famously suggested by Pigou (1938) or a quantity constraint such as a cap and trade system as proposed by Dales (1968) and others, the point is to "internalise the externality" by raising the cost of pollution to the firm or individual so that they have the appropriate incentives to engage in the socially optimal level of this activity. Weitzman (1974) provides a framework for choosing between price and quantity approaches when benefits and costs of abatement are uncertain.

All of these approaches assume that policymakers will address externalities by making them more costly. The experience with US energy policy has been to take another approach. Rather than making energy sources that contribute to pollution more costly the approach has been to subsidise clean energy alternatives. Such has been the case to date with policies to reduce energy-related greenhouse gas emissions. Until such time as the US enacts a national cap-and-trade system or a carbon tax, tax-based subsidies provide some of the most substantial incentives to reduce greenhouse gas emissions.

In Metcalf (2009), I review the current set of tax-based subsidies for low-carbon energy and provide a critique of a subsidy-based approach to energy policy. The single largest subsidy is the 45 cents per gallon excise tax credit for ethanol. But in addition to this credit there are production and investment tax credits for renewable electricity production, for clean-fuel burning vehicles, as well as credits and subsidies for energy efficiency investments both in the home and in the workplace. Many of these subsidies were recently renewed and extended in the American Recovery and Reinvestment Act of 2009. Even if a national cap and trade bill such as the American Clean Energy and Security Act bill (HR 2454) recently reported out of the House Energy and Commerce Committee were enacted it is likely that many of these subsidies to clean energy will remain in the tax system.

Subsidies for clean energy are appealing but they suffer from four problems. First they lower the cost of energy; second, they play favourites with technologies; third they are often "inframarginal"; and finally they often interact in unexpected ways with other policies.

Tax-based subsides achieve the important goal of adjusting relative prices of polluting and non-polluting energy sources in the right direction. If fuel source X causes pollution that is equal to 10% of its cost then we can provide the right incentive to fuel users choosing between fuel sources X and Y by raising the price of X by 10% or by lowering the cost of fuel source Y by 1/(1.10) or 9.1%. Either way the relative cost of fuel source X to Y is now 10% higher than it was prior to the implementation of the new energy policy. Either a tax or a subsidy can be effective on the margin of choosing among fuel sources where some sources cause pollution.

This creates a problem, however, on a different margin. Efficiency requires that consumers make decisions taking into account the full cost of using commodities - including the pollution costs associated with using energy. Raising the cost of the polluting fuel source X raises the overall cost of energy use and encourages a reduction in energy consumption. Subsidising the clean substitute undermines this consumer substitution effect as it leads to a lower cost of energy overall. Consumers do not reduce energy consumption as much as they would under a cost-raising policy.

Problem 2: Subsidies favour particular technologies

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Subsidies tend to favour particular technologies. Consider the tax credit for hybrid vehicles put in place in the Energy Policy Act of 2005. The credit ranges from zero to $3,000 per vehicle depending on whether the vehicle meets the specific hybrid criteria and on how many vehicles have been sold. The credit phases out as the vehicle hits certain sales targets over time. Table 1 shows the subsidy cost per gallon of gasoline saved through this credit for a number of model 2009 vehicles.

Table 1. Hybrid vehicle tax credit - Model 2009 values

Source: Metcalf (2009). Author's calculations of savings relative to a vehicle that gets 20 miles per gallon and is driven 12,485 miles per year. Vehicles are assumed to be driven for ten years and savings are annualised with a ten percent discount rate.

Table 1 illustrates several points. First, the tax credit per gallon of gasoline saved varies from zero to over $11 per gallon. Second, certain hybrid vehicles that get high mileage are excluded from the credit because they have been successful in the market place. Third, certain high mileage vehicles are excluded from the subsidy because they do not use specified technology. Note that the Corolla gets nearly the same mileage as the Tribute Hybrid. This is the most egregious violation of technology neutrality. The tax credit provides no incentive to tinker with the internal combustion engine to achieve increases in vehicle efficiency despite the many opportunities that exist to make the internal combustion engine more efficient. US tax policy should provide the same incentives to improve mileage regardless of the technology put in place.

Problem 3: Subsidies are wasteful

Ideally we want subsidies targeted to marginal investments. But often they end up supporting inframarginal investments, i.e. investments that would have taken place in the absence of the policy. A good example of this is the $0.50 per gallon alternative fuels mixture credit. This credit is intended to encourage the addition of biodiesel and other biomass based fuels to petroleum to reduce petroleum use. Recently it has emerged that many paper firms are taking the credit for mixing diesel fuel with black liquor, a biomass by-product of paper making that historically has been used by the industry as a fuel source for their boilers. Controversy has arisen over whether paper firms are adding diesel fuel to black liquor purely for the purpose of claiming the tax credit biodiesel mixture tax credit (Mouawad and Krauss 2009). This is troubling on two levels. First, it may be highly inefficient if credits are being provided for inframarginal activities. This is a common problem with any subsidy. We want to provide the incentive to firms that would not have undertaken the desirable activity in the absence of the subsidy. But we don't want to provide the subsidy to firms that would have undertaken the activity regardless of the subsidy. Yet the example from the paper industry is troubling beyond the inframarginal nature of the subsidy. If the tax credit is raising the demand for diesel fuel in order to make the biofuel eligible for the credit, then it is having the perverse effect of raising rather than lowering demand for petroleum products.

Problem 4: Subsidies interact in unexpected ways with other policies

Subsidies can be rendered ineffective or more expensive through their interaction with other policies. A simple example here is the interaction of the hybrid vehicle tax credit and the Corporate Average Fuel Economy standards. Allowing tax credits for hybrids encourages the production and purchase of high mileage vehicles. But the Corporate Average Fuel Economy sets minimum fleet mileage standards for automakers. Producing more hybrid vehicles relaxes the mileage constraint for automakers and allows them to sell more low mileage vehicles. The result is that federal tax collections are reduced with no improvement in automobile mileage.

An alternative to subsidies

Most if not all of the problems identified above disappear if we replace the current system of tax subsidies for carbon free technologies with a market-based system to set positive and gradually increasing carbon prices. It looks like we're on track to set the carbon price, either through a cap and trade system or some form of carbon charge. But insufficient attention is being paid to removing the various tax subsidies currently in place.

Author: Gilbert E. Metcalf

Affiliation: Professor of Economics, Tufts University

Source: VoxEU.org