Energy Tax Policy: An Economic Analysis

Order Code RL30406

CRS Report for Congress

Received through the CRS Web

Energy Tax Policy: An Economic Analysis

Updated June 28, 2005

name redacted

Specialist in Public Finance

Resources, Science, and Industry Division

Congressional Research Service ˜ The Library of Congress

Energy Tax Policy: An Economic Analysis

Summary

This report provides background on the theory and application of tax policy as

it relates to the energy sector, particularly with respect to the theory of market failure

in the energy sector and suggested policy remedies.

Economic theory suggests that producers of energy-related minerals be taxed no

differently than non-mineral producers: Exploration and development costs and other

investments in a deposit (including geological and geophysical costs and delay

rentals) should be capitalized. In general, competitive mineral producers subject to

a pure income tax would not exploit resources as fast (compared with the rate of

exploitation under the present system of subsidies). Over the longer term, depletion

of fossil fuels and mineral resources leads to higher real energy prices, which would

eventually promote the optimal amount of investment in energy efficiency and

alternative fuels supply.

Under principles of neutrality of tax policy, there is no purely economic

rationale for energy taxes or tax subsidies to (1) raise revenues; (2) conserve energy

(with one exception); (3) promote alternative fuels; (4) compensate for any extra

market risk; or (5) promote, as an industrial policy, specific industries such as the

fossil fuels industry. However, even under a pure income tax, economic efficiency

suggests a system of energy taxes (in addition to the income taxes) to correct for any

environmental externalities caused by the production, importation, and use of each

fuel, and energy taxes in the form of user charges for benefits received, such as the

highway trust fund. In the case of energy conservation, market failures in the use of

energy in rental housing provide an efficiency rationale for the current gross income

exclusion for conservation subsidies provided by electric utilities. There are other

market failures in energy use that suggest efficiency standards, energy labeling, or

government-provided information, but not necessarily tax subsidies.

Tax subsidies for domestic oil production tend to stimulate domestic supply of

petroleum and reduce demand for petroleum imports. This may enhance national and

economic security in the short run, but it might damage national and economic

security in the long run as domestic energy resources are depleted faster than they

otherwise would be. The economically efficient policy to reduce import dependence

would impose a tax (or tariff) on imported petroleum based on the per-barrel estimate

of these costs (the so-called oil import “premium”). The problem of vulnerability to

embargoes and price shocks, which relates to dependence on imported oil from the

Organization of Petroleum Exporting Countries (OPEC) and other potentially

unstable or unfriendly foreign countries, is more effectively addressed in a policy of

stockpiling oil, as is being done with the Strategic Petroleum Reserve.

In terms of environmental protection and management, energy taxes can be a

cost-effective and efficient market-based instrument, and they are economically

superior to the command and control approach. In sum, energy taxes are generally

distortional (except to correct for externalities, or when imposed as user fees for

benefits received) and regressive, and may have adverse macroeconomic

consequences, particularly sizeable taxes on energy production or oil imports.

Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Recent Actions in Energy Tax Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Issues Raised by Energy Policy Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Purpose of the Report . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Energy as a Commodity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Neutral Income Tax Treatment of Fossil Fuel Producers . . . . . . . . . . . . . . . . . . . 6

Externalities and Other Market Failures, and the Rationale for Energy Taxes

and Subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Environmental Pollution Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

The Emissions Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Energy Taxes Aa Pollution Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Clinton’s Btu Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Oil Import Dependence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Production/Investment Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Energy User Charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Taxes vs. Tax Subsidies (Incentives) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

Energy Tax Subsidies as an Industrial Policy . . . . . . . . . . . . . . . . . . . . . . . 14

The Economic Justification for Tax Subsidies as an

Industrial Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

The Social Rate of Discount and Market Failures . . . . . . . . . . . . . . . . . . . . 15

Energy Conservation and Energy Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Renewable vs. Conventional Fuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Does Oil and Gas Have a Competitive Advantage? . . . . . . . . . . . . . . . . . . 19

Energy Taxes to Increase Revenues and Reduce Deficits . . . . . . . . . . . . . . . . . . 19

Energy Taxes vs. Regulation to Achieve Environmental Policy Goals . . . . . . . 21

Taxes or Tradeable Emissions Permits . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

The Economic Effects of Energy Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

Efficiency Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

Distributional Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

Macroeconomic Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

List of Tables

Table 1. Energy Market Failures and Energy Tax Policy Remedies . . . . . . . . . . 5

Table 2. A $1 Million BTU Tax on Selected Fuels as % of 2003 Fuel Price . . 11

Energy Tax Policy: An Economic Analysis

Introduction

Energy tax policy involves the use of the government’s main fiscal instruments

— primarily tax subsidies (tax credits, deductions, exemptions, and lower tax rates)

as financial incentives, and increased taxes as financial disincentives — to alter the

allocation or configuration of energy resources and thereby achieve policy objectives.

The idea of applying tax policy instruments to the energy markets is not new, but

until the 1970s energy tax policy had been little used, except to promote oil and gas

development.1

Recent Actions in Energy Tax Policy

Recurrent energy-related problems since the 1970s — oil embargoes, oil price

and supply shocks, wide petroleum price variations and price spikes, large

geographical price disparities, tight energy supplies, rising oil import dependence, as

well as increased concern for the environment — have caused policymakers to look

toward energy taxes and subsidies with greater frequency. In a typical Congress

hundreds of bills are introduced that propose to amend energy tax policy directly, and

hundreds of others have indirect effects that either reduce costs (energy tax

incentives) or increase costs (energy taxes) in the energy industry. In the 108th

Congress, over200 such bills were introduced.

More recently, energy tax incentives and subsidies (and also some reductions

in energy taxes) have been the dominant part of comprehensive energy policy

legislation — dominant in the sense that the changes in taxes resulting from the

incentives produce the greatest economic effects in terms of cost reductions or

increases. In the 107th and 108th Congresses, an emerging “energy crisis” —

fluctuating oil prices, spiking petroleum product prices, the California energy crisis,

spiking natural gas prices, the collapse of Enron in 2001, the northeast electricity

blackout on August 14, 2003 — led to several comprehensive energy policy reform

bills. These bills proposed to, among other things, stimulate additional production

of oil and gas and reduce petroleum import dependence, expand electricity supply

and infrastructure, promote energy conservation and efficiency, and expand the

supply of alternative (renewable and unconventional) fuels.2 Sizeable energy tax

1

The two major tax subsidies for oil and gas were percentage depletion, and expensing of

intangible drilling costs. Percentage depletion has been largely eliminated and expensing

has been significantly reduced. See U.S. Senate, Tax Expenditures: Compendium of

Background Material on Individual Provisions, Committee on the Budget, Committee Print,

108th Cong, 2nd sess. (Washington, GPO, 2004), pp. 77-83.

2

In 2002 the energy tax provisions were part of comprehensive energy bill H.R. 4 (107th

(continued...)

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subsidies (tilted more toward fossil fuel supply) were part of H.R. 6, the

comprehensive energy policy bill of the 108th Congress. The conference version of

that bill proposed a $23.5 billion ten year energy tax cut.3

Failure of the comprehensive energy legislation caused several energy tax

incentives to expire in 2003, so the 108th Congress enacted retroactive extension of

several of the provisions as part of the Working Families Tax Relief Act of 2004

(P.L. 108-311). Those provisions, which reduced revenues by about $1.3 billion over

ten years, were enacted on enacted on October 4, 2004. About $5 billion in energy

tax incentives — mostly from the expansion and liberalization of the renewable

electricity tax credit — were part of the American Jobs Creation Act of 2004 (P.L.

108-357) enacted on October 22, 2004. That leaves roughly $17 billion in tax breaks

embodied in the failed comprehensive legislation H.R. 6 (108th Congress) that have

not been enacted.

Many of the energy tax incentives that have not been enacted over the past four

or five years have been repackaged as H.R. 6 (109th Congress), which the House

approved with its tax title on April 13, 2005. The tax provisions provide about $8.1

billion of energy tax cuts over ten years as compared with $23.5 billion in H.R. 6 in

the 108th Congress, and $33.5 billion in House version of H.R. 4 in the 107th. The

Senate is expected to vote on an Senate Finance Committee approved bill that

provides about $17 billion in energy tax subsidies. This bill is tilted less toward

fossil fuel production and more toward energy conservation and alternative fuels than

the $8 billion tax incentives package in the House-passed energy bill. President

Bush’s FY2006 budget request proposed a $6.7 billion, ten-year energy tax incentives

package.

Finally, not all of the recent actions in the area of energy tax policy have

involved tax subsidies or incentives — some have involved taxation. For example,

during the spike in gasoline and diesel prices of spring 2000, there were several

proposals (e.g., S. 2285, 106th Congress) to suspend the motor fuels excise taxes to

relieve consumers the burden of high and spiking prices.4 More recently, there are

bills to reinstate the crude oil windfall profit tax of the 1980 to reduce the windfall

profits allegedly being earned by oil companies from high crude oil and petroleum

product prices.

2

(...continued)

Congress). H.R. 4 was dropped on November 13, 2002, due to controversy over ANWR

development and fuel economy standards. In 2003 and 2004 (the 108th Congress) these

provisions were part of H.R. 6. On November 24, 2003, the conference report failed to

secure the necessary 60 votes to overcome a Democratic filibuster before Congress’s

adjournment for the holiday season. This represented the third attempt to pass

comprehensive energy legislation, a top priority for Republicans and for President Bush.

3

CRS Report RL32402, Energy Tax Incentives in H.R. 6: The Conference Agreement as

Compared with the House Bill and Senate Amendment, by (name redacted).

4

See CRS Report RL30497, Suspending the Gas Tax: Analysis of S. 2285, by (name red

acted).

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Issues Raised by Energy Policy Proposals

Proposals to amend the current federal tax treatment of the energy industry, and

to either impose energy taxes or provide tax subsidies, raise several important

economic and other public policy issues:

!

The nature and seriousness of the nation’s energy problems, and the

appropriate policy instruments to deal with them. What exactly are

the problems in U.S. energy markets? Is the problem one of

excessive demand for, and consumption of, energy? Is it insufficient

supply? Or is it both? Moreover, are the problems an inherent part

of the market system — that need a government solution? Or does

government interference worsen the situation? Are there market

failures, or just simply barriers that could be overcome by the market

itself if the economic variables were aligned just right?

!

More specifically, what are the various problems in each of the

energy markets, the petroleum, natural gas, and electricity markets?

How serious is growing petroleum import dependence and what are

the tax policy instruments that may be effectively used to address

this problem?

!

Assuming that energy tax policy instruments are the recommended

policy choice, how should the specific change in tax burdens be

achieved? Should energy tax burdens be changed by a tax credit, tax

deduction or exemption, or by reducing some energy tax rate? What

is the relative effectiveness of each of these tax subsidy instruments

in achieving policy effectiveness (the most “bang-for-the-buck”)?

!

What is, and what should be the federal tax treatment of the energy

industry, including the tax treatment of investments in oil and gas

wells and coal mines, and the tax treatment of other expenses such

as exploration and development costs? Does the oil and gas industry

receive federal tax subsidies and if so how much? Do these subsidies

adversely affect the production, consumption, and importation of

energy? Do they also inhibit the development of renewable energy

(such as solar, wind, and biomass) and investments in energy

efficiency? Should federal tax subsidies for oil and gas and other

fossil fuels be increased to stimulate exploration and supply to

address our energy problems or would budgetary resources be better

used to reduce energy demand by providing tax incentives for energy

efficiency and renewable energy?

!

How should the tax code allow for depletion of mineral reserves and

other mineral production expenses. For example, should it use cost

depletion, adjusted cost depletion, percentage depletion, or complete

expensing? How would the various tax reform proposals (for

example, a cash-flow tax or a consumption tax) affect the treatment

of the oil and gas and other energy sectors?

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!

Is there an economic or policy rationale for energy taxes to raise

revenue or energy tax subsidies to encourage greater energy

conservation or increased supply of alternative fuels? Further,

assuming the policy objective is to promote fossil fuel conservation,

would the more effective incentives target energy efficiency or the

supply of alternative (including renewable) forms of energy?

!

What are the economic effects — the effects on allocational

efficiency, distribution of income, macroeconomic effects, effects on

energy supply, demand, and imports — of taxing or subsidizing

energy?

Purpose of the Report

This report provides background on the theory and application of tax policy as

it relates to the energy sector, particularly with respect to the theory of market failure

in the energy sector and the possible policy remedies. More specifically, it provides

an overview for policymakers on the types of energy tax policy interventions that are

likely to improve the functioning of energy markets, and the efficiency with which

the general economic system allocates resources (i.e., the general welfare).

Table 1 summarizes the market failures discussion in the report. It lists the types

of energy market failures likely to cause economic inefficiencies and the tax policy

remedy suggested by economists. It also cites examples in current law that are

consistent with this theory — energy tax provisions that enhance economic

efficiency. The text following the table discusses each of these failures in detail.5

Energy as a Commodity

At the outset, it is important to address the notion that there is something

inherently different about energy, or fuels from various energy resources, that

requires government intervention through the tax code. Often energy tax proposals

are premised on such arguments, that energy is too important to be left to the

unfettered private market system.

5

While there may be other factors, this report addresses those problems and solutions

grounded in economic efficiency.

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Table 1. Energy Market Failures and Energy Tax Policy Remedies

Type of Market

Failure

Description

Distortion

Damage/Benefit

Possible Energy Tax Policy

Examples in Current

Law

Environmental

Externalitities

Air pollution,

discharges of wastes

and effluents

Underpricing of energy resources

and higher production; excessive

use due to uncompensated spillover

effects

Harmful to health,

property damage, and

economic damage

Emission taxes (or energy

excise taxes where feasible)

Tax on Ozone Depleting

Chemicals under IRC

§4681

Oil Import

Dependence

Excessive and rising

importation of crude

oil and petroleum

products

Underpricing of crude oil &

petroleum products

Harm to national, energy,

and economic security;

excessive defense

spending

Oil Import Tax

Energy R&D

Manufacturers do not

undertake sufficient

R&D activities

Unpriced benefits to free riding

firms from R&D activities

Under supply of R&D;

costly and insufficient

energy efficiency and

alternative fuel

technologies

Tax subsidies for R&D

expenditures

Tax credit under IRC §30,

and expensing under IRC

§174

Public

Goods/Energy

Complementarity

Private market fails to

provide goods that are

consumed collectively

and for which

exclusion is too costly

Under-supply, or no supply of

public goods such as roads,

bridges, infrastructure

Unrealized benefits;

under-developed

economy, and slower

productivity growth

Benefit charges, and user

fees, but also energy taxes

and congestion pricing

Excise taxes of gasoline

and other motor fuels

under IRC§s 4081-4093

none

Tax incentives for landlords

Exclusion of subsidy from

Environmental damages,

or tenants for energy

gross income under IRC

excessive import

dependence, and other

efficiency investments

§136

damages due to excessive

energy use

Source: Adaptation based on Fisher, Anthony and Michael H. Rothkopf. Market Failure and Energy Policy: The Rationale for Selective Conservation. Energy Policy, v.17, August,

1989.

Landlord/Tenant

Problem

Landlords, tenants

have no incentive to

conserve energy

Under investment in energy

conservation items in rental

housing (over consumption of

energy)

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According to economists, energy is a commodity that is produced to provide

utility to consumers or end users, and, in general, is no different than any other

economic good. Three features of energy as an economic good, however, differentiate

it from other commodities. First, most energy is derived from depletable mineral

resources: Petroleum products are derived from crude oil, natural gas resides in

depletable reservoirs or deposits (such as coal mines), and electricity is (currently)

mostly derived from coal. While this does not necessarily impede the smooth

functioning of the competitive market system, it does mean that production decisions

have to be made functioning of the competitive market system, it does mean that

production decisions have to be made in an inter-temporal framework. That raises the

important inter-generational question: Do markets optimally deplete resources over

time, or do they exploit them for short run gain at the expense of the long-term

benefits of the future generation of consumers?

The second distinguishing feature of energy is that the activities required to

produce it generate adverse environmental effects, and the process of transforming

it to do work involves combustion, which also generates pollution from emissions.

In the presence of such pollution — or externalities as discussed below — markets

generally fail to produce and use the optimal quantities of energy — they produce and

use too much energy, i.e., more than the optimal amounts that maximize social wellbeing.

Finally, energy is different from other commodities (say, e.g., food, clothing or

housing) in that both at the micro and macroeconomic level it enters the production

process of many firms and industries in an important extent — it is a major factor of

production, just as are labor, capital, and managerial ability. This has important

implications for the macro-economy: It means that changes in energy prices,

particularly crude oil prices which are benchmarks for all energy prices, have the

potential to move the markets, and the macro-economy, in a major way. Fluctuations

in energy prices could have major effects on the business cycle, affecting aggregate

output (GDP), employment, interest rates, and prices (i.e., inflation). Two examples

of this are the recession of 1974-75, which was caused by the 1973 oil embargo, and

the stagflation of the late 1970s, which was caused by the sharp run-up of crude oil

prices of the 1970s.

Neutral Income Tax Treatment of

Fossil Fuel Producers

Under generally accepted economic and accounting principles, producers of

depletable resources (such as oil, gas, or coal), who attempt to maximize profits over

a finite stock of a resource, should be taxed in the same manner as non-energy

producers not subject to the finite resource constraint. Under a pure income tax,

depreciation deductions would be based on economic depreciation; exploration and

development drilling expenditures would be subject to cost depletion (capitalized)

instead of expensed (entirely deducted from current-year taxable income) as is

currently done; and depletion allowances would be based on the actual decline in

economic value of the mineral deposit (or approximated by indexed cost depletion

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instead of percentage depletion).6 A neutral tax system would also generally

capitalize dry hole costs, the intangible costs of drilling unsuccessful wells, as such

expenses may be viewed as part of the cost of developing successful wells —

essentially the costs of creating an asset of value. In the event that there are no

successful wells, then a deduction for such costs in the year incurred is appropriate

under a neutral income tax system. Such an income tax would be neutral; i.e., it

would not distort resource allocation, the optimal allocation that would otherwise

result in a competitive market.7

The current tax treatment of mineral producers — which permits expensing of

intangible drilling costs and dry hole costs, percentage rather than cost depletion for

smaller companies and for some royalty owners, exemption from passive loss

limitation rules that apply to other industries, and special tax credits and other

subsidies (such as the tax credit for oil and gas produced from marginal wells) —

differs from this neutral tax treatment in that it provides several tax subsidies for oil

and gas.8 While the magnitude and value of the subsidies in the aggregate are not

large relative to the size of the oil and gas industry, this can still lead to increased

investments in locating reserves (increased exploration), more profitable production,

and some acceleration of oil and gas production (increased rate of extraction) and

excessively rapid depletion of the resource (i.e., they provide an unambiguous

incentive to deplete sooner rather than later). It also would lead to a channeling of

resources into these activities that otherwise would be used for oil and gas activities

abroad or for other economic activities in the United States.

While a change from the present tax system of tax subsidies to a neutral tax

system would have a heavy adverse effect on many smaller oil and gas companies,

particularly those that concentrate on onshore exploration, if the theory is correct, it

would be more than offset by the positive welfare effect on the country generally as

market distortions are reduced, and resources would be allocated more efficiently.

6

An income tax is only neutral if, with equity-financed projects, the cost of capital goods

is expensed rather than depreciated. However, as long as depreciation is consistently

applied to all sectors, then economic depreciation would not distort resource allocation

among sectors.

7

The only exception to the efficiency of a competitive market in energy production is the

case of a production externality arising out of a common property resource. If oil and gas

reservoirs lay beneath the property of several different owners, each one has the incentive

and the legal right to open wells on his property and extract as much oil and gas as he can

before the other owners do so. This leads to excessive production and resource depletion,

which may suggest some type of regulatory or perhaps tax policy, if the problem were of

sufficient national magnitude.

8

See, e.g., U.S. Senate, Tax Expenditures: Compendium of Background Material on

Individual Provisions, pp. 71-89.

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Externalities and Other Market Failures, and the

Rationale for Energy Taxes and Subsidies

Perhaps more than other markets, the energy markets have characteristics which

can lead to market failure and thus a misallocation of resources. Production,

importation, and use of energy frequently generate non-market costs or benefits not

accounted for by the producers, importers, or consumers (and therefore not measured

in the marketplace) that spill over to people who are not a party to the transaction.

These spillovers — or externalities — are an energy market shortcoming because

they are uncompensated, not reflected in the equilibrium market prices for the fuel

(because without government intervention there are no economic incentives to do so).

With externalities operating, markets can fail to establish energy prices equal

to marginal costs of supply. With inaccurate cost/price signals, a competitive freemarket system may fail to achieve the socially optimal mix — the allocationally

efficient mix — of output. The presence of externalities does not alter the economic

argument that competitive mineral producers should be taxed under the same income

tax rules as the competitive non-mineral producers, but it does suggest either a

separate energy tax (in the case of a negative production externality, where

production and use of energy generates costs) or an energy tax subsidy (in the case

of a positive production externality, where the firm’s competitive free market output

generates benefits to third parties).

Environmental Pollution Externalities

Environmental damage is perhaps the major negative externality created as a

result of energy production and consumption activities. This consists mostly of air

pollution resulting from mining, transportation and transmission, and refining and

industrial use of oil, gas, and coal, but also includes discharges of effluents into the

water, runoff from streets, and damages to the land from mining. For example, coal

mining can be the source of external costs such as black lung disease (from

underground mining), destruction of landscape, and water pollution from acid

drainage. Combustion of coal in coal-fired powerplants produces large emissions of

harmful gases, fine particulate matter, and urban smog linked to a wide range of

health and environmental damages.9 The use (or combustion) of fossil fuels at the

final consumer level by households, motorists, and businesses is also a significant

source of air pollution and other environmental damages that impose uncompensated

costs on society (those not paying for the use of the fuel directly). While much of the

air pollution is from the combustion of fossil fuels (gasoline and diesel) in

transportation, it also includes industrial and residential fuels such as natural gas,

heating oil, and coal.

9

CO2 (linked to possible global warming), SO2 (linked to acid deposition, which is harmful

to rivers, streams, wildlife, and infrastructure), NOx (linked to acid rain, and an ozone

precursor, which when it reacts with volatile organic compounds creates smog, which is

linked to lung and other health problems), and mercury contamination (that pollutes lakes

rivers, and streams, and harms wildlife and human health).

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The Emissions Tax. Most public finance and environmental economists

argue that a market-based instrument such as a tax, e.g., an emissions tax in the case

of air pollution from the combustion of fossil fuels, would be an economically

preferred instrument to correct for the market distortions caused by the pollution

externality.10 The tax would be equal to the monetary value, per unit of emissions,

of the damages to third parties, and structures, and other damages resulting from the

harmful emission. While current federal tax law does not provide an example of a

theoretically pure pollution tax, the tax on ozone-depleting chemicals resembles such

a tax.11 This tax, which is part of Internal Revenue Code (IRC) §4681 and §4682,

assesses a per-pound tax on the sale or use of a variety of chlorofluorocarbons

(CFCs) and other chemicals that have been proven to be harmful to the Earth’s ozone

layer. The tax varies based on the degree of harm of each of the taxed chemicals,

being lowest for methyl chloroform and highest for Halon-1301.12 Another example

might be the black-lung excise tax on domestically mined coal.13

Energy Taxes Aa Pollution Taxes. Some have proposed energy taxes

based on the assumption that there is roughly a direct proportional relationship

between emissions and the quantity of the fuel used. This tax would be imposed on

the quantity of polluting fuel used, with rates varying directly with the amount of

external cost generated by each fuel based on estimates of the monetary value of the

harm to third parties. Thus, it would be highest on coal, then oil, then gas, and any

non-polluting renewable energy resources such as hydropower would be either taxed

at very low rates or tax exempt, depending on the degree of environmental damage.14

Two example of such a tax are the carbon tax and the British Thermal Unit or Btu

tax. While a carbon tax in theory should be a charge on the emissions of CO2, in

practice this tax is conceived of as an energy tax on the quantity of three fossil fuels

burned — coal, petroleum, and natural gas — with the tax rate based on the carbon

content, in the ratio of 1.0 to 0.8 to 0.6 respectively. An example of an energy tax

that approximates the effects of a theoretically pure environmental tax might be a tax

on vehicle fuel as proxy for the pure tailpipe emissions tax. This could be

10

Thomas Sterner, Policy Instruments for Environmental and Natural Resource

Management, Resources for the Future, 2003.

11

Thomas A. Barthold, “Issues in the Design of Environmental Taxes,” Journal of

Economic Perspectives, v. 8, Winter 1994, pp. 133-151.

12

The excise tax on ozone-depleting chemicals was part of the Revenue Reconciliation Act

of 1989. It was enacted primarily to meet the U.S. obligations under the Montreal Protocol

of 1987, which required the 162 signatories to reduce production and consumption of

substances that deplete the ozone layer. The United States ratified the treaty in 1988, and

it went into effect in 1989. In 1996, the Montreal Protocol banned production of CFC’s

altogether. Since the tax raises revenues, it was also viewed, during the heated 1989

debates over budget reconciliation, as an option for reducing the persistent and large federal

budget deficits.

13

14

See CRS Report RS21935, The Black Lung Excise Tax on Coal, by (name redacted).

Renewable resources are generally thought to be less polluting than conventional fossil

fuels, but they can also harm the environment and are not pollution free. Hydroelectric

power affects wildlife habitats, as do wind farms. The combustion of biomass fuels

generates air emissions. The negative externalities engendered by the use of renewables

would also have to taxed, in theory.

CRS-10

implemented as an addition to the existing motor fuels excise tax (the taxes on

gasoline and diesel fuel). This externality tax would be in addition to the current

excise taxes on these fuels that are mainly user charges for the benefits received from

federal highway infrastructure.15

Clinton’s Btu Tax. The Btu (British thermal unit) tax is a broadly-based

energy tax based on the heat content or heating potential of a fuel, or energy content

in the form of heat. The standard Btu tax — the type considered by the Congress in

the 1980s and again in 1990 and the Clinton Administration in 1993 — is a flat or

unit excise tax on all forms of energy based on the Btu. For example, one barrel of

oil has, on average, about 5.8 million Btu’s, meaning that it has 5.8 million units of

heat capable of raising one pound of water at maximum density by one degree

Fahrenheit. One short ton of coal (2,000 lbs.) contains about 22 million Btu’s, about

four times the Btu’s in one barrel of oil; one thousand cubic feet (mcf) of natural gas

contains about 1 million Btu’s, about 1/6th that of oil.16 One gallon of gasoline

contains about 125,000 Btu’s. Thus, for example, a fixed rate Btu tax of $1.00 per

million of Btu’s would impose the following taxes: $5.80 per barrel on oil (about

15% of the 2003 oil price), $0.97 per mcf of natural gas (about 20% of natural gas

prices paid by pipelines); $20 per ton of coal (about 114% of coal prices), and 12.5¢

per gallon of gasoline (about 11% of recent average gasoline prices).17

Oil Import Dependence

On the eve of the 1973 oil embargo, petroleum imports supplied 33.4% of U.S.

consumption. Import dependence increased to 44.9% of consumption in 1978, and

remained relatively flat through 1992. Since then, however, petroleum imports have

increased to over 60% of consumption. For example, during the four week period

ending on June 3, 2005, petroleum imports were 60.7% of total supplies.

15

The current excise taxes on gasoline, diesel, and most other motor fuels include only the

user charge component and the 0.1¢/gallon Leaking Underground Storage Tank (LUST)

fund components. For example, the 18.4¢/gallon tax on gasoline consists of the 18.3¢ user

charge that goes into the highway trust fund, and the 0.1¢ that goes into the LUST trust

fund. Thus, there is no externality component on these fuels to correct for the cost imposed

on society from the harm caused by emissions from the combustion of the fuels. There are

three exceptions: 4.3¢ of the taxes on diesel used by railroads and by boats on inland

waterways, and 6.8¢ of the tax on gasoline used by recreational motorboats, goes into the

general fund of the U.S. Treasury, which might be thought of as externality taxes. On the

various components of these taxes by fuel type, as well as the total tax rate per gallon by

fuel type, see CRS Report RS20281, Transportation Fuel Taxes and Legislative Issues, by

(name redacted).

16

In the U.S. coal is traded in short tons (2,000 lbs.) and transported in long tons (2,240

lbs.); in Europe coal is traded in metric tons (about 2,204 lbs).

17

All prices are for the year 2003. 2003 was selected because that is the most recent year

for which average annual prices are available for each of the fuels. Prices, which can vary

substantially between fuel grades, quality, and heat content are measured at follows: Oil

prices are average refiner acquisition costs; natural gas prices are measured at the wellhead;

the coal price is the average minemouth price for both underground and surface mines;

electricity prices represent the average for all uses; gasoline price is the refiner price

excluding taxes; and diesel price is the refiner price, excluding taxes, of No.2 diesel fuel.

CRS-11

Table 2. A $1 Million BTU Tax on Selected Fuels

as % of 2003 Fuel Price

Fuel

Heat or Energy

Content in

Btu’s/unit

Average Prices

in 2004

$1/million

Btu tax Per

Unit of Fuel

$1/ million

Btu Tax as

% of Fuel

Price

Crude Oil

5,800,000/barrel

$27.56/barrel

$5.80/barrel

21%

1,030/mcf

$4.88/mcf

$0.97/mcf

20%

20,411,000/short

ton

$17.85/short ton

$20.41/short

ton

114%

3,412/kWh

$0.0742/kWh.

$0.003412/kW

h

5%

Gasoline

(conventional)

125,000/gallon

1.16/gallon

$0.125/gallon

11%

Diesel

139,000/gallon

0.94/gallon

$0.139/gallon

15%

Natural Gas

Coal

Electricity

Source: All data from Monthly Energy Review, May 2005. Coal price data are from the Energy

Information Administration’s website.

A variety of external costs may be associated with petroleum importation. These

may result when petroleum importers fail to take into account the non-market costs

of (“excessive”) dependence on imported petroleum from countries that are

politically unstable or perhaps unfriendly to the United States. These costs are:

!

the weakened defense posture and greater military vulnerability in

the event of an embargo or supply disruption;

!

the cost of allocating greater resources to national defense in order

to maintain the level of national security preferred (compared with

the quantity that would be allocated with much lower oil imports);

and

!

the economic and social costs in terms of unemployment, inflation,

and shortages that would result from an effective oil embargo, or oil

price spikes.18

One economically efficient policy to correct for these distortions would impose

a tax (or tariff) on imported petroleum based on the per-barrel estimate of these costs

(the so-called oil import “premium”). Such a tax, however, would likely violate trade

agreements, and thus policymakers focus on alternative policies such as tax

incentives for domestic petroleum production, which also reduce the demand for

imported petroleum.

18

CRS Report 98-1 ENR, Oil Imports: An Overview and Update of Economic and Security

Effects, by (name redacted), (nameedacted),

r

and (name redacted).

CRS-12

The problem of vulnerability to embargoes and price shocks, which relates to

dependence on imported oil from the Organization of Petroleum Exporting Countries

(OPEC) and other unstable foreign countries, is distinct from the problem of import

dependence, and might be better addressed in a policy of stockpiling oil as is being

done with the Strategic Petroleum Reserve.

Production/Investment Risk

Some have argued that oil price volatility might be a possible source of market

failure because it raises the risks associated with investing in oil and gas and may

result in under-investment in domestic oil and gas extraction.

For much of the first part of the 20th Century, crude oil prices declined in real

terms and the energy markets were relatively stable. The price of oil varied during

this period, but new discoveries kept the trend of prices downward; gasoline, natural

gas, and electricity prices were also essentially declining in nominal terms during

much of this period.19 The 1973-74 Arab oil embargo against the United States

reduced oil supplies by 10-15% and oil prices more than doubled in just two years.

The 1978-79 political turmoil in Iran (and the resulting abdication of the Shah) and

the Iranian oil workers strike virtually shut off this source of oil supplies from the

world market. Iranian oil output dropped from 6 million bpd to 1.2 million bpd in

December 1978, although other OPEC producers made up Iran’s shortfalls. This was

followed by a war between Iran and Iraq, which also threatened world oil supplies

and supplies to the United States.

Although the loss of imports to the United States was not that large (about

500,000 bpd), the threat of another supply disruption, combined with oil price

controls, caused panic buying on the part of consumers and strategic behavior on the

part of oil producers, which resulted in substantial oil price hikes. Crude oil prices

more than doubled during this period from about $10/barrel to over $24/barrel. By

1980, the official OPEC price was $36/barrel, but spot market prices reached nearly

$40/barrel. Thus, between 1970 and 1980 crude oil prices had increased from around

$1.50/barrel to around $35/barrel, an increase of over 2,200%. In 1985-86 there was

a sharp decline in oil prices, which were welcomed by consumers and beneficial to

the general economy, but which hurt the domestic oil industry (particularly upstream

operations), and oil producing regions of the United States (Texas, Louisiana,

Oklahoma, and Alaska)

From 1986-1999 oil prices averaged about $17.00 per barrel, but they fluctuated

from between $12 and $20 per barrel. Domestic crude oil prices reached a low of

about $8/barrel in December 1998, among the lowest crude oil prices in history after

correcting for inflation. By the summer of 1999, crude oil prices had recovered to

about $20 per barrel; and by the summer of 2000 prices peaked at well over $30 per

barrel, due largely to output reductions by OPEC, but also due to the increased energy

19

U.S. Congress, The Energy Factbook, Committee Print 96-IFC-60, November 1980.

Prepared by the Congressional Research Service at the request of the Subcommittee on

Energy and Power.

CRS-13

demand accompanying increasing growth in the world (particularly the Asian)

economies.

Crude prices were still high by November 2000 ($30.30/barrel), but they fell in

December after OPEC, which in 2004 produced 42% of the world’s oil, increased

production. OPEC’s prodigious oil reserves, sizeable production capacity, and cartel

-type behavior make it the swing producer, capable of affecting short-run prices in

either direction, thus making both world and domestic crude oil prices more volatile

than they otherwise would be. During the winter of 2002-2003, there was another

crude oil price increase, this time due to the anticipated war with Iraq and political

upheaval in Venezuela and Nigeria, which are major oil producers and suppliers to

the United States. Most recently, prices have reached $60/barrel and have remained

above $50 for several months.

Wide fluctuations in the market price of oil increase investor risk in the energy

industry (particularly for oil and gas investments), but it can also inhibit investments

in the development of alternative energy resources, both unconventional and

renewable, and in energy efficiency. However, all prices fluctuate in a free market,

although some more than others. And such fluctuations or risks are part of being in

business — they are not necessarily market failures. Further, if oil and gas prices

fluctuate “excessively” so that they generate unusual risks that may affect energy,

economic, or national security, the preferred approach from an economist’s point of

view would be to attempt to stabilize the price of oil — this might be done by a

variable oil import tax — rather than to provide tax subsidies.20

Energy User Charges

Sometimes energy taxes may act as a quasi user fee, a charge for the benefits

received by taxpayers from the provision of a public good or quasi-public good

financed from the user fee revenues. This is the economic rationale for the gasoline

tax, which charges motorists generally in proportion to their use of the interstate

highways and highway infrastructure and uses the revenues to build and maintain that

infrastructure. To the extent that charges approximate individual benefits received,

the tax would be efficient and equitable.21 Such taxes, however, are less precise

instruments than tolls and other benefit charges because 1) they do not actually

charge users for the marginal cost of using the infrastructure (including pavement

costs, congestion costs, and environmental costs), and 2) some of the highway trust

fund revenues — currently the revenues from 2.86¢ of the tax — are allocated for

mass transit, which means that motorists are paying to subsidize users of mass transit.

It is true that all motorists benefit from reduced congestion, but the most efficient

way of addressing this problem is to price the use of the roads to account specifically

for the congestion externality.

20

21

A variable oil import fee was proposed in the 103rd Congress as title I of H.R. 1024.

If G is the gasoline tax rate, and MPG is automobile fuel efficiency in miles per gallon,

then the COST/MILE = G/MPG. So that if G = 18.4¢/gal. and MPG = 30, then the tax cost

per mile is 18.4/30 = 0.613¢/mile. If the value of the marginal benefits also equal

0.613¢/mile, then the gasoline tax rate could be construed as economically efficient.

CRS-14

Taxes vs. Tax Subsidies (Incentives)

When the externalities or spillover effects are positive, i.e., when a market

transaction or activity confers unpriced benefits on third parties, the market system

would Under supply the commodity or activity. The classic case of positive

externalities is research and development (R&D) that leads to technological

innovations. An individual firm that undertakes R&D activities obviously incurs the

cost of these efforts and activities, but it typically does not obtain the entire return,

some of which accrues to other firms (free riders) that do not undertake these

expenditures. Energy R&D engenders similar spillover effects, whether it is from

research in clean-coal technologies, photovoltaic solar systems, electric cars, fuel

cells, or energy efficiency technologies. The manufacturer of building equipment and

energy-using technologies may not have adequate incentives to support sufficient

levels of research to improve building or equipment efficiency because some of the

gains may accrue to firms not undertaking the expenditures.

In cases of positive externalities, the social return exceeds the purely private

returns to individual companies, and from an economic perspective a subsidy is

warranted to bring the marginal costs of production in balance with the marginal

social benefit (private benefits + external benefits, at the margin). Such support has

produced major innovations in the energy efficiency of various energy usingequipment such as heat pumps and resulted in significant reductions in the price of

generating alternative energy such as photovoltaic solar energy. Such is the rationale

for the present tax subsidies for such technologies (the tax credit, and expensing

treatment of R&D expenditures) as well as government expenditures for energy

R&D.

The amount of the subsidy on the product or activity would be the value of the

benefits per unit of the commodity traded — proportional to the spillover —

conferred on the source of the external benefits. Energy R&D is unlikely, however,

to require a differential subsidy — above and beyond that provided for non-energy

R&D — since there is no a priori reason to believe that the external benefits from

energy R&D are higher or lower than for non-energy R&D.

Energy Tax Subsidies as an Industrial Policy

Many of the incentives or subsidies that are proposed for oil and gas as well as

for alternative fuels appear to be based on the supposition that government ought to

support business, particularly when times are bad. Such, for example, was the

rationale for numerous proposals to help the domestic oil industry, particularly small

producers, that were harmed by the downward trend in crude oil prices since the mid1980s, and the sharp drop in those prices during 1998-99.

The low prices of 1998-99 fostered proposals for economic relief through the

tax code for the particularly small independent drillers and producers, which were the

harbingers of current comprehensive energy bills. The 1998-99 proposals mainly

focused on production tax credits for marginal or stripper oil, which were later

included in the American Jobs Creation Act of 2004, P.L. 108-357, enacted on

October 22, 2004 (also referred to as the “jobs bill”). A $500 million package of loan

CRS-15

guarantees for small independent oil and gas producers, which became law (P.L. 10651) in August 1999, was enacted in lieu of the tax incentives.

The Economic Justification for Tax Subsidies as an Industrial

Policy. There is no purely economic justification, either on efficiency or

stabilization grounds, for using tax subsidies as an industrial or employment policy

to help a distressed industry — including the conventional fossil fuels industry and

the alternative fuels industry. An industrial policy is usually the context for

government subsidies to businesses whenever those businesses experience sustained

or sharp economic hardships, due generally to any cause but targeted toward

industries experiencing declining prices, suffering cost/price squeezes, or competition

from foreign firms.

Economic theory does recognize that market failures such as barriers to entry

into markets, and other failures that inhibit market competition, may be used to

justify government intervention. Intervention may also be justified by “externalities”

or spillovers, previously discussed. The U.S. and world crude oil markets are

certainly not perfectly competitive, as there are elements of market power particularly

in the world oil market, which is significantly affected by the OPEC. But these

markets are certainly more competitive today then they have ever been. It does not

appear that the imperfections may be exhibited by either the U.S. or world crude oil

markets, that they would justify tax subsidies to oil and gas producers on grounds of

economic efficiency. Depressed or volatile oil prices (or any other price) are not

market failures. An industrial policy is an inefficient way to stimulate aggregate

employment.

The Social Rate of Discount and Market Failures

Some have argued that the competitive free-market system may establish

interest rates (or private discount rates) that are too high, which may lead producers

to discount the future excessively and therefore deplete energy and other minerals too

rapidly. Rapid depletion increases environmental damages for the current generation

and reduces economic living standards (real income) for future generations who

would have a lower capital stock.

In general, economic theory and empirical evidence refute the proposition that

competitive markets lead to excessive exploitation of mineral resources. Capital

markets are also believed to function fairly close to competition, and there is no

market failure that results in interest rates higher than the competitive rates. Even if

the argument were true, however, it would at the very least suggest policies to lower

interest rates, elimination of all federal tax subsidies for nonrenewable resources, and

the imposition of a federal severance tax to reduce production of these resources.

Energy Conservation and Energy Efficiency

Energy taxes on producers and consumers that factor in the external costs of

energy use, such as air pollution, would contribute significantly to energy

conservation by raising energy prices and reducing the demand for energy. The

CRS-16

demand for energy would decline both through a direct demand response, i.e.,

curbing energy use through reductions in output, service, or utility levels (e.g., by

reducing the number of miles driven, indoor temperatures during winter by turning

down the thermostat, etc.) and through substitution of more energy-efficient for less

energy-efficient technologies. This would be true for all energy that generates

external costs, but is particularly true for fossil fuels, whose external costs are

generally greater than for other energy types.

However, energy taxes to encourage conservation should be unnecessary on

economic grounds because over the longer term, as depletion gradually diminishes

the stock of exhaustible energy resources (such as petroleum), conventional energy

prices would be expected to increase in real terms, all else (such as technological

advancements and innovations, and the degree of recycling) remaining the same.22

As a result, more of the energy efficient technologies would become profitable and

investment in energy-efficient technologies would increase (for example, more

energy efficient housing, automobiles with higher miles per gallon, and more energy

efficient industrial equipment such as boilers).23

Thus, aside from energy taxes or subsidies to correct for energy production and

consumption externalities, and aside from possible user charges, economists

generally argue there is no economic justification for additional taxes or tax subsidies

to encourage greater energy conservation, or energy efficiency. This is because there

is generally no market failure in energy use (notwithstanding the environmental

externalities discussed above, or the exceptions discussed below) or in investment

in energy-using technologies — at either the household or business level — that

requires such tax subsidies. Just as the competitive market system, corrected for

externalities, automatically and efficiently leads to the optimal production and use

of energy resources, it also leads to the optimal amount of investment in energy

efficiency technologies. All this is done without the effect of subsidies, in terms of

revenue losses and allocational distortions, which reduce aggregate output and the

general welfare.

There are four market failures in energy use, however, that may be an economic

justification for government intervention, but only one is a rationale for certain types

of conservation tax subsidies. In rental housing, the tenant and the landlord lack

strong financial incentives to invest in energy conservation equipment and materials,

even when the benefits clearly outweigh the costs, because the benefits from such

conservation may not entirely accrue to the party undertaking the energy-saving

expenditure and effort. Builders and buyers may also lack sufficient information, a

problem which is also discussed below.

22

23

Technical change and recycling can offset the depletion effect of resource exhaustion.

Energy efficiency, an engineering concept or measure that has little in common with

economic efficiency, basically measures the energy/output ratio — the amount of energy

input required to generate one unit of output. For example, the average thermal efficiency

of coal-fired steam generators is about 34%, which means that it takes an average of 100

Btu’s of fuel to generate an average of 34 Btu’s of electricity (64% of the energy from the

fuel is lost or “wasted”).

CRS-17

As a general rule, tenants are not going to improve the energy efficiency of a

residence that does not belong to them, even if the unit is metered. They might if the

rate of return (or payback) is sufficiently large, but most tenants do not occupy rental

housing long enough to reap the full benefits of the energy conservation investments.

Part of the problem is also that it is not always easy to calculate the energy savings

potential (hence, rates of return) from various retrofitting investments. Landlords

may not be able to control the energy consumption habits of renters to sufficiently

recover the full cost of the energy conservation expenditures, regardless of whether

the units are individually metered or not. If the units are individually metered, then

the landlord would not undertake such investments since all the benefits therefrom

would accrue to the renters, unless a landlord could charge higher rents on

apartments with lower utility costs. If the units are not individually metered, but

under centralized control, the benefits of conservation measures may accrue largely

to the landlord, but even here the tenants may have sufficient control over energy use

to subvert the accrual of any gains to the landlord. In such cases, from the landlord’s

perspective, it may be easier and cheaper to forego the conservation investments and

simply pass on energy costs as part of the rents. Individual metering can be quite

costly and while it may reduce some of the distortions, it is not likely to completely

eliminate these, because even if the landlord can charge higher rents, he may not be

able to recover the costs of energy conservation efforts or investments.

These market failures may lead to Under investment in conservation measures

in rental housing and provide the economic rationale for Internal Revenue Code

(IRC) §136, which allows the value of any energy conservation subsidy provided by

electric utilities to households to be excluded from gross income. Without such

explicit exclusion, such subsidies would be treated as gross income and subject to

tax. This exclusion, however, applies to both owner-occupied and rental housing,

and to a limited extent to business conservation subsidies.

There are other types of market failures in energy use that may suggest either

minimum efficiency standards or government-provided information such as energy

efficiency labels. As suggested above, many homeowners may not know the precise

payback or rate of return of a particular energy-efficiency enhancing investment, or

may not know how to calculate it. This may be a particularly serious problem for

older homes, which are less energy efficient then newer models — those built since

the energy crisis of the 1970s. This market failure problem suggests governmentprovided information as a solution, however, rather than tax subsidies.

A third energy market failure arises out of asymmetric information between

energy consumers and manufacturers of energy efficient equipment. The energy

consumer may have little incentive to become fully informed about the energy

efficiency of a particular energy-using or -saving item, while the producer, who has

complete and accurate information, doesn’t have the incentive to produce a higher

priced and more energy efficient product, since it is might be more difficult to market

and sell such a product. Thus, while a particular energy-saving device may have a

high rate of return, the market may not provide it. This problem suggests either

government mandated efficiency standards or labeling as is currently being done with

appliance energy labels and fuel economy labels.

CRS-18

Finally, although capital markets are generally competitive and efficient, lowincome consumers may have difficulty acquiring loans for conservation investments,

even when such investments are profitable (the present value of the energy

expenditure savings is greater than the capital costs). This suggests that low or zero

interest rate loans for low income consumers or even weatherization grants could

address the problem.

Renewable vs. Conventional Fuels

The higher energy prices that would result from taxes imposed on conventional

energy to address external costs would also lead to more investment to increase the

supply of alternative fuels, which would, in time, lead to even more conservation of

(reduced demand for) conventional fuels. Over the longer term, the supply of these

alternatives would tend to increase as depletion of conventional energy raises its real

price. Even without increases in conventional fuel prices, alternative energy could

gain a price advantage through future technological advances.

As in the case of energy conservation, there are no externalities or market

failures that cause under-investment in alternative energy technologies and undersupply of alternative fuels. The private market system works effectively and

efficiently in developing any form of energy and its technologies if there are

sufficient profit incentives, i.e., if the rate of return on such investments is above the

opportunity cost of capital. Moreover, the market ensures that the least-cost, most

efficient alternatives become commercialized first, and the market adjusts quickly

and efficiently to the changing dynamics of the marketplace.

In general, in cases where alternative fuels have difficulty penetrating the

market, it is because they cannot be competitively priced, relative to conventional

fuels, generally because either oil prices are too low, capital costs of alternative fuels

technologies are too high, or both. To illustrate, compare the estimated 30-year

levelized costs, per unit of electrical output, and the capital costs of various

technologies for producing electricity using conventional fuels (primarily coal, but

also natural gas) and alternative fuels such as biomass and wind energy systems.24

Electric utilities can upgrade existing coal-fired units at a cost of 2.0¢/kWh, or they

can invest in the latest efficient and cleaner technology (the advanced combinedcycle natural gas unit) at a cost of about 3.5¢/KWh. These are substantially lower

than some estimates of the cost/KWh of the following energy alternatives: 15.0¢ for

photovoltaics; 5-10¢ for small hydroelectric; 6-8¢ for solar thermal power; 4-7¢ for

wind power; and 4-6¢ for biomass. Much of these cost differences are due to the

significantly higher capital costs of generating electricity with alternative energy

resources ($7,000/KW for photovoltaics, $1,500/KW for biomass, $1,000/KW for

wind) as compared with conventional fuels ($400/KW for the combined cycle natural

gas and $200/KW for retrofitting existing coal-fired units).25

24

Levelized costs converts a series of nonuniform costs over time into an average annual

cost over that time period.

25

For the cost of the advanced combined-cycle (and other coal technology options) options

see CRS Report 98-615 ENR, Electricity Restructuring: Implications for Air Quality, by

(continued...)

CRS-19

Volatile oil prices can increase investor risk and inhibit the development of

alternative, renewable (solar, wind, etc.), and unconventional resources. This is

because oil is the benchmark energy resource that sets the long-term price (and

therefore influences the profitability) of all other fuels. Hypothetically, if alternative

fuels would be profitable at oil prices of $40 per barrel, but prices fluctuate between

$20 per barrel and $60 per barrel, there will generally be less investment in

renewable and unconventional resources than if the price were stable at $40 every

year. However, as discussed before, tax subsidies for alternative fuels are a costly

and inefficient policy to correct for such risks.

Does Oil and Gas Have a Competitive Advantage?

It is sometimes argued that alternative fuels such as solar and wind energy and

other ‘renewables’ are at a competitive disadvantage, vis-a-vis fossil fuels, because

of the production tax subsidies — expensing, percentage depletion, and others —

bestowed on the oil and gas industry over decades, and that this justifies

countervailing subsidies to alternative fuels to “level the playing field.” Historically

the large tax subsidies for oil and gas — which totaled tens of billions of dollars to

date — helped keep domestic and world oil prices low, encouraged consumption, and

discouraged the development of alternatives fuels. Past subsidies, however, do not

determine the economic viability of alternative fuels at the present time — past

subsidies do not significantly affect the current competitive structure of the energy

market.

As to the current oil and gas tax subsidies, there are two reasons that these

subsidies are unlikely to reduce the competitiveness of alternative fuels. First, current

oil and gas tax subsidies are smaller than they have been historically. Indeed, some

evidence suggests that current oil and gas tax subsidies are smaller, in relationship

to industry size, than the tax subsidies for alternative fuels.26 Second, and more

importantly, the structure of the world crude oil market since the 1970s has changed

in a fundamental but critical way: Crude oil prices have since the 1970s been

determined in a world oil market, a market which has become more competitive and

in which U.S. domestic producers are price takers. In such a market, the subsidies

for oil and gas have little if any effect on the market price of crude oil, hence little,

if any, effect on the competitiveness of alternative fuels.

Energy Taxes to Increase Revenues

and Reduce Deficits

Energy taxes have also been proposed for primarily fiscal reasons — to generate

revenues for deficit reduction. The first federal gasoline tax was enacted in 1932 (at

1¢/gal. for gasoline and 2¢ for diesel fuel) as a way of cushioning federal deficits,

25

(...continued)

(name redacted). The estimates for renewables

are from Ulf Hansen, “Technological Options

for Power Generation,” The Energy Journal, v.19, 1998, table 3.

26

See Table 1 in CRS Issue Brief IB10054, Energy Tax Policy, by (name redacted).

CRS-20

which were mounting with the Great Depression. Energy tax proposals for deficit

reduction were commonplace during the 1982-1993 period as budget deficits

mounted due to huge tax cuts under the Economic Recovery Tax Act of 1981 (P.L.

97-34) and the nation experienced reduced inflation, economic recession, defense

buildups, and the federal inability to control spending. Several energy taxes were

proposed at that time:

!

an increase in the excise taxes on gasoline, diesel, and other motor

fuels;

!

a sizeable tax on imported oil (in addition to the customs duties that

are already imposed on imported petroleum);

!

a tax on both imported and domestically produced crude oil; and

!

a broadly-based or general energy tax on all or most types of energy

consumption, either based on the heat content of the fuel (Btu tax),

the carbon content of the fuel (the carbon tax), or on the sales price

(the ad valorem energy tax).

Eventually, only the tax on gasoline and other motor fuels was increased (by 5¢ in

1982, 5¢ in 1990, and by 4.3¢ in 1993).

As a general economic principle there is no distinct fiscal rationale for a federal

energy tax as a source of general fund financing of federal activities or for deficit

reduction. Economic principles suggest federal programs ought to be financed by

general income or general consumption taxes. Such taxes, however, while less

distortive and more equitable than energy taxes and other selective excise taxes (or

differential commodity taxes) are also distortional. Income taxes, for instance, distort

the choice between work and leisure by raising the price of work relative to the price

of leisure, which tends to increase leisure and reduce work. Income taxes also distort

the choice between consuming and saving for the future by raising the price of

consuming in the future (i.e., saving).

If an efficiency enhancing tax, such as an externality correcting energy tax,

could be substituted for a distortional tax in a revenue neutral way, not only would

there be no budgetary effect, but there would be a gain in efficiency (e.g., a reduction

in pollution to the environment).27 In some cases, the revenue gain — hence the

possible efficiency gain — could be substantial. For example, a $30/ton tax on

carbon emissions, which would roughly stabilize carbon emissions at their 2000

levels, would generate about $40 billion annually; a $100 per ton tax could generate

as much as $100 billion annually.28

27

Some label the environmental gains and the efficiency gains from green taxes as the

“double dividend,” but it is really the same effect.

28

Revenue estimates run at about $1/ ton of CO2, at least for relatively small taxes per ton.

See U.S. Congressional Budget Office, Reducing the Deficit: Spending and Revenue

Options, March 1997, p. 392; and U.S. Congressional Budget Office, Carbon Charges As

(continued...)

CRS-21

Another example is the gasoline tax. Currently, the burden of the gasoline tax

is largely offset or counterbalanced by the benefits received from highways and

infrastructure financed from the tax. This means that under current law, and indeed

since the inception of the gasoline tax, there has never been a tax on gasoline that

accounts for the external costs of driving: the environmental costs of oil production

and refining, the environmental costs from tailpipe emissions, the costs of oil import

dependence, and the road congestion. A policy to impose a tax on gasoline as a

substitute for a distorting income tax would not only make drivers pay for the

external costs of driving, it would reduce income tax distortions, and enhance

economic efficiency. Moreover, higher gasoline prices would promote petroleum

conservation, reduce air pollution, and carbon emissions substantially, and would

promote the development of alternative fuels without a large cost, in terms of reduced

revenues from subsidization, to the federal budgetary. However, gasoline taxes of

this magnitude could be, unless phased-in gradually, a significant shock to the

economy.

Energy Taxes vs. Regulation to Achieve

Environmental Policy Goals

Energy taxes and subsidies, when used to correct for externalities and other

market failures, offer an efficient alternative or supplement to regulations as an

instrument of environmental policy. Regulations prescribe the type of technology or

equipment for environmental protection, the maximum permitted rate of emission for

a particular pollutant, or a minimum energy-efficiency standard, and are part of the

“command-and-control” approach to environmental protection. Regulations, such

as standards, give policymakers more assurance that environmental policy goals will

be achieved regardless of cost, but are often more costly and less economically

efficient than taxes or tradeable emissions permits.

To illustrate the fundamental reason why a standard would be economically less

efficient than the tax, consider a regulation that prescribes that electric utility

generators must be at least 45% energy-efficient as a way of conserving energy and

reducing power plant emissions. That is, every fossil-fuel-fired generator in use

would have to have an efficiency rate of 45%. In response to the standard, and given

current economics of alternative generation strategies, most utilities would invest in

the advanced combined-cycle natural gas system (ACCNG), which is the cheapest

and most energy efficient technology, with an efficiency rate close to 50%.

Subjecting all firms to the same regulatory standard essentially ensures the same

behavioral response regardless of differences in the marginal costs of reducing air

emissions. But, while the ACCNG system is the least-costly technology among those

feasible technologies that meet the 45% energy efficiency standard, it may not be the

least-cost energy conservation or air pollution control strategy for every single utility,

in every single plant, every single generating unit, and for each of the various types

of emissions.

28

(...continued)

A Response to Global Warming: the Effects of Taxing Fossil Fuels, August 1990, p. 21.

CRS-22

Intuition suggests, and many studies have confirmed, that the marginal costs of

pollution control (marginal abatement costs) vary for each type of pollutant and with

the type of technology that utilities use. With the regulation as described, no account

would be taken of the differences among utilities, plants, and generating units in their

capacity to reduce emissions. Yet, because of differences in site characteristics,

design, and utilization rate, current generating units differ significantly with respect

to the difficulty (or ease) and the cost of reducing emissions. As a result, those firms

with the greater pollution abatement costs would have to undertake the same level

of abatement as those with lower marginal abatement costs.

Because of these cost differences, there are many different strategies and options

that utilities might use to reduce exhaust emissions from power plants. For example,

some utilities might just reduce output, others might invest in pollution control

equipment, and still others might replace their coal-fired units with advanced

technologies. If there are enough differences among utilities and their marginal

abatement costs, then the total costs of reducing emissions with the regulatory

standard would be greater (less efficient) than any of the market-based approaches.

In contrast, a tax would provide the incentive for each polluter to reduce

pollution in the least costly way — up to the point at which the tax just equals the

marginal abatement costs. In the above illustration, the utility with the lower

marginal abatement costs of reducing pollution would undertake more pollution

abatement than the utility with higher marginal abatement costs. In that way the total

cost of abatement would be minimized. Tax revenues could be used to compensate

the parties that are harmed by the emissions. The total costs of emissions control

from utilities would be much lower if utilities were permitted to use various

technologies and control options that are the least cost for that particular utility, that

particular plant, and that particular generating unit, to address different emissions,

which is how a tax would work. By using a tax instead of a standard, all those antipollution activities that cost less than the tax will, in theory, be undertaken.

Taxes or Tradeable Emissions Permits

An alternative market-based approach for environmental protection — an

efficient alternative to emissions taxes or their practical equivalent, energy taxes —

is the tradeable emission permit or allowance, also known as “pollution rights,”

“cap-and-trade,” or marketable pollution permits. Under this approach, the

government (the Congress and the environmental authorities) requires each emitter

of a particular pollutant to have a legal permit to emit a fixed amount of that

pollutant. The authorities establish a target level for aggregate emissions of a

particular pollutant (say so many hundreds of thousand of tons per year), and the

pollution equivalence of the tradeable permits (one permit equals one ton of X

pollutant). It also allows these permits to be traded in the marketplace among source

emitters (or among anyone), who can either buy and use them (if the costs of a permit

are less than the marginal abatement costs), save them for future use (if they expect

marginal abatement costs to rise above the cost of each permit) or sell them (if their

marginal abatement costs per ton are less than the price of a permit). The idea

underlying this approach is that it achieves any given level of pollution at lower

costs, and is thus economically efficient. Those firms with relatively low marginal

abatement costs will choose abatement over permits; those with relatively high

CRS-23

abatement costs will choose to purchase permits rather than control pollution. The

aggregate level of pollution is fixed, however.

While in theory allowances are equivalent to an emissions tax — and thus also

more efficient than standards — in practice there are differences that may make

tradeable permits generally more appealing to the policymaker in certain situations

while the emissions tax approach is more appealing in others.29 First, tradeable

permits fix the level of aggregate pollution and let the price adjust, whereas the tax

fixes the price (the statutory tax rate per unit) and lets the quantity of pollutant (or its

equivalent amount of energy) adjust. Thus, tradeable permits appear to give the

authorities greater certainty of control over the level of pollution, and therefore

control over air and water quality. Tradable permits are considered by many a

superior instrument when pollution is reaching some critical level and the

government needs to control the quantity of the emissions. Another advantage of

tradeable permits is that they avoid the information problem associated with

emissions taxes, which would require authorities to know both the marginal external

costs (the monetary value of the damages) and the marginal abatement costs per unit

of pollution. This information, none of which is required with tradeable permits, is

difficult and costly to estimate and in some cases not available at all. None of this

is required with tradeable permits. Finally, taxes may be eroded by inflation and

affected by the entry and exit of firms. This is not a problem for tradeable permits.

Under a tradeable permit system the authorities must establish a system for

monitoring the emissions of the polluter. This is relatively simple when the number

of polluters is relatively small in relationship to the magnitude of the emissions,

which is the case with SO2 emitted by electric utilities. As the number of polluters

increases, the complexity of emissions monitoring and program administration

increases exponentially, which raises the transactions costs of the permit system to

such levels that it would no longer make tradeable permits efficient. Such is the case

with CO2 emissions which have millions of sources. In such a case an emissions tax

is more appealing.

The economic efficiency advantages of market-based approaches to

environmental protection are suggested by the documented evidence on the success

of the tradeable permit system — mandated by title IV of the Clean Air Act — in

controlling emissions of sulfur dioxide (SO2) by electric utilities while lowering

compliance costs as compared to initial or regulatory costs.30 According to the

Environmental Protection Agency: “Both the Acid Rain Program’s rate-based

29

See David W. Pearce and R. Kerry Turner, Economics of Natural Resources and the

Environment (The Johns Hopkins University Press, Baltimore, 1990), p. 92.

30

Paul L. Joskow, Richard Schmalensee, and Elizabeth M. Bailey, “The Market for Sulfur

Dioxide Emissions,” American Economic Review, September 1998, pp. 669-685. See also

Richard Schmalensee, Paul L. Joskow, A Denny Ellerman, Juan Pablo Montero, and

Elizabeth M. Bailey, “An Interim Evaluation of Sulfur Dioxide Emissions Trading,”

Journal of Economic Perspectives, v. 12, summer 1998, pp. 53-68; and Carl E. Zipper and

Leonard Gilroy, “Sulfur Dioxide Emissions and Market Effects Under the Clean Air Act

Acid Rain Program,” Journal of Air & Waste Management Association, vol. 48, September

1998, pp. 829-837.

CRS-24

approach to NOx reduction and cap-and-trade approach to SO2 reduction have been

very successful.”31 Tradable permits are also being discussed as an instrument of

controlling greenhouse gases worldwide, part of an international framework to

control emissions of CO2 and other greenhouse gases.

The Economic Effects of Energy Taxes

The level of, and changes to, energy taxes and subsidies can affect energy prices

and output, economic growth rates, income distribution, and international trade.

Thus, they can be a very powerful energy and economic policy instrument.

Efficiency Effects

As was discussed above, energy taxes and subsidies can be a useful instrument

to correct for pre-existing distortions in the allocation of resources and

simultaneously generate tax revenues, if they are imposed on activities or

commodities such as energy resources whose production and use generate external

costs, or if they are imposed as user fees for the services of a public good. Otherwise,

selective energy excise taxes for either greater production, improved technical energy

efficiency, or increased supply of alternative fuels reduce the efficiency of the

economy. Reduced efficiency implies reduced output and lower standards of living.

Distributional Effects

With respect to energy taxes on supply, there is generally no separate equity case

that can be made for taxing energy at a higher rate than other commodities. Due to

nonrenewable resources’ finite stock, economic rents (also called scarcity rents) are

created when these resources are produced. Under competitive conditions such rents

would be expected to rise at the rate of interest so as to achieve asset or capital

market equilibrium. Such rents are not excessive under competitive supply and need

not be taxed away on equity grounds.32 Energy taxes on consumers (e.g., gasoline

taxes, oil taxes, or general energy taxes) also frequently have negative distributional

consequences because the incidence of such taxes often falls disproportionately on

lower incomes. Finally, energy tax subsidies frequently also have adverse

distributional effects. One example — there are others — is the income tax credit

31

U.S. Environmental Protection Agency, 1997 Compliance Report: Acid Rain Program,

EPA-430-R-98-012, August 1998, p. 22.

32

The existence of a successful cartel or some other force or factor that inhibits competition

might generate substantial economic rents, particularly for low-cost producers. For example,

clearly Saudi Arabia and other Persian Gulf producers earn substantial economic rents from

their oil production as it costs only a few dollars per barrel (average production costs of

Saudi oil have been estimated at about $1.50/barrel) to produce oil. However, U.S. oil

producers are basically the high cost or marginal producers from the perspective of the

world crude oil market and do not generally earn such high rents. In any event, as noted

before, the world crude oil market is much more competitive today than at any time during

the last 30 years; it is thought that even OPEC cannot establish, for sustained periods of

time, crude oil prices above competitive equilibrium levels.

CRS-25

(the §29 tax credit) for non-conventional energy resources, which in addition to

distorting resource allocation, losing tax revenues, and not reducing oil import

dependence (since it has basically increased the supply of methane gas rather than

alternatives to petroleum) is also questionable on tax equity grounds. Supporters of

the credit contend that it encourages domestic energy production, however, and could

become more important in the future. They also note that domestic methane resulting

from the credits helps offset the growing U.S. need for natural gas imports.

Macroeconomic Effects

Increases in energy taxes are basically a contractionary fiscal policy that would

tend to reduce aggregate output and employment, and produce a temporary increase

in the rate of inflation above the baseline. Increases in taxes on final energy demand,

such as a hike in the gasoline tax, tend to be (dollar for dollar) less contractionary

than energy taxes on industry (such as an oil tax) although these, too, reduce

household income, consumer spending, and to some extent business costs and profits.

Sizeable taxes on oil increase the price of all energy and can trigger relatively large

cutbacks in industrial energy use and energy used as inputs into production. Such

taxes, including an oil import tax, can produce macroeconomic effects akin to an oil

price shock, resulting in a temporary but sharp slowdown in the economy’s growth.

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