2012 Spring Symposium, Griswold Center for Economic Policy Studies at Princeton University

Reforming Energy Tax Policy

This speech was delivered by Ted Gayer at a symposium titled Reforming the U.S. Tax System. The symposium was hosted by the Princeton University Griswold Center for Economic Policy Studies on February 10-11, 2012, and Gayer was invited to speak on the subject of "out of the box" tax reform.

I'm going to start with a critique of existing energy tax policy and then move on to examine how we might re-think energy tax policy within the context of broader tax reform.

Our federal tax code contains a few energy taxes, such as the tax on motor fuels, which is currently 18.4 cents per gallon of gasoline and 24.4 cents per gallon of diesel. But our tax code contains many more energy tax expenditures, which are subsidies granted to items by excluding them from the tax base, such as allowing intangible drilling costs to be fully deductible in the first year rather than depreciated over time.

Already you can see an example of the conflicting nature of our energy policy. We frequently tax an energy source while we simultaneously subsidize it. Or we subsidize an energy source while we also subsidize a substitute energy source. These inconsistencies arise because at different times throughout the last hundred years, we have shifted back and forth across three different, competing goals. And at times, we've even tried to embrace these competing goals within the same energy legislation.

Broadly stated, the goals have been as follows: 1) We should promote domestic energy production; 2) We should raise tax revenue; and 3) We should reduce pollution caused by energy use. It is not the case that these three goals must always contradict each other. For example, the gas tax, which was created in 1932, promotes the goal of pollution reduction and the goal of raising revenue.

But the goals frequently are incompatible. For example, tax subsidies for such things as renewable energy or electric vehicles, are the preferred policy choice for reducing pollution, even though they undermine the goal of raising revenue.

We have also seen conflicts between the goal of reducing pollution and the goal of promoting domestic energy production. So, for example, we have subsidized renewable fuels in an attempt to reduce pollution, while also providing subsidies for oil and gas production, electric utilities, and refineries. The list can go on of energy policies working at competing ends. I'll only note for now that the complexities have increased, as we now have around 50 different energy tax expenditures in our tax code.

So how would I re-consider our three competing goals in a way that would lead to more coherent and efficient energy policies?

First, I would de-emphasize the goal of promoting domestic energy production. The main reason given to justify this goal is that of energy security, which I interpret as a desire to insulate domestic energy prices - especially oil prices - from supply disruptions that can occur in volatile or hostile nations. But because crude oil is traded throughout the world, any supply disruptions in other countries will affect domestic prices even if the U.S. produced all of its oil domestically. So we wind up incurring large costs to shift towards domestic production, we still wind up with the same domestic oil price because the price is set in global markets.

Second, I would emphasize the goal of reducing pollution. The problem with pollution is that it incurs costs on bystanders, and these costs are not considered in the market transaction between producers and consumers. We should enact policies that include these external costs in the market decision, which would lead to a reduction - although not an elimination - of pollution.

The most cost-effective way to reduce pollution is by taxing it, not by subsidizing cleaner energy alternatives. Subsidies are no doubt more politically appealing than taxes; but it is important to remember that such subsidies have real budget costs, which ultimately means they must be financed by increasing other taxes, cutting other spending, or running larger budget deficits. Taxes are also more effective than subsidies, because they send a signal to consumers to conserve energy and they send a signal to producers to innovate and develop low-cost and cleaner alternatives.

Subsidies on the other hand require the government to pick the best alternative fuels and technologies, which puts it in the role of venture capitalist - a job it is ill-equipped to perform, especially given the unavoidable political considerations that influence decision-making. The simplest and most efficient way to account for the external costs associated with pollution is with a tax that is designed to raise the price of different energy sources in proportion to the environmental harm they cause.

The final goal to consider is that of raising tax revenue. The description thus far of my preferred energy policy leaves us with many fewer tax expenditures and with a pollution tax. Both of these indeed provide us with more tax revenue. But note that the goal of a pollution tax is not to maximize revenue. A tax that maximizes revenue will lead to economic costs that outweigh the environmental gains from less pollution.

Once you've established a tax, there is a clear economic case for using the revenues to offset existing inefficient taxes or to reduce the deficit. A pollution tax would increase the price of energy and transportation, which in effect would lower real wages. This decrease in real wages would magnify distortions from pre-existing taxes, such as the income tax. This is known as the tax-interaction effect, and it can mean that a tax on pollution can impose substantial economic costs, even in some cases leading to negative net benefits. The way to reduce these costs is by using the pollution tax revenue to offset economically harmful taxes or deficits.

But while there are clear economic gains to using pollution tax revenues efficiently, such revenue can only go so far to reducing our deficits. A tax of similar stringency to the climate cap-and-trade bill that passed the House in 2009 would raise about $60-$80 billion annually in the early years, rising to about $100 billion in about 25 years, before dropping again thereafter. This is a substantial amount of tax revenue, but it would only play a small part in closing our fiscal gap. If one focuses on just the 10-year window, annual tax revenue would be on par with our expected revenue from excise taxes, which amounts to about half a percent of GDP annually. This is slightly smaller than the revenue loss due to the mortgage interest deduction. Over the longer-term, which is when we face our most pressing fiscal problems, we could expect the tax revenue to contribute less to closing our fiscal shortfall, since emission reductions would be likely to outpace increases in the tax rate.

If our goal is to indeed use pollution tax revenues for deficit reduction, then unfortunately our policy track record here has not been good. Our existing sulfur dioxide cap-and-trade program - which is our most successful market-based program - gives away all of the cap allowance value to electric utilities. For climate policy, the bill that passed the House in 2009 called for about 60 percent of the total allowances to be given away over the life of the program. The remaining 40 percent was to be auctioned by the government, but the auction revenue for the most part was not to be used for deficit reduction. Of the total allowance value in 2016, less than one percent was targeted for deficit reduction. The bulk of the value went to such things as subsidizing electric utilities, helping trade-exposed industries, and transfers to low-income consumers.

In the Senate, the climate bill proposed by Senators Kerry and Boxer would have given away 77 percent of the allowances in 2012. Only about 10 percent was targeted for deficit reduction. The bill proposed by Senators Cantwell and Collins auctioned all of the allowances, but then would have allocated 75 percent of the revenue evenly across all U.S. residents and would have allocated 25 percent to fund such things as transition assistance, carbon sequestering projects, and clean energy investments. Nothing was allocated for deficit reduction.

The administration's original cap-and-trade proposal did call for all allowances to be auctioned. However, none of the revenue was targeted for deficit reduction. Instead, about 80 percent of the revenue was to go to permanently extending the Making Work Pay tax credit, and the remainder was to go to subsidizing clean energy technology.

So our limited policy history and proposals with pollution revenue recycling is one in which the revenues are largely either given away to the regulated industry or are used to fund government programs or tax credits, not to fund deficit reduction or tax rate reduction.

But perhaps the pressing fiscal challenges we face today present an opportunity for better policy now. I suspect a political consensus is indeed achievable with respect to tax reform. Our current tax system is economically harmful, complex, unpredictable, and often unfair, which strikes me as thus creating a broad negotiating space for improvement.

But I do think it is correct that the organizers of this meeting placed energy taxes in the "out of the box" category of tax reform. The most likely route towards tax reform would entail changing our existing tax code, rather than creating a new tax, especially one as controversial as a pollution tax on energy sources. Indeed, President Bush's tax reform panel in 2005, and more recently the Simpson-Bowles fiscal commission in 2010, both focused on reforming the current tax code by broadening the base through reducing tax expenditures while lowering marginal tax rates. Neither of these commissions proposed the adoption of new taxes. I should note that the Debt Reduction Task Force co-chaired by Senator Pete Domenici and my colleague Alice Rivlin (and in which Len was a member) did include a new consumption tax, called the Debt Reduction Sales Tax. But I think it would be politically challenging to expand the dimensions of tax reform to include new taxes, especially a pollution tax, rather than focus on reforming the tax system we currently have.

Let me touch on another possible path towards a pollution tax. I think an underexplored opportunity exists to couple a tax with broader environmental policy reform. It is true that one of the points previously used in favor of the climate cap-and-trade bill was that it could substitute for the default policy, which stemming from a Supreme Court ruling is that the EPA will issue emission rules for greenhouse gases under the Clean Air Act. This Clean Air Act approach to climate policy is considerably less cost-effective than a modest, gradually increasing, and predictable tax on emissions.

But I would take this one step further. Not only can a tax substitute for the default policy of imposing inflexible greenhouse gas regulations throughout the economy, it can also substitute for a broader set of other existing environmental and energy regulations. For example, fuel economy standards and energy efficiency standards are largely redundant given a clear and predictable price on emissions. And a pollution tax should yield co-benefit reductions in pollutants that are currently regulated by the EPA, thus obviating the need for some existing, costly regulations.

In the midst of an election campaign, and with the unemployment rate forecasted to be at about eight percent by the end of this year, we are unlikely to soon see a shift in political momentum towards the type of policy I have described here. But the urgent need for fiscal reform, and the political appeal of broader environmental policy reform, could provide an opportunity to achieve a sensible and effective comprehensive energy policy.

Thank you.