Report

Subsidizing Energy Efficient Household Capital: How Does It Compare to a Carbon Tax?

Warwick J. McKibbin, Adele Morris, and Peter J. Wilcoxen

Abstract

Current U.S. law offers a variety of tax credits for different kinds of energy efficient household
capital. This study uses an intertemporal general equilibrium model to compare the
environmental and economic performance of two policies: (1) a tax credit of 10 percent of the
price of household capital that is 20 percent more energy efficient than its unsubsidized
counterpart, assuming half of new household investment qualifies for the credit; and (2) a tax
starting at $30 ($2007) per metric ton of carbon dioxide (CO2) and rising 5 percent (inflation
adjusted) each year. By 2040, the carbon tax reduces emissions by 60 percent while the
investment tax credit for energy-efficient capital reduces emissions by about 1.5 percent. Under
the assumption that other countries do not adopt a price on carbon, we find that although the
carbon tax reduces U.S. GDP, it improves the welfare of U.S. households because it reduces the
world price of fuels, strengthens U.S. terms of trade, and makes imported goods cheaper. The
revenue neutral tax credit reduces welfare but boosts U.S. GDP growth slightly in the first few
years. Both policies have similar impacts on the federal budget, but of opposite signs.

1. Introduction

Proponents of ambitious climate policy often support imposing both a price on carbon
and “complementary policies” to provide incentives for the deployment of energy-efficient and
low carbon technologies. Current U.S. law offers an extensive variety of tax benefits for certain
kinds of energy production and conservation, including incentives for renewable electricity
production, energy efficient household investments, and bio-fuel production. The U.S.
Congress expressed its continued enthusiasm for these measures in the American Recovery and
Reinvestment Act of 2009 (Recovery Act), which extended many consumer energy-related tax
incentives as part of the fiscal stimulus package.

In particular, the Recovery Act expanded two energy-related tax credits for households:
the non-business energy property credit and the residential energy efficient property credit. The
non-business energy property credit equals 30 percent of homeowner expenditure on eligible
investments, up to a maximum tax credit of $1,500 over 2009 and 2010. The capital and labor
costs of certain high-efficiency heating and air conditioning systems, water heaters and stoves
that burn biomass qualify, as does the capital (but not labor) cost of certain energy-efficient
windows, doors, insulation and roofs. The residential energy efficient property credit equals 30
percent of the installed costs of solar electric systems, solar hot water heaters, geothermal heat
pumps, wind turbines, and fuel cell systems.

Another potential expansion of subsidies for energy efficiency appears in HOME STAR,
a bill designed to strengthen short-term incentives for energy efficiency improvements in
residential buildings. This proposal would establish a $6 billion rebate program for energyefficient
appliances, building mechanical systems and insulation, and whole-home energy
efficiency retrofits. The program targets energy efficiency measures that would achieve an
energy efficiency gain of 20 percent.

One key goal of subsidies for energy efficiency investments is to reduce electricity
generation and thereby reduce carbon dioxide emissions and other air pollutants. Some analyses
suggest that increasing energy efficiency is a relatively low, possibly negative, cost way to abate
greenhouse gas emissions and other air pollutants as well. However, adoption rates for energy
efficient technologies fall short of levels that many believe are justified by the potential return on
such investments. For example, the rates of return households apparently require for investments
in energy efficiency are considerably higher than the rates of return used by electric utilities
when investing in new generation. That difference in rates of return has spurred the development
of utility-based demand side management (DSM) programs which often include subsidies for
household energy efficiency. A growing economic literature explores this “energy-efficiency
gap.”

Regardless of the net benefits from investments in energy efficient capital, recent
expansions in policies to promote those investments raises the question of how much they reduce
carbon emissions and how they compare to policies that target carbon more directly. This paper
uses an intertemporal general equilibrium model called G-Cubed to compare and contrast the
environmental and economic performance in the United States of a tax credit for energy efficient
household capital and an economy-wide price signal on carbon from fossil fuels used in the
energy sector. We choose the tax credit and carbon tax rates of those policies so that they have
roughly comparable fiscal impact on the US government; that is, if the policies were
implemented together, the revenue from the carbon tax would offset most of the reduction in
revenue associated with the tax credit. When examining the policies individually, we use a lump
sum tax or rebate in order to hold federal spending and the budget deficit constant.
A tax credit for energy-efficient household capital reduces its relative price to
homeowners and induces them to invest more. As household capital turns over, the energy
saving properties of the policy accrue along with the aggregate tax expenditure up to the point
where households have adopted all the energy efficient capital that is cost-effective at the
subsidized rate. Unless market conditions evolve to the contrary, the government must sustain
the subsidy to prevent households from reverting to purchasing relatively lower efficiency
capital. As a result, it will have permanent effects throughout the economy. By raising the rate
of return on household capital relative to capital in other sectors, the subsidy permanently shifts
the economy’s overall portfolio of physical capital.

The empirical evidence on the effects of investment tax credits is limited and pertains
primarily to the effect of tax credits on investment levels and energy savings. Gillingham et al.
(2006) summarize the literature on tax credits to promote energy efficiency. Hassett and Metcalf
(1995) show that a 10 percentage point change in the tax price for energy investment would lead
to a 24 percent increase in the probability of energy conservation investment.
The degree to which households and firms anticipate policies can significantly affect the
results, particularly in the early years of the policy. For example, if households anticipate a
subsidy to capital then they will delay acquiring capital they would otherwise purchase in order
to take advantage of the subsidy later. Similarly, Hassett and Metcalf (1995) and others point out
that tax credits are unlikely to be efficient tools for reducing carbon emissions. Consumers who
would have purchased energy efficient capital in the absence of the subsidy receive a windfall,
and unless the subsidy is perceived to be permanent, the effect could be to induce an
intertemporal substitution in investments more than a net increase. This intertemporal
substitution can be an important real-world policy effect, and it is captured in the G-Cubed
model via forward-looking behavior on the part of households and other investors.

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