DATE:
TO:
FROM:
TOPIC:
January 31, 2007
Dr. David Hunger
Steve Caldwell
Economic Assessment of Energy Tax and Subsidy Policies
EXECUTIVE SUMMARY
Congress and President Bush have recently proposed a variety of tax, subsidy, and regulatory
programs billed as part of a “cleaner, greener” energy policy. An economic assessment of energy tax
and subsidy policies finds that:

Fossil fuel consumption has costs to society not reflected in market prices

Taxes or trade-able permits can force the market to take account of such costs in the most
economically efficient way

Subsidies of alternative energy research and development promote economic efficiency but
subsidies and quotas for the production of alternative energy may not

Americans must make political value judgments regarding the distributional effects of
different energy policies
POLITICAL BACKGROUND
High gasoline prices, increasing awareness of the danger of global warming, the Iraq War and other
factors have fed growing public concern about energy policy. Congressional Democrats plan to
enact changes to energy policy—such as mandating increased use of biofuels. President Bush’s State
of the Union address highlighted energy policies, including research grants and quotas for alternative
energy.
NEGATIVE EXTERNALITIES OF FOSSIL FUELS
In 2005, petroleum, coal, and natural gas provided 86% of all US energy. 1 However, the market
prices of these energy sources do not reflect their true costs to society. Negative effects of fossil fuel
use not reflected in market prices, or negative externalities, fall into three main categories:
1

Environment– the extraction of fossil fuels can damage natural environments, and their
combustion releases harmful substances, such as SO2, NOx and ozone. Roughly 80% of US
greenhouse gas (GHG) emissions come from fossil fuel combustion, and the US emits a
fifth of all global GHG emissions.2 The US faces potentially severe damages from global
warming including: loss of valuable coastal property to rising sea levels; disruption of
agricultural production; and more frequent severe weather events.

Economic Growth – the US imports 60% of its petroleum supply. Disruptions to supply
could lead to significant price spikes and impact economic growth.

National Security – To at least some extent, the US appetite for petroleum funds entities
hostile to US national security interests and necessitates political and military entanglements
Annual Energy Review 2005, US Energy Information Administration <http://www.eia.doe.gov/emeu/aer/>
“Greenhouse Gases, Climate Change, and Energy,” US Energy Information Administration
<http://www.eia.doe.gov/oiaf/1605/ggccebro/chapter1.html>
2
in the Middle East. In addition, fossil fuel energy infrastructure (e.g. pipelines) presents
attractive potential targets to terrorists.
EFFICIENCY GAINS FROM ENERGY TAXES AND TRADE-ABLE PERMITS
Because market prices do not reflect the negative externalities described above, the US consumes
more fossil fuel than it ought to from the perspective of economic efficiency—i.e. when one includes
the damage from negative externalities, the costs of the current level of fossil fuel consumption
exceed the benefits to society. Economists espouse taxes as a means to make the market take
account of negative externalities. In terms of policy, the government could set a per-unit tax on fossil
fuels to reflect the damage from negative externalities. Such a tax would raise fossil fuel prices faced
by consumers and reduce quantity demanded to the socially optimum level.
Taxes, however, present a host of practical and political challenges. Taxes on fossil fuels could
prove politically unpopular since concern over already high gasoline prices lies behind much of the
public attention to energy policy. Instituting the optimal level of taxation requires extensive
knowledge of market supply and demand. Setting a tax too low or too high could lead to over- or
under-consumption of fossil fuels from an economic efficiency perspective. Finally, adjustment of
energy taxes to reflect changing circumstances (e.g. inflation, new technology) would require
administrative and possibly legislative action leading to a degree of inflexibility.
The US could also address negative externalities via a system of trade-able permits. Under such a
system, the government would auction off permits for fossil fuel consumption equal in sum to the
optimal level of consumption. Firms who could reduce fossil fuel consumption most inexpensively
could sell excess permits to firms who could not as easily reduce fossil fuel usage, thus achieving
aggregate reductions at minimum expense. Trade-able permits offer some advantages. First, the
government does not need extensive knowledge of supply and demand in order to achieve a targeted
level of consumption. Also, a trade-able permit system does not require the administrative
adjustments needed to optimize a tax program. While trade-able permits would have largely the
same effect as taxes on energy prices faced by consumers, trade-able permits might prove more
politically viable since they affect costs less directly than taxes.
Economic theory offers important lessons for the design of a tax or trade-able permit system. The
government should avoid setting different tax levels or permit allocations across different industries.
In the case of reducing GHG emissions, for example, the most economically efficient tax or tradeable permit system would treat a one unit reduction in GHG emissions from transportation the same
as a one unit reduction from electricity generation so that market forces would generate the most
efficient reduction of GHG emissions. In addition, the government must carefully assess the
interaction of energy taxes or trade-able permits with existing taxes in order to avoid harmful
distortionary effects.
SUBSIDIES AND MANDATES FOR ALTERNATIVE ENERGY
To date, the federal government and states have used three primary tactics to promote alternative
energy:

Production Subsidies –the federal government offers subsidies to producers of alternative
energy, such as wind energy and corn-based ethanol

Minimum Usage Mandates – federal and state policies require certain minimum levels of
alternative energy usage. For example, a current Senate energy bill would set requirements
for minimum use of ethanol and biodiesel.

Research & Development Subsidies – the federal government offers tax credits and grants
to fund research and development in alternative energy. For example, President Bush’s
2008 budget includes $179 million for the Biofuels Initiative.
Economic theory does not recommend production subsidies or minimum usage quotas as optimal
policies. These policies force the government to choose winners from among the various alternative
energy technologies and, in the case of minimum usage mandates, to set quantity. In contrast, under
tax or trade-able permit systems that address negative externalities, the “invisible hand” of market
forces would lead to the most efficient mix of energy sources. Nonetheless, government subsidies
may be needed to overcome economies of scale barriers to the adoption of alternative energies—e.g.
retail availability of ethanol or biodiesel. Moreover, the government must ensure that businesses can
make confident long-term forecasts of subsidies in order to plan investments appropriately.
Economic theory does justify government subsidies for alternative energy research and
development. The benefits to society from research into alternative energy exceed the benefits to the
individual firms that undertake the research. As such, without subsidies, firms will under-invest in
research and development from the perspective of overall economic efficiency.
DISTRIBUTIONAL EFFECTS AND EQUITY CONCERNS
Any energy tax, subsidy, or trade-able permit policy will have distributional consequences—i.e.
differential effects on the welfare of different groups. While economists can identify the most
efficient policies and forecast their distributional effects, society must make political value
judgments regarding the distributional effects and decide on policies to mitigate them.
Energy taxes or trade-able permits would likely raise the prices of certain goods and services and
reduce the quantity demanded. This effect could hurt Americans employed in certain industries.
For example, US autoworkers might suffer job losses and reduced incomes if a tax on gasoline
reduced the quantity of automobiles demanded. In addition, higher energy costs might lead to a
larger reduction in welfare for lower income Americans than for more affluent Americans.
In addition to costs, one must examine the distribution of benefits from energy policies. For
example, policies that reduce air pollution from auto emissions mainly benefit Americans living in
urban areas. In the case of global warming, many of the benefits from American GHG reductions
would actually accrue to residents of developing nations in Africa and Asia. Domestically,
Americans dwelling in vulnerable coastal regions like Florida might disproportionately benefit from
GHG reductions.