Energy Tax Preferences: Rid Them All (Cato letter to House working group revisited)

By Robert Bradley Jr. -- July 29, 2013

“Some might argue that some existing preferences increase energy production and thus, contribute to lower energy prices. Yet many of the preferences at issue have little or no impact on energy production; they simply represent wealth transfers.

Those preferences that do reduce energy production costs simply encourage market actors to produce costly, economically uncompetitive energy. Markets are not made more efficient by producing costly relative to less costly energy.”

Earlier this year, Jerry Taylor and Peter Van Doren of the Cato Institute wrote a tax policy missive to the Energy Tax Reform Working Group of the  House Ways and Means Committee. This committee, chaired by Kevin Brady (R-Texas), is one of eleven such working groups chaired by Dave Camp (R-MI) and Ranking Member Sandy Levin (D-MI).

Taylor and Van Doren espouse cleaning out the tax code to allow a more neutral tax structure to determine the production and consumption of competing energies. Their analysis also opens the door to fundamental tax reform that would  address the size of the tax itself, while eliminating differential tax treatment.

The Cato-based analysis, with subtitles added, is excerpted below.

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Energy tax preferences at present are substantial. A good catalogue of such preferences, recently published by the Center for American Progress, finds that only 40 percent of government spending in the energy sector comes from direct appropriations. The balance comes from tax expenditures. [1]

Our recommendations regarding potential reforms are premised upon three priors.

1. Government intervention in energy markets should only be entertained when clear market failures are at issue. Otherwise, intervention will make energy markets less – not more – economically efficient.
2. When market failures are identified, the intervention should be crisply targeted to directly address the market failure(s) at issue.
3. Energy tax preferences represent governmental intervention in markets; they are designed to direct private investment away from some activities to activities favored by the tax preference(s).

While there is resistance from some quarters to label tax preferences as “tax expenditures” or “subsidies” (the argument being that allowing parties to keep x percent of their earnings is not to “subsidize” them by x percent), that semantic debate ignores the broader point; tax preferences represent the government’s attempt to take resources from some parties in the energy sector and reallocate them to other parties in the energy sector.

Whether that reallocation occurs via direct taxation-and-appropriation or via the tax code does not change this underlying reality.

Market-Failure Arguments

There are three alleged market failures that are frequently cited to justify energy tax preferences:

-the national security costs and economic risks associated with energy imports;

– the inability of “infant industries” to compete in the market due to a mix of incumbent market power and (past and present) government preferences to market incumbents; and

– the environmental costs of energy consumption that are not internalized in energy prices.

While other rationales for intervention are frequently offered–for  instance, steering investment into more labor-intensive energy investments–those rationales are not related to any identifiable market failure in energy markets. Those rationales are only persuasive if we posit that government actors are better judges of how to efficiently allocate resources than private actors … and we find that proposition unpersuasive.

The only market failure charge that we find persuasive relates to the issue of environmental costs. The alleged national security costs of energy imports are for the most part nonexistent. [2]

The infant industries argument ignores both the long record of incumbent market actors that have been displaced by new competitors without significant governmental help and the inability of government to successfully promote politically promising infant industries.

Pollution Externalities

While there is a good argument to be made that energy prices do not fully account for the environmental costs imposed on others when energy is consumed (resulting in more pollution-intensive energy production and consumption than would otherwise be the case), [3] tax preferences are a poor means of addressing this problem.

A far better remedy would be to internalize those environmental costs by either increasing existing regulation to address emissions or – better – to tax emissions so as to internalize those costs directly. [4]

Tax preferences constitute interventions that presuppose that governmental agents know a priori the most efficient mix of energy investments that would occur in a well functioning energy market (a dubious proposition). The market failure at issue, however, is not that market actors make poor investment choices; it is that prices are inaccurate and thus market actors invest inefficiently. Correct the price signals and efficient investment will follow.

We believe that the above analysis provides a good road map for reform. To wit, the Congress should completely eliminate all energy tax preferences. If the Congress is interested in addressing the environmental issues associated with energy consumption, it should do so directly via increased environmental regulation or via emission taxes. [5] It should not do so via tax preferences.

The largest tax preference claimed by the energy industry – the Section 199 deduction afforded to all U.S. manufacturers – is best addressed by eliminating the Section 199 deduction in full. Allowing all manufacturers save for those in the energy sector to claim this credit will likely increase the economic inefficiencies associated with this particular tax preference. That’s because a narrower, more targeted tax preference is – all things being equal – more distortionary than a broader, less targeted tax preference.

Energy Taxation as Wealth Transfers

Some might argue that some existing preferences increase energy production and thus, contribute to lower energy prices. Yet many of the preferences at issue have little or no impact on energy production; they simply represent wealth transfers.

Those preferences that do reduce energy production costs simply encourage market actors to produce costly, economically uncompetitive energy. [6] Markets are not made more efficient by producing costly relative to less costly energy.

Direct Reform, Not Preferential Taxation

Recipients of these energy tax preferences – most notably, the oil and gas industry – have argued that their corporate income tax burden is already punishingly high (effectively paying over 40 percent on earnings) and that eliminating tax preferences in this context is unjustifiable.

While we will not address here the larger issue of what constitutes a “first-best” corporate income tax regime, we simply note that the best remedy for excessive corporate income tax burdens is a direct reform of the corporate income tax. Targeted tax preferences to moderate industry tax burdens are a poor way to address the problem. [7] ….

FOOTNOTES

[1] Richard W. Caperton and Sima Gandhi, “America’s Hidden Power Bill: Examining Energy Tax Expenditures,” Center for American Progress, April 2010.

[2] Jerry Taylor and Peter Van Doren, “The Energy Security Obsession,” The Georgetown Journal of Law & Public Policy6:2, Summer 2008.

[3] Ian Parry, Margaret Walls, and Winston Harrington, “Automobile Externalities and Policies,” Journal of Economic Literature45:2, 2007, p. 373. Michael Greenstone and Adam Looney, “Paying Too Much for Energy? The True Costs of Our Energy Choices,” Social Science Research Network #2010862, February 2012.

[4] Ian Parry, “Are Energy Efficiency Standards Justified?” Social Science Research Network #1713991, November 2010. Gilbert Metcalf, “Market-Based Policy Options to Control U.S. Greenhouse Gas Emissions,” Journal of Economic Perspectives 23:2, 2009, p. 5.

[5] An example of how to execute nationwide pricing of conventional emissions can be found in Nicholas Z. Muller and Robert Mendelsohn, “Weighing the Value of a Ton of Pollution,” Regulation, Summer 2010, p. 20.

[6] Gilbert Metcalf, “Using Tax Expenditures to Achieve Energy Policy Goals,” The American Economic Review 98:2, May 2008, pp. 90-94. A longer version of that paper can be found in Gilbert Metcalf, “Federal Tax Policy Towards Energy,” NBER Working Paper w12568, October 2006.

[7] Jerry Taylor and Peter Van Doren, “Eliminating Oil Subsidies: Two Cheers for President Obama,” Forbes.com, May 3, 2011.