Energy and Tax Policies Must be Reconsidered as Wind Subsidy Comes to an End

Wind power has been a success story of green energy. After several years of rapid growth, it now accounts for about 3 percent of all electricity produced in the United States. It has benefitted from federal support, but that support is scheduled to end on December 31, throwing the industry into a crisis of layoffs and cancelled installations.

The country needs wind power, and wind power needs a favorable policy environment. For those reasons, it is tempting to support a simple extension of the current policy. However, it would be even better to use the looming deadline as an occasion to rethink both energy policy and tax policy.

Makers, Takers, and Energy Policy

It has become fashionable during this presidential campaign to glorify “makers” and disparage “takers.” The distinction applies as much to energy as to any other industry. Makers are those who produce energy that has a value to users that exceeds its costs. Takers are those who make a profit from producing energy that costs more than it is worth by shifting part of those costs to others.

Producers of fossil fuels head the list of takers. Federal tax breaks for mining and drilling are part of the problem, but not the biggest part. More importantly, fossil fuel companies are takers because production and use of coal and oil (and to a lesser extent, of natural gas) have harmful spillover effects on the persons and property of third parties who are neither producers nor users themselves.

Those spillover effects, which economists call externalities, take several forms. Local smog and regional acid rain pollution are examples. Climate change caused by carbon emissions from coal, oil, and natural gas is another. National security costs arising from dependence on unreliable foreign energy supplies are a third. Issues related to water use, land use, and aesthetic values are still other categories of external cost.

People differ in how they rank the importance of these costs, but no one places them all at zero. For example, the most fervent deniers of climate change within the oil industry are often the loudest in warning against the security risks of dependence on foreign sources of supply.

If market prices captured all of the costs and benefits of each form of energy, we would not need an energy policy at all. The trouble is, they do not. The forms of energy that produce the most harmful externalities are systematically underpriced. That is the sense in which producers and users of fossil fuels are takers. Their “take” is the free lunch they get by shifting part of the costs of production to the innocent bystanders they harm.

What we need is a policy to level the playing field, one that makes sure that the relative prices of different forms of energy reflect not just their direct costs of production, but their external costs as well. What would such a policy look like?

Subsidy or tax?

The current policy tries to level the playing field by giving everyone a chance to be a taker. Under this approach, if uncompensated externalities cause fossil fuels to be underpriced, the solution is to subsidize cleaner, renewable energy. Fossil fuel producers get to take from pollution victims; producers of renewables get to take from taxpayers.

Here is how the policy works for wind power: The Renewable Energy Production Tax Credit (REPTC) gives renewable electricity producers a tax credit of 2.2 cents per kWh for all power generated. Together with renewable energy initiatives of individual states, the credit is often enough to make wind power competitive with power from conventional sources. If a company’s profits are not great enough to use its credits fully, it can carry them forward up to 20 years.

When first enacted, the REPTC was a step forward by comparison with an earlier policy that had subsidized wind power installations. The older policy encouraged the construction of towers that produced little electricity. If the purpose of policy is to encourage wind power, it is certainly better to encourage production rather than construction, but is a subsidy of any kind the best way to do it?

An alternative way to level the playing field would be to impose the full cost of each kind of energy, including all external costs, on producers and users. The simplest way to do so would be to tax each form of energy at a rate equal to the harm from its externalities. (I discuss other methods of imposing full costs on users, including property rights remedies, tort law, and cap-and-trade, in detail here. In principle, all of them level the playing field in much the same way.)

Suppose, for the sake of discussion, that the external costs come to 3 cents per kWh for electricity generated by coal, 1.5 cents for natural gas, and 0.8 cents for wind. (Wind turbines create no pollution in operation, but manufacturing them causes a little, and we might also want to give some weight to aesthetic values and bird kills.) A full-cost policy would impose a tax on utilities equal to the external costs of each kWh generated. The utilities would pass the cost along to consumers in the form of a surcharge.

To simplify the discussion, I will ignore details like marginal vs. average costs and possible variations in externalities according to season or time of day. I will also skip over the issue of whether the tax would be an unreasonable burden on low-income users of electricity; I dealt with that issue in an earlier post, “When does ‘It Will Hurt the Poor’ Outweigh ‘It’s Good for the Environment?’”

Since either a 2.2 cent tax or a 2.2 cent subsidy would have the same effect on the competitiveness of wind power, does it really make a difference which one we use? Yes, it definitely does. The difference is that the tax on externalities would encourage consumers to economize on the use of electricity in general, whereas the subsidy, by keeping the retail price low, encourages use.

True, even in places where electric rates are already high, consumers are often wasteful. Many of them fail to buy efficient light bulbs and refrigerators even when doing so is cost effective. Those who use electric heat fail to insulate adequately or switch from resistance heat to efficient heat pumps. Still, consumers are not completely insensitive to prices. A tax reflecting external effects would give one more nudge toward conservation.

A Tax Policy Perspective

So far, we have discussed the Renewable Energy Production Tax Credit and its shortcomings as environmental policy, but it is, at the same time, a tax policy, and a bad one.

The REPTC is an example of what economists call a tax expenditure. Giving producers a 2.2 cent tax credit for each kWh of wind power they generate has exactly the same impact on the budget as would a policy that subjected wind power to the full corporate tax rate and then used the proceeds to give producers a 2.2 cent cash subsidy. The REPTC is only a small part of a vast web of tax expenditures, some 172 of them by one count, that have a total cost to the budget of $1 trillion. That is roughly equal to the entire revenue generated by the individual income tax.

Tax expenditures violate a fundamental principle of tax economics, namely, that, for any given amount of revenue collected, the economic burden is least when the tax base is kept broad and marginal rates are kept low. The corporate profits tax is an especially noxious swamp of exemptions, deductions, and preferences—so much so that the United States, with the highest corporate tax rates in the world, collects less revenue from it than do many countries with lower marginal rates.

Nearly all serious proposals for tax reform include closing corporate tax loopholes and lowering marginal rates. Some proposals envision eliminating the corporate profits tax altogether and taxing all corporate profits as personal income on a pass-through basis, as the code now allows for Subchapter S corporations. Other proposals combine such a move with reform of the individual income tax to remove preferential treatment of capital gains and dividends, now justified on the grounds of reducing the double taxation of corporate profits.

A comprehensive tax reform that swept away the REPTC along with other, larger tax expenditures would once again leave wind power and other forms of renewable energy at a cost disadvantage unless a tax on externalities, as described above, replaced it. How well would an externalities tax score by the standards of tax economics?

At first glance, a tax on externalities from fossil fuels might seem to violate sound tax principles, since it its base is narrow and because it would raise the marginal tax rate paid by producers of fossil fuel energy above the rate paid by producers of renewable energy. However, a second principle of tax economics overrides that objection, namely, that taxes on harmful externalities improve, rather than degrade, the efficiency of markets.

In fact, taxing harmful externalities has a double benefit. First, it levels the playing field by taking away the free ride that producers of the dirtiest forms of energy would otherwise enjoy. Second, an externalities tax raises revenue that can be used for other purposes. Your favorite purpose might be deficit reduction or it might be social programs. Even if you think the government already has all the tax revenue it needs, you could use the revenue from taxes on harmful externalities to reduce taxes you like even less, like taxes on work, saving, or production of beneficial goods and services.

The Bottom Line

The bottom line: Wind power is good. It deserves a supportive policy environment. But extending the REPTC is not the best way to go about it. True, there is not enough time between now and the end of the year to accomplish a comprehensive reform of environmental and tax policies. In the short run, extending the REPTC may be better than abruptly shutting down the wind power industry and hoping that it will revive later under a better-designed policy.

Still, even if it is too late to carry out the needed reforms before the REPTC expires, that does not mean it is too late to start thinking about them. In fact, we should have started thinking about them long ago.

By. Ed Dolan