Low-Energy Fridays: Are energy subsidies reducing electricity bills?

With fresh debates on energy subsidies, a lot of focus has been on how the presence (or repeal) of energy subsidies impacts energy costs. As a matter of economic principle, subsidies reduce costs by transferring them to taxpayers. Consequently, there are analyses noting that the repeal of exceptionally large energy subsidies could also lead to commensurately large energy cost increases. But a quirk in the data is that the energy costs for wind and solar—the biggest beneficiaries of subsidies—have gone up in recent years. If subsidies were expanded but costs went up, what gives?

There are many factors that affect energy costs, but merely having a subsidy doesn’t guarantee a reduction in cost. Rather, when it comes to subsidies it is important to understand the concept of “tax incidence.” Most Americans are familiar with the idea of tax incidence at a basic level. In many states, there are sales taxes. This tax is levied against businesses, which must report sales and send the tax revenue to the government. But everyone who has bought something with a sales tax knows that we as the buyers are the ones hit with that fee; businesses pass the sales tax onto us and do not pay the tax themselves. This is the idea of tax incidence: The entity the government taxes is not always the same entity that pays the tax.

Most frequently, this issue comes up in debates about corporate income taxes. Corporations don’t pay taxes; people do. But which people? Because corporate taxes are directly levied against corporate profits, conventional wisdom is that it is the biggest beneficiaries of corporate profits—i.e., the richest Americans—that pay the most for corporate taxes. But the more substantive body of research is that corporate workers are the ones who bear most of the tax, in the form of lower wages. Why is this the case?

The answer is that, like in the sales tax example, the taxed entity has the ability and incentive to pass the tax downstream. How does this matter to subsidies? For subsidies, the effect is inverted. The subsidized entity has an incentive to retain as much of the subsidy for themselves and pass as little of it down to their customers.

To understand this, consider a hypothetical: In a bizarro world, the federal government creates a subsidy for energy policy analysis, and identifies Philip Rossetti as the sole entity that should receive a $100k subsidy for producing energy policy analysis. Now would I have to pass that value onto my employer, R Street? No, because R Street’s willingness to pay for analysis is unchanged, and presumably, they would still be willing to pay my current salary. Under this scenario, I keep all the government cheese for myself.

Now consider the above hypothetical, but instead the government offers a $100k subsidy to every energy policy analyst. Under this scenario, my incentive would be to pass some, or all the value of the subsidy onto R Street so that I would be the more attractive hire compared to other energy policy analysts. Under this scenario, R Street receives most or all the subsidy.

Note that the primary distinction is competition. Or more accurately, the elasticity on either the supply or demand side of the equation. If there is only one subsidized seller and many potential buyers, the seller gets to keep the subsidy; invert it with many subsidized sellers and few buyers and it’s the buyers who get the subsidy. Just as a taxed firm seeks to pass the tax downstream if possible, subsidized firms seek to retain the subsidy value. This is why subsidy and tax design is so important to achieve intended effects.

Returning to the topic of energy subsidies, because it is energy investors that are the direct recipients of the subsidy, they need only pass the value of the subsidy down to energy consumers when market conditions—i.e., the presence of competition—force them to reduce costs to retain market share. In other words, the effectiveness of a subsidy in reducing costs is dependent upon many factors, and policymakers should not assume subsidies will always have the hoped-for effect.

It would require deeper analysis to say exactly how much of energy subsidies are effectively reducing costs, but policymakers and analysts should appreciate that it is unlikely that the subsidies are being fully passed onto consumers. Additionally, there is another factor to consider which is what happens on the other side of the tax policy equation: The negative economic effect that comes from increasing taxes to pay for subsidies.

Because a subsidy in and of itself does not reduce the cost to produce a good and merely reduces the price one must charge for it, a reduction in costs from subsidies necessarily entails an equal or greater increase in current or future tax burden. In other words, if a policy grants $1 billion of subsidies to an industry, there must also be $1 billion (or more) of taxes to pay for it. Given that most people who pay for electricity are also taxpayers, there should be some consideration of the net effect, which is likely to vary substantially depending upon where someone lives (and what supplies their electricity) as well as their income and tax rate. As such, we always need to be wary of analyses that look at the effect of a subsidy on an industry in isolation without considering the broader economy-wide effects.

Ultimately, energy subsidies reduce energy costs. But there are still some outstanding questions as to how effective they have been in that regard, and if the current form of subsidy design enables clean energy developers to avoid fully passing the subsidy value onto consumers.