Policy Studies Energy and Environment

Bringing tax reform to the energy sector

The attached policy study is co-authored by R Street Federal Energy Policy Manager William Murray.

For the first time in more than a decade, Congress and the White House are both controlled by Republicans, most of whom want to achieve the long-overdue goal of fundamental tax reform. That conversation has inevitable intersections with the yearslong battles, small and large, over various industry- and technology-specific provisions related to energy. From resource exploration and production, to research and deployment, to consumer purchasing behavior, energy tax policy is shot through with subsidies, carve-outs and preferences that make for a much-distorted market.

In a frustrating sign of policymaking dysfunction, these provisions often act at cross purposes to one another. For example, America’s tax code famously includes a number of industry-specific policies that are highly beneficial to the oil industry, ostensibly to foster the production of domestic oil resources and help maintain access to low-cost transportation fuel. However, it also includes valuable preferences for the purchase of electric or plug-in hybrid automobiles, ostensibly to push customers to consume less of the very same oil that other tax policies aim to support.

In each such provision can be found a symptom of the disease that has led to a government as expensive and powerful as the one we see today: concentrated benefits and diffuse costs. The benefits of any particular tax policy tend to flow to a distinct group, which will often mobilize its members to lobby in its support. Meanwhile, the costs—whether explicit (as in the case of outright subsidies) or implicit (as in the case of market distortions)—are borne by the American public as a whole. After playing out hundreds of times over the course of decades, the result is a tax code that looks less like a “level playing field” and more like a mountain range.

Such an ambiguous and complicated tax code is a result of dozens of policy interventions by Congress, each one theoretically justified by an appeal to nudge supply or demand of energy in one direction or the other. But as Tufts University professor Gilbert Metcalf has argued, the “arguments for using the tax code to affect energy supply and demand are poorly related to existing energy tax policy.” In other words, while there are many political justifications for such preferences, there are few legitimate policy justifications for them. Despite claims to the contrary, energy preferences tend to be spectacularly inefficient and costly strategies that distort markets and impose significant costs on consumers.

Much of the attention on energy tax preferences has rightly focused specifically on the Production Tax Credit (PTC) and Investment Tax Credit (ITC) for various forms of renewable energy. These credits have allowed generators of designated forms of energy to claim a dollar-for-dollar reduction in tax liabilities based either on the amount of electricity generated or a percentage of the initial investment in the project. Such provisions, however, were designed to be temporary, and as of this writing, many of the credits have either expired or are set to be phased out over the coming years.

While the phase-out and elimination of the PTC and ITC is something to celebrate, it would be a mistake to see their repeal as the end of the story. In fact, even without these provisions, the tax code remains riddled with special preferences for different energy types, some of which are even more deeply embedded in the tax code.

At the same time, not every tax provision that affects energy sources in different ways can be said to be an illegitimate one. Some provisions actually reflect design elements derived from solid tax policy and thus eliminating them would either decrease the overall efficiency of the tax system or create new forms of lopsided treatment elsewhere in the code. Still other provisions may be better candidates for modification or expansion, rather than outright elimination.

Many politicians and analysts pay lip service to the notion of eliminating a wide range of tax preferences. For devotees of limited government, this is generally paired with a commitment to lower tax rates across the board to better facilitate economic growth. In an effort to help craft a vision of a truly free energy market, numerous proposals from nonpartisan research organizations and coalitions have expressed support for a wideranging effort to eliminate tax preferences, subsidies and distorting regulations.

Such a goal is simple to articulate and comprises the following “best practices”: a tax code should not seek to influence energy markets unduly; it should be neutral as to specific energy technologies; and it should not advantage or disadvantage the energy sector as a whole over other sectors. Further, Congress should only act to tweak the energy-related portions of the code in the case of a significant market failure.

Despite the relative ease with which such goals can be articulated, they remain difficult to execute. While support for a “level playing-field” for all energy is reasonably widespread on the center-right, it also lacks the kind of details that might help bring it to fruition. After all, it is one thing to assert blithely that we should eliminate all preferences, but it is quite another to map out how that might be achieved, and to grapple with the difficult questions that lurk just beneath the surface.

Accordingly, the present study seeks to determine a more specific path from where we are today toward the level playing field that many seek, and to identify some of the obstacles that may be faced. Specifically, we will evaluate major energy tax provisions based on whether they single out a specific type of energy for preferential or negative treatment, or whether they apply legitimate tax principles. We will then apply that criteria to a selection of major energy provisions, and recommend modification or elimination of policies that fail to meet the test. Finally, we will discuss the implications such a reform would have across various energy sectors.

The topic of energy preferences is so vast that even an attempt to give a broad outline could easily become unwieldy. As such, a few caveats about what this paper will not cover are warranted. First, this study is restricted to an examination of energy preferences in the tax code. There are, of course, many legal provisions outside the code that give special preference to particular forms of energy. For example, the loan guarantees for nuclear power plants contained in the Price Anderson Act apply different standards to nuclear plants than to other forms of energy. Further, even policies that may seem to have little to do with energy, as such, can still have a differential impact. Government funding for transportation infrastructure, for instance, arguably benefits energy types that rely on that infrastructure over types that do not. While a broader examination of these issues could be a fruitful area for future research, it is outside the scope of this paper.

Second, this analysis does not consider provisions in the tax code designed to correct for market externalities through the use of pollution taxes. The use of pollution pricing as a means to deal with environmental externalities raises a number of thorny issues, which are extensively discussed elsewhere. A tax targeted to a specific type of pollution, however, raises different issues than a tax provision meant to benefit or harm a particular type of energy. This is our focus here.

Finally, even with respect to the tax code, we do not aim to be 100 percent comprehensive, as there are simply too many specific provisions to allow for an exhaustive analysis of each in the space of a short paper. We do, however, hope to categorize many prominent tax policies and make recommendations for reform, where needed.

Image by Feng Yu


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