COMMENT: US should reconsider fuel ethanol’s excise tax exemption

June 13, 2005
As the US Senate takes up comprehensive energy legislation, it has an opportunity to fix an increasingly wasteful tax incentive that has directly increased the prices and profits enjoyed by energy producers in times of tight supply.

As the US Senate takes up comprehensive energy legislation, it has an opportunity to fix an increasingly wasteful tax incentive that has directly increased the prices and profits enjoyed by energy producers in times of tight supply. Given the recent focus on oil companies’ profitability, it may come as a surprise that I am speaking of the federal gasoline excise tax exemption that the fuel ethanol industry has enjoyed since 1979. In recent years, this incentive has undergone a dramatic transformation from supporting a nascent industry to needlessly adding billions of dollars to the federal deficit while conferring windfall profits on producers.

Most debates about ethanol subsidies focus on the question of whether ethanol deserves any federal support. Yet, even if ethanol does deserve support, it has never been clearer that this can be achieved at far less cost to taxpayers.

During 2004, a year in which ethanol demand strained production capacity, wholesale ethanol prices averaged above $1.60/gal and peaked above $2/gal-far above ethanol’s production costs of about $1/gal, according to a US Department of Agriculture report. Ethanol producers earned margins that likely averaged above 60¢/gal over the entire year and at times reached $1/gal, dwarfing the margins earned by refiners that often spur public outrage.

Profits, not production?

These windfall profits were largely caused by ethanol’s excise tax exemption (recently renamed the Volumetric Ethanol Excise Tax Credit). Rarely is there such clear evidence of a tax incentive simply adding to producers’ profits, rather than increasing production. Moreover, as ethanol’s use grows in the coming years, the tax exemption’s effect on the deficit, which stood at nearly $2 billion in 2004, could grow to more than $8 billion-a 160-fold increase in size since the exemption’s early years.

Without the tax exemption, fuel marketers would be willing to buy ethanol from producers at a price near that of wholesale gasoline. This is because ethanol is allowed to replace up to 10% of each gallon of gasoline that marketers sell. By reducing the excise taxes that marketers must pay on their retail sales of gasoline-ethanol blends, the tax exemption makes marketers willing to pay an additional 51¢/gal of ethanol. At the same time, the federal deficit increases by 51¢/gal of ethanol used.

Because of the low gasoline prices that US fuel consumers enjoyed for much of the past 2 decades, without ethanol’s tax exemption, marketers historically would not have bought ethanol at prices high enough to support its production.

But, with pretax wholesale gasoline prices around $1.50/gal in recent months, marketers now have plenty of incentive to use ethanol, even without the tax exemption. Rather than being essential to encourage ethanol use, for more than a year the exemption has simply magnified an already strong market incentive for ethanol growth.

If this strong incentive persists (and oil futures prices suggest it will), ethanol use will grow dramatically in coming years, even without the renewable fuels standard being considered by Congress. Along with imposing a growing deficit burden, the exemption will continue to generate windfall profits for ethanol producers, as it did in 2004. By accelerating demand growth, the exemption will make periods of tight supply more common, leading ethanol prices to rise above costs until demand falls back in line with supply. Because it increases the maximum price that marketers would willingly pay for ethanol, in times of tight supply the exemption can add up to 51¢/gal to ethanol prices and hence to its producers’ windfall profits.

While ethanol use will continue to increase absent a dramatic decline in oil prices, the unique characteristics of ethanol demand can cause temporary slowdowns in otherwise surging growth. When this occurs, prices will fall back toward costs, as they have in recent months. However, the recent fall in ethanol prices is likely just a temporary reprieve from future periods of tight supply, higher prices, and higher profits.

A better solution

As many years have passed since ethanol needed the full 51¢/gal tax exemption to be competitive with gasoline, the exemption clearly must be changed.

If Congress wishes to continue federal support for ethanol, a redesigned tax exemption could adjust to changing gasoline prices. Starting at 51¢/gal, the exemption could decline 1¢/gal for every cent that gasoline prices rise above an agreed-upon threshold, reducing federal support when rising gasoline prices offer increasing market incentives for ethanol use. Such an exemption could offer producers similar support as the current exemption when ethanol cannot otherwise compete with gasoline. But, when gasoline prices rise, the redesigned exemption’s deficit burden would decline, and the exemption would not add to windfall profits.

The exemption could also be replaced with a renewable fuels standard, which would require marketers to use a particular volume of ethanol in gasoline each year. By requiring ethanol use, a well-designed standard can ensure ethanol prices that encourage supply growth without generating windfall profits. It is unnecessary to provide an incentive for ethanol use with a tax exemption if that use also is required by regulation. Therefore, if a renewable fuels standard is adopted, the tax exemption should be eliminated.

Either way, the ethanol excise tax exemption must be addressed. Otherwise, it will continue needlessly increasing the deficit and generating windfall profits, while supporting ethanol use that could be sustained at far less cost to taxpayers.

The author

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Judson Jaffe is a manager at Analysis Group Inc., where he specializes in the application of economic analysis to environmental and energy regulatory matters. Before joining Analysis Group in 2002, Judson spent 2 years as a staff economist at the Council of Economic Advisers. He holds an MPhil degree in economics from Cambridge University in the UK and an AB in environmental science, public policy, and economics from Harvard University. His e-mail address is [email protected].