Taxes and energy policy

Our tax system is in desperate need of reform, and the most promising path to reform is to reexamine the many tax preferences in our code.

Last week I had the opportunity to testify before two Ways and Means subcommittees–Select Revenue Measures and Oversight–about the way our tax system is used as a tool of energy policy. Here are my opening remarks. You can find my full testimony here.

As you know, our tax system is desperately in need of reform. It’s needlessly complex, economically harmful, and often unfair. Because of a plethora of temporary tax cuts, it’s also increasingly unpredictable.

We can and should do better.

The most promising path to reform is to reexamine the many tax preferences in our code. For decades, lawmakers have used the tax system not only to raise revenues to pay for government activities, but also to pursue a broad range of social and economic policies. These policies touch many aspects of life, including health insurance, home ownership, retirement saving, and the topic of today’s hearing, energy production and use.

These preferences often support important policy goals, but they have a downside. They narrow the tax base, reduce revenues, distort economic activity, complicate the tax system, force tax rates to be higher than they otherwise would be, and are often unfair. Those concerns have prompted policymakers and analysts across the political spectrum—including, most notably, the Bowles-Simpson commission—to recommend that tax preferences be cut back. The resulting revenue could then be used to lower tax rates, reduce future deficits, or some combination of the two.

In considering such proposals, lawmakers should consider how tax reform, fiscal concerns, and energy policy interact. Six factors are particularly important.

• Our tax system needs a fundamental overhaul. Every tax provision, including those related to energy, deserves close scrutiny to determine whether its benefits exceed its costs. Such a review will reveal that many tax preferences should be reduced, redesigned, or eliminated.

• The code includes numerous energy tax preferences. The Treasury Department, for example, recently identified 25 types of energy preferences worth about $16 billion in 2011. These include incentives for renewable energy sources, traditional fossil fuel sources, and energy efficiency. In addition, energy companies are also eligible for several tax preferences that are available more broadly, such as the domestic production credit.

• Tax subsidies are an imperfect way of pursuing energy and environmental policy goals. Such subsidies do encourage greater use of targeted energy resources. But, as I discuss in greater detail in my written testimony, they do so in an economically wasteful manner. Subsidies require, for example, that the government play a substantial role in picking winners and losers among energy technologies. The associated revenue losses also require higher taxes or larger deficits.

• A key political challenge for reform is that energy tax subsidies are often viewed as tax cuts. It makes more sense, however, to view them as spending through the tax code. Reducing such subsidies would make the government smaller even though tax revenues, as conventionally measured, would increase.

• Tax subsidies are not created equal. Production incentives reward businesses for producing desired energy and are agnostic about what mix of capital, labor, and materials firms use to accomplish that. Investment incentives, in contrast, reward businesses merely for making qualifying investments and encourage firms to use relatively more capital than labor. For both reasons, production incentives tend to be more efficient than investment incentives.

• Well-designed taxes can typically address the negative effects of energy use more effectively and at lower cost than can tax subsidies. I understand that higher gasoline taxes or a new carbon tax are not popular ideas in many circles, but please bear with me. As I explain at length in my written testimony, well-designed energy taxes are a much more pro-market way of addressing energy concerns than are tax subsidies. Taxes take full advantage of market forces and, in so doing, can accomplish policy goals at least cost and with minimal government intervention. Subsidies, in contrast, make much less use of market forces and inevitably require the government to pick winners and losers. Energy taxes also generate revenue that lawmakers can use to cut other taxes or to reduce deficits.

P.S. Not surprisingly, that last point wasn’t picked up by anyone else, at least during my panel (one of three at the hearing). New energy taxes would, of course, be problematic for the macroeconomy if enacted immediately. And we’d have to make some adjustment, either in the tax code or in benefit programs, to offset the impact on low-income families. In the long-run, however, I think that would be a much better way to address many energy concerns, including carbon emissions and oil dependence. But that’s not the way our system works. Instead, as noted, it’s much more popular to use tax preferences, whose benefits are visible and whose costs are obscure, to pursue energy and environmental goals. Other participants discussed the particular incentives, existing and proposed, in greater detail; their testimony is available here.