Energy Implications of Tax Reform

I've been thinking about the implications for energy of a major deficit reduction effort along the lines suggested by the co-chairs of the President's fiscal responsibility and reform commission. Our present approach to providing incentives for various energy sources and technologies, new and old, is embedded in a tax code and taxation philosophy that might not survive the upheaval required to bring the US deficit and resulting federal debt back into a manageable range. This goes far beyond the comparatively minor question of extending expiring grants and tax credits that I discussed the other day; under the most stringent of the proposals from Mr. Bowles and Senator Simpson, such things wouldn't even exist. It's not clear how the Administration or Congress would promote favored energy technologies and strategies without these well-established but costly tools.

Start with renewable energy. We currently promote renewable fuels and electricity generation with a combination of mandates--policies such as the federal Renewable Fuels Standard (RFS) and state Renewable Portfolio Standards--and subsidy payments. Until last year's stimulus bill established the Treasury renewable energy grants, for which eligibility is due to expire in a few weeks, most of those subsidy payments have come in the form of reductions in federal taxes, via either an investment tax credit (ITC) based on the cost of a project or a production tax credit (PTC) for actual energy generated. Both of these measures, which have had a checkered history of expirations and extensions, fall into the broad category of "tax expenditures". The Zero Option proposed by Messrs. Bowles and Simpson would permanently eliminate over $1 trillion of such tax expenditures, in exchange for much lower tax rates.

Even if the renewable energy tax credits were reloaded into a streamlined tax code under the "Wyden-Gregg-style" reform presented as Option 2 from the co-chairs, the value of those credits would be reduced--or at least rendered harder to extract--because the corporate tax rate would be reduced from the current 35% to 26%. That means that a higher proportion of companies would likely not pay large enough taxes to take full advantage of the renewable energy tax credits--or have as much appetite for others' credits via "tax equity" swaps. Compounding that, the likelihood of enacting cash grants to get around this restriction would probably be much lower in an environment in which entire herds of sacred cows were being slaughtered in the cause of averting a looming national deficit and debt crisis.

In the absence of such tax credits, renewable energy developers and manufacturers would be forced to rely even more on state-level mandates or a proposed federal renewable electricity standard. The first test of such a mandates-only approach might come in a few weeks, if the ethanol blenders' credit is allowed to expire, while the annual RFS mandate continues to ratchet up. Or companies might simply conclude that without generous tax subsidies for renewable energy deployment here, their best opportunities would be found in markets that are growing much faster than ours, based on actual energy demand, rather than better incentives. Developing Asia comes to mind. That shift might not be the worst outcome, in terms of both the US trade deficit and global emissions reductions.

Conventional energy firms wouldn't escape unscathed, either. They stand to lose significant tax expenditures as well, in the form of oil & gas depletion allowances, the Section 199 manufacturing deduction, and other benefits. However, the oil and gas industry has been paying an effective corporate tax rate above 40% even after all these credits and deductions. A drop to 26% might more than offset the loss of the other benefits, while more importantly bridging the competitive gap between US firms and foreign competitors that operate under lower tax rates and a territorial tax system, rather than being taxed on worldwide earnings, as US companies are today. Bowles/Simpson also proposed increasing the federal gasoline tax by 15¢ per gallon to restore the Highway Trust Fund to solvency. That's a worthy goal, but as I've pointed out previously the Highway fund faces complex challenges as the US car fleet becomes steadily more fuel efficient and increasingly moves away from liquid fuels taxed at the pump. Raising the gas tax is a stop-gap measure, at best, on the way to a different means of collecting road taxes.

With regard to climate policy, tax reform that eliminated tax credits or reduced their value would also tend to nudge the debate back in the direction of putting an explicit price on carbon, either via cap & trade or with an outright tax. Might that prospect suddenly look more attractive as an adjunct to a fairer and simpler income tax system, than it seemed when it would have come as a further complication to an already enormously convoluted tax system that is widely viewed as unfair by both liberals and conservatives? My guess is not, without something else that motivates us to tackle climate change on a much more urgent basis.

Now let's come back to reality. The proposals of the commission's co-chairs have already received a frosty reception or outright hostility from both sides of the aisle, and they haven't yet gotten the buy-in of the rest of their team; the final report requires the consent of 14 of the 18 members. Their ideas must also compete with a growing number of deficit-reduction alternatives, including a widely-reported plan from another bi-partisan group, plus at least one solo proposal from another member of the President's commission. The chances are low for any of these proposals to gain enough traction to be enacted without first being significantly watered down. However, it is starting to look just as risky to assume that the present tax system--and its cornucopia of energy incentives--will continue unchanged indefinitely. A quick glance at the US debt clock ought to make that abundantly clear.

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Deficits and Energy

After reading several articles about the administration's proposed 2011 fiscal-year budget, I decided to look through the figures myself. My primary interest was in finding indications of what might lie in store for energy-related taxes and incentives. However, once I noticed how the projected deficits accumulate and examined the assumptions behind them, it struck me that the larger concern for energy and everything else is whether this budget represents a reasonable and sustainable picture of our future national finances. The expected 10-year deficit for the 2009-2018 period appears to have grown by $1.5 trillion relative to last year's budget. And that's after counting roughly $2 T in newly-proposed spending reductions and tax increases, including higher taxes on the energy industry. Against that backdrop the extra few billion dollars for renewables and other favored energy technologies nearly get lost in the rounding.

As a veteran strategic planner, I started by examining the economic assumptions for the budget. While everyone hopes for a strong rebound that would boost tax revenues by moving millions of the un- and under-employed back onto the tax rolls, it seems overly optimistic to assume that on top of an expected 2.7% growth rate in real GDP for this year, real GDP growth would then average 4% per year from 2011-2015 (calendar years.) The last time we had a five-year growth spurt like that was in the late 1990s--thanks to the Tech Bubble--and prior to that in the late 1980s. Yet despite such strong projected growth and the addition of roughly $2 T in "savings" and new taxes, the Treasury would still need to borrow an additional $14 T over the next decade. Even less realistically, perhaps, given such robust growth and massive borrowing, the budget also assumes that consumer-price inflation will not rise above 2.1% for the next decade, while nominal interest rates go up only gradually, never averaging more than 5.3% for 10-year Treasuries.

All this suggests that the current budget might be merely a placeholder awaiting the recommendations of the proposed deficit-reduction commission, while generating a set of figures that just manages to keep the total federal debt level--Table S.14, not the same as the "debt held by the public" shown in summary table S-1--below around 106% of GDP. Of course, this hinges on achieving those higher tax revenues, some from growth and some from higher taxes, including the termination of the Bush tax cuts for "upper-income" Americans. Even if the Congress passed all the required tax legislation, which is not inconceivable since for the biggest portion they'd be voting for a tax cut for everyone except "upper-income" taxpayers, the chances of things turning out even this well seem low. If growth doesn't reach the projected levels and stay there for years, tax revenues will fall short, deficits will grow, and at some point interest rates will rise, requiring even bigger deficits to cover the cost of debt service that under this budget exceeds $800 billion a year by 2020.

Then there are the tax increases, starting with energy. The big difference vs. last year is the absence of $646 billion from cap & trade. Even if cap & trade is eventually enacted, it now seems likely that most of its proceeds would be rebated to taxpayers or spent on new energy programs, so it doesn't look like a way to close the budget gap. The proposed budget has roughly $3.6 billion per year in increased revenue from eliminating what the oil industry regards as appropriate tax benefits and the administration calls tax loopholes. Either way the budget would increase the cost of producing oil and gas in the US by around $0.60 per barrel of oil equivalent (BOE) after tax. While that won't break the industry, it also won't make US exploration and production any more attractive or competitive. In case you're wondering why we should care about that in light of our new emphasis on green energy, it turns out that the entire energy contribution of the record 10,000 MW of wind turbines installed in the US last year equates to about 100,000 BOE per day, the equivalent of one good-sized Gulf of Mexico oil platform or roughly 0.2% of our total energy consumption. We need more renewables and more conventional energy.

The budget also includes roughly three-quarters of a billion over 10 years in new fees on "non-producing oil and gas leases." Grounded in the mistaken notion of "idle leases," this was ill-advised last year and remains so, not just because oil companies don't bid on leases to take them off the market and keep them idle--they already pay rentals on any leases that aren't producing, which revert to the government after 10 years--but because adding these fees will merely reduce the up-front bonuses companies would be willing to bid to get them in the first place. As a result, the net revenue from this item ought to be zero.

Of course in terms of total revenue all of this pales in comparison to what the administration expects to collect from upper-income Americans, who seem unlikely to get any more sympathy than the oil companies. (Ironically this segment probably includes the bulk of the potential early buyers for the advanced technology vehicles that the government is lending or granting carmakers billions to produce.) The budget includes about $700 billion of additional revenue over 10 years from reversion to the pre-2001 tax rates for this group, along with some less obvious increases involving phaseouts of itemized deductions and exemptions and the treatment of deductions for those in the new 39.6% federal bracket as though they were incurred in the 28% tax bracket. Together these features would impose effective marginal tax rates much higher than that notional 40% on the folks at the bottom of the new bracket, creating a heck of a disincentive on earning a little more once you're near that threshold. But aside from making additional work or investment unrewarding for those unlucky enough to qualify narrowly for this bracket, this approach increases our collective reliance on this group to fund our government. These folks were already paying 86.3% of the federal income tax before these increases, and that share would go up under this budget. I wouldn't call that either reform or a sound basis for responsible democracy.

What we're left with, then, is a federal budget that even under a rosy set of assumptions expands the cumulative deficit and total US indebtedness into a range that greatly multiplies the large-scale uncertainties we face, while making minimal cuts to spending and increasing taxes only on unpopular corporations and upper-income Americans. Unfortunately, this scenario doesn't look conducive to generating the enormous private investments in new energy technology and infrastructure that will be necessary and that the government can't afford to make, particularly as mounting debt constrains its freedom of action. We seem to be stuck in a zone in which the only real solutions are unpopular, while most of the ideas that are popular wouldn't be real solutions.

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Cash for Guzzlers

Congress appears to be moving closer to providing financial incentives for Americans to trade in older cars for more efficient new models. There are good reasons to support such a measure--and a few caveats--though the longer it takes to implement, the less relevant its benefits might seem. That argues against incorporating it as yet another element of the mammoth American Clean Energy and Security Act of 2009--the Waxman-Markey Bill. (Monday's posting examined another aspect of that legislation.) If this provision were enacted quickly, the US would join Germany and the UK, both of which have instituted similar, temporary "cash for clunkers" programs to spur car sales that have been devastated by the recession and credit crisis. This has important implications for the recovery of ailing US automakers, including the Fiat/Chrysler alliance that is expected to result from the latter's bankruptcy filing.

The incentives of up to $4,500 per car are intended to promote the sale of up to a million new, more energy-efficient cars at a time when total US car volumes are down by roughly a third from their pre-crash levels. Despite a drop in the market share of large SUVs, the resulting slower turnover of the US car fleet will delay efforts to make the fleet more efficient, with a corresponding impact on both oil consumption and emissions. The measure also targets the most valuable segment of available fuel economy gains: "gas guzzlers" for which every one-mpg improvement can translate into 40-75 gallons per year in savings for the average driver, compared to gains of less than 10 gallons per year for each one-mpg increment above 35 mpg. While it's not clear that the implied price of oil associated with these subsidies could justify the outlay, it at least stands a much better chance of delivering a financial payout for taxpayers and consumers than devoting subsidies of many thousands of dollars per car to chasing the rapidly-diminishing returns on fuel economy above 50 mpg.

At the same time, we should be clear about what such a program can and can't do. While it could provide a well-timed boost to help struggling carmakers get back on their feet, the program's one-year timeline risks merely accelerating car sales that would happen anyway, leaving Detroit in an even bigger hole next year, after the benefit expires. It is a stop-gap, not a substitute for the sales growth that should accompany the eventual economic recovery. Nor would the old cars traded in disappear from the fleet, unless the final legislation required their scrapping. That compromises the measure's fuel-efficiency benefits in two ways, by keeping the same guzzlers on the road, just in different hands, and by depressing used car prices, making other older, less efficient cars more affordable, relative to the more efficient new cars the measure is intended to promote.

It also can't summon into existence vehicles that don't yet exist. That means it probably won't help the Euro-style economy cars that Ford is gearing up to produce in a converted truck factory, because they likely wouldn't be ready in time. It can't help GM with the launch of its new Chevrolet Cruze 40-mpg subcompact, which is apparently still over a year away. And it certainly won't affect the retooled cars Chrysler is supposed to build using Fiat's technology--they will still be on the drawing board when this benefit ends. The cars (and carmakers) that will benefit the most are the ones already on offer. While it should help Toyota reverse the slide in Prius sales that accompanied lower oil prices and the expiration of its eligibility for hybrid car tax credits, most of the cars likely to benefit will be solid, mid-mpg models like the Honda Accord and Chevy Malibu. A revolution in fuel economy is not in prospect with this legislation.

My advice is to view this measure as a belated addition to the economic stimulus package that might also do a bit of good in reducing oil consumption and emissions. And unlike some of the slow-acting and less-well-defined elements of the February stimulus--which I've recently heard referred to as the "porkulus"--this program appears to be prompt, precisely targeted, and well-bounded.

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