Big Ethanol's 'Trifecta' of Goodies

Rep. Peter Welch (D-Vt.) offered an astute observation recently about federal ethanol policy. Speaking at a National Journal event titled, “Biofuels Mandate: Defend, Reform, or Repeal,” Welch pointed out that the ethanol industry has benefited from a “trifecta” of preferential federal policies: subsidies, tariffs, and mandates.

Beyond wasting taxpayer funds, these policies have real, harmful effects on the American people. We’ll explain each policy and address their impacts, starting with subsidies. Subsequent posts will explore tariffs and mandates.

Tax Credits and Grant Programs

Over the years, the federal government has offered several tax subsidies for biofuel production. The most expensive subsidy is the Volumetric Ethanol Excise Tax Credit (VEETC), a 45 cents-per-gallon credit to refiners for ethanol blended with gasoline. The VEETC, which expired at the end of 2011, cost taxpayers $3.8 billion for just the four months it was available in fiscal year 2012. Had it not expired, the VEETC was projected to cost $7.2 billion annually, on average, between 2014 and 2021, according to a recent report by the National Research Council.

Though VEETC expired, other tax subsidies for biofuel production remain. The biodiesel tax credit awards $1 per gallon of biomass-based biodiesel produced. Passed by Congress as part of the Energy Policy Act of 2005, the credit has expired twice, in 2010 and 2012. Congress revived the credit at the end of 2012 as part of the deal to avert the fiscal cliff and will give retroactive payments to biodiesel producers who produced fuel in 2012 even though the credit had lapsed. The U.S. produced 991 million gallons of biodiesel in 2012, which means taxpayers will likely fork over close to $1 billion for fuels that were produced when the credit was no longer in effect.

In addition to tax subsidies, biofuel producers also benefit from numerous federal grant programs. The Energy Policy Act of 2005, for instance, directed the U.S. Department of Energy (DOE) to provide funding for biorefinery projects. To date, DOE has awarded more than $929 million for 29 projects, including $561 million from the federal stimulus in 2009. Last month, a DOE Inspector General report found that more than $600 million in biorefinery funding “had not yet achieved its biorefinery development and production goals.”

Other grant programs include the U.S. Agriculture Department’s (USDA) Bioenergy Program for Advanced Biofuels, which spent more than $211 million[1] since fiscal year 2010, and the Biomass Research and Development Initiative, a joint DOE and USDA program that spent more than $144 million[2] since fiscal year 2009. All told, the biofuel industry has benefited from billions of dollars in federal tax preferences and grant programs.

Subsidies Distort Markets

Tax subsidies and grant programs harm consumers by distorting markets. In a free market, profits and losses serve as indicators of consumer preferences. But grants and tax credits replace consumer preferences with political preferences. Companies have less incentive to serve customers if they can still turn a profit by collecting government handouts. This can lead to less innovative companies that spend more time lobbying for subsidies than delivering superior products to their customers.

In addition to replacing consumer preferences with political preferences, subsidies can also distort the price signals received by consumers. Subsidies, to the extent that they allow companies to reduce prices, can make uneconomical products seem like a good deal to consumers. For example, the VEETC made ethanol appear more economical to refiners than it really was. But this does not create real value for consumers, since those consumers are also usually taxpayers. What appears to be a valuable purchase for consumers is really just a wealth transfer from consumers to producers.

Rather than giving tax preferences and government grants to specific energy technologies, a more effective approach is to reduce the marginal tax rate across all energy sources. A simplified tax code with low marginal rates promotes economic growth and prevents legislators and bureaucrats from picking winners and losers by rewarding favored groups with tax preferences and punishing other groups with punitive tax hikes.

As will be discussed in subsequent posts, the distortionary effects of subsidies are compounded when combined with tariffs and mandates. Before it expired in 2011, the ethanol tariff protected domestic producers from foreign competitors, potentially raising prices on consumers. The federal ethanol mandate, the Renewable Fuel Standard (RFS), provides ethanol producers guaranteed, rising market share by forcing domestic competitors to purchase their products.

IER Policy Associate Alex Fitzsimmons authored this post.