Energy Efficiency: Can Tax Incentives Reduce Consumption?

Share

Mr. Chairman and members of the committee, thank you forinviting me to testify today regarding energy efficiency and thefederal tax code.

Additional tax incentives, such as tax credits, probably couldreduce U.S. energy consumption modestly.1 However, narrow incentives complicate the taxcode, create distortions that reduce growth, and move down theslippery slope of widespread social engineering through the taxsystem.

On the other hand, Congress should reform tax provisions thathinder new investments in energy production and conservation.Current business depreciation rules for energy and conservationinvestments are unfavorable compared to the rules in othercountries. Congress should reform those rules, and it should pursuebroader tax reforms to spur more rapid replacement of olderstructures and equipment with newer, more energy efficientinfrastructure throughout the economy.

Investment, Consumption, and the Income Tax

Policymakers have long considered major reforms to the federaltax system. Some favor a broad-based consumption tax, while othersfavor a broad-based (or Haig-Simons) income tax. The differencebetween the two is the treatment of savings and investment.Consumption taxes apply one layer of tax to savings and investment,while income taxes apply two layers. The current federal "incometax" is a hybrid between the two systems.

Reforms to move the current tax code toward a consumption-basedsystem dovetail with the goals of those concerned about America'senergy future. A consumption tax would limit current consumption,including energy consumption, while removing tax barriers toinvestment-including investment in energy production, energytechnologies, and energy conservation. As discussed below, morefavorable depreciation rules would be an important step in aconsumption tax direction.

Rising Tax Complexity

The federal tax system has become enormously complicated inrecent years. The anti-investment bias and high tax rates under thecurrent system have encouraged the proliferation of narrowloopholes and special preferences. There seems to be more intereston Capitol Hill these days in creating new tax credits than insimplifying the tax code to provide fair and equal treatment of alltaxpayers.

By contrast, during the 1980s there was bipartisan agreementthat the tax code should be reformed to have a broad and neutralbase with low rates. One congressional leader on tax reform at thetime, Richard Gephardt (D-MO), noted in 1985:

The main argument for tax reform, I believe, is toachieve greater efficiency in the way the tax code works. WhenCongress gets into the business of figuring out $370 billion of taxbreaks a year, the House Ways and Means Committee and the SenateFinance Committee really are put in the business of trying, atleast partially, to plan the American economy. ... I confess that Iam not qualified to act as a central planner and I do not knowanybody on either committee who is.2

The Reagan administration held similar views about tax reform.The Congressional Research Service noted that theadministration

opposed using the tax law to promote oil and gasdevelopment, energy conservation, or the supply of alternativefuels. The idea was to have a more neutral and less distortionaryenergy tax policy, which economic theory predicts would make energymarkets work more efficiently and generate benefits to the generaleconomy.3

The two parties came together and agreed on the landmark TaxReform Act of 1986, which ended many narrow tax breaks and reducedrates.4 Unfortunately,"central planning" through the tax code has come back into voguesince then. The number of pages in the federal tax code,regulations, and related rules has increased from 40,500 in 1995 to67,204 in 2007, an increase of two-thirds.5

The number of narrow provisions, or loopholes, in the tax codeis rising. Figures 1 and 2 show the number of "tax expenditures" inthe income tax, based on data from the Office of Management andBudget.6 The number of taxexpenditures for energy jumped from 11 to 23 between 1996 and 2006.The total number of tax expenditures increased from 121 in 1996 to161 in 2006.

There are problems with these measures of tax expenditures. Someitems, such as accelerated depreciation, are counted as loopholesunder the income tax. But such pro-investment provisions would notbe considered loopholes under a consumption tax. Nonetheless, theOMB's tally of tax expenditures shows that Congress is moving awayfrom the ideal of a neutral tax base toward micromanagement of theeconomy.

Charts

The rising number of narrow provisions in the tax code reduceseconomic efficiency. Such provisions distort market price andprofit signals, which redirects capital and labor into lessproductive uses. That's why a tax code with a neutral base and lowrates is preferable to one with narrow carve-outs and high rates.The economic cost of today's Swiss cheese tax base is large. U.S.output would be substantially higher if the tax base were reformedand effective tax rates across industries were equalized andreduced.7

Rising tax code complexity also

  • Creates high compliance costs for record keeping, tax filing,and learning tax rules.
  • Causes frequent tax filing errors by taxpayers and the InternalRevenue Service.
  • Impedes economic decisionmaking by confusing taxpayers. Manytaxpayers do not understand the tax rules for education incentives,retirement savings, and other items.8
  • Promotes an invasion of privacy by the government. With specialbreaks, such as those for education and energy, the IRS needs tohunt for volumes of added documentation to carry out itsenforcement activities.

Going forward, creating new tax incentives for energy andconservation would exacerbate these complexity problems. New taxincentives would add to the paperwork burden, create more errors intax administration, further confuse economic decisionmaking, andprovide further reason for the IRS to dig into personalaffairs.

Pandora's Box

Current federal tax incentives for energy and conservation arenot large. Total income tax expenditures for these items are valuedat just $7 billion in 2007.9That represents just 0.3 percent of total federal revenues. Thus,the discussion about tax incentives for energy and conservation isnot a discussion about how high federal taxes ought to be.

Instead, the important issue for policymakers is to consider thesort of tax code that America ought to have. Should we have a taxcode that treats families and businesses as equally as possible? Orshould we have a tax code full of special provisions that treatpeople differently as Congress micromanages family and businessdecisions? I favor the former. After all, equality under the law isa bedrock American principle.

Proponents of tax incentives no doubt think that their favoredactivities deserve special attention. Many energy and environmentalanalysts argue that federal tax policies should be used to fix"externalities" in energy markets.10 But such an approach risks opening a Pandora'sbox of widespread social engineering through the code.

Many interest groups, such as those promoting education,housing, and scientific research, argue that their favoredactivities are subject to externalities that need special tax codetreatment. But, in theory, there are an endless number ofexternalities that governments could meddle in. At the risk ofpromoting bad ideas, tax lobbyists could champion tax creditsfor

  • Obesity. This is a serious and growing problem thatimposes negative externalities on nonobese Americans through thehealth system and elsewhere. How about a tax credit for membershipcosts at Gold's Gym?
  • Neighborhood Beautification. Neat lawns and abundantgreenery create positive externalities for neighborhoods. How abouta tax credit for tree planting?
  • Guns. Some analysts say that if more households ownedguns it would reduce crime through deterrence. How about a taxcredit for gun ownership because of this safety externality?

I'm not advocating these tax credits, but they illustrate theslippery slope of social engineering if Congress wanted to fixevery externality through the tax code. Just this year, the CRSfinds that more than 150 bills on energy efficiency and renewableenergy have been introduced, with many proposing narrow tax breaks.I hope Congress resists the temptation to create more taxloopholes.

Conservation and Competitive Markets

The Congressional Research Service noted that the "Reaganadministration believed that the responsibility for commercializingconservation and alternative energy technologies rested with theprivate sector and that high oil prices ... would be ampleencouragement for the development of alternative energyresources."11 I thinkReagan got it right.

Competitive markets have made a huge contribution towardAmerica's energy security and conservation. Businesses, forexample, have powerful market incentives to reduce energyconsumption. They are relentless in cutting costs-labor costs, taxcosts, production costs, fuel costs, heating costs, cooling costs,and lighting costs. Lower costs mean higher profits. That's whybusinesses strive continually to improve efficiency, includingenergy efficiency, particularly in today's competitive globaleconomy.

Market forces are behind huge improvements in U.S. energyefficiency in recent decades. The amount of energy consumed foreach unit of gross domestic product has fallen dramatically sincethe 1970s. Economist Gilbert Metcalf found that if U.S. energyintensity were still at the level of 1970, the nation would beconsuming 187 quadrillion BTUs annually.12 Instead, the United States consumes just 98quadrillion BTUs annually, and thus we have cut our energyintensity almost in half since 1970.

Some of this improvement stemmed from the changing structure ofthe U.S. economy. But Metcalf calculates that at least two-thirdsof the improvements since 1970 came from rising energy efficiency.And much, perhaps most, of that I think is due to the naturalcompetitive processes in the economy, not government policy.

Consider the rising energy efficiency of household appliances.Federal efficiency standards for appliances went into effect in1990, and appliance efficiency has improved since then. Butappliance efficiency also improved markedly between the early 1970sand 1990, apparently as a market response to rising electricityprices.13 The averageenergy consumption of U.S. refrigerators fell from 1,800 kWh peryear in 1974 to just 800 kWh by 1990.

If Congress does not change efficiency standards or enact newtax credits for energy conservation, it seems likely that U.S.energy intensity will continue to fall in coming years due tonatural market forces.

What Should Congress Do?

Congress can make tax policy reforms to improve energyefficiency. A first step would be to end any tax provisions thatencourage excess energy consumption. A good example are the taxpreferences for owner-occupied homes, which some economists thinkfavor the acquisition of particularly large homes.14 Larger homes need more heating,cooling, and lighting. Thus, one reform would be to combine repealof the mortgage interest deduction with marginal tax rate cuts.

Another avenue for reform would be to reduce the tax code's biasagainst capital investment. The income tax encourages currentconsumption and discourages long-term investment. To fix this bias,Congress should consider more favorable depreciation rules,optimally moving toward immediate expensing of capital purchases.That would remove barriers to all types of investments includingthose in energy production, alternative fuels, and conservationtechnologies. The Energy Policy Act of 2005 took some modest stepsin this direction, but more could be done.15

Policymakers often say that America needs more job-creatinginvestments in computers, automotive plants, transportation, andother activities. Those concerned with energy policy seek greaterinvestment in electricity generation and transmission, oilrefining, alternative fuels, pollution control, and conservationtechnologies. Thus, more favorable tax treatment of capitalinvestment should be a common cause on Capitol Hill.

A new study by Ernst & Young and the American Council forCapital Formation shows that the current tax code stands in the wayof energy and energy efficiency investments.16 The study compared U.S. cost recovery, ordepreciation, rules to the rules in 11 other countries for 11 typesof energy investment. Faster write-offs of assets over shorterperiods of time reduce effective tax rates on new investment.

The study found that the United States has less favorable taxrules than most other countries for investments in petroleumrefining, electricity, pollution control equipment, electricitysmart meters, and other items. Here are the results for capitalcost recovery after the first five years of an investment:

  • Nine of the 11 other countries had more favorable cost recoveryfor gas and nuclear electricity generation assets than the UnitedStates.
  • Seven of the 11 other countries had more favorable costrecovery for oil refinery assets.
  • Nine of the 11 other countries had more favorable cost recoveryfor pollution control equipment.
  • Ten of the 11 other countries had more favorable cost recoveryfor electricity smart meters.

Consider electricity smart meters. If a U.S. utility installedthese assets, it would take depreciation deductions worth 30percent of the cost over the first five years. The comparable costrecovery values in other countries are Canada (63 percent), Germany(63 percent), Korea (58 percent), and Malaysia (90 percent).

America's less favorable depreciation rules combined with theindustrial world's second-highest corporate tax rate creates abarrier to investment in new and traditional energy technologies.Because Congress is concerned with energy security, conservation,global warming, and high gasoline prices (partly caused byrestricted refining capacity), it should focus on removing taxbarriers to investment in energy production and energyefficiency.

Congress should consider reinstating the 50 percent capitalexpensing provisions that were in place in 2003 and2004.17 That would spureconomic growth while promoting the replacement of all types ofolder business assets with new, more efficient assets. New machinesdon't just replace similar old ones, they embody new technologiesthat increase economic and energy efficiency.

Thank you for holding these important hearings. I look forwardto working with the committee on energy tax policy issues.


1 Kevin Hassett, "The Roleof Tax Incentives in Energy Policy," American Enterprise Institute,July 10, 2001. For a history of federal tax incentives, see ChrisEdwards, Ada Rousso, Peter Merrill, and Elizabeth Wagner, "CoolCode: Federal Tax Incentives to Mitigate Global Warming," NationalTax Journal 51, no. 3 (September 1998).

2 Richard Gephardt, "TheEconomics and Politics of Tax Reform," Cato Journal 5, no. 2 (Fall1985): 458.

3 Salvatore Lazzari,"Energy Tax Policy: History and Current Issues," CongressionalResearch Service, July 28, 2006, p. 5.

4 However, the 1986 Acthad numerous anti-savings and anti-investment provisions.

5 This page count is basedon CCH data. See Chris Edwards, "Income Tax Rife with Complexityand Inefficiency," Cato Institute Tax & Budget Bulletin no. 33,April 2006.

6 Budget of the U.S.Government: FY2008, Analytical Perspectives, p. 291.

7 The literature issummarized in Chris Edwards, "Options for Tax Reform," CatoInstitute Policy Analysis no. 536, February 24, 2005.

8 CCH, "CompleteTax SurveySuggests Taxpayers Confused by Tax Code Complexity," March 16,2005.

9 Budget of the U.S.Government: FY2008, Analytical Perspectives, p. 291.

10 For background on thehistory and purposes of federal energy policy, see Gilbert Metcalf,"Federal Tax Policy Towards Energy," National Bureau of EconomicResearch, Working Paper no. 12568, October 2006.

11 Salvatore Lazzari,"Energy Tax Policy: History and Current Issues," CongressionalResearch Service, July 28, 2006, p. 5.

12 Gilbert Metcalf,"Energy Conservation in the United States: Understanding Its Rolein Climate Policy," National Bureau of Economic Research, WorkingPaper no. 12272, May 2006, p. 2. See also International EnergyAgency, "The Experience with Energy Efficiency Policies andPrograms in IEA Countries," August 2005.

13 Ronald Sutherland,"The High Costs of Federal Energy Efficiency Standards forResidential Appliances," Cato Institute Policy Analysis no. 504,December 23, 2003, p. 5.

14 The homeowner taxpreference results from the combination of the mortgage interestdeduction and the exemption from taxable income of imputed rent onhomes.

15 For a discussion ofthe 2005 law and background on the depreciation of energy assets,see Gilbert Metcalf, "Federal Tax Policy Towards Energy," NationalBureau of Economic Research, Working Paper no. 12568, October2006.

16 Ernst & Young forthe American Council for Capital Formation, "InternationalComparison of Depreciation Rules and Tax Rates for Selected EnergyInvestments," May 2, 2007.

17 For background, seeChristopher House and Matthew Shapiro, "Temporary Investment TaxIncentives: Theory With Evidence from Bonus Depreciation," NationalBureau of Economic Research, Working Paper no. 12514, September2006.

Chris Edwards

Subcommittee on Energy, Natural Resources, and Infrastructure
United States Senate Committee on Finance