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Summary STUDY ORIGINS AND SCOPE The U.S. Congress charged the National Academies with conducting “a comprehensive review of the Internal Revenue Code to identify the types of and specific tax provisions that have the largest effects on carbon and other green- house gas emissions and to estimate the magnitude of those effects.” To address such a broad charge, the National Academies appointed a committee composed of experts in tax policy, energy and environmental modeling, economics, envi- ronmental law, climate science, and related areas. For scientific background informing the study, the committee relied on the earlier findings and studies by the National Academies, the U.S. government, and other research organizations. The committee has relied on earlier reports and studies to set the boundaries of the economic, environmental, and regulatory assumptions for the present study. The major economic and environmental as- sumptions are those developed by the U.S. Energy Information Administration (EIA) in its annual reports and modeling. Additionally, the committee has relied upon publicly available data provided by the U.S. Environmental Protection Agency, which inventories greenhouse gas (GHG) emissions from different sources in the United States. The tax system affects emissions primarily through changes in the prices of inputs and outputs or goods and services. Most of the tax provisions consid- ered in this report relate directly to the production or consumption of different energy sources. However, there is a substantial set of tax expenditures that we call “broad-based” that favor certain categories of consumption—among them, employer-provided health care, owner-occupied housing, and purchase of new plants and equipment. The committee examined both tax expenditures and ex- cise taxes that could have a significant impact on GHG emissions. SELECTION OF TAX PROVISIONS AND METHODS OF ANALYSIS Limited time and other resources compelled the committee to focus its work. Accordingly, the committee decided to concentrate its attention on four groups of tax code provisions and some related regulatory policies. Table 2-4 (Chapter 2) lists the tax code provisions examined and their associated revenue 1

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2 Effects of U.S. Tax Policy on Greenhouse Gas Emissions consequences and lists the chapters where the analysis of each provision is dis- cussed. In the end, the committee analyzed tax provisions that account for 46 per- cent of all energy-related excise tax revenues as well as those accounting for 71 percent of the calculated revenue loss from the 10 largest energy-related tax ex- penditures in 2011. As estimated by the Treasury Department, the broad-based tax expenditures selected account for about one-third of the cost of all tax ex- penditures that year. REVIEW OF EXISTING RESEARCH The next step was to review existing research on the impact of the tax code on greenhouse gas emissions. This was undertaken by the committee, the staff, and a team of consultants hired specifically for this study. The committee found that a substantial body of research relating tax poli- cy to greenhouse gas emissions is limited to two areas: highway taxes and emis- sions taxes. Studies of the impact of highway motor fuels taxes, particularly those on gasoline, go back decades. However, most of these studies do not in- corporate important features of the U.S. tax or other regulatory mandates, such as biofuels taxes and subsidies, or Corporate Average Fuel Economy (CAFE) standards, and very few examine the impacts on GHG emissions. Moreover, most studies do not incorporate the GHG impacts coming from linkages to the rest of the economy. A second set of studies examines the efficiency and effectiveness of taxes on GHG emissions. These studies incorporate both empirical studies as well as model simulations. Such studies include both individual models and model comparison studies, and consider taxes for the United States as well as for other countries. In view of the insufficiency of existing research and need to use a unified set of baseline assumptions to compare effects of different tax provisions, the committee concluded that it would be necessary to commission new economic modeling studies capable of estimating these effects on investment decisions, their effects in turn on energy production and consumption, and the resulting effects on emissions. Chapter 2 describes in detail the models and the rationale for their selection. The models used in the analysis have different structures and assumptions (as described in Appendix A), and most are limited in their capacity. For exam- ple, some were unable to analyze global as well as U.S. emissions, and only one could analyze the general equilibrium or economy-wide impacts of tax policies. For these reasons, readers should regard the numerical results as suggestive ra- ther than definitive. For each of the models, the committee specified a set of baseline assump- tions on gross domestic product (GDP) growth, oil prices, and the regulatory environment, as well as the tax system. The rate of U.S. GDP growth and path

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Summary 3 of world oil prices are those used in the Energy Information Administration’s baseline, the Annual Energy Outlook for 2011 (AEO11), used widely in the en- ergy and economic modeling community. The tax code and regulatory environ- ment of 2011 was chosen by the committee as the basis of its analysis, in part because these are also included in the AEO11 baseline. Tax code provisions that have expired or are scheduled to expire are assumed to be extended indefinitely in our reference scenario. The committee took regulations in place in 2011 as the regulatory baseline. The time period of the study was generally 2010–2035. To estimate the effects on emissions of particular tax code provisions, the commit- tee instructed the modeling consultants to run scenarios where they removed each of the taxes or tax preferences from the baseline one at a time, keeping all other policies, assumptions, and taxes unchanged. One model, which focused on agricultural markets, is designed to represent changes in global GHG emissions. The others—two focused on the energy sector and one focused economy-wide— can estimate only domestic U.S. emissions. Nevertheless, the first-order tax pol- icy effects of principal interest to Congress are on U.S. GHG emissions.1 PROVISION-BY-PROVISION FINDINGS Production Tax Credits for Renewable Electricity The production and investment tax credits for renewable electricity pro- vide a tax credit of 2.3 cents per kWh of power for the first 10 years of electrici- ty production generated from qualifying renewable sources (primarily solar, wind, and biomass) or a credit equal to 30 percent of investment in qualifying equipment. These credits lower the cost of electricity generated from renewable resources, encouraging their substitution for fossil fuels and thereby tend to re- duce GHG emissions. The committee’s analysis indicates that these provisions do lower CO2 emissions under the macroeconomic conditions in the AEO11 reference and high GDP growth cases, but the impact is small, about 0.3 percent of U.S. CO2 in the reference case. Oil and Gas Depletion Allowances The percentage depletion allowance permits independent (nonintegrated) domestic producers of oil and gas to deduct a percentage of gross income asso- ciated with sale of the commodity up to certain limits. The depletion rate is set at 15 percent of gross revenues associated with production. In modeling completed 1 This original modeling was undertaken by four independent consultants. Each of those consultants produced reports to the committee detailing the results of their model- ing efforts. Readers can download those reports at the National Academies Press website, http://www.nap.edu/catalog.php?record_id=18299.

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4 Effects of U.S. Tax Policy on Greenhouse Gas Emissions for this report, removing the percentage depletion allowances (and substituting cost depletion) has virtually no effect on oil production and associated GHG emissions. Although natural gas production goes down as the tax preference is removed, the complex substitution patterns among fuels lead to offsetting mar- ket forces and to a minimal impact on overall emissions. Home Energy-efficient Improvement Credits The committee examined Credits for Energy Efficiency Improvements to Existing Homes qualitatively, because time and budget constraints precluded obtaining detailed and reliable estimates of its impacts. Using market analysis, the committee expects that this credit is unlikely to produce major reductions in GHG emissions. However, the size of the tax expenditure and the evidence of unexploited energy-efficiency gains in the housing sector led the committee to conclude that this provision merits high priority for future research. Nuclear Decommissioning Tax Preference A further provision that was analyzed qualitatively was the special tax rate on reserves set up to decommission nuclear power plants at the end of their life- time. Based on the available evidence, including the projections of nuclear pow- er under different scenarios, the committee finds that the decommissioning pro- vision is likely to have little impact on GHG emissions. Highway Motor Fuels Taxes The federal excise taxes on highway motor fuels in 2011 included a tax of $0.183 per gallon for gasoline, $0.243 per gallon for diesel fuel and kerosene, and $0.197 per gallon for diesel-water fuel emulsion. This chapter reviewed four commissioned studies of the effect of removing the excise taxes on highway fuels. All four models find that removing the excise taxes on highway fuels would result in increasing greenhouse gas emissions. But the magnitude of the estimated effects varies dramatically for the different models. Having studied the model results and the broader literature, the committee concludes that the differences among the models are large and incompletely understood. The differences arise from the types and values of price elasticities used by the different models, from assumptions about increasing biofuels pro- duction and consumption to meet the RFS mandates, from the volumetric bias of highway fuels taxes, and from application of the tax within each model’s struc- ture. A close examination of the results leads the committee to conclude that the NEMS-NAS and the FAPRI models capture the forces at work in this sector most reliably and therefore form the basis of our estimates. Taking these two modeling results together produces a striking conclusion: The impact of remov-

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Summary 5 ing highway fuels taxes on GHG emissions is estimated to be very small be- cause of special features of the taxes and the market. The results on highway taxes are contingent on special features of this market because the results depend upon the structure, timing, and implementation of the renewable fuels standards (RFS) as well as a quirk in the tax structure (its volumetric bias). The magnitude of the differences across models leads the committee to caution against relying on specific numerical results from a single model and recommends drawing only broad conclusions about the nature and direction of impacts. Policy makers and analysts should rely on multiple models, methodologies, and estimates in calcu- lating impact of the tax code and other policies on greenhouse-gas emissions and climate change. Aviation Fuel Taxes The federal excise tax for commercial aviation fuel is $0.043 per gallon and $0.193 for noncommercial aviation. The exhaustive literature searches did not find any detailed study of the impact of these taxes on GHG emissions. Ad- ditionally, the models used for detailed analysis in this study were unable to adequately represent the taxes. This, therefore, is a high-priority area for further work given that aviation is producing rapidly growing emissions, and as yet there are no substitutes for jet fuels. Biofuels Provisions One particularly important set of tax provisions involves the use of ethanol and other biofuels, particularly as substitutes for petroleum products. These pro- visions involve a complex combination of taxes, tax expenditures, import tariffs, and regulatory mandates that interact to change the composition of fuels and even affect agriculture. Most of these provisions expired in 2012, but under the committee’s methodology, each of these provisions is included in the reference scenario. The committee analyzed the biofuels provisions with three different mod- els, although it concentrated its analysis on the Food and Agricultural Policy Research Institute at the University of Missouri (FAPRI-MU) model, which had the most detailed treatment of the biofuels sector. The findings indicate that re- moving all tax code provisions and the import tariff would result in a decrease of emissions of 5 million metric tons (MMT) per year of CO2 equivalent globally. This is less than 0.02 percent of global emissions. The results are complicated by the mandates for renewable fuels. If the mandates are removed along with the subsidies, the estimated emissions are smaller than the estimates with the man- dates. The results of the other modeling studies are consistent with the central FAPRI estimates. These results show the often-counterintuitive nature of the effects of tax subsidies. Although it may seem obvious that subsidizing biofuels should reduce

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6 Effects of U.S. Tax Policy on Greenhouse Gas Emissions CO2 emissions because they rely on renewable resources rather than fossil fuels, many studies we reviewed found the opposite. As structured, the biofuels tax credits encouraged the consumption of motor fuels because they lower prices, and this effect appears to offset any reduction in the GHG intensity of motor fuels that occurs because of the incentives to blend biofuels with gasoline. Accelerated Depreciation Accelerated depreciation is one of the largest business tax expenditures in the federal income tax code. This set of provisions allows businesses to write off the value of their capital assets at a rate that is faster than the estimated econom- ic depreciation. Modeling runs indicate that eliminating accelerated depreciation would reduce the GHG intensity of national output by shifting production away from GHG-intensive activities such as coal mining and electric power genera- tion to low-GHG activities such as communications. However, the net effect depends upon how the resulting revenues are recycled. If the revenues were to be returned by lowering marginal tax rates, the net impact on GHG emissions is expected to be negligible. If revenues are refunded through lump-sum rebates, however, then GHG emissions should decrease. Owner-occupied Housing Provisions The significant incentives in the federal income tax code for owner- occupied housing include deductibility of mortgage interest and property taxes and exclusion from taxation of the first $250,000 ($500,000 for couples) of capi- tal gains on home sales. The estimates prepared for the committee suggest that eliminating the tax subsidies for owner-occupied housing and using the revenue to lower marginal tax rates would improve the efficiency of allocation of the capital stock and increase national output. GHG emissions would increase at about the same rate as GDP increases. However, the simulation does not fully capture the effects of the subsidies on housing size or materials (affecting energy consumption) or location (changing patterns of automobile use and gasoline consumption). We therefore find the results inconclusive, underscoring the need for models that integrate effects on the housing stock with general equilibrium effects. Employer-provided Health Care Provisions The exclusion of employer-provided health insurance from the taxable in- come of employees is the largest single tax expenditure in the Internal Revenue Code. The committee expected that eliminating health care subsidies would raise GHG emissions per unit of output because the health care sector is less GHG intensive than the rest of the economy. The Intertemporal General Equilib- rium Model (IGEM) results show the opposite effect, however, with a small

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Summary 7 decrease in GHG intensity. The committee’s inability to understand the structur- al features of the model that produced these results leads it to conclude that the impact of the health provisions on GHG emissions remains an open question and an important subject for future research. Further Observations on Broad-based Tax Provisions The committee’s major finding is that the broad-based provisions influ- ence GHG emissions primarily through their effects on overall national output. In most cases, the percentage change in GHG emissions was close to or equal to the percentage change in national output induced by removing the tax provision. A second finding is that the way the revenues generated by eliminating tax pref- erences are recycled significantly affects output and emissions. A third finding is that the broad-based provisions generally have little effect on emissions intensi- ties. Finally, the committee reiterates that the results are highly sensitive to as- sumptions about how tax revenues from eliminating the provisions are returned to the economy. We conclude that changes in broad-based tax provisions are likely to have a small impact on overall GHG emissions except through the im- pact on economic output. However, we caution that these results rely on a single model and therefore require further study. COMPARISON WITH CBER MODELING RESULTS We compared the results of our detailed modeling with those of a compre- hensive study of energy tax expenditures by a modeling group at the University of Nevada at Las Vegas’s Center for Business and Economic Research (CBER). The committee used the CBER model to obtain an order-of-magnitude estimate of the impact of all energy-related tax expenditures. Under the methods and as- sumptions of that study, if all tax subsidies would have been removed, then net CO2 emissions would have decreased by 30 MMT per year over the 2005-2009 period. This total represented about ½ percent of total U.S. CO2 emissions over this period. The CBER results are consistent with the basic findings of the de- tailed modeling studies we conducted—that the overall effect of current energy tax subsidies on GHG emissions is close to zero. GENERAL FINDINGS Our report does not estimate an aggregate impact of tax provisions on greenhouse gas emissions due to the complexity of the tax code as well as the difficulty of determining the impact of several important provisions. The sum- mary table of impacts of different studies and provisions is contained in Table 7-1. The following provides a summary of the results from different sectors. First, the combined effect of current energy-sector tax expenditures on GHG emissions is very small and could be negative or positive. The most com-

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8 Effects of U.S. Tax Policy on Greenhouse Gas Emissions prehensive study available suggests that their combined impact is less than 1 percent of total U.S. emissions. If we consider the estimates of the effects of the provisions we analyzed using more robust models, they are in the same range. We cannot say with confidence whether the overall effect of energy-sector tax expenditures is to reduce or increase GHG emissions. Second, individual energy-sector tax expenditures in some cases contrib- ute to, and in other cases subtract from, U.S. and global GHG emissions. The subsidies on ethanol that expired in 2012 clearly added to global GHG emis- sions. By contrast, the balance of the evidence is that the production and invest- ment tax credits for renewable electricity slightly reduce U.S. GHG emissions. The depletion allowance has virtually zero impact on emissions. Third, the best existing analytical tools are unable to determine in a relia- ble fashion the impact of some important subsidies. Important tax expenditures that have resisted analysis include ones subsidizing residential energy efficiency. The difficulties in this case involve such factors as the discount rate consumers apply to future fuel savings, the strength of any rebound effect, and the extent to which consumers understand and respond to tax law changes. Fourth, the revenues foregone by energy-sector tax subsidies are substan- tial in relation to the effects on GHG emissions. The Treasury estimates that the revenue loss from energy-sector tax expenditures in fiscal years 2011 and 2012 totaled $48 billion. Few of these were enacted to reduce GHG emissions. As policies to reduce GHG emissions, however, they are inefficient. Very little if any GHG reductions are achieved at substantial cost with these provisions. Fifth, the emissions impacts of the broad-based tax expenditures are pri- marily through their impact on the level of national output. Broad-based tax ex- penditures entail roughly 50 times more revenues foregone than the energy- sector subsidies. We investigated a subset of provisions representing about one- third of the revenue losses from tax expenditures—subsidies to equipment in- vestment through accelerated depreciation, to health care, and to owner- occupied housing. Except for accelerated depreciation, we were unable to reach a definite conclusion on whether they increase or decrease GHG emissions per unit of output. Rather, the principal effect of these provisions is on national out- put. If removing broad-based subsidies were offset by reducing distortionary taxes, the resulting increase in national output would be accompanied by in- creased GHG emissions. If the subsidies were replaced with lump-sum tax cuts that do not reduce distortions, there would likely be little effect on national out- put or emissions. Sixth, it is difficult to estimate the impact of the broad-based tax expendi- tures on GHG emissions intensity. The committee examined the existing literature and commissioned modeling studies to estimate the effects of changes in the broad-based provisions on the overall GHG intensity of the economy. The results were not judged to be sufficiently reliable to draw firm conclusions. Seventh, the effects of many tax provisions are complicated by their inter- action with regulations. Very few tax provisions take place in a regulatory vacu- um. Particularly in the energy sector, energy and environmental regulations

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Summary 9 overlay and interact with tax provisions. Prime examples are the interaction of highway motor fuels excise tax provisions with the CAFE standards for light- duty vehicles, the air pollution standards for the mix of electricity generation, the Renewable Portfolio Standards (RPS) for electricity generation, and the Re- newable Fuel Standards for motor fuels blended from petroleum and ethanol. There are cases where regulations or mandates reinforce the effects of tax provi- sions and others where they offset their impacts. Analyses of the impacts of tax- es on GHG emissions must take special care to include consideration of the reg- ulatory environment. Eighth, energy excise taxes reduce GHG emissions, but the impact is lim- ited because of special features of the tax and because of regulatory constraints. The committee’s estimates show unambiguously that highway fuel excise taxes reduce fuel consumption and GHG emissions. The analysis for this report finds that the current highway fuels taxes have a relatively small impact on GHG emissions because of the volumetric bias of the taxes as well as the constraints imposed by the renewable fuels standards. RESEARCH RECOMMENDATIONS The following recommendations to the Congress, the modeling communi- ty, the research support agencies, as well as the broader community provide guidance on the areas where the committee finds that more attention is needed. The committee recommends continued support of energy-economic modeling to better understand the impacts of taxes and other public policies on greenhouse gas emissions and the broader economy. Particular attention should be given to improving current models in the following ways: First, models need to be made more transparent by clarifying both their as- sumptions and their structure; second, models should include measures of eco- nomic welfare that can be used to measure the efficiency and equity of policies; third, there should be more work to integrate partial equilibrium models with general equilibrium models so that the impact of revenue recycling and overall economic impacts can be more reliably estimated; and fourth, the committee recommends increased attention to studies that compare energy-economic mod- els as a tool for improving understanding of models, narrowing the range of es- timates, and improving model reliability. GUIDANCE FOR SCORING GHG EMISSIONS Because of the difficulties and resources required to provide reliable esti- mates, the committee discourages requiring the formal scoring of tax proposals for their impacts on GHG emissions. Much further work needs to be done before it can be accomplished routinely and reliably.

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10 Effects of U.S. Tax Policy on Greenhouse Gas Emissions GUIDANCE FOR CLIMATE-RELATED TAX POLICY In addition to estimating the impacts of the tax code on GHG emissions, the committee was asked to examine broader implications of taxes and climate- change policy. Although the committee does not make any recommendations about specific changes, the analysis undertaken for this report leads to several important insights and cautions about tax policy in the context of climate change. First, current tax expenditures and subsidies are a poor tool for reducing greenhouse gases and achieving climate-change objectives. The committee has found that several existing provisions have perverse effects, while others yield little reduction in GHG emissions per dollar of revenue loss. The feedback ef- fects within the energy sector (e.g., the fuel substitution effects when tax policy favors one source over others) or the international spillover effects (e.g., shifts in trade flows due to tax treatment differences) can offset or even reverse the ex- pected direct effects of these policies. Such leakages and regulatory and tax arbi- trage are common features of indirectly targeted provisions. Thus, if tax expend- itures are to be made an effective tool for reducing GHG emissions, much more care will need to be applied to designing the provisions to avoid inefficiencies and perverse offsetting effects. Second, some tax expenditures are more efficient than others. At their cur- rent scale, however, existing energy-related tax expenditures achieve small re- ductions in GHG emissions and are costly per unit of emissions reduction. Third, the committee’s reservations about tax expenditures and subsidies do not necessarily apply to tax incentives directly targeted on activities such as research and development on technological advances that will help the nation and the world transition to a low-carbon energy system. Fourth, tax reforms that increase the economic efficiency of our economy may increase GHG emissions, but the increased output is likely much more than sufficient to pay for reducing the higher emissions as efficient climate-change policies are employed to reduce emissions. Finally, a central finding of many studies in this area is that the most effi- cient way to reduce GHG emissions is through policies that create a market price for CO2 and other GHGs. The committee finds that tax policy can make a substantial contribution to meeting the nation’s climate-change objectives, but that the current approaches will not accomplish that. In order to meet ambitious climate-change objectives, a different approach that targets GHG emissions di- rectly through taxes or tradable allowances will be both necessary and more efficient.