Energy Tax Policy: An Economic Analysis

Publication Date: June 2005

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics; Energy

Type:

Abstract:

This report provides background on the theory and application of tax policy as it relates to the energy sector, particularly with respect to the theory of market failure in the energy sector and suggested policy remedies.

Economic theory suggests that producers of energy-related minerals be taxed no differently than non-mineral producers: Exploration and development costs and other investments in a deposit (including geological and geophysical costs and delay rentals) should be capitalized. In general, competitive mineral producers subject to a pure income tax would not exploit resources as fast (compared with the rate of exploitation under the present system of subsidies). Over the longer term, depletion of fossil fuels and mineral resources leads to higher real energy prices, which would eventually promote the optimal amount of investment in energy efficiency and alternative fuels supply.

Under principles of neutrality of tax policy, there is no purely economic rationale for energy taxes or tax subsidies to (1) raise revenues; (2) conserve energy (with one exception); (3) promote alternative fuels; (4) compensate for any extra market risk; or (5) promote, as an industrial policy, specific industries such as the fossil fuels industry. However, even under a pure income tax, economic efficiency suggests a system of energy taxes (in addition to the income taxes) to correct for any environmental externalities caused by the production, importation, and use of each fuel, and energy taxes in the form of user charges for benefits received, such as the highway trust fund. In the case of energy conservation, market failures in the use of energy in rental housing provide an efficiency rationale for the current gross income exclusion for conservation subsidies provided by electric utilities. There are other market failures in energy use that suggest efficiency standards, energy labeling, or government-provided information, but not necessarily tax subsidies.

Tax subsidies for domestic oil production tend to stimulate domestic supply of petroleum and reduce demand for petroleum imports. This may enhance national and economic security in the short run, but it might damage national and economic security in the long run as domestic energy resources are depleted faster than they otherwise would be. The economically efficient policy to reduce import dependence would impose a tax (or tariff) on imported petroleum based on the per-barrel estimate of these costs (the so-called oil import "premium"). The problem of vulnerability to embargoes and price shocks, which relates to dependence on imported oil from the Organization of Petroleum Exporting Countries (OPEC) and other potentially unstable or unfriendly foreign countries, is more effectively addressed in a policy of stockpiling oil, as is being done with the Strategic Petroleum Reserve.

In terms of environmental protection and management, energy taxes can be a cost-effective and efficient market-based instrument, and they are economically superior to the command and control approach. In sum, energy taxes are generally distortional (except to correct for externalities, or when imposed as user fees for benefits received) and regressive, and may have adverse macroeconomic consequences, particularly sizeable taxes on energy production or oil imports.