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Looming Demise of Wind Power Subsidy Shows the Need to Rethink Both Energy and Tax Policy

Wind power has been a success story of green energy. After several years of rapid growth, it now accounts for about 3 percent of all electricity produced in the United States. It has benefitted from federal support, but that support is scheduled to end on December 31, throwing the industry into a crisis of layoffs and cancelled installations.

The country needs wind power, and wind power needs a favorable policy environment. For those reasons, it is tempting to support a simple extension of the current policy. However, it would be even better to use the looming deadline as an occasion to rethink both energy policy and tax policy.

Makers, Takers, and Energy Policy

It has become fashionable during this presidential campaign to glorify “makers” and disparage “takers.” The distinction applies as much to energy as to any other industry. Makers are those who produce energy that has a value to users that exceeds its costs. Takers are those who make a profit from producing energy that costs more than it is worth by shifting part of those costs to others.

Producers of fossil fuels head the list of takers. Federal tax breaks for mining and drilling are part of the problem, but not the biggest part. More importantly, fossil fuel companies are takers because production and use of coal and oil (and to a lesser extent, of natural gas) have harmful spillover effects on the persons and property of third parties who are neither producers nor users themselves.

Those spillover effects, which economists call externalities, take several forms. Local smog and regional acid rain pollution are examples. Climate change caused by carbon emissions from coal, oil, and natural gas is another. National security costs arising from dependence on unreliable foreign energy supplies are a third. Issues related to water use, land use, and aesthetic values are still other categories of external cost.

People differ in how they rank the importance of these costs, but no one places them all at zero. For example, the most fervent deniers of climate change within the oil industry are often the loudest in warning against the security risks of dependence on foreign sources of supply.

If market prices captured all of the costs and benefits of each form of energy, we would not need an energy policy at all. The trouble is, they do not. The forms of energy that produce the most harmful externalities are systematically underpriced. That is the sense in which producers and users of fossil fuels are takers. Their “take” is the free lunch they get by shifting part of the costs of production to the innocent bystanders they harm.

What we need is a policy to level the playing field, one that makes sure that the relative prices of different forms of energy reflect not just their direct costs of production, but their external costs as well. What would such a policy look like?

Subsidy or tax?

The current policy tries to level the playing field by giving everyone a chance to be a taker. Under this approach, if uncompensated externalities cause fossil fuels to be underpriced, the solution is to subsidize cleaner, renewable energy. Fossil fuel producers get to take from pollution victims; producers of renewables get to take from taxpayers.

Here is how the policy works for wind power: The Renewable Energy Production Tax Credit (REPTC) gives renewable electricity producers a tax credit of 2.2 cents per kWh for all power generated. Together with renewable energy initiatives of individual states, the credit is often enough to make wind power competitive with power from conventional sources. If a company’s profits are not great enough to use its credits fully, it can carry them forward up to 20 years.

When first enacted, the REPTC was a step forward by comparison with an earlier policy that had subsidized wind power installations. The older policy encouraged the construction of towers that produced little electricity. If the purpose of policy is to encourage wind power, it is certainly better to encourage production rather than construction, but is a subsidy of any kind the best way to do it?

An alternative way to level the playing field would be to impose the full cost of each kind of energy, including all external costs, on producers and users. The simplest way to do so would be to tax each form of energy at a rate equal to the harm from its externalities. (I discuss other methods of imposing full costs on users, including property rights remedies, tort law, and cap-and-trade, in detail here. In principle, all of them level the playing field in much the same way.)

Suppose, for the sake of discussion, that the external costs come to 3 cents per kWh for electricity generated by coal, 1.5 cents for natural gas, and 0.8 cents for wind. (Wind turbines create no pollution in operation, but manufacturing them causes a little, and we might also want to give some weight to aesthetic values and bird kills.) A full-cost policy would impose a tax on utilities equal to the external costs of each kWh generated. The utilities would pass the cost along to consumers in the form of a surcharge.

To simplify the discussion, I will ignore details like marginal vs. average costs and possible variations in externalities according to season or time of day. I will also skip over the issue of whether the tax would be an unreasonable burden on low-income users of electricity; I dealt with that issue in an earlier post, “When does ‘It Will Hurt the Poor’ Outweigh ‘It’s Good for the Environment?’”

Since either a 2.2 cent tax or a 2.2 cent subsidy would have the same effect on the competitiveness of wind power, does it really make a difference which one we use? Yes, it definitely does. The difference is that the tax on externalities would encourage consumers to economize on the use of electricity in general, whereas the subsidy, by keeping the retail price low, encourages use.

True, even in places where electric rates are already high, consumers are often wasteful. Many of them fail to buy efficient light bulbs and refrigerators even when doing so is cost effective. Those who use electric heat fail to insulate adequately or switch from resistance heat to efficient heat pumps. Still, consumers are not completely insensitive to prices. A tax reflecting external effects would give one more nudge toward conservation.

A Tax Policy Perspective

So far, we have discussed the Renewable Energy Production Tax Credit and its shortcomings as environmental policy, but it is, at the same time, a tax policy, and a bad one.

The REPTC is an example of what economists call a tax expenditure. Giving producers a 2.2 cent tax credit for each kWh of wind power they generate has exactly the same impact on the budget as would a policy that subjected wind power to the full corporate tax rate and then used the proceeds to give producers a 2.2 cent cash subsidy. The REPTC is only a small part of a vast web of tax expenditures, some 172 of them by one count, that have a total cost to the budget of $1 trillion. That is roughly equal to the entire revenue generated by the individual income tax.

Tax expenditures violate a fundamental principle of tax economics, namely, that, for any given amount of revenue collected, the economic burden is least when the tax base is kept broad and marginal rates are kept low. The corporate profits tax is an especially noxious swamp of exemptions, deductions, and preferences—so much so that the United States, with the highest corporate tax rates in the world, collects less revenue from it than do many countries with lower marginal rates.

Nearly all serious proposals for tax reform include closing corporate tax loopholes and lowering marginal rates. Some proposals envision eliminating the corporate profits tax altogether and taxing all corporate profits as personal income on a pass-through basis, as the code now allows for Subchapter S corporations. Other proposals combine such a move with reform of the individual income tax to remove preferential treatment of capital gains and dividends, now justified on the grounds of reducing the double taxation of corporate profits.

A comprehensive tax reform that swept away the REPTC along with other, larger tax expenditures would once again leave wind power and other forms of renewable energy at a cost disadvantage unless a tax on externalities, as described above, replaced it. How well would an externalities tax score by the standards of tax economics?

At first glance, a tax on externalities from fossil fuels might seem to violate sound tax principles, since it its base is narrow and because it would raise the marginal tax rate paid by producers of fossil fuel energy above the rate paid by producers of renewable energy. However, a second principle of tax economics overrides that objection, namely, that taxes on harmful externalities improve, rather than degrade, the efficiency of markets.

In fact, taxing harmful externalities has a double benefit. First, it levels the playing field by taking away the free ride that producers of the dirtiest forms of energy would otherwise enjoy. Second, an externalities tax raises revenue that can be used for other purposes. Your favorite purpose might be deficit reduction or it might be social programs. Even if you think the government already has all the tax revenue it needs, you could use the revenue from taxes on harmful externalities to reduce taxes you like even less, like taxes on work, saving, or production of beneficial goods and services.

The Bottom Line

The bottom line: Wind power is good. It deserves a supportive policy environment. But extending the REPTC is not the best way to go about it. True, there is not enough time between now and the end of the year to accomplish a comprehensive reform of environmental and tax policies. In the short run, extending the REPTC may be better than abruptly shutting down the wind power industry and hoping that it will revive later under a better-designed policy.

Still, even if it is too late to carry out the needed reforms before the REPTC expires, that does not mean it is too late to start thinking about them. In fact, we should have started thinking about them long ago.

Related Posts:

On distributional impacts of environmental policy: When does ‘It Will Hurt the Poor’ Outweigh ‘It’s Good for the Environment?

On reform of preferences for capital gains and dividends: Controversy over Romney’s Taxes Underlines the Need for Broad Reform

On reform of the corporate profits tax: What Happened to Corporate Tax Reform?

9 Responses to “Looming Demise of Wind Power Subsidy Shows the Need to Rethink Both Energy and Tax Policy”

ThomasGrennesSeptember 25th, 2012 at 3:40 pm

Are there reliable empirical estimates of external costs per KWh by energy source? My impression is that wind power is the most land-intensive source, and Nature Conservancy has referred to wind farms as "energy sprawl". The strongest winds are in
the mountains and the seashore, where they are visible for miles and impose external costs on tourists and permanent residents. Because strong winds are often located far from electricity demanders, miles of transmission lines are required. In Eastern North Carolina, a proposed wind farm is opposed because it would interfere with a bird sanctuary and flights from a naval airbase. How clean is windpower when all external costs are included?

EdDolanSeptember 25th, 2012 at 7:29 pm

You raise a very important issue that I did not explore in detail in this post. Yes, for sure, wind power has some negative externalities. Those externalities should be charged against electricity produced by wind power. My estimate of 0.8 cents is purely for the sake of discussion; it is not meant to be an empirical estimate. However, there are good reasons to believe that wind power has lower externalities than coal or oil. Here are some of the considerations in general terms:

1. Manufacture of wind power equipment produces some carbon and other pollutants (steel making, transportation, etc.). These are more easily measured than some other impacts. They appear to be recouped in less than a year. It should be pointed out that estimates of carbon from fossil fuels does not always include full lifecycle impacts, including manufacture of mining equipment, transport, etc. Like should always be compared with like.

2. Aesthetic impacts are very hard to put a number on, especially since some people think wind towers look cool and futuristic, whereas others think they are ugly. Probably the best thing to say is that ideally, the charge for aesthetic impacts should be site-specific; towers on a ridge in Yosemite park are not the same as towers in a North Dakota wind field.

3. The issue of mortality to birds and bats is hard to resolve, but its importance is partly a matter of framing. For example, one study suggests that bird kills from wind farms are 5,000 times fewer than from windows and 2,500 less than from cars. I can't vouch for those numbers, but it does illustrate the point that any numbers need a context. Another consideration is that climate change itself is a very severe threat to many kinds of birds, so there is a trade-off there, too. No doubt wildlife impacts and charges for them should also be site specific, in the same way that mining coal in Wyoming may need a different evaluation than mountaintop removal in West Virginia.

4. The best winds for wind farms are not necessarily in the mountains and shores, although they sometimes are. Steadiness of winds is more important than average speed. Range land and wheat fields in the plains states are especially good sites with relatively low impacts.

5. I do not know about the eastern NC wind farm proposal. I do note, though, that the NC Chapter of the Sierra Club has a web site strongly supporting wind power (windpowernc.org).

The Wikipedia article "Environmental Impacts of Wind Power" has an unusually complete bibliography of studies on all of these issues (115 items cited). http://en.wikipedia.org/wiki/Environmental_impact…

EdDolanSeptember 25th, 2012 at 8:41 pm

Tom, I forgot to say the most important thing in the my comment regarding the externalities of wind power:

Yes, wind power does some environmental harm, even though I am confident it is less than coal or oil, except perhaps in highly sensitive sites. The environmental harms of all forms of energy are the number one reason it is so important to approach things with a policy that imposes FULL COSTS on producers and users. The specific mechanism for imposing the cost is a secondary issue–a tax, cap-and-trade, the tort law/property rights approach, any of them can, in principle, do the job.

Above all what we DO NOT want is a policy that levels the playing field by subsidizing the costs of various forms of energy down to where they are "competitive" or "affordable," to use the favorite euphemisms of the free-lunch seekers. That only encourages people to behave irresponsibly by using electricity that harms their neighbors and their planet, whether that harm is bird kills, water pollution, climate change or whatever.

ThomasGrennesSeptember 26th, 2012 at 10:06 am

Yes, quantifying external costs is crucial. Otherwise self-proclaimed "green entrepreneurs" would spend $10 of taxpayer money to save $1 of external costs.
Would subsidizing $100,000 electric cars pass an environmental cost-benefit test?

There has already been a major substitution of natural gas for coal in the energy sector.
Is it possible that the benefits from this shift have been as large or larger than the benefits from wind farms?

EdDolanSeptember 26th, 2012 at 10:23 am

I didn't go into natural gas much, partly because the margin between gas and wind is narrower, and partly because I wrote a long post on fracking not long ago http://www.economonitor.com/dolanecon/2012/05/04/…

However, a back-of-the-envelope calculation suggests that you are surely right that the aggregate reductions in carbon emissions from fracking are almost surely greater than those from producing 3% of US energy with wind power.

I am amazed by the French attitude: Cut carbon, reduce reliance on nuclear, and ban fracking. One of those three is going to have to give.

Jardinero1September 30th, 2012 at 3:33 pm

"The bottom line: Wind power is good. It deserves a supportive policy environment. " I used to believe this and I live in Texas, the largest wind power state in the nation. But I don't believe it anymore because the subsidy has produced its own externalities which have had an adverse effect on baseload power producers and destroyed any incentive they have to invest in more generation in Texas. Now they are lobbying ERCOT for their own special subsidy to create more traditional baseload power plants. Imagine that!

The problem arises because the wind producers, via the subsidy, are charging negative rates to electric retailers in the fall and spring when wind production is greatest and baseload demand is at a nadir. Without the subsidy it would be impossible to charge negative rates. The baseload producers are not able to recoup enough when demand is highest in the summer and winter and thus no longer find it worthwhile to invest in more production.

EdDolanOctober 1st, 2012 at 9:45 am

Thanks for the negative rate/baseload example. I'll try to look into it. I think I understand the basic idea, though, because I know there are other cases when environmental regulation has unintended consequences, especially when different types of regulation interact.

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