Featured Article The Social Costs and Benefits of Biofuels: The Intersection of Environmental, Energy and Agricultural Policy

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1 Applied Economic Perspectives and Policy (2010) volume 32, number 1, pp doi: /aepp/ppp010 Featured Article The Social Costs and Benefits of Biofuels: The Intersection of Environmental, Energy and Agricultural Policy Harry de Gorter* and David R. Just Harry de Gorter, Department of Applied Economics and Management, Cornell University, Ithaca, NY; David R. Just, Department of Applied Economics and Management, Cornell University, Ithaca, NY *Correspondence to be sent to: hd15@cornell.edu Abstract The efficacy of alternative biofuel policies in achieving energy, environmental and agricultural policy goals is assessed using economic cost-benefit analysis. Government mandates are superior to consumption subsidies, especially with suboptimal fuel taxes and the higher costs involved with raising tax revenues. But subsidies with mandates cause adverse interaction effects; oil consumption is subsidized instead. This unique result also applies to renewable electricity that faces similar policy combinations. Ethanol policy can have a significant impact on corn prices; if not, inefficiency costs rise sharply. Ethanol policy can increase the inefficiency of farm subsidies and vice-versa. Policies that discriminate against trade, such as production subsidies and tariffs, can more than offset any benefits of a mandate. Sustainability standards are ineffective and illegal according to the WTO, and so should be re-designed. Key words: biofuels, mandates, subsidies, tariffs, externalities, greenhouse gases, traffic congestion, air pollution, burden of taxation. JEL Codes: H21, H23, R48, Q48, Q54, Q56. Introduction Biofuel policies are motivated by a plethora of political concerns related to reducing dependence on oil, improving the environment and increasing agricultural incomes (Rajagopal and Zilberman 2007). 1 In response to these concerns, a myriad of policies are employed for U.S. biofuels, including consumption subsidies, mandated minimum levels of consumption, production subsidies (including feedstocks), import barriers and sustainability standards (Tyner and Gardner 2007). 2 To fulfill the goals of 1 The desire to diversify energy types and sources because of rising and unstable oil prices is the main concern over oil dependence. Mitigating global climate change and local air pollutants are the major environmental goals. Note that the goal to improve farm incomes is a double-edged sword: the effects of the tax on animal agriculture can offset any benefits from biofuel production. 2 Using life-cycle accounting, U.S. corn-ethanol is required to reduce CO 2 emissions 20% less than gasoline. # The Author(s) Published by Oxford University Press, on behalf of the Agricultural and Applied Economics Association. All rights reserved. For permissions, please journals.permissions@oxfordjournals.org 4

2 The Social Costs and Benefits of Biofuels reduced dependence on oil and an improved environment, U.S. policy-makers deem biofuel policy crucial to complementing existing energy policies such as fuel taxes and cap and trade. Additionally, politicians advocate biofuels as a substitute for existing farm subsidy programs (Johnson and Libecap 2001). Many studies emphasize several key benefits of ethanol policy, including reduced tax costs for farm subsidy programs, reduced fuel prices, and improved international terms of trade in both corn exports and oil imports (Gardner 2007; Rajagopal et al. 2007; de Gorter and Just 2009a; Schmitz, Moss, and Schmitz 2007; Bourgeon and Tréguer 2008; Du, Hayes, and Baker 2008; Babcock 2008). Other studies emphasize the impact of biofuel policies on carbon dioxide (CO 2 ) emissions and vehicle miles traveled (Vedenov and Wetzstein 2008; Khanna, Ando, and Taheripour 2008; de Gorter and Just 2008a; 2009d; Lapan and Moschini 2009). The deadweight costs of the ethanol import tariff are emphasized by Martinez-Gonzalez, Sheldon and Thompson (2007), de Gorter and Just (2008c), and Lasco and Khanna (2009). Some studies argue that ethanol policies fail to pass an overall cost-benefit test (Taylor and Van Doren 2007a; Metcalf 2008; Hahn and Cecot 2009), that they have an adverse impact on food prices and poverty especially in developing countries (Runge and Senauer 2007; Mitchell 2008) and create higher greenhouse gas emissions due to indirect land use changes (Searchinger et al. 2008). In assessing the relevant literature, Gardner and Tyner (2007, p. 3) take many of these counteracting effects into account and conclude: Under current farm programs at current world price levels, deadweight losses of U.S. commodity support may be quite small, so that second-best gains of the ethanol subsidy [e.g., due to reduced taxpayer cost of farm subsidy programs] are small.... Our findings, however, are that the welfare effects of a biofuel policy can be quite large. Furthermore, most countries are using several biofuel policies in concert. 3 When used in some combinations, biofuel policies can be contradictory, where the effects of a policy are reversed. These biofuel policies never complement each other, but can on rare occasions be complementary to energy or environmental policy. Rarely does a biofuel policy have a neutral effect. The effects of each biofuel policy and their interaction with other policies (biofuel or otherwise) are very complex, the economics of which can seem impenetrable. This is due to the intricate interrelationships between energy and commodity markets and the varied environmental consequences. Nevertheless, in this paper we disentangle the key interactions in this byzantine system of policy instruments by analyzing each biofuel policy on its own merits, in relation to each other, as well as to other environmental, energy and agricultural policies. As complex as the economics are, however, once understood, a set of relatively clear policy implications emerge. This is unlike the traditional literature, where the choice of environmental policy instrument (e.g., a carbon tax versus cap and trade) is normally deemed as inherently difficult because of competing criteria (see Goulder and Parry 2008 for further discussion). 3 Kojima, Mitchell, and Ward (2007, p. 54) state Among various support measures, fuel tax exemptions are most widely used while Jull et al. (2007, p. 21) state Virtually all existing laws to promote...biofuels set blending requirements, meaning the percentages of biofuels that should be mixed with conventional fuels. 5

3 Applied Economic Perspectives and Policy One clear policy implication of the relative merits of biofuel policies is that a quantity-based biofuel mandate is superior to a price-based consumption subsidy (Lapan and Moschini 2009). Empirically, we find that the mandate can potentially increase social welfare substantially. On the other hand, a consumption subsidy likely decreases welfare significantly, primarily because of the taxpayer burden but also because it encourages negative externalities related to vehicle miles traveled, local air pollution and CO 2 emissions (de Gorter and Just 2008a; 2009d). These differences are magnified if one is saddled with a suboptimal fuel tax, as is arguably the case in the United States. Thus, a mandate being both a subsidy on biofuel and a tax on fuel is a rare example of when a biofuel policy is complementary to an environmental policy (de Gorter and Just 2009d). This clear picture on biofuel policies is atypical in the debate comparing alternative policy instruments in the environmental economics literature. 4 However, the benefits of a market-based policy like mandates can easily be eradicated if mandates are used in conjunction with biofuel subsidies (de Gorter and Just 2009b,d). Subsidies cannibalize the positive effects of a mandate and fuel tax (de Gorter and Just 2009d). Therefore, hybrid instruments that combine policies can cause severe adverse policy interaction effects. Furthermore, any potential benefits of a biofuel policy can easily be offset by trade barriers such as domestic production subsidies, import tariffs and sustainability standards. One would have expected it to be doubly difficult to analyze a complex web of biofuel policies seeking to fulfill manifold environmental, energy and agricultural policy goals. Pointing to the good biofuel policy turns out to be relatively simple, however. But it is also very easy for politicians to select a bad policy, sometimes simply by using policies in combination. We conclude that the toolkit of biofuel policies is needlessly extensive. Furthermore, these same combinations of policies have also been adopted for renewable electricity (Fischer and Newell 2008). Meanwhile, governments worldwide use similar combinations for all renewable energy sources. With the growing momentum for expanded renewable energy mandates and subsidies of various forms, the choice of policy instrument made by policy-makers is therefore crucial. Much is at stake. Several other important issues will be explored in our discussion: Ethanol policy can have a substantial impact on corn prices. However, production costs of U.S. corn-ethanol are very high. The gap between the intercept of the ethanol supply curve and the oil price creates large deadweight costs that may overwhelm any external benefits. Subsidies and mandates by themselves do not discriminate against international trade. However, production subsidies, import tariffs and sustainability standards do. These trade distorting policies can create huge inefficiencies; U.S. production would otherwise be replaced by Brazilian production, resulting in far lower CO 2 emissions. Sustainability standards which set a maximum amount of CO 2 emissions per gallon are ineffective because of leakage to other sectors or countries not covered by the standard. Further, the U.S. standard is highly unlikely to survive a legal challenge in the WTO under the 4 For example, see the debate over whether there is a functional equivalence between a price versus quantity-based environmental policy in Weisbach (2009), which appears not to hold in the case of a biofuel mandate versus a subsidy. 6

4 The Social Costs and Benefits of Biofuels exception for the environment, because the latter requires a measure that is necessary and least trade-restrictive, and not discriminatory or arbitrary (criteria that a sustainability standard does not meet). Historically, corn subsidies were also required in addition to ethanol policy for U.S. ethanol production to occur. Because farm subsidies make ethanol policy more inefficient, and viceversa, the claim that ethanol policy reduces the tax costs of farm subsidy programs may not be borne out. The rest of this article is organized as follows. The next section explains the various factors affecting the ethanol price and how one can tell if the mandate or the consumption subsidy determines the price. Section 3 compares the effects of a mandate to a consumption subsidy and analyzes the implications of a suboptimal fuel tax. Section 4 explains why the effect of a consumption subsidy is reversed when used in combination with a binding mandate. Section 5 explains the price link between corn and ethanol, while section 6 explores the effects of biofuel policies on farm subsidy costs. Section 7 summarizes the implications of our general framework for analyzing biofuel policies in an international trade context, while the penultimate section of our article examines the recent controversy over biofuel sustainability standards and indirect land use change. The final section summarizes conclusions and offers some lessons and guidance for governments regarding current biofuel policies. Ethanol Price Determination: A Consumption Subsidy or Mandate? We will show later that adding an ethanol consumption subsidy to a binding mandate causes gasoline consumption to be subsidized instead. It is therefore important to understand when a mandate is binding or when the consumption subsidy determines the market price for ethanol. Keeping with standard economic theory, consumers of fuel (a blend of ethanol and gasoline) obtain utility from the number of miles traveled. Denote the volumetric fuel tax by t. In this case, the fuel tax per mile for each fuel is t divided by the miles per gallon of the fuel. Thus, because the number of miles per gallon of ethanol is only about 0.70 times the miles per gallon of gasoline, the tax per mile traveled using ethanol is about 1.42 times higher than that for gasoline. Define l as the ratio of miles per gallon of ethanol to miles per gallon of gasoline, where l ¼ The maximum price that consumers are willing to pay for ethanol is l times the consumer price of gasoline, l(p G þ t), where P G is the market price of gasoline. 5 If the ethanol price is above this, consumers could purchase the same distance traveled by using gasoline exclusively. In the absence of other policies, market forces will render the price of a mile using ethanol and the price of a mile using gasoline to be equal. This relationship implies that the wholesale price of ethanol is given by: P E ¼ lp G ð1 lþt: ð1þ 5 Interestingly, the price consumers pay for ethanol can be greater or less than the market price for gasoline P G, depending on the relative values of the gasoline price P G, fuel tax t and the relative miles per gallon parameter l. 7

5 Applied Economic Perspectives and Policy Refiners and blenders are required to pay the fuel tax on ethanol by volume, yet consumers value ethanol for its contribution to miles, and so are willing to bear a smaller portion of the fuel tax for ethanol than for gasoline. Hence, the market price blenders are willing to pay for ethanol is lower by (1 2 l)t, the penalty on ethanol due to the fuel tax being levied on a volume basis rather than on a miles traveled basis, thus leading the market to favor gasoline more than would be suggested by the simple advantage in miles per gallon. An ethanol consumption subsidy (or tax exemption) equal to the penalty is required to minimize this distortion caused by the fuel tax. 6 The implicit penalty on biofuel production can be very significant in countries like the United Kingdom, which has a fuel tax of $3.40 per gallon, thus imposing a penalty on ethanol producers of $1.02 per gallon. 7 We now introduce a volumetric ethanol consumption subsidy given by the U.S. blender s tax credit t c. To take advantage of the government subsidy offered them, blenders of ethanol and gasoline will bid up the price of ethanol (moving up the supply curve for ethanol) until it is above the predicted wholesale price of ethanol given in Equation (1) by the amount of the tax credit. Otherwise, blenders would be foregoing money represented in the tax credit. The wholesale price of ethanol is now given by: P E ¼ lp G ð1 lþt þ t c: ð1 0 Þ Because fuel consumers are indifferent to using gasoline and using a mileage equivalent amount of ethanol, and because gasoline prices do not change much with ethanol production, the incidence of the tax credit is such that ethanol producers derive most of the benefit. 8 However, when the mandate is binding, the wholesale price of ethanol will be determined by the point on the ethanol supply curve that corresponds to the required level of production. In this case, Equation (1 0 ) will not hold, but a higher price of ethanol will be realized. Currently the tax credit is approximately 52 /gallon if we aggregate state and federal tax credits. From September 2007 to June 2008, the ethanol price predicted by Equation (1 0 ) closely tracked the actual ethanol price (see figure 1). 9 The mandate was dormant in that time period, but after that the mandate became binding again, with particularly high price premiums beginning in October 2008 in anticipation of an increase in the blend requirement from 7.76% in 2008 to 10.21% for But from June 2009 to October 2009, the tax credit appears to determine the ethanol market price. A standard car cannot burn fuel with greater than 10% ethanol. This blend wall has been met under the 10.21% mandate. 6 Another penalty often imposed on biofuels is when the consumer price of gasoline is fixed below market prices or is subsidized, thereby causing a reduction in the price that refiners are willing to bid for the biofuel (e.g., many EU countries subsidize diesel consumption). 7 Interestingly, Brazil s tax exemption for ethanol is often not very much higher than the volumetric tax penalty (see de Gorter, Just, and Kliauga 2008). 8 The market price of ethanol can be above or below the consumer price paid for ethanol l(p G t), depending on whether the tax credit t c is greater than or less than the fuel tax t. For a more detailed derivation of Equation (1 0 ), see de Gorter and Just (2008b). 9 Ethanol production increased so fast in 2007 that the market was unable to absorb it all due to a lack of infrastructure, and so a market disequilibrium occurred in October 2007 (see figure 1). The exceptionally high price premiums in 2006 were due to the ban on a competing fuel additive, making ethanol a much more favorable alternative. 8

6 Figure 1 Portion of the ethanol price that cannot be explained by the tax credit or gasoline price* 9 The Social Costs and Benefits of Biofuels

7 Applied Economic Perspectives and Policy Hence, all ethanol beyond the blend wall is determined by the sale of additional ethanol (e.g., in 85% ethanol, E85, blends) and as may be expected, the ethanol price equals that predicted by Equation (1 0 ). But it is also possible for market prices to exceed that in Equation (1 0 ) if E-85 sales are insignificant such that the mandate is binding even with a blend wall. The fact that ethanol production did not surge above mandated levels at price levels determined by the tax credit in the latter half of 2009 suggests that higher prices from a binding mandate are required (as in previous years) to cause significant increases in ethanol production from current levels (unless oil prices surge or there is a sharp drop in the opportunity cost of corn for food). For much of the time period , the actual ethanol price exceeded that predicted by Equation (1 0 ) with an average premium of 35 /gal. (the average premium in figure 1 is 34 /gal.). 10 However, there were no significant negative values prior to 2004, unlike in figure 1, but formal mandates did not exist or were not physically binding. Instead, we argue that the ethanol price premium was above the tax credit in the past because of de facto mandates either in the form of environmental regulations or because ethanol was purchased for its additive value as an oxygenator or octane enhancer (Tyner 2007; de Gorter and Just 2008b; 2009a). The Clean Air Act of the 1990s or the recent implicit ban on methyl tert-butyl ether (MTBE), a lower cost substitute for ethanol as an oxygenator, are examples of environmental regulations that may have acted as a mandate in this case. As an oxygenator or octane enhancer, ethanol is used as a fixed proportion of total fuel, and therefore the market price is determined as if there were a mandated blend of ethanol and gasoline in place. 11 A common mistake is to conclude that the mandate is not binding if observed annual ethanol consumption is above mandated levels (e.g., GAO 2009, chapter 5). Although the U.S. employs a consumption mandate requiring that a fixed amount of ethanol be used as fuel each year, it is nevertheless implemented as a blend mandate. The blend is based on a forecast of total fuel consumption for the upcoming year. If the forecast is wrong, then actual consumption does not equal observed consumption ex post. But that does not mean the mandate was not binding. Even if there is no forecast error, if the mandate binds for every day of the year but one, then observed consumption ex post is greater than the mandated volume. But is it then reasonable to conclude that the mandate did not bind? For these and other reasons, comparing prices predicted by Equation (1 0 ) to actual prices, we believe, is a more sound way in determining if a mandate is binding or not at any given point in time. One cannot simply compare annual quantities ex post due to the dynamic issues involved. The important implication is that if the tax credit determines ethanol market prices, then the mandate is dormant. However, the reverse is not true. If a mandate, de facto or real, is binding, then the tax credit may not be dormant; it may be subsidizing gasoline 10 Borrowing from other economic studies, Koplow (2009) estimates the premium due to mandates to be 14 /gallon, which is significantly lower than the analysis here suggests. 11 If fuel consumers do not recognize the difference in contribution to miles between ethanol and gasoline, they value gallons of fuel rather than miles traveled. This behavioral economic model is developed in de Gorter and Just (2008b), which leads to different price and equilibrium formulas, though the nature of the relationships remains. Evidence from Brazil suggests that consumers learn to recognize the difference. 10

8 The Social Costs and Benefits of Biofuels consumption instead. 12 We provide our explanation of this perverse effect in the section on what happens when a tax credit is added to a mandate, but first we explain the economics of mandates versus tax credits. The Economics of a Mandate and Tax Credit Compared Let us first consider a mandate requiring a minimum amount of ethanol consumption. 13 To show how a mandate works, assume the world price of gasoline (oil) is unaffected by ethanol production. The extra ethanol production in this case is funded entirely by a tax on fuel consumers. Consumers pay the weighted average cost of ethanol and gasoline with the weights formed by the required consumption of ethanol. The mandate is at once a subsidy to ethanol and a tax on fuel consumers. Gasoline consumption declines not only because the extra ethanol displaces gasoline, but also because total fuel consumption declines due to the fuel tax effect of a mandate. Total fuel consumption unequivocally declines. Again, assuming a fixed price of gasoline, a tax credit inducing the same ethanol quantity reduces gasoline consumption only by the increase in the amount of ethanol, while total fuel consumption is unchanged. Under a binding mandate, fuel prices are higher than with a tax credit generating the same quantity of ethanol. Now consider an endogenous gasoline price. Surprisingly, although gasoline consumption still declines under a mandate, it is possible for total fuel consumption to increase. This is because the mandate is acting at once as a monopolist against fuel consumers and a monopsonist against gasoline producers. If the elasticity of ethanol supply is greater than that for gasoline, then fuel consumers are subsidized and fuel prices are lower compared to free markets (Fischer and Newell 2008; de Gorter and Just 2007). 14 Gasoline producers are always worse off. With a tax credit, on the other hand, fuel consumption always increases. Gasoline consumption is lower in both cases, but more so with a mandate. The Effects on CO 2 Emissions and Externalities Related to Miles Traveled Because a mandate has an ambiguous impact on total fuel consumption, the change in CO 2 emissions and externalities related to vehicle miles traveled is also ambiguous. It is possible that a mandate increases CO 2 emissions even if ethanol emits less per mile traveled than gasoline The importance of this for policy is lessened somewhat when you consider that even if the mandate is not binding, it otherwise could be and so represents the true opportunity cost of tax credits and production subsidies that subsidize oil consumption. 13 The U.S. mandate is modeled as a consumption mandate (de Gorter and Just 2008a, 2009d; Lapan and Moschini 2009) or a blend mandate as implemented (de Gorter and Just 2007; 2009b); analysis to follow holds for either case. 14 Holland, Hughes and Knittel (2009) obtain the same result when analyzing California s low carbon fuel standard, which is basically the same as a blend mandate. 15 There are two alternative formulations for lower CO 2 emissions with ethanol: recognize that CO 2 emissions for ethanol are net zero (see discussion in the penultimate section of this article) while gasoline emits pounds of CO 2 per gallon at combustion; or use the life-cycle accounting approach, which finds that ethanol emits 20% less CO 2 than gasoline s pounds per gallon (CARB 2009). Alternatively, one can assume ethanol emits more CO 2 than gasoline if life-cycle analysis includes indirect land use changes as well (Searchinger et al. 2008) The life-cycle approach in welfare analysis is employed by Holland, Hughes, and Knittel (2009) and Lasco and Khanna (2009). 11

9 Applied Economic Perspectives and Policy However, a reduction in the fuel price is not a sufficient condition for CO 2 emissions to increase. The resulting change in emissions will depend not only on the ratio of emissions from the two fuels, but also on the price responsiveness of producers. If gasoline production is very price inelastic, the increase in ethanol consumption due to the mandate may not be completely offset by the reduction in gasoline consumption, potentially leading to greater emissions (de Gorter and Just 2008a; Lapan and Moschini 2009). A tax credit unambiguously increases miles traveled, but CO 2 emissions may either increase or decrease depending on the amount of the increase in ethanol consumption due to the tax credit and on the assumption made regarding ethanol s contribution to CO 2 emissions. Even though ethanol is considered to emit less CO 2 per mile traveled than gasoline, there is the chance that subsidizing ethanol may increase emissions. This is because subsidizing ethanol lowers the overall price of fuel. 16 Regardless, a mandate results in a lower level of total fuel consumption, CO 2 emissions and miles traveled compared to a tax credit for the same quantity of ethanol. 17 This result is important because the U.S. is widely believed to have a suboptimal gasoline tax (Parry and Small 2005) and thus an excess consumption of fuel. Furthermore, the highest cost externality due to fuel consumption is traffic congestion and traffic-related accidents (Parry and Small 2005) and not CO 2 emissions. As a result, a mandate will reduce externality costs of transportation more than a tax credit. What is the Optimal Policy? The best policy can be achieved either with a combination of a fuel tax and ethanol tax credit or a fuel tax and mandate (Holland, Hughes, and Knittel 2009; Lapan and Moschini 2009; de Gorter and Just 2009d). 18 The optimal gasoline tax under the fuel tax/tax credit combination is equal to the marginal external cost of consuming gasoline, with the optimal tax credit for ethanol making up the difference between the marginal external cost of consuming gasoline and ethanol. The combination of the optimal fuel tax and mandate results in the same amount of ethanol consumption, fuel consumption and fuel prices as the optimal tax and tax credit combination. Mandates naturally result in higher fuel prices than tax credits. Thus, the fuel tax under the tax and mandate combination must be lower than the fuel tax under the tax and tax credit combination. Both optimal policy combinations result in an identical equilibrium. 16 The resulting impact on emissions will also depend on the relative price responsiveness of fuel demand and gasoline supply. A greater relative price elasticity of demand increases emissions under an ethanol subsidy (see de Gorter and Just 2008a; Lapan and Moschini 2009). 17 For a full explanation of these results, see the discussion in de Gorter and Just (2008a; 2009b). 18 Fuel taxes are a second (or worse) best answer for all three identified externalities, but political or administrative constraints generally preclude the use of first-best instruments. Taylor and Van Doren (2007b) argue the first-best means of addressing congestion is a time-varying toll, while that for addressing accident-related externalities is to adopt pay-as-you-drive insurance under which premiums would vary in direct proportion to vehicle miles traveled and the insured s risk factor as determined by insurance companies. The first-best means of addressing tailpipe emissions is via a tax on the same. Fuel use per se does not perfectly correlate with any of these problems. 12

10 The Social Costs and Benefits of Biofuels Optimal Biofuel Policy with a Sub-optimal Fuel Tax With a suboptimal fuel tax, the efficacy of a mandate over a tax credit becomes even more pronounced. A suboptimal fuel tax makes an ethanol tax credit even more distortionary because the tax credit lowers the fuel price, which is already too low because of the suboptimal fuel tax. On the other hand, under most circumstances, an increase in the mandate is required to achieve the second-best outcome. This is because a mandate compensates for the suboptimal fuel tax. However, the optimal fuel tax cannot be achieved indirectly with a mandate alone because of the inefficiencies associated with the higher cost ethanol. The ranking of a mandate and a tax credit becomes more complicated if general equilibrium effects are incorporated in the analysis (Goulder and Williams 2003). For example, with a pre-existing wage tax, if a mandate involves less taxpayer costs than a tax credit, and the savings are used to reduce the wage tax, then the superiority of a mandate over a tax credit widens when this revenue-recycling effect is taken into account. In theory, a mandate results in lower taxpayer costs (compared to a tax credit that generates the same ethanol quantity) if the fuel supply curve is more elastic than the fuel demand curve. Empirically, this appears to be the case for U.S. corn-ethanol (de Gorter and Just 2008a; 2009d). But a mandate involves a transfer from consumers in the form of higher gasoline prices than otherwise would be the case with a tax credit. Therefore, there is a second effect that works in the opposite direction; the fuel price increase magnifies the inefficiency of the pre-existing wage tax by reducing real wages and thus discourages work. This results in a leftward shift in the labor supply curve and generates deadweight costs because the tax base erodes as consumers substitute away from the taxed good. This is termed the tax-interaction effect and can possibly more than offset the beneficial revenue-recycling effect. What Happens When a Tax Credit is Added to a Mandate? So far we have compared the efficiency of a mandate to that of a tax credit for a given level of ethanol consumption. But policy-makers worldwide seem intent on using mandates and tax credits in concert. We now evaluate these policies jointly. 19 Recent U.S. energy legislation mandates the use of at least 36 billion gal. of biofuels in Tax credits by themselves encourage ethanol production as a replacement for gasoline consumption. But with mandates in place, the tax credits will unintentionally subsidize gasoline consumption instead. This contradicts the new energy bill s stated objectives of reducing dependency on oil, improving the environment and enhancing rural prosperity. This result is independent of the issues related to indirect land use change and CO 2 life-cycle analysis that is currently in the forefront of the public debate over biofuels. The unintended result of a tax credit switching to a gasoline subsidy in the presence of a government mandate is easily explained. Consider the 19 In other countries, the consumption subsidy for biofuels is a tax exemption at the fuel pump, while in the United States, it takes the form of a blender s subsidy. In theory, the two methods have identical effects except for specific cases in international trade (de Gorter, Just, and Kliauga 2008; Drabik, de Gorter, and Just 2009). 13

11 Applied Economic Perspectives and Policy case where the ethanol price is determined by the binding mandate and there is no tax credit. The consumer fuel price is a weighted average of the ethanol and gasoline prices, where consumers pay a higher price for gasoline to finance the mandated ethanol quantity. The mandate induces higher ethanol prices to fund the increase in ethanol production, causing a price premium for ethanol above the natural market price. Now introduce a tax credit alongside the mandate. So long as the tax credit does not exceed the difference between the cost to blenders of ethanol and gasoline, it would be more profitable to blend additional gasoline on the margin than ethanol. In this case, there is no incentive for blenders to bid up the price of ethanol as was the case before. The additional revenues from the tax credit and the price of ethanol fail to exceed the opportunity cost of production for any additional ethanol. Instead, competition will lead blenders to offer a lower fuel price to consumers to take advantage of the tax credit offered to them by the government. However, the blenders input prices of ethanol and the level of production of ethanol cannot decline due to the mandate. Instead, blenders could increase profits by lowering the retail price of fuel and gaining market share. Thus, blenders will compete for the government subsidy by reducing the implicit price paid by consumers for blended fuel, sliding down the demand curve and increasing the total amount of fuel consumed. But, because the mandate is binding, ethanol consumption remains constant. Thus, all increases in fuel consumption will be in the form of gasoline. This increases gasoline consumption and thus increases the market price of gasoline and oil. The price of gasoline paid by consumers declines until the per unit subsidy on ethanol is exactly exhausted on an adjusted per-unit basis of gasoline consumption hence the reversal of the intended policy effects. Given the fixed amount of fuel mandated, we can calculate the costs of the tax credits. The 52 /gal. tax credit for corn-ethanol, $1.00/gal. tax credit for biodiesel and $1.01/gal. production tax credit for cellulosic ethanol were altogether worth over $6.5 billion in This total increases three-fold, to $21 billion, by 2022 due to the increase in mandated production, particularly among the more heavily subsidized cellulosic fuels. In total, between 2008 and 2022, taxpayers could pay out over $200 billion to the biofuels industry. If President Obama s proposals for 60 billion gal./year were to be realized, taxpayer-financed subsidies could be over $34 billion per year by the end of the period, for a cumulative subsidy during the period of close to $400 billion. 20 In addition to adverse revenue-recycling effects of the tax credit, we must also add the external costs of added gasoline consumption related to vehicle miles traveled, oil dependence, increased CO 2 emissions and a decline in the terms of trade in oil imports. Due to the combination of the mandate and tax credit alone, the annual deadweight costs are expected to be about $11 billion by 2022 (de Gorter and Just 2009d), depending on the assumed value of the price of carbon, revenue-recycling effects and the estimated CO 2 emissions from ethanol. 20 Data are from Koplow (2009) and excludes his estimates of market price support and tax exempt benefits. If these are included, then Koplow (2009) estimates total transfers to the U.S. ethanol sector from consumers and taxpayers to exceed $1 trillion from 2008 to

12 The Social Costs and Benefits of Biofuels Due to the unique way in which mandates reverse the market effects of a tax credit, the intentions of policy-makers cannot necessarily be faulted. We know of no other example in the economics literature of the interaction between a price-based and quantity-based policy measure that generates such a unique result as that of a biofuel tax credit and mandate. Furthermore, this policy mistake is not unique to the United States, but is a worldwide error of judgment, as most countries use both mandates and tax credits simultaneously. It is also not unique to biofuels: electricity markets have mandates ( renewable portfolio standards ) and production tax credits, tax exemptions and emission taxes, all of which simply subsidize the consumption of electricity produced from fossil fuels. How Ethanol Prices and Hence Ethanol Policy Affect the Price of Corn The corn price is directly linked to that of ethanol. 21 Denote b as the gallons of ethanol produced from one bushel of corn (about 2.8 gallons) and denote d as the proportion of the value of corn returned to the market in the form of animal feed by-products (about 30%). Ethanol producers buy one bushel of corn at the price P c, and convert it to 2.8 gallons of ethanol that can be sold at the price for ethanol P E, and additionally, 0.30 bushels of corn by-product that can be sold back to the corn feed market at P c, the price of corn. Thus, per bushel, the input cost is P c, while revenues equal bp E þ dp c. Ethanol producers must bid up the price of corn and bid down the price of ethanol until marginal revenue equals marginal cost, P c ¼ bp E þ dp c, implying a static relationship between the price of ethanol and the price of corn. 22 This means that any change in corn prices must equal b/(1 d) (about 4 times) the change in ethanol prices. The reasoning behind why one divides b by (1 d) is that as the value of the by-product increases, the benefits of ethanol production also increases and thus producers are willing to pay more for corn. This means the corn price is very sensitive to a change in the price of ethanol (induced by either a change in ethanol policy or the world oil price). For example, state plus federal tax credits of 52 /gal. for ethanol would increase corn prices by $2.08 per bushel in the absence of a binding mandate. A binding mandate would suggest a premium that is larger than $2.08. Both possibilities seem very unlikely, given that corn prices averaged $2.35 over the past 25 years. So how does one explain this? The reason is that the intercept of the ethanol supply curve is historically above the price of oil. This gap is the reason the ethanol price premium (due to either the de facto mandates or tax credit) did not have a large impact historically on corn prices. This gap between the oil price and the intercept of the ethanol supply curve, which we call water, represents the amount of the deficit in marginal revenue to ethanol producers that must be met before any ethanol will be produced. Take the tax credit as an example: water means that a reduction in the tax credit will have an impact on corn prices until the opportunity cost of corn in other uses is 21 Pre-2004, there is not much empirical evidence of a link between ethanol and corn prices, suggesting the model developed here is more applicable to recent and future events. 22 This of course ignores other processing costs; see de Gorter and Just (2008b) for a detailed derivation of this relationship between ethanol and corn prices. 15

13 Applied Economic Perspectives and Policy above the marginal benefit from converting corn to ethanol; further decreases in the tax credit will have no effect as ethanol ceases to be produced. The intercept of the ethanol supply curve is the intersection of the supply curve for corn and the demand curve for non-ethanol corn. Denote this intersection by P NE, the shut down price for ethanol production. This intercept of the ethanol supply curve is the opportunity cost of corn used in ethanol production and can be very high in some years. In many years, the price of ethanol including the tax credit is above the intercept of the ethanol supply curve, but the price without the tax credit would be below the intercept. In this case, there would be no ethanol production without the tax credit. Removing the tax credit would lower the corn price to P NE, where ethanol output is zero, but no further. Thus, the drop in corn price due to removing the tax credit could be much smaller than b/(1 d) times the tax credit. Taxpayer costs are given by ethanol production multiplied by the tax credit. Because of water in the tax credit, part of the tax cost is devoted to raising the producer price of ethanol to the intercept of the ethanol supply curve. This part of the tax cost, which is equal to the gap between the oil price and P NE multiplied by total ethanol production, is deadweight loss defined as that part of the ethanol price premium due to policy that is not a transfer to domestic producers. This deadweight loss due to water magnifies the social costs of ethanol policies compared to standard analysis because the rectangular area given by multiplying water by ethanol production is so much larger than the deadweight cost triangles, which are also a component of inefficiency costs. For example, Gardner (2007) estimated triangular deadweight costs to be in the $ million-range, similar to de Gorter and Just (2008b; 2009a). However, the latter studies found rectangular deadweight costs to be an additional annual waste of over $2 billion. Only when oil prices increased sharply in recent years did the ethanol price premium due to policy have a measurable impact on corn prices. With higher oil prices, the gap between oil prices and the intercept of the ethanol supply curve narrowed. 23 The ethanol price premium due to policy then had a larger impact on corn prices. Assuming there was no water in the price premium due to policy when oil prices were very high (the intercept of the ethanol supply curve was above the price of ethanol with no tax credit), the contribution of the U.S. ethanol policy price premium to corn prices ranges from 39% to 87% depending on base values and current corn prices. Other studies, however, obtain much lower estimates (McPhail and Babcock 2008). Elobeid and Tokgoz (2008) conclude that biofuel policy adds 5 /bushel to the corn price, while FAPRI assigns a 14 /bushel price increase due to biofuels. Although von Braun and Torero (2009) recognize that biofuels were one of many supply and demand factors affecting food prices, they focus instead on the contribution of ad hoc trade policy interventions such as export bans, high export tariffs or high import subsidies, and of the flow of speculative capital from financial investors into agricultural markets. Mitchell (2008) not only attributes a larger direct impact of biofuels on corn prices, but also argues that biofuels precipitated the two factors von Braun and 23 GAO (2009, chapter 5) finds a consensus among economists that the intercept of the ethanol supply curve is no lower than an oil price of $80 per barrel and can be as high as $120 per barrel. 16

14 The Social Costs and Benefits of Biofuels Torero (2009) deem most important in explaining commodity price increases, namely, ad hoc policy interventions and speculation. The award winning study by Abbott, Hurt, and Tyner (2008) determined that oil prices caused 75% of the corn price hike and 25% was due to biofuel policy. This relatively smaller impact is potentially plausible if one considers water in the ethanol policy price premium. But Abbott, Hurt, and Tyner (2008) did not consider water. Indeed, their study also failed to take into account the by-product value of corn, which is part of the price relationship b/(1 d) that drives the relationship between oil prices and corn prices. It must be understood that studies which assume d ¼ 0 and thereby ignore the by-product value of corn underestimate the impact of biofuel policy on corn prices. Studies that include b/(1 2 d), like Collins (2008) and Lapan and Moschini (2009), attribute a higher share of the commodity price increase to biofuel policy. Some argue that increased biofuel production reduces oil prices and so the effect on corn prices is not so high. Du and Hayes (2008) determine that gasoline prices declined by up to 40 /gal. due to ethanol in Assuming all ethanol production is due to policy, and given that the tax credit determined ethanol prices in 2007, the increase in the ethanol price due to the tax credit according to Du and Hayes (2008) is 24 /gal., far below the decline in gasoline prices. This is highly unlikely. The supply of gasoline is likely less elastic than the supply of ethanol. Additionally, biofuels make up less than 1% of the world oil market, and an even smaller portion of the primary energy market. This makes it unlikely that the price of gasoline would drop by much more than the increase in the price of ethanol due to the tax credit. 24 Furthermore, OPEC may react to biofuel policies to counter any price decreasing effect of biofuels on oil prices. Hence, any moderating effect of reduced oil prices (resulting from increased production of ethanol) on the price of corn is likely to be modest. 25 The Impact of Corn and Ethanol Production Subsidies Because of water in the ethanol price premium (the intercept of the ethanol supply curve is above the price of gasoline), ethanol policy has less than a full impact on corn prices and thereby generates rectangular deadweight costs. But the ethanol policy price premium in dollars per bushel was historically often greater than the price of corn itself (de Gorter and Just 2008b). This can occur with high costs of ethanol production, low gasoline prices, and a price of corn that is less than the intercept of the ethanol supply curve, P NE. This may seem contradictory in that P NE by definition is the price of corn without ethanol: how is it possible for the price of corn to go below P NE? This condition occurs when there are production subsidies for either corn or ethanol that lower the consumer price of corn below the competitive equilibrium level without ethanol 24 Taylor provides a detailed assessment of imperfect competition that drives the results in Du and Hayes (2008). 25 This is different than the plausible hypothesis put forward by Schmitz, Moss, and Schmitz (2007) and Rajagopal et al. (2007), namely that the change in gasoline prices due to increased ethanol supply need not be large in order for significant welfare gains to occur because the quantity of gasoline consumption is so high. 17

15 Applied Economic Perspectives and Policy production. The fact that ethanol policy price premiums have historically been larger than the corn price itself is evidence that the tax credit alone would not have induced ethanol production. Rather, there would not have been ethanol production in many years in the past without corn and ethanol production subsidies. 26 But the inefficiency of production subsidies for corn and ethanol are even more disturbing because they may subsidize gasoline consumption when there is a binding mandate. The reasoning for this is similar to that of adding a tax credit to a mandate as discussed earlier. Unlike with a tax credit, however, a subsidy for corn and/or ethanol results in a lower ethanol wholesale price. With production subsidies for corn and ethanol, even though the market price of ethanol declines, ethanol production (and consumption) remains constant because it is determined by the mandate. 27 Due to environmental policies and the ban on MTBE, an effective mandate may have been binding for many years in the past, even in the recent past, and will likely bind in the future, especially for cellulosic ethanol. Do Ethanol Policies Really Reduce Taxpayer Costs of Farm Subsidy Programs? Proponents of U.S. ethanol policy argue that the tax credit reduces the tax costs of farm subsidy programs because two of the biggest farm subsidy programs are contingent on market prices for crops: the loan deficiency payment and countercyclical payment programs (e.g., Gardner 2007; Du, Hayes, and Baker 2008). This was highlighted in one of the earliest cost-benefit studies on ethanol policy by Gardner (2007). On the face of it, an increase in ethanol prices does increase the price of corn and of other crops (because corn competes for land with other crops and are substitutes in consumption). However, Gardner (2007) compares a loan rate to a tax credit, but overlooks cases where these policies are used in conjunction. In fact, corn production subsidies were required in addition to ethanol tax credits, mandates, production subsidies and tariffs in order for any ethanol production to occur at all. Further, adding a tax credit to a mandate has no impact on corn prices and hence on the tax costs of farm subsidy programs. 28 Thus, once policies are analyzed in combination (as they are used), then Gardner s (2007) conclusion can easily fall apart. For example, corn subsidies increase the taxpayers costs of both the tax credit and ethanol production subsidies, and increases rectangular deadweight costs. 29 The tax credit and ethanol production subsidies increase the tax costs and inefficiencies of the farm subsidy programs. When used in conjunction with a mandate, corn production subsidies increase the taxpayers costs of the tax credit, while ethanol production subsidies increase the tax costs of both the tax credit and farm subsidy programs. Hence, one may not want 26 The different situations under which this can occur are explained in detail in de Gorter and Just (2008b; 2009a). 27 The production of corn declines with an ethanol production subsidy, but increases with a corn production subsidy. For the same per unit subsidy, the ethanol price declines more with an ethanol production subsidy than a corn subsidy. In both cases, the consumption of non-ethanol corn increases. 28 Because market prices of gasoline increase by adding a tax credit to a mandate, farmers are actually worse off, as energy is a significant share of crop input costs. 29 Recall that a tax credit is an ethanol consumption subsidy and so has different impacts on the market with other policies in place compared to an ethanol production subsidy. 18