COOL CODE: FEDERAL TAX INCENTIVES TO MITIGATE GLOBAL WARMING CHRIS EDWARDS,

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1 FEDERAL TA INCENTIVES TO MITIGATE GLOBAL WARMING COOL CODE: FEDERAL TA INCENTIVES TO MITIGATE GLOBAL WARMING CHRIS EDWARDS, * ADA ROUSSO, * PETER MERRILL, * & ELIZABETH WAGNER * Abstract - The Clinton Administration s fiscal year 1999 budget marks a revival of interest in using the federal income tax Code to influence energy demand. In the 1970s, Congress enacted tax incentives for energy conservation and alternative fuels. Now, the threat of global warming has again focused attention on energy use. This paper evaluates the proposed federal tax incentives to mitigate global warming, concluding that most of the government s funding for energy conservation, alternative fuels, and other global warming mitigation related expenditures is through the tax Code, rather than direct spending programs. The tax incentives in the Administration s budget proposal are best viewed as demonstration projects designed to provide information about the commercial potential of certain technologies, not a least cost method of reducing greenhouse gas emissions. * Pricewaterhouse Coopers LLP, Washington National Tax Services, Washington, D.C INTRODUCTION The Clinton Administration s fiscal year 1999 budget proposes an array of new tax incentives, with an estimated revenue cost of $3.8 billion 1 over five years, that primarily are directed at reducing usage of fossil fuels. The budget also includes $2.7 billion of funds for research and other measures aimed at promoting the use of energyefficient technologies. These proposals mark a revival of interest in using the federal income tax Code to influence energy demand. In the 1970s, the sharp rise in the international price of crude oil prompted Congress to enact tax incentives for energy conservation and alternative fuels in the Energy Tax Act of 1978 and the Crude Oil Windfall Profit Tax Act of Most of these tax incentives had sunset provisions and were allowed to expire in the mid 1980s when world oil prices collapsed. Now, the threat of global warming has again focused attention on energy use, because a reduction in fossil fuel consumption would lower emissions of 465

2 NATIONAL TA JOURNAL VOL. LI NO. 3 carbon dioxide, which many scientists believe contributes to global warming. This paper evaluates the proposed federal tax incentives to mitigate global warming. The following section provides a brief background on the global climate change convention signed last year by the United States in Kyoto. The next section summarizes current and prior federal tax incentives relating to energy conservation and alternative fuels. The paper then describes the tax incentives for global warming mitigation contained in the Administration s fiscal year 1999 budget. The last section evaluates these global warming tax incentives from a tax policy perspective. KYOTO AGREEMENT The December 1997 Kyoto Protocol to the United Nations Framework Convention on Climate Change is the beginning of a long-term process for the United States and over 160 other participating countries to implement substantial cuts in greenhouse gas (GHG) emissions. If ratified, the Convention would require the United States to reduce emissions of six specified GHGs to 93 percent of 1990 levels by Achievement of the 2012 target would require a 14-percent reduction from 1996 levels and an estimated 31- percent reduction from otherwise projected levels in The GHGs covered by the Convention are carbon dioxide (CO 2 ), methane (CH 4 ), nitrous oxide (N 2 O), perfluorocarbons (PFCs), hydrofluorocarbons (HFCs), and sulfur hexafluoride (SF 6 ). The latter three gases are present in only trace amounts but have a much greater potential global warming impact on a pound-for-pound basis. 3 The signatory nations will assemble again in late 1998 to flesh out details of the agreement, and the Administration may submit a global warming treaty to the Senate for ratification as early as At this time, ratification of the treaty by the U.S. Senate is considered tenuous because of the potential economic costs of compliance and a concern that less developed countries would not bear a fair share of the burden of GHG reduction. Energy conservation and increased use of alternative fuels would provide the primary means for U.S. compliance with the Convention, if ratified. The principal GHG, carbon dioxide, is emitted as a byproduct of the combustion of fossil fuels, including petroleum, coal, and natural gas, and other organic material (e.g., wood). Fossil fuels currently account for 84 percent of total U.S. energy consumption. 4 Global warming policy seeks both to reduce energy consumption generally and to promote conversion to fuels with GHG emission rates that are either relatively low (natural gas) or zero (e.g., wind, solar, and hydro power). The Administration s budget proposals are part of the first stage of the threestage White House Initiative on Global Climate Change, announced on October 22, The first stage involves a variety of pump priming activities, including tax incentives, federal funding of R&D, and industry consultations. The second stage is a comprehensive review and evaluation in preparation for a GHG emission permit trading system. The third stage, which would not begin until 2008, involves achieving binding reductions in GHGs through the use of an ambitious domestic and international emission trading program. 466

3 FEDERAL TA INCENTIVES TO MITIGATE GLOBAL WARMING TA PROVISIONS RELATING TO ENERGY CONSERVATION AND ALTERNATIVE FUELS The current tax incentives relating to energy conservation and alternative fuels were enacted as part of the Energy Tax Act of 1978, the Crude Oil Windfall Profit Tax Act of 1980, and the Energy Policy Act of Many of the provisions contained in the 1978 and 1980 Acts have subsequently been allowed to expire or are scheduled to expire. Because the tax incentives for alternative fuels were enacted primarily in response to concerns over the security of foreign oil supplies, the goal was to encourage use of fuels other than crude oil and fuels made from crude oil. For example, the credit for production of nonconventional fuels (which applies to oil produced from a variety of carbonbased resources other than crude oil) originally was intended to reduce the demand for crude oil (about half of which is imported), rather than to reduce GHG emissions. Alternative fuels, such as synthetic gas produced from coal, may also reduce GHGs because combustion of synthetic gas results in lower GHG emissions per British thermal unit (Btu) than combustion of coal. Over the five-year period , the Congressional Joint Committee on Taxation estimates that the foregone tax revenues ( tax expenditures ) attributable to existing tax incentives for energy conservation and alternative fuels will be $10.6 billion (Table 1). Approximately two-thirds of the projected tax expenditure is attributable to the nonconventional fuels credit, which may have an effect on GHG emissions. 5 About 25 percent of the tax expenditure is attributable to the alcohol fuels credit. By comparison, budgeted federal outlays for the Administration s Climate Change Technology Initiative, funded through the Department of Energy and the Environmental Protection Agency, currently are about $3.5 billion over the period (not including the additional amounts requested in the Administration s fiscal year 1999 budget proposal). Thus, in the budget baseline, the government incentives for energy conservation and alternative fuels provided through the tax Code are approximately three times larger than the subsidies provided through the budget. Provisions Enacted in the Energy Tax Act of 1978 Business tax credit for solar and geothermal energy property (sec. 48(a)) Under present law, ten percent of the cost of qualified solar and geothermal energy property is allowed as a nonrefundable tax credit. Qualified solar property includes any equipment that uses solar energy to generate electricity or to heat or cool (or provide hot water for use in) a structure to provide solar process heat. Qualified geothermal energy property includes any equipment for production, distribution, or use of energy derived from a geothermal deposit, but only, in the case of electricity generated by geothermal power, up to (but not including) the electrical transmission stage. When enacted in 1978, the credit for solar energy property (and wind energy property) was refundable to the extent it exceeded the taxpayer s tax liability before credit. Special stacking rules were provided to allow maximum use of the energy credit and the ten-percent regular investment tax credit that was in effect at that time. 467

4 NATIONAL TA JOURNAL VOL. LI NO. 3 Item TABLE 1 TA INCENTIVES RELATING TO ENERGY CONSERVATION AND ALTERNATIVE FUELS (TA EPENDITURE ESTIMATES, FY ) Tax credit for production of nonconventional fuels Tax credit for alcohol fuels and exemption of alcohol fuels from excise taxes Tax credit for solar and geothermal energy property Tax credit for wind and biomass electricity production Tax credit for electric vehicles Exclusion of conservation subsidies provided by electric utilities Deduction for clean-fuel vehicles and property Total Source: Joint Committee on Taxation. Tax Expenditure ($ Millions) $6,700 2, $10,600 Business tax credit for other energy property (expired) In addition to solar and geothermal property, the 1978 Act also provided an investment tax credit of ten percent for certain other types of energy property. The credit generally was available for costs incurred for qualifying property after September 30, 1978, and before January 1, (The credits for solar and geothermal energy property continue to be in effect.) In addition to solar and geothermal energy property, energy property was defined to include the following: (1) boilers and burners that use a substance other than oil or natural gas (an alternative substance ) as a fuel, plus related on-site fuel handling and pollution control equipment; (2) equipment to convert an alternate substance into a synthetic fuel or industrial feedstock, and costs to modify existing oil or gas burning equipment to use an alternate substance as a partial fuel or feedstock, as well as related equipment for fuel or feedstock handling and pollution control; (3) wind energy equipment; (4) recycling equipment; (5) shale oil equipment; (6) equipment to produce natural gas from geopressured brine; and (7) certain specially defined equipment that reduces energy consumption in an existing commercial or industrial facility or process. Residential energy credits (expired) Insulation and other energy-conserving items Effective for taxable years beginning after December 31, 1977, a 15-percent credit was available for the first $2,000 of qualifying expenditures for installations of eligible insulation and energy conservation items on a taxpayer s principal residence. No credit was allowed for expenditures made after December 31, Unused credits could be carried over to succeeding taxable years. However, no credit could be carried to any taxable year beginning after December 31, Eligible energy conservation items were the following: (1) a replacement burner for an oil- or a gas-fired furnace; (2) a device to modify flue openings; (3) an electrical or mechanical furnace ignition system; 468

5 FEDERAL TA INCENTIVES TO MITIGATE GLOBAL WARMING (4) a storm or thermal door or window; (5) an automatic set-back thermostat; (6) caulking or weather stripping for an exterior door or window; and (7) a meter that displays the cost of energy use. Renewable energy source property A credit was provided for homeowners and renters of 30 percent on the first $2,000 and 20 percent of the next $8,000 of expenditures (a maximum credit of $2,200) made in connection with a taxpayer s principal residence for the installation of (1) solar, (2) wind, or (3) geothermal energy equipment. If a credit was allowed for expenditures in a prior year, the dollar amount allowed in the current year for qualified expenditures had to be reduced by the prior year s expenditures that were taken into account. Principal residences included condominiums and cooperative housing. Credits for installations in 1977 had to be claimed on 1978 tax returns. Unused credits could be carried over through 1987 (two years after expiration of the credit). The Crude Oil Windfall Profit Tax Act of 1980 increased the credit rate for renewable energy source property to 40 percent of the first $10,000 of expenditures (a maximum credit of $4,000), and included in the definition of renewable energy source property costs incurred to install roof-top solar panels. In addition, equipment to produce electrical energy from renewable energy source property installed with respect to a residence was made credit-eligible. These amendments generally applied to expenditures made after December 31, 1979, and before January 1, Incentives for vanpooling (expired) Investment credit for certain commuter vehicles An employer was eligible for the full 10- percent investment credit, rather than the 7-percent credit generally applicable to motor vehicles and other short-lived property, on the purchase of a new van or bus if the vehicle had a useful life of at least 3 years, accommodated 9 or more persons (including the driver), and would be used 80 percent or more of the time for transporting employees to or from work. The credit was available for vehicles purchased after November 8, 1978, and before January 1, Exclusion from income of certain employerfurnished transportation Gross income did not include the value in excess of the employee s cost of transportation to or from work that was furnished by an employer if such transportation was in a commuter van or bus. This provision applied to transportation furnished in taxable years beginning after December 31, 1978, and before January 1, In general, to qualify, the transportation must have been furnished by a commuter highway vehicle under a plan established in writing by the employer, which met the antidiscrimination requirements generally applicable to tax-exempt pension plans. Provisions Enacted in the Crude Oil Windfall Profit Tax Act of 1980 Credit for production of nonconventional fuels (sec. 29) As originally enacted, an income tax credit was available for qualified fuels produced from wells that were drilled, or property placed in service, before January 1, Revised and extended several times, the credit is equal to $3 adjusted for inflation ($6.10 in 1997) per barrel (or Btu equivalent) of oil produced from nonconventional 469

6 NATIONAL TA JOURNAL VOL. LI NO. 3 sources and sold to unrelated parties. Qualified fuels include oil produced from shale and tar sands; gas produced from geopressured brine, Devonian shale, coal seams, tight formations, or biomass; and liquid, gaseous, or solid synthetic fuels produced from coal (including lignite), including such fuels when used as feedstocks. In general, the credit is available only with respect to fuels produced from wells drilled or facilities placed in service after December 31, 1979, and before January 1, 1993, except for facilities producing gas from biomass and synthetic fuel from coal, if the facility producing the fuel is placed in service before July 1, 1998, pursuant to a binding contract entered into before January 1, The credit may be claimed for qualified fuels produced and sold before January 1, 2003 (in the case of nonconventional sources subject to the January 1, 1993 expiration date), or January 1, 2008 (in the case of biomass gas and synthetic fuel facilities eligible for the extension period). Alcohol fuels credit (sec. 40) Currently scheduled to expire for sales or uses after December 31, 2000, this credit was added to the Code in 1980, effective for sales and uses after September 30, This incentive is available in lieu of an exemption from the gasoline excise tax. The per gallon credit applies to neat alcohol fuel and alcohol used to produce qualified alcohol fuel mixtures. The credit is 60 cents per gallon for alcohol with a proof of 190 or more and 45 cents per gallon for alcohol with a proof of at least 150 but less than 190. A qualified mixture is a mixture of renewable-source alcohol and gasoline that is sold by the taxpayer producing the mixture to any person for use as a fuel. Alcohol includes methanol and ethanol, but not any alcohol produced from petroleum, natural gas, or coal (including peat), or alcohol with a proof of less than 150. Credit for ocean thermal equipment (expired) A 15-percent tax credit was allowed for qualifying investments after December 31, 1979, and through December 31, 1985, for qualifying ocean thermal equipment at two locations designated by the secretary of the treasury after consultation with the secretary of energy. Credit for small-scale hydroelectric equipment (expired) An 11-percent tax credit was provided for small-scale hydroelectric equipment, including hydroelectric generating equipment such as turbines and generators, powerhouses and similar structures to house generating equipment, penstocks to carry water from the impoundment to the turbine, and fish passageways for the period from January 1, 1980 through December 31, The effective period was extended for three additional years, through December 31, 1988, for qualifying investments that arise from a hydroelectric project for which an application was docketed by the Federal Energy Regulatory Commission before January 1, Credit for cogeneration equipment not fueled by oil or gas (expired) A ten-percent tax credit was provided for cogeneration equipment not fueled by oil or gas installed in an existing (as of January 1, 1980) industrial or commercial facility as part of an energy-using system. This credit was allowed from January 1, 1980, through December 31, Provisions Enacted in the Energy Policy Act of 1992 Credit for qualified electric vehicles (sec. 30) A credit is allowed against a taxpayer s income tax equal to ten percent of the 470

7 FEDERAL TA INCENTIVES TO MITIGATE GLOBAL WARMING cost of a qualified electric vehicle that the taxpayer places in service during a taxable year. A qualified electric vehicle is any motor vehicle that is powered primarily by an electric motor that draws its current from rechargeable batteries, fuel cells, or other portable sources of electrical current. The credit was enacted in 1992 and is effective for property placed in service after June 10, 1993, and before December 31, The maximum credit allowable is $4,000, phasing out after December 31, 2001 by $1,000 per year. Electricity produced from certain renewable sources (sec. 45) Enacted in 1992, and effective for tax years ending after 1992, this income tax credit of 1.5 cents per kilowatt hour was established for electricity generated from wind or from closedloop biomass systems and sold to persons unrelated to the producer during the tax year. The amount of the credit is adjusted for inflation by an inflation adjustment factor for the calendar year of sale (1.95 cents in 1997). The electricity must be produced from qualified energy resources and at a qualified facility during the ten-year period beginning on the date the facility was originally placed in service. A facility using closed-loop biomass to produce electricity must be placed in service after December 31, 1992 (December 31, 1993, in the case of other facilities), and before July 1, Closed-loop biomass systems use organic material from plants that are grown exclusively for electricity production, creating a renewable energy source. Any plant used exclusively for electrical generation, except standing timber, qualifies for the credit. The credit is not available for electricity generated from waste material and most other types of biomass. Energy conservation subsidies provided by public utilities (sec. 136) Added to the Code in 1992, and effective for amounts received after 1992, Code section 136 exempts from gross income the value of any subsidy provided (directly or indirectly) by a public utility to a customer for the purchase or installation of any energy conservation measure. The term energy conservation measure means any installation or modification primarily designed to reduce consumption of electricity or natural gas or to improve the management of energy demand with respect to a dwelling unit. However, the subsidy is not available for any payment to or from a qualified cogeneration facility or qualifying small power production facility. Deduction for clean-fuel vehicles and certain refueling property (sec. 179A) Taxpayers, both individual and corporate, can deduct from adjusted gross income a portion of the costs associated with the purchase of alternative fuel vehicles or the installation of refueling facilities for alternative fuels. Alternative fuels are defined as compressed natural gas, liquefied petroleum gas, liquefied natural gas, hydrogen, electricity, and any other fuel that includes 85 percent alcohol fuels, ether, or any combination of the foregoing fuels. PROPOSED GLOBAL WARMING TA INCENTIVES The Clinton Administration s fiscal year 1999 budget contains nine separate tax incentives designed to reduce GHG emissions in the United States (Table 2). Seven of these incentives are designed to encourage energy conservation and the use of alternative fuels. The remaining two incentives are intended to reduce leakage into the environment of certain man-made chemicals (used as 471

8 NATIONAL TA JOURNAL VOL. LI NO. 3 Item TABLE 2 GLOBAL WARMING MITIGATION TA INCENTIVES IN FY 1999 BUDGET PROPOSAL (ESTIMATED REVENUE EFFECT, FY ) Tax incentives for energy conservation and alternative fuels 1. Tax credit for energy-efficient building equipment 2. Tax credit for purchase of new energy-efficient homes 3. Tax credit for high-fuel-economy vehicles 4. Equalize treatment of parking and transit benefits 5. Provide investment tax credit for CHP systems 6. Provide tax credit for rooftop solar equipment 7. Extend credit for wind and biomass electricity production Subtotal Estimated Revenue Loss ($ Millions) $1, $3,730 Tax incentives relating to GHGs with high global warming potential 1. Tax credit for replacement of certain circuit breakers 2. Tax credit for certain PFC and HFC recycling equipment Subtotal Grand total Source: Joint Committee on Taxation $78 $3,808 solvents and insulators) with very high global warming potential. According to the Joint Committee on Taxation, these global warming tax incentives are estimated to reduce federal tax receipts by $3.8 billion over the fiscal year period. These incentives would increase the revenue loss attributable to the existing tax incentives for energy conservation and alternative fuels by one-third over the fiscal year period. Tax Incentives for Energy Conservation and Alternative Fuels Credit for purchase of energy-efficient building equipment A credit would be provided for the purchase of certain types of highly energy-efficient building equipment including fuel cells, electric heat pump hot water heaters, advanced natural gas and residential size electric heat pumps, and advanced central air conditioners. This credit would equal 20 percent of the purchase price, subject to an unspecified cap, and would be nonrefundable. For businesses, it would be subject to the limitations on the general business credit and would reduce the basis of the equipment. The credit would generally be available for final purchases from unrelated third parties between December 31, 1999, and before January 1, 2004, for use within the United States. The credit for fuel cells would be available for purchases after December 31, 1999, and before January 1, Credit for purchase of energy-efficient new homes A tax credit of 1.0 percent of the purchase price of a home up to a maximum credit of $2,000 would be available to purchasers of highly energyefficient new homes. To claim the credit, the taxpayer must use the new home as the taxpayer s principal residence, and the new home must use at least 50 percent less energy for heating, cooling, and hot water than the Model Energy Code standard for single family residences. The credit would generally be available for final homes purchased after December 31, 1998, and before January 1,

9 FEDERAL TA INCENTIVES TO MITIGATE GLOBAL WARMING Credit for purchase of high-fuel-economy vehicles The budget would provide two temporary tax credits for the purchase of fuelefficient vehicles: (1) a credit of $4,000 for each vehicle that has three times the base fuel economy for its class, and (2) a credit of $3,000 for each vehicle that has twice the base fuel economy for its class. These credits would be available for all qualifying light vehicles, including cars, minivans, sport utility vehicles, light trucks, and hybrid and electric vehicles. Taxpayers who claim one of these credits would not be able to claim the qualified electric vehicle credit or the deduction for clean-fuel vehicle property for the same vehicle. The $3,000 credit would apply to vehicles purchased after 1999, phasing down after 2003, and terminating after The $4,000 credit would begin for vehicles purchased after 2002, phase down after 2006, and terminate after Equalize treatment of parking and transit benefits Currently, transit passes and vanpool benefits are only excludable if provided in addition to, and not in lieu of, any compensation otherwise payable to an employee and are limited to $60 per month (in 1993 dollars). By contrast, parking benefits are treated as an excludable fringe benefit even if provided in lieu of compensation and are limited to $155 per month (in 1993 dollars). The budget proposal would conform the tax treatment of transit and vanpool benefits to that applicable to parking benefits. The proposal would be effective for years beginning after December 31, Credit for combined heat and power systems The budget would establish a ten-percent tax credit for certain combined heat and power (CHP) systems (used to produce electricity and process heat and/or mechanical power from a single primary energy source) with an electrical capacity in excess of 50 kilowatts (or with a capacity to produce mechanical power equivalent to 50 kilowatts). Investments in qualified CHP systems that are assigned cost recovery periods of less than 15 years would be eligible for the credit, provided that a 15-year recovery period and 150-percent declining balance method are used to calculate depreciation allowances. 6 Property placed in service outside the United States would be ineligible for the credit. The credit would be subject to the limitations on the general business credits. The depreciable basis of qualified property for which the credit is taken would be reduced by the amount of the credit. Regulated public utilities claiming the credit would be required to use a normalization method of accounting with respect to the credit. Taxpayers using the credit for CHP systems would not be entitled to any other tax credit for the same equipment. The credit would apply to investments in CHP systems placed in service after December 31, 1998, but before January 1, Credit for rooftop solar equipment A tax credit would be available for purchasers of rooftop photovoltaic systems and solar water heating systems located on or adjacent to the building for uses other than heating swimming pools. The credit would be equal to 15 percent of qualified investment up to a maximum of $1,000 for solar water heating systems and $2,000 for rooftop photovoltaic systems. This credit would be nonrefundable. For businesses, this credit would be subject to the limitations of the general business credit. The depreciable basis of the qualified 473

10 NATIONAL TA JOURNAL VOL. LI NO. 3 property would be reduced by the amount of the credit claimed. Taxpayers would have to choose between the proposed credit and the present business energy credit for each investment. The proposal would be effective for equipment placed in service after December 31, 1998, and before January 1, 2004, for solar water heating systems, and for equipment placed in service after December 31, 1998, and before January 1, 2006, for rooftop photovoltaic systems. Extend tax credit for wind and biomass electricity production The budget proposal would extend for five years the placed in service date for the current income tax credit allowed for the production of electricity from either qualified wind energy or qualified closed-loop biomass facilities. The credit is equal to 1.5 cents (plus adjustments for inflation since 1992) per kilowatt hour of electricity produced from these qualified sources during the ten-year period after the facility is placed in service. The proposal maintains this ten-year limit on production. Closedloop biomass is the use of plant matter, where the plants are grown for the sole purpose of being used to generate electricity. It does not apply to the use of waste materials (including, but not limited to, scrap wood, manure, and municipal or agricultural waste). It also does not apply to taxpayers who use standing timber to produce electricity. In order to claim the credit, a taxpayer must own the facility and sell the electricity produced by the facility to an unrelated party. The credit for electricity produced from wind or closed-loop biomass is a component of the general business credit. The proposal would be effective on the date of enactment. Tax Incentives Relating to GHGs with High Global Warming Potential Credit for replacement of certain circuit breaker equipment Some power circuit breakers use a technology that is prone to leak sulfur hexafluoride (SF 6 ). This chemical is one of the most potent GHGs, with a global warming potential over 20,000 times greater than carbon dioxide. Under the budget proposal, a tax credit would be available for the installation of new power circuit breaker equipment, used in the transmission and distribution of electricity, to replace older power circuit breakers that are prone to leak SF 6. The tax credit would be ten percent of qualified investment. The replaced circuit breaker equipment would need to be destroyed to prevent further use. The credit would be subject to the limitations on the general business credit. The depreciable basis of qualified property for which the credit is taken would be reduced by the amount of the credit claimed. The credit would be available for new equipment placed in service in the five-year period beginning January 1, 1999, and ending December 31, Credit for PFC and HFC recycling equipment Emissions of PFCs and HFCs have a potent global warming effect due to long-term stability in the atmosphere and high absorption of radiation. Under the proposal, a tax credit would be available for the installation of PFC and HFC recovery/recycling equipment in semiconductor manufacturing plants. The tax credit would be ten percent of qualified investment. The credit would be subject to the limitations on the general business credit. The depreciable basis of qualified property for which the credit is taken would be reduced by the amount of the credit claimed. Equip- 474

11 FEDERAL TA INCENTIVES TO MITIGATE GLOBAL WARMING ment would qualify for the credit only if it recovers at least 99 percent of PFCs and HFCs. The credit would apply to property placed in service after December 31, 1999, and before January 1, TA POLICY ISSUES Policy Goals and Instruments Through the Kyoto agreement, the Administration has committed to achieve substantial reductions in U.S. GHG emissions. The government could seek to achieve these reductions through taxes, subsidies, or regulation. The three-phase White House Initiative on Global Climate Change calls for use of relatively small subsidies during the first two phases, and then implementation of a global regulatory system (involving tradable GHG emission permits) beginning after Subsidies, delivered both through the budget and the tax system, are viewed by the Administration as policy instruments that can be put in place over the short term, when the mechanics of a more comprehensive regulatory scheme are being developed. The subsidy program during the first two phases of the Initiative on Global Climate Change appears to have two main policy purposes (in addition to a variety of political purposes). First, the program is intended to fund research that has the potential to reduce the cost to the economy of meeting GHG reduction targets. Second, the program is intended to encourage the development, marketing, and purchase of certain highly energy-efficient products. The subsidy program can be compared with the adoption of a tax or fee on GHG emissions, weighted by global warming potential. 7 Emissions of GHGs from fuel consumption may be estimated reasonably accurately from a fuel s chemical composition, so that tax may be imposed on the fuel (e.g., coal, oil, and natural gas) rather than the actual emission. This provides the theoretical basis for a carbon tax, which is an excise tax on fossil fuels levied according to carbon content. Variants of carbon taxes have been enacted by Finland, the Netherlands, Sweden, and the United Kingdom, and have been considered by the European Commission. 8 If the Administration s objective had been to achieve the largest reduction in GHG emissions at the least social cost, a carbon tax would have dominated a tax subsidy program for at least three reasons. First, budgetary constraints limit the amount of GHG reduction that can be financed. Second, tax writers do not have adequate information to allocate subsidies efficiently. Third, subsidies for pollution abatement are inherently less efficient than taxes on the pollutants themselves, because the subsidy causes overproduction of pollution-causing goods. 9 Presumably, a carbon tax was not recommended as a result of other policy objectives, such as the international competitiveness of U.S. manufacturers. Notwithstanding the limitations of tax subsidies, efficiency considerations would suggest targeting those GHGs with the highest global warming potential, such as SF 6 and HFCs, which have global warming potentials thousands of times greater than CO 2 on a pound-for-pound basis (Appendix A). The Administration s budget includes two tax incentives related to high global warming potential gases, but their effects are uncertain. For example, the 475

12 NATIONAL TA JOURNAL VOL. LI NO. 3 budget includes a ten-percent tax credit for the replacement of older circuit breakers that are prone to leak SF 6. As described in the budget documents, however, the proposal would not require that the SF 6 in these circuit breakers be permanently sequestered or destroyed. Without further clarification, this proposal actually could aggravate global warming. Revenue versus Expenditure Side of the Budget The government can subsidize activities either through direct spending programs or through tax incentives typically crafted as income tax credits or deductions. The Administration s budget proposal contains a mix of tax incentives and new spending programs. Tax incentives typically work best where the administrative costs of implementing a new direct spending program are likely to be high, for example, in the case of a program that is intended to deliver a relatively small subsidy to a large number of claimants. In such cases, using the existing income tax administration system may be preferable. There are, however, a number of disadvantages to the use of the tax system. First, tax incentives are vulnerable to fraud, and the Internal Revenue Service (IRS) has limited ability to verify the accuracy of claims without Congressional approval of additional resources. 10 Moreover, the Administration s budget proposal does not include additional funding for IRS administration of the energy and environmental tax incentives. Second, tax incentives are ineffective for individuals and businesses who cannot absorb tax benefits because, for example, they have no tax liability or are subject to the alternative minimum tax (AMT). Tax incentives can be made more widely available through the use of refundable tax credits, which are credits that may be claimed from the IRS if the taxpayer cannot use the credit to offset taxes otherwise due. The tax credits in the Administration s budget proposal are not refundable, and generally may not be used by taxpayers subject to the AMT. Third, many tax administrators and policymakers believe that the tax Code should not be used for social policy purposes that are extraneous to the basic mission of raising revenue. The proliferation of tax preferences increases complexity for taxpayers and the IRS, causes individuals with similar incomes to pay different amounts of tax (socalled horizontal inequity), and may reduce taxpayer morale. Moreover, unlike spending programs, which are in the jurisdiction of authorizing committees (e.g., the House Energy and Commerce Committee or the Senate Environment and Public Works Committee), tax incentives are within the jurisdiction of the tax-writing committees, whose members and staff may have little expertise in energy or environmental policy matters. Direct spending programs are particularly suitable where a relatively large subsidy is intended to be delivered to a small number of beneficiaries. This is particularly true of government funding for basic research, where considerable expertise is required to determine whether proposed research programs are promising and are targeted consistent with government objectives. The Administration s budget proposal subsidizes climate change research through direct spending programs, 476

13 FEDERAL TA INCENTIVES TO MITIGATE GLOBAL WARMING while using tax incentives to encourage purchases of energy-efficient buildings and equipment. This appears to be an appropriate division of labor between the tax and outlay sides of the budget. Policy Consistency As national energy and environmental policies have evolved over the last three decades, the tax Code has been used to achieve varied objectives. For example, present law includes tax incentives for production of fossil fuels from both conventional and nonconventional sources. Over 90 percent of the revenue cost of existing energy conservation and alternative fuel tax incentives is attributable to the tax credit for the production of nonconventional fuels and the credit and exemption for alcohol fuels (see Table 1). Certain limited tax incentives are also provided for the drilling and production of oil and gas by conventional means. These incentives have been justified by, among other things, concerns that the United States is overly dependent on petroleum imports, which account for about half of the crude oil input to U.S. refineries. Some may question policies that simultaneously (1) encourage production of nonconventional fuels, (2) encourage production of fossil fuels, and (3) discourage consumption of fossil fuels, since they appear to be at odds with each other. All of these policies, however, do have the effect of reducing petroleum imports and, from this perspective, may be viewed as consistent. 11 Demonstration Projects Ideally, subsidies for the adoption of global warming mitigation technology would be efficiently targeted to achieve the greatest reduction of global warming. However, this is a virtually impossible task. For example, efficient targeting would dictate that tax incentives for residential energy conservation be higher in parts of the country where electric utilities primarily use coal-fired power plants, and lower in parts of the country where electric utilities use nuclear and hydroelectric power. This type of finetuning of tax incentives is not practical. Thus, the Administration s proposed tax incentives are more in the nature of demonstration projects than a serious attempt to achieve the greatest reduction in global warming for a fixed amount of government expenditure. Like a demonstration project, the Administration s proposed energy conservation tax incentives have a limited trial period and are designed to promote a few promising technologies in each of the major energy using sectors: buildings, transportation, industry, and electric utilities (Appendix B). Government demonstration projects typically are intended to produce information that is useful to the public and/or private sectors for guiding future investment decisions. As their value lies primarily in the information generated, a plan for the collection and analysis of demonstration project data is critical to their success. Viewed in this light, the Administration s global warming mitigation tax incentives are incomplete, as there appears to be no plan for gathering data on the utilization and efficacy of the proposed tax incentives, nor for analyzing such data after the incentive is terminated. Most of the tax credits in the Administration s budget have maximum dollar caps. The effect of these caps is that the effective credit rate drops below the statutory rate as the price of energy property rises above the amount at which the maximum credit is earned. As these tax credits ostensibly are intended to be 477

14 NATIONAL TA JOURNAL VOL. LI NO. 3 demonstration projects, a better design would be to provide higher maximum credit amounts for higher efficiency investments. This idea is incorporated in the Administration s proposed tax credit for high-fuel-economy vehicles. In theory, such a design elicits greater information about the technological frontier. Sector-by-Sector Evaluation The Administration s proposed energyefficiency tax incentives can be divided into four categories: incentives related to energy used in (1) buildings, (2) transportation, (3) industry, and (4) electricity generation. Allocating emissions from electricity generation to the appropriate end-use sector, buildings (residential and commercial), transportation, and industry each currently account for approximately one-third of GHG emissions, although transportation-related emissions are projected to grow more rapidly than other sectors through Buildings The Administration s budget proposal contains three tax incentives relating to energy-efficiency in buildings: (1) a 20- percent credit (up to an unspecified cap) for certain highly energy efficient heating and cooling devices; (2) a 1-percent credit (up to a maximum credit of $2,000) for the purchase of new homes (as a principal residence) that are 50 percent more efficient than the Model Energy Code; and (3) a 15- percent credit for purchases of rooftop photovoltaic and solar water heating systems (up to a maximum credit of $2,000 and $1,000 for photovoltaic and solar water heating, respectively) for use in a home or building. Compared to the prior law residential energy credits, the Administration s proposal relating to the purchase of energy-efficient building equipment is more narrowly targeted to advanced technology (for use in homes and buildings). Under prior law, a 15-percent tax credit (up to a maximum credit of $300) was available for such mundane investments as storm windows and weather stripping. The Administration s 15-percent credit relating to rooftop photovoltaic and solar water heating also is more narrowly targeted than the prior law residential credit for renewable energy source property and is considerably less generous (under prior law, a purchase credit of 40 percent, up to a maximum credit of $4,000, was allowed). Responding to a perceived abuse of the prior law credit, the Administration s proposal denies the credit for solar systems used to heat swimming pools. Business taxpayers would have to choose between the existing 10-percent credit for solar and geothermal property and the Administration s proposed 15- percent credit. In general, the Administration s proposed credit will be more favorable than the existing business credit in the case of rooftop photovoltaic systems costing less than $20,000 and solar water heating systems costing less than $10,000. Consequently, unlike most of the other energy conservation tax credits in the Administration s budget, the rooftop photovoltaic and solar water heating tax credits for business taxpayers are not targeted toward the most advanced and expensive technologies. The credit for energy-efficient new homes is unlike the prior residential energy credits, which were primarily oriented toward retrofitting existing homes. The impact of the credit obviously is quite limited, as new homes constructed each year represent less than two percent of the existing 478

15 FEDERAL TA INCENTIVES TO MITIGATE GLOBAL WARMING housing stock. Moreover, the credit apparently would not be available for rental property. As a demonstration project, however, the new home credit may produce useful information, because builders would have considerable flexibility in selecting technologies which, together, reduce energy consumption by 50 percent as compared to the Model Energy Code. The base of the credit is the entire purchase price of the home, so the effective credit rate theoretically could exceed 100 percent, if the incremental cost of achieving the energy-efficiency standard is less than the lower of 1 percent of the home price or $2,000. For homes costing more than $200,000, the effective credit rate declines as the incremental cost of meeting the 50 percent standard rises. Transportation The budget includes two proposals relating to energy-efficient transportation: (1) a tax credit of $4,000 for vehicles that have three times the base fuel economy for their class ($3,000 for vehicles with two times the base fuel economy); and (2) an expansion of the income exclusion for employer-provided transit benefits. Taxpayers would have to choose between (1) the existing ten-percent credit for electric vehicles (up to a maximum credit of $4,000); (2) the existing deduction for a portion of the cost of qualified alternative fuel vehicles; and (3) the new credit for highly energy-efficient vehicles. For electric vehicles, the Administration s proposed credit generally will be more favorable than the existing ten-percent credit for vehicles costing less than $40,000 for vehicles that have three times the base fuel economy for their class ($30,000 for vehicles with two times the base fuel economy). The Administration s proposal to conform the income exclusion for employer-provided transit benefits with that currently provided for parking benefits would remove a bias in current tax law toward employee usage of private automobiles rather than mass transit. The proposal is broader than the tax incentives for vanpooling contained in prior law, because the tax benefit would not be limited to this one form of mass transit. Industry The budget includes a ten-percent tax credit for certain CHP systems that produce electricity and heat (or mechanical power) from a single energy source. The budget proposal differs from the ten-percent credit for cogeneration equipment under prior law, because this latter credit was only applicable to equipment not fueled by oil or gas. This is consistent with the global warming mitigation orientation of the budget proposal as compared to the imported oil reduction focus of the Crude Oil Windfall Profit Tax Act of Electricity generation The budget would extend for five years the placed in service date for the current income tax credit for electricity produced from (1) wind or (2) closed-loop biomass. The credit is 1.5 cents (adjusted for inflation since 1992) per kilowatt hour of electricity (produced from these qualifying sources) for the ten-year period after the facility is placed in service. Extending the current credit would appear to have little incremental value as a demonstration project. Moreover, as biomass is carbon based, the global warming benefit from burning biomass rather than fossil fuels may be limited. The very narrow spectrum of qualifying 479

16 NATIONAL TA JOURNAL VOL. LI NO. 3 technologies further limits the usefulness of this incentive as a means of demonstrating new, GHG reducing technologies. The main argument in favor of this proposal would appear to be simplicity, since the administrative mechanisms are already in place to implement this credit. Trade Policy After the signing of the Framework Convention on Climate Change in Rio de Janeiro in 1992, the European Commission sought to develop consensus for a community-wide carbon tax as a policy instrument for reducing GHGs. Ultimately, the European Commission declined to adopt such a carbon tax on a unilateral basis because it would have harmed the international competitiveness of energy-intensive European industries. Similar concerns were important in the rejection by the U.S. Congress of the Administration s proposed Btu tax in Climate change policy frequently implicates trade policy. Indeed, the 1997 Kyoto Protocol may not win support in the U.S. Congress as a result of concerns that the exclusion of the nonindustrialized countries from the long-term GHG reduction requirements would adversely affect the international competitiveness of the United States jeopardizing both U.S. employment and investment. The Administration s global warming tax incentives also may have trade policy implications. For example, the proposed credit for the purchase of high-fueleconomy vehicles, if enacted, might be used to purchase primarily imported vehicles, and thus act as an import subsidy. Reconciling the international interest in mitigating the risks of global climate change with the national interest in competitiveness is perhaps the central challenge in developing a successful climate change policy. Conclusions Most of the government s funding for energy conservation, alternative fuels, and other global warming mitigation related expenditures is through the tax Code, rather than direct spending programs. The Administration s fiscal year 1999 budget proposal maintains this pattern, with over half of the fiveyear cost of new climate change initiatives attributable to tax incentives of various kinds. The nine separate tax incentives for global warming mitigation included in the budget proposal represent a mix of old and new ideas for promoting energy conservation and alternative fuels, as well as two new credits intended to reduce leakage of certain gasses with extremely high global warming potential. This grab bag of tax incentives is an inefficient tax strategy for achieving interim reductions of GHG emissions prior to the binding reductions scheduled beginning in 2008 under the Kyoto agreement. Rather, the elements of the Administration s proposal generally are better viewed as demonstration projects, with a limited duration, designed to provide information about the commercial potential of certain technologies to achieve GHG reductions in buildings, transportation, electricity generation, and industry. If the goal is demonstration, however, the design of these tax incentives could be improved. (1) A reporting system should be included so that the government 480