On February 20th, 1999 the Joint Committee on Taxation released the "Description of Revenue Provisions Contained in the President’s Fiscal Year 2000 Budget Proposal". The President’s proposal would provide targeted tax cuts of about $80 billion over a ten-year period, according to a separate analysis of the revenue impact issued by the Joint Committee on Taxation. These cuts were more than offset by approximately $170 billion in revenue raisers.
In today’s world, people are becoming more socially aware of the costs of environmental pollution and traditional energy production methods on the atmosphere’s structure. The President is conscious of this factor and included six energy and environmental tax credit provisions in his proposal.
These were as follows :
- Tax credit for energy-efficient building equipment
- Tax credit for purchase of energy-efficient new homes
- Extend tax credit for high-fuel-economy vehicles
- Tax credit for combined heat and power ("CHP") systems
- Tax credit for rooftop solar equipment
- Extend wind and biomass tax credit
The most interesting aspect of these energy and environmental credit is not the detailed conditions that you are required to meet to be able to claim the credits. But, the reason and rationale behind these credits and the objectives that the President is trying to achieve through these proposed credits. However, there are economic and environmental advantages and disadvantages associated with these credits.
President’s Rationale for the Proposed Energy and Environmental Tax Credits
The whole basis of these tax credits is based upon the fact that externalities exist. An externality exists when, the consumption or production of a certain good results in a different cost or benefit to an individual compared to society as a whole. There are two types of externalities:
- Positive Externality – Social benefits from consumption or production exceed private benefits of consumption or production.
- Negative Externality – Social costs from consumption or production exceed private costs of consumption or production. An example is pollution.
The level to which individuals will consume or produce goods depends on their marginal costs and marginal benefits. An individual will consume a good until the personal marginal cost of consumption equals the personal marginal benefit of their consumption. After that point an individual is no longer experiencing a net benefit. However, this level of consumption will unlikely be the same level of consumption which would result in the marginal social cost equaling the marginal social benefit. Thus we have a positive or negative externality.
When we have a situation when the personal marginal costs and benefits are the same as the social marginal costs and benefits, we have the optimal situation and there have no externalities. The purpose behind the above proposed credits is to establish this optimal situation or positive externalities.
It would appear that in today’s world the only way that we can achieve this optimal situation is with government intervention. There would appear to be two approaches that the government could adopt:
- Tax credits (as proposed). In essence you are paying existing or potential polluters to reduce pollution.
- Taxation of polluting activity. Basically here you would be taxing the consumer for the right to you the product of the polluting activity. For example you could have a tax of $0.20 per gallon of gasoline purchased, which the consumer would pay upon refueling his vehicle.
The tax credit methodology is a preventive method of pollution control. Whereas taxation of the polluting activity is in effect an attempt to raise funds to cure the pollution. People should focus on preventative methods of pollution control as "prevention is better than cure."
Advantages and Disadvantages of Tax Credits.
Five of the proposed tax credits are what are called "investment credits", i.e. you receive your credit upon investment in the respective purchase. The only "production credit" is the wind and biomass credit. Each of these different types of credit has their own pros and cons.
Investment Credit – Advantages
- Investment is encouraged in areas where investment is below the socially optimum level. This lower than socially optimum level may have resulted from the fact that these environmental investments cost more than conventional purchases. Therefore, without the credits they are not as economically attractive.
- Investment credits encourage people to make investments that provide a combined social (7%) and private rate of return (8%) that is higher that the cost of the investment (10%) to the individual. If you look at the private rate of return in isolation the investment does not make economic sense. Therefore, the purpose of the credit is to make up the shortfall between the required rate of return (10%) and the actual rate of return to the individual (8%). Thus, we need to provide the individual with a credit equivalent to a rate of return of 2%, to ensure that the investment occurs.
- Investment credits make individuals aware of investments that are economically sound even without the credit. Thus, the credit gives individuals that little extra impetus and incentive to make that environmentally and economically favorable investment.
- These investment credits also enable "infant industries" to expand. A lot of these industries don’t have access to economies of scale of well established businesses. These credits help these companies to expand and thus be able to develop economies of scale. Then hopefully, these investment credits can be phased out and the industry is able to survive in an unsubsidized competitive market.
Investment Credits – Disadvantages
- Investment credits may encourage individuals to invest in pollution reduction purchases that are not the most cost-effective or efficient. Therefore it is important on a regular basis to review these investment credits in conjunction with the most cost-effective and efficient pollution methods and revise the tax credit provisions accordingly.
- Sometimes these investment credits are inefficient from a governmental budgetary perspective. This happens were an investment would be undertaken even without the credit. Say for example an individual was going to invest $1,000,000 before he hears about the tax credit. On hearing about the 10% investment credit he decides to invest a further $100,000. Therefore, you can see that he will receive a credit of $110,000. Thus, only $100,000 of investment was undertaken due to the credit, at a budgetary cost of $110,000.
- There are several limitations placed on these investment credits which make them unattractive o certain taxpayers. They are all nonrefundable, a disadvantage it you don’t have enough tax liability to cover the credit. They can not be offset against an Alternative Minimum Tax liability. Most of the credits are subject to dollar capping limits which can be viewed as potentially discouraging investment.
Production Credit – Advantages
- The production tax credit is paid to the investor as he produces electricity for example. The advantage of this type of tax credit is that the individual has a constant stream of monetary benefit as production occurs.
- This credit could encourage the production of an environmentally cleaner source of electricity if the level of credit is set at a level that would mean it was more cost effective than producing electricity from fossil fuels for example.
Production Credit – Disadvantages
- The main disadvantage of this credit is its uncertainty. With an investment credit the investor receives all the monetary aid at the time of investment/purchase. However, with a credit related to production there is always the possibility that Congress in the future could repeal the credit. This fact means that it is a lot riskier investing in purchases that are subject to tax credits based on production.
- Without the tax credit, production of the cleaner source of electricity may be unprofitable. Therefore, this credit could be construed as encouraging investors to produce unprofitable goods. This fact in itself is not a sound business decision. Just think that if the credit was stopped, then the business would potentially become insolvent.
- Linked to the above comment the level of credit may have to be set at too high a level in order to make the production of electricity profitable. One must be aware that the cost of the credit must not exceed the value of the positive externality which the credit is attempting to establish.
Recent Developments
The National Audubon Society is concerned that if the wind energy tax credit is extended as proposed above, that Enron Corp. will erect 53 wind turbines next to a critical habitat for the California condor, which is near extinction. The concern is that the turbine blades will create a death trap for the condor. It is ironic that an environmental source of energy is being attacked by a Society concerned with an environmental issue!
Conclusions
These various energy and environmental tax credit are very progressive. However, it is worth noting that there are a lot of issues that need to be considered and evaluated to ascertain whether the desired results are achieved by implementing the provisions of these tax credits. I think that there is scope for a hybrid tax credit which includes a part investment and a part production tax credit to be considered.
Reference Sources:
Joint Committee on Taxation, Description of Revenue Provisions Contained in the President’s Fiscal Year 2000 Budget Proposal (JCS-1-99), February 22, 1999.
The Bureau of National Affairs, Inc. Daily Tax Reporter, Tuesday September 14, 1999.
