The Role of Tax Subsidies in Energy Efficiency

With primaries fast approaching, every presidential hopeful seems to have his or her own view on the government’s role (or lack thereof) in the energy sector. One thing all candidates can probably unanimously support, however, is cost cutting.

Many analysts believe that by improving energy efficiency, consumers can save money: increased efficiency entails less energy required and thus a lower bill for the same level of goods and services. But the U.S. lags the developed world in energy efficiency, ranking 13 out of 16 of the world’s largest economies with respect to energy efficiency and energy efficiency policy. Because it is hard to determine optimal levels of efficiency, it is hard to determine the magnitude of the energy efficiency gap. The energy efficiency gap essentially measures the difference between current efficiency levels and optimal efficiency levels.

However, there are still some economists who believe that current evaluations of the magnitude of underinvestment in energy efficiency are too large. They suggest that popular figures such as $1.2 trillion in energy savings from McKinsey’s Unlocking Energy Efficiency in the U.S. Economy report are liable to overestimation. Despite this uncertainty about the magnitude of the energy efficiency gap, advancements in energy efficiency may still increase savings.

As one of the top consumers of energy per capita in the world, the United States certainly has sufficient reason to be concerned with energy efficiency. Economists think, due to imperfect information, people do not invest enough in energy efficiency projects; they either lack knowledge of energy investment opportunities, or information regarding the efficiency of different energy options is too difficult or costly to procure.

For example, when an apartment hunter looks for potential residences, she may not have the means of calculating energy efficiencies. As such, energy efficiency is not an important factor when deciding amongst her options. As a cost-minimizing agent with no means of assessing energy efficiency levels of each home, the apartment hunter will not be willing to pay a higher price for a more energy efficient home. Subsequently, landlords have a smaller incentive to increase energy efficiencies of their property than if apartment seekers had this information. When it is difficult to provide better information to investors and consumers, a specific type of subsidy, a tax credit, may be of use to promote energy efficiency.

In fact, on September 16, 2015, Secretary Moniz unveiled a strategic plan, Accelerate 2030, which lays out certain strategies to advance energy efficiency. One particular measure regarding setting the financial foundation for more investment in energy efficient projects is the use of tax credits. Tax credits give a credit reduction to a taxpayer’s income liability. For example, the New York residential solar tax credit offers a 25% rebate for solar-electric (PV) and solar-thermal systems, with a cap at $5000.

If the cost of a PV system was $1000 in 2015, you can claim a credit of $250 on your 2015 federal income tax return. If the system was $100,000, your credit would be the maximum credit allowed, $5000. Unlike deductions, which reduce your taxable income, tax credits are direct reductions on your taxes. The purpose of tax credits is to incentivize investment in energy efficiency products or processes by lowering risk for investors.

For example, according to the Accelerate 2030 plan, a tax credit aimed at energy efficient home construction quadrupled the number of doubly efficient homes built between 2006 and 2009. There are, however, issues in the way tax credits have been administered that are diminishing their effectiveness. General issues regarding tax credits include:

  1. Target

Different regions have different energy needs, and so a universal, nationwide tax credit may not be so efficacious. For example, solar tax credits are probably more effective in California rather than Washington.

Similarly, there are typically sub-populations for whom tax credits should be targeted. Energy efficiency subsidies are mostly used by consumers who are relatively wealthy, informed, and concerned about energy costs. The purpose of a subsidy is to offer financial incentive to convince a consumer to change their behavior. Yet, research shows that subsidies are being given to those who need the least convincing. Professor Christopher Knittel of the Sloan School of Management highlights an example: an energy subsidy may motivate “a person to purchase a battery-operated Tesla instead of a gasoline-hungry Hummer.” However, in this scenario, the tax credit is only efficient if the consumer would have bought a Hummer in its absence. In addition, a subsidy for a Tesla doesn’t concern low-income populations who do not have the necessary funds to purchase a car of this caliber.

  1. Inconsistency & Expiration

The key to effective tax policy is stability and predictability. Sporadic expiration and renewal of subsidies harms investment: investment falls when profitability is uncertain. For investors, the option to invest is less attractive when there is uncertainty about whether a tax credit will be extended in the upcoming years, especially with projects, like infrastructure development, that have long time horizons. And, unlike the oil and gas industries’ tax credits, which require affirmative action from Congress to remove, renewable energy subsidies require affirmative renewal from Congress. Since 2000, Congress has allowed the Renewable Electricity Production Tax Credit to expire almost every two to three years. Particularly with the volatility of the outcomes of each congressional race, the future extension of such credits is uncertain.

Execution of tax reform is difficult, especially because one cannot market policy implications to policy makers without a comprehensive body of research regarding the current energy efficiency gap. However, even acknowledging the fact that more research is necessary, eliminating known inefficiencies in tax policy is better than allowing them to persist.

Image courtesy Wikimedia Commons. 


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