The Welfare Economics of an Excise-Tax Exemption for Biofuels and the Interaction Effects with Farm Subsidies

Abstract

A general theory is developed to analyze the efficiency and income distribution effects of a biofuel consumer tax exemption and the interaction effects with a price contingent farm subsidy. Using U.S. policy as an example, ethanol prices rise above the gasoline price by the amount of the tax credit. Corn farmers therefore gain directly while gasoline consumers only gain from any reduction in world oil prices due to the extra ethanol production. Domestic oil producers lose. Because increased ethanol production improves the terms of trade in both the export of corn and the import of oil, we determine the optimal tax credit and the conditions affecting it. Historically, the intercept of the ethanol supply curve is above the gasoline price. Hence, part of the tax credit is redundant and represents `rectangular' deadweight costs that dwarf standard triangular deadweight cost measures of traditional farm subsidies. We show under what conditions corn subsidies can eliminate, create, have no effect or have an ambiguous effect on rectangular deadweight costs. There are situations where corn subsidies have been the sole cause of ethanol production (and therefore of rectangular deadweight costs), even with the tax credit. Corn producers do not benefit from a tax credit when the subsidy program is in effect. Proponents of ethanol argue that the tax credit reduces tax costs of farm subsidies. But this ignores rectangular deadweight costs. To assess this, we calibrate a stylized empirical model of the U.S. corn market and determine that total rectangular deadweight costs averaged $1,520 mil. from 2001-2006. Over 25 percent of this is due to the farm subsidy program which also increased the tax costs of the tax credit by 50 percent. Furthermore, the tax credit itself doubles the deadweight costs of the corn production subsidies. Ethanol policies can therefore not be justified on the grounds of mitigating the effects of farm subsidy programs.