Toward an optimal U.S. ethanol fuel subsidy

doi:10.1016/j.eneco.2007.02.004

Energy Economics

Volume 30, Issue 5, September 2008, Pages 2073-2090

https://doi.org/10.1016/j.eneco.2007.02.004 Get rights and content

Abstract

Enhanced environmental quality, fuel security, and economic development along with reduced prices of ethanol–gasoline blends are often used as justifications for the U.S. federal excise tax exemption on ethanol fuels. However, the possible effect of increased overall consumption of fuel in response to lower total price, mitigating the environmental and fuel security benefits, are generally not considered. Taking this price response into account, the optimal U.S. ethanol subsidy is derived. Estimated values of the optimal subsidy reveal that the subsidy's environmental and security benefits are questionable. However, positive environmental and security benefits from the ethanol tax-exemption subsidy may be obtained if the subsidy is combined with an increase in the excise tax on gasoline.

Section snippets

Current ethanol tax exemption provisions and benefits

The force behind the recent rapid expansion of the ethanol–fuel market is the current phasing-out of MTBE (methyl–tertiary–butyl ether) as a fuel oxygenate and its replacement with ethanol. The ethanol–fuel market received a further boost from the 2005 Energy Bill which, while eliminating the oxygenate requirement, sets a new goal for expanding domestic fuel supplies with renewable fuels, mainly ethanol and biodiesel. In particular, the renewable fuels standard sets a national minimum usage

Theoretical model

As outlined by Parry and Small (2005) a number of previous studies have investigated the external costs of vehicle transportation in an attempt to develop an optimal gasoline tax. Parry and Small (2005) in their analysis identify a Pigovian and Ramsey tax along with congestion feedback as components of an optimal gasoline tax. Limited if any studies have attempted to model the optimal ethanol fuel subsidy. Using the past studies on deriving the optimal gasoline tax, in particular Parry and

Parameter values

Benchmark values and parameter ranges used for estimating the optimal ethanol subsidy (21) are summarized in Table 1. The proportion of ethanol fuel used was determined from U.S. FHWA (2003) using 2003 estimates of 2.75 billion total gallons of ethanol used, and dividing it by the total fuel consumed, 134.1 billion gallons.²

Results

Applying the benchmark parameter values from Table 1 directly to (21) yields an estimated optimal ethanol subsidy s^⁎ = $0.22 per gallon of ethanol (Table 2), which is less than the current highway tax exemption of $0.51 per gallon. As indicated from Table 2, the negative marginal external benefits accounts for a large portion of this optimal/actual discrepancy. The ethanol fuel subsidy does yield positive benefits from increased share of renewable fuel in the form of reduction in greenhouse gases

Sensitivity analysis

The wide range of parameter values in Table 1 suggests the benchmark optimal subsidy in Table 2 has an associated rather large variance. In order to investigate the sensitivity of the optimal ethanol subsidy, s^⁎, to ranges of the parameter values, both individual parameter variation and Monte Carlo analysis were implemented. Fig. 1, Fig. 2 illustrate the response of the optimal ethanol subsidy to a range of elasticities and external benefits and costs. As indicated from Fig. 1, the optimal

Implications

It is very important in public policy analysis to consider the market effects of such policies. The government providing market incentives for the establishment of a renewable fuels industry is a case in point. The objective of establishing a renewable fuel industry within the U.S. is to increase social welfare by improving air quality, reducing greenhouse gas emission, increasing energy security, and contributing to economic development. The U.S. 2005 Energy Bill takes a step in this direction

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Toward an optimal U.S. ethanol fuel subsidy

Abstract

Section snippets

Current ethanol tax exemption provisions and benefits

Theoretical model

Parameter values

Results

Sensitivity analysis

Implications

Increasing America's Fuel Economy

Fuel Economy Study: Comparing Performance and Cost of Various Ethanol Blends and Standard Unleaded Gasoline

Spring Break in the U.S. Oil Industry: Price Spikes, Excess Profits, and Excuses

The Economic Impact of the Demand for Ethanol

Renewable Fuels Association Reports and Studies

Some long-run effects of growing of growing markets and renewable fuel standards on additives markets and the U.S. ethanol industry

Journal of Policy Modeling

Welfare maximization, pricing, and allocation with a product performance or environmental quality standard: illustration for the gasoline and additives market

International Journal of Production Economics

Impact of pay-at-the-pump on safety through enhanced vehicle fuel efficiency

Energy Journal

Ford, GM make big push to promote ‘flex-fuel’ vehicles

Wall Street Journal

Demand for Ethanol Aggravates Pain at the Pump

Business News

Will Increasing the Use of Ethanol in Gasoline result in Lower Prices and Cleaner Air?