oversight

Tax Policy: Effects of the Alcohol Fuels Tax Incentives

Published by the Government Accountability Office on 1997-03-06.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                United States General Accounting Office

GAO             Report to the Chairman, Committee on
                Ways and Means, House of
                Representatives


March 1997
                TAX POLICY
                Effects of the Alcohol
                Fuels Tax Incentives




GAO/GGD-97-41
                 United States
GAO              General Accounting Office
                 Washington, D.C. 20548

                 General Government Division

                 B-271977

                 March 6, 1997

                 The Honorable Bill Archer
                 Chairman, Committee on Ways and Means
                 House of Representatives

                 Dear Mr. Chairman:

                 In the late 1970s and early 1980s, Congress enacted tax incentives for
                 biomass-derived alcohol fuels.1 Proponents maintained that the incentives
                 would reduce U.S. dependence on petroleum imports and provide an
                 additional market for U.S. agricultural products. Subsequent
                 environmental legislation has increased the demand for alcohol fuels.
                 These alcohol fuels currently are blended with gasoline to increase its
                 oxygen content in certain areas of the country that have mandatory
                 minimum oxygen requirements for transportation fuel.2

                 In recent months, Congress has debated the need for continuing to provide
                 tax incentives for alcohol fuels. In this context, you asked the following
                 questions relating to tax incentives for alcohol fuels, which we address in
                 this report:

             •   Whom do the incentives benefit and disadvantage economically?
             •   What environmental benefits, if any, have the incentives produced?
             •   Have the incentives increased the nation’s energy independence?
             •   To what extent has the partial exemption from the excise tax for alcohol
                 fuels reduced the flow of revenue into the Highway Trust Fund?


                 In the 1970s and 1980s, the federal government adopted numerous policies
Background       to encourage the use of alternatives to imported fossil fuels.3 Among these
                 policies were tax incentives that were specifically targeted at the use of
                 alcohol fuels derived from biomass materials. Supporters claimed that the
                 tax incentives would not only reduce U.S. reliance on imported petroleum
                 but would also help support farm incomes by finding another market for
                 the agricultural products from which alcohol can be produced, such as
                 corn. In the late 1980s, Congress’ attention turned to the possible benefits
                 of using alcohol fuels as additives to fossil-based fuels to reduce urban air

                 1
                  Biomass-derived alcohol fuels are chemical compounds made from nonfossil material of biological
                 origin and constitute a renewable energy source.
                 2
                  Ethanol, which is an alcohol fuel, has been used traditionally as a gasoline extender and octane
                 enhancer mainly in those areas of the Midwest where it is produced.
                 3
                  See appendix I for a chronology of events and federal legislation relating to alcohol fuel use.



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                             pollution. The Clean Air Act Amendments of 1990 required that
                             transportation fuel used in some urban areas have a minimum oxygen
                             content to reduce these areas’ levels of carbon monoxide and ground-level
                             ozone. In the early 1990s, congressional attention turned to the possible
                             benefits of using renewable energy sources, including alcohol fuels, to
                             reduce emissions of greenhouse gases that may contribute to global
                             warming.4


Tax Incentives for Alcohol    The federal tax incentives that are specifically targeted for motor fuels
Fuels5                       containing biomass alcohol are (1) a partial exemption from the federal
                             motor fuel excise taxes that are earmarked for the Highway Trust Fund6
                             and (2) a set of three credits against the income tax. The partial excise tax
                             exemption has been much more important than the income tax credits in
                             terms of the amount of tax benefits claimed.

                             The size of the partial exemption depends on how much and what type of
                             alcohol is contained in each gallon of fuel. Virtually all of the excise tax
                             exemptions for alcohol fuels claimed in 1995 were for fuel mixtures of
                             gasoline and ethanol. The partial exemption lowers the after-tax cost of
                             the gasoline that fuel blenders mix with ethanol. Each of the three income
                             tax credits is directed at a distinct line of business. The “alcohol mixtures
                             credit” allows blenders to reduce their income taxes by 54 cents for each
                             gallon of biomass ethanol that they use in their blended fuel. The “alcohol
                             credit” allows businesses to reduce their income taxes by 54 cents for each
                             gallon of “qualified” biomass ethanol fuel (which must contain at least
                             85-percent alcohol) that they sell at the retail level or use themselves.7
                             Finally, the “small ethanol producers credit” allows businesses that
                             produce less than 15 million gallons of ethanol for fuel each year to reduce
                             their income taxes by 10 cents for each gallon produced. Taxpayers who

                             4
                              The preponderant greenhouse gas is water vapor. Other greenhouse gases are carbon dioxide,
                             methane, and nitrous oxide. Greenhouse gases are emitted when a fossil fuel, such as gasoline, natural
                             gas, or coal, or a renewable fuel is combusted. There are also substantial natural sources of
                             greenhouse gases in addition to human-made sources. Greenhouse gases collect in the earth’s
                             atmosphere, trapping heat and, some believe, raising the earth’s surface temperature. (See Energy
                             Information Administration, Emissions of Greenhouse Gases in the United States 1995,
                             DOE/EIA-0573(95), October 1996, for more information.)

                             5
                              This section provides only a summary description of the tax incentives. Details and estimates are
                             provided in appendix II.
                             6
                              The Highway Trust Fund was established in 1956 as an accounting mechanism to finance the
                             federal-aid highway program.
                             7
                              “Qualified” biomass ethanol fuel is often referred to as “neat” alcohol fuel. Blenders or producers of
                             neat alcohol fuel that use biomass alcohols other than ethanol can earn income tax credits or excise
                             tax exemptions equal to 60 cents for each gallon of alcohol used.



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                           claim the alcohol mixtures credit or the alcohol credit must reduce their
                           credits by the amount of the partial excise tax exemption that is
                           associated with the same fuel.


Current Alcohol Fuel Use   According to U.S. Department of Energy (DOE) data, almost all of the
                           alcohol that was used as transportation fuel in the United States in 1995
                           was either ethanol or alcohol that was used to make methyl tertiary butyl
                           ether (MTBE), which is a fuel additive derived from methanol. In 1995, MTBE
                           accounted for about 3 percent of the total transportation fuels consumed
                           and ethanol accounted for less than 1 percent.8 Alcohol fuels usually are
                           blended with gasoline, where they serve as oxygenates, octane enhancers,
                           and/or fuel extenders.9

                           Currently, 95 percent of the U.S. production of ethanol fuel is derived from
                           corn. In contrast, the methanol used to produce MTBE is currently derived
                           from natural gas because that is how it can be produced most
                           cost-effectively. Despite the fact that nonbiomass MTBE does not qualify for
                           the tax incentives, according to DOE, it is more widely used than ethanol.
                           This is, in part, because MTBE’s lower volatility, compared with ethanol,
                           makes it a more acceptable ingredient to blenders of reformulated
                           gasoline (RFG)10 in summer months. MTBE’s lower volatility permits the
                           gasoline fraction of RFG to have a higher volatility than otherwise would be
                           permitted in achieving the RFG standard. In addition, ethanol has
                           transportation problems that MTBE does not have (see app. IV), and MTBE
                           may be a cheaper oxygenate than ethanol.


                           The value of the ethanol tax incentives is shared among different groups in
Results in Brief           the economy, including alcohol fuel blenders, ethanol producers, and corn
                           farmers. The tax incentives effectively lower the blenders’ after-tax cost of
                           using ethanol when they mix ethanol with gasoline. However, the
                           blenders’ increased demand for ethanol raises the market price of ethanol
                           above what it would have been without the incentives. For this reason, the
                           after-tax cost to the blenders is not lowered by the full value of the

                           8
                            Table III.1 in appendix III shows the composition of U.S. transportation fuel consumption from 1992
                           to 1996. Table III.2 shows the percentage share of each fuel, by air quality area.
                           9
                            In addition, a negligible amount of alcohol fuel is used as a fuel in alternative-fuel vehicles.
                           10
                             RFG, which is a subset of oxygenated fuel, is gasoline whose composition has been changed (from
                           that of conventional gasoline sold in 1990) to (1) include combustion-enhancing oxygenates and
                           (2) reduce emissions of the ozone precursors, volatile organic compounds and nitrogen oxides, and
                           toxic components. (Toxic components of fuel include benzene, butadiene, and other harmful
                           substances.)



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incentives. Other groups in the economy, such as ethanol producers and
corn farmers, share in the value of the incentives because the blenders’
increased demand for ethanol increases the prices and sales of the
products of these groups.

According to the analysts we contacted or whose work we read, the tax
incentives allow ethanol to be priced to compete with substitute fuels,
such as gasoline and MTBE; thus, without the incentives, ethanol fuel
production would largely discontinue. This information implies that
ethanol producers benefit from the tax incentives because the blenders’
demand for ethanol raises its price at least high enough to cover
production costs. However, we did not estimate how much of the value of
the incentives is shifted to ethanol producers. According to economic
theory, the extent to which the benefits of the tax incentives are shifted
depends on (1) the responsiveness of ethanol supply and demand to price
changes and (2) whether producers control prices and, if so, how much
control they have over prices that they charge. We could not obtain
sufficient information on these factors to quantify the shift in value.

The tax incentives benefit farmers who grow corn and may benefit farmers
who grow crops such as soybeans by increasing the prices that they
receive for these products. According to analysts at the U.S. Department of
Agriculture (USDA) and Congressional Budget Office (CBO), corn farmers
benefit because the tax incentives create a demand for ethanol by the
blenders, which in turn creates a demand for corn by the ethanol
producers. Corn prices and incomes are higher as a result, providing
incentives to farmers to plant corn on idle land and switch other crop
acreage (mainly soybean acreage) into corn production. Soybean farmers
may also benefit because lower soybean production is likely to raise the
price of soybeans. However, by raising the prices of corn and soybeans,
the tax incentives may cause farmers who raise livestock to pay higher
prices for feed. We have not estimated the size of these effects on prices
and income or the net effect on aggregate farm income because recent
changes in government farm policy, which allow more flexibility in
farmers’ planting decisions, have not been in place long enough to provide
information on how farmers respond to price changes under the new
policy. The recent changes in government farm policy may cause farmers’
responses to price changes to differ from historical experience because
farmers’ planting decisions will now be based more on market forces than
on government programs.




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The tax incentives may affect producers and consumers of fuels that
substitute for ethanol and the consumers of some food products. The
producers of some fuels, such as gasoline and MTBE, may be adversely
affected because increased competition from ethanol may cause the
producers of these fuels to lower their prices. However, the available
evidence indicates that the decrease in the price of a gallon of fuel is likely
to be small. Furthermore, the price decrease that adversely affects
producers will benefit the consumers of these fuels. Although the
producers receive slightly less revenue from each gallon they sell because
of the price decrease, consumers pay slightly less for each gallon that they
purchase. Similarly, the price increases that benefit farmers may adversely
affect the consumers of some food products. As previously noted, the tax
incentives may benefit farmers by causing the prices of some crops to be
higher, which could mean that consumers would have to pay slightly
higher prices for some food products. Thus, if the prices of some food
products are slightly higher due to the incentives, the benefit to consumers
from slightly lower gasoline prices might be partly offset.

Available evidence, including the views of analysts we interviewed,
indicates that the ethanol tax incentives have had little effect on the
environment. The substitution of other fuels for ethanol, if the tax
incentives were removed, would likely have little effect on air quality given
current technologies for ethanol production. In areas where gasoline
containing oxygenates is mandated to help meet existing air quality
standards, the likely substitute for ethanol would be MTBE. Both ethanol
and MTBE meet existing standards for gasoline containing oxygenates, and
gasoline oxygenated with MTBE already has more than a 50-percent share
of the market for gasoline containing oxygenates in areas where its use is
required.11

In areas that already meet existing air quality standards, ethanol has been
used mainly as a gasoline extender and octane enhancer. According to the
analysts we interviewed, the elimination of ethanol use in these areas
would be expected to result in little reduction in overall air quality.
Because ethanol is difficult to transport, it traditionally has been used
mainly where it is produced, in midwestern corn-farming states. In these
areas, which generally meet existing air quality standards, the likely
substitute for ethanol-blended gasoline would be conventional

11
  Ethanol also is used as an octane enhancer in gasoline. Refiners have other alternatives than using an
oxygenate to increase the octane level of gasoline. However, in the absence of ethanol, at the current
time, the oxygenate MTBE would likely supply almost the entire market for octane enhancers with no
likely effect on air quality, according to officials at DOE and the Environmental Protection Agency
with whom we spoke.



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(unblended) gasoline. According to the best available data, if gasoline
entirely replaced ethanol, gasoline use would likely increase by no more
than 4 percent in the most ethanol-intensive state. According to the
Environmental Protection Agency (EPA), even if ethanol use were
eliminated, these areas would most likely continue to meet national
ambient air quality standards.12 However, according to analysts we
interviewed, if ethanol use were eliminated there would likely be small
changes in emissions in these areas that would have both positive and
negative effects on air quality. A negative effect would likely be slightly
increased carbon monoxide emissions. A positive effect would likely be
slightly decreased emissions of ozone precursors.13

The effect on global environmental quality (i.e., global warming) through
changes in greenhouse gas emissions that would occur if ethanol fuel were
not subsidized is likely to be minimal. The net effect on the quantity and
quality of greenhouse gas emissions from the ethanol fuel cycle versus
from the conventional gasoline fuel cycle is not precisely known.
However, according to the EPA analyst we interviewed, the global-warming
effects of using ethanol are likely to be no better than, and could be worse
than, those of using conventional gasoline. Furthermore, even if current
ethanol use were to contribute to lowered greenhouse gas emissions,
ethanol is such a small part of total U.S. fuel use that global environmental
quality should not be significantly affected if ethanol use were
discontinued.

Although available evidence suggests that the tax incentives for alcohol
fuels increase ethanol fuel use, it also indicates that these incentives do
not significantly reduce petroleum imports. Therefore, the tax incentives
do not significantly contribute to U.S. energy independence. Today’s
petroleum imports account for about 20 percent of the total U.S. energy
consumption and about 50 percent of the U.S. petroleum consumption.
This consumption is about the same as the petroleum imports accounted
for in 1978, before ethanol incentives were offered (see table III.3 in app.
III). By comparison, ethanol currently accounts for less than 1 percent of
U.S. motor vehicle fuel consumption.

In addition, ethanol tax incentives have not significantly enhanced U.S.
energy security. This lack of increased energy security is because the tax


12
 EPA has developed the national ambient air quality standards based on all of the known health
effects from air pollutants.
13
 The most commonly used ethanol-gasoline blends release more ozone precursor compounds than
does conventional gasoline. These precursors combine to produce ozone in the presence of sunlight.
Ozone concentrations most often exceed the ozone standard during summer months.


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                     incentives have not created enough usage to reduce the likelihood of oil
                     price shocks and their consequences, which are increased U.S. fuel prices
                     and reduced economic output and employment. As we recently reported,
                     oil consumption, not oil imports, creates vulnerability to oil price shocks.14
                      If technological breakthroughs were to occur and the resulting increased
                     ethanol production lowered oil’s share of total U.S. fuel consumption
                     significantly, then energy security could be improved. The impact of an
                     increase in the worldwide price of oil on U.S. fuel prices depends chiefly
                     (1) on the share of oil in total U.S. fuel consumption and (2) on whether
                     fuel production from alternative sources could be expanded rapidly in the
                     event of an oil price shock. However, ethanol currently constitutes less
                     than 1 percent of the total U.S. fuel consumption and, according to DOE,
                     cannot be rapidly expanded with existing technologies.

                     We estimate that the partial exemption for alcohol fuels reduced motor
                     fuels excise tax revenues by about $7.1 billion from fiscal years 1979 to
                     1995.15 We estimate that about 108 billion gallons of alcohol fuel mixtures
                     were sold over that period and that about $7.5 billion of motor fuels excise
                     tax revenues were collected on the sales of this fuel. Without the partial
                     exemption, the amount of tax paid on an equivalent gallonage of gasoline
                     would have been about $14.6 billion. Virtually all of the revenue forgone
                     due to the exemption is money that otherwise would have been earmarked
                     for the Highway Trust Fund. In fiscal year 1995, the gross federal highway
                     user tax receipts for the Highway Trust Fund were $23.1 billion. We
                     estimate that without the partial exemption for alcohol fuels, an additional
                     $617 million of revenue would have been allocated to the Highway Trust
                     Fund for fiscal year 1995.


                     To meet our first objective of determining whom the ethanol tax
Objectives, Scope,   incentives benefit and disadvantage economically, we relied on economic
and Methodology      theory and the empirical literature to describe the factors that determine
                     how the reduced demand for ethanol would likely affect (1) the prices of
                     various goods and (2) the incomes and profits derived from the production




                     14
                      Energy Security: Evaluating U.S. Vulnerability to Oil Supply Disruptions and Options for Mitigating
                     Their Effects (GAO/RCED-97-6, Dec. 12, 1996).
                     15
                       These estimates are based on excise tax data compiled by the Internal Revenue Service and
                     published data on ethanol fuel production. Unless otherwise noted, all revenue figures presented in
                     this report are stated in constant 1996 dollars. Appendix II contains a discussion of our estimating
                     methodology in which we note some reasons why this estimate may slightly overstate the revenue
                     loss.



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of those goods. We used our prior work,16 studies of the ethanol industry,
and estimates of consumer demand for ethanol to provide, where possible,
an indication of the direction and broad magnitude of changes in prices,
incomes, and profits that would likely occur if the incentives were
removed. We did not try to determine who may have paid for the tax
incentives in the form of higher taxes, less federal spending on other
programs, or increased government borrowing. Nor did we look at any
economywide efficiency losses resulting from the resource reallocations
that have been made in response to the tax incentives.

To meet our second objective of determining what, if any, environmental
benefits the incentives have produced, we relied on the empirical
literature on fuel characteristics and emissions and air quality and also on
interviews with energy and air quality analysts. Our major sources of
information were DOE and EPA. We relied on fuel usage data and on expert
opinion from DOE, EPA, and the U.S. Department of Transportation to
determine what percentage of total fuel consumption ethanol represents
and what fuels would likely have been used in place of ethanol if tax
incentives had not existed. We used these sources to describe the
differences in vehicle emissions with and without ethanol fuels and the
likely effects of these differences on environmental quality.

To meet our third objective of determining whether the incentives have
increased the nation’s energy independence, we examined DOE data on
U.S. energy consumption and petroleum imports to determine if the
incentives had reduced U.S. reliance on imported petroleum. Concern over
this reliance had been one of the reasons Congress originally adopted the
incentives. We also relied on the energy economics literature, including
work by DOE and Resources for the Future, and on data on fuel supply and
fuel prices, mainly by DOE, to determine if U.S. vulnerability to oil price
shocks were likely to be different if tax incentives for ethanol use had not
existed.

To meet our fourth objective of determining to what extent the partial
exemption from the excise tax for alcohol fuel reduced the flow of
revenue into the Highway Trust Fund, we used Internal Revenue Service
(IRS) excise tax data and published data on alcohol fuel production to
estimate the amounts of excise tax exemptions that have been claimed for
alcohol fuels for fiscal years 1979 to 1995. We also compiled estimates
made by the Department of the Treasury and the Joint Committee on

16
 GAO/RCED-97-6; Motor Fuels: Issues Related to Reformulated Gasoline, Oxygenated Fuels, and
Biofuels (GAO/RCED-96-121, June 27, 1996); and Ethanol Tax Exemption (GAO/RCED-95-273R, Sept.
14, 1995).



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                       Taxation of the projected future revenue costs of both the partial excise
                       tax exemptions for alcohol fuels and the alcohol fuels tax credits. We
                       restated all of these estimates in terms of constant 1996 dollars. We spoke
                       with analysts from Treasury and CBO to ensure that we correctly
                       characterized the estimates presented in this report.

                       We conducted our review from March 1996 through November 1996 in
                       accordance with generally accepted government auditing standards. We
                       obtained written comments on a draft of this report from IRS and EPA, oral
                       comments from Treasury and DOE, and both written and oral comments
                       from USDA. Treasury’s oral comments were provided by the Director of the
                       Office of Tax Analysis and by economists from that office and from a tax
                       legislative counsel at a meeting on November 22, 1996. USDA’s oral
                       comments were provided by the Deputy Director, Office of Energy and
                       New Uses, Economic Research Service, and by policy analysts from that
                       office and the Office of the Chief Economist at a meeting on November 21,
                       1996. DOE’s oral comments were provided by policy analysts from the
                       Offices of Energy Efficiency, Alternative Fuels, and Oil Policy; Fuels
                       Development; and Technology Utilization on November 20, 1996. The
                       written and oral comments are summarized and discussed at the end of
                       this report.


                       The groups that are legally required to pay a tax do not always enjoy the
The Ethanol Tax        entire benefit of a tax incentive. The alcohol fuels tax incentives affect
Incentives May         prices and incomes of other groups in the economy because they lower
Benefit or             the after-tax cost of using ethanol, thereby increasing the demand for
                       ethanol and causing changes in the price and production level of ethanol,
Disadvantage Certain   as well as changes in the price and production level of other products.
Groups in the          Some groups that do not claim the tax incentives would benefit if they
                       paid lower prices or received higher incomes because of the tax
Economy                incentives, while other groups would be adversely affected if they paid
                       higher prices and received lower incomes. The positive and negative
                       impacts of the tax incentives are shifted among groups in the economy
                       through these price and income changes.

                       Although the tax incentives lower the after-tax cost of gasoline to ethanol
                       blenders, the blenders do not enjoy the full benefit of the tax incentives.
                       The analysts that we contacted, or whose work we read, agreed that the
                       blenders’ demand for ethanol raises the price of ethanol above what it
                       would have been without the incentives, and that this price increase
                       offsets part of the benefit that the blenders receive from the tax reduction.



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                            As explained in the following sections of this report, the available data
                            indicate that the incentives are shifted, in part, back to the ethanol
                            producers as higher ethanol prices and back to farmers as higher corn
                            prices. The incentives may also be shifted forward to consumers because
                            an increase in the supply of ethanol-blended gasoline is likely to cause a
                            small decrease in the price that consumers paid for motor fuels.


Ethanol Tax Incentives      Without the tax incentives, ethanol-blended gasoline currently cannot be
Benefit Ethanol Producers   priced to compete with the substitute fuels, and ethanol fuel production
                            would largely discontinue. The ethanol producers benefit because the
                            incentives create a demand for ethanol by the blenders that raises the
                            price of ethanol at least high enough to cover production costs. This
                            conclusion is based on recent estimates of ethanol production costs by
                            USDA and on the opinions of analysts on the ethanol industry. This
                            conclusion is also based on the results from simulation models of DOE’s
                            Energy Information Administration (EIA) that estimate the effect of
                            removing the ethanol tax incentives.17

                            The incentives permit ethanol blends to be priced competitively with
                            substitute fuels, such as gasoline and MTBE, even though the cost of
                            producing ethanol with the current technology and corn prices exceeds
                            the prices of these fuels. Because the incentives generally are equivalent to
                            54 cents per gallon of ethanol, the effective, or after-tax, price to the
                            ethanol blenders is 54 cents per gallon less than the price charged by the
                            ethanol producers. The ethanol producers can charge a price high enough
                            to cover their costs, while blenders buy ethanol at an effective price that is
                            competitive with substitute fuels.

                            If the ethanol tax incentives were eliminated, the effective cost of ethanol
                            to the blenders would increase because they would not get a tax benefit
                            from using the fuel. In this case, the blenders would be expected to
                            purchase less expensive substitute products. As the blenders demand less
                            ethanol, the price that ethanol producers can charge would decrease. If
                            the price declined below production costs, some ethanol producers would
                            likely stop producing ethanol. The large-scale ethanol producers with the
                            lowest production costs might continue to produce ethanol over the short
                            term, but, over the long term, the ethanol-fuel industry would largely
                            discontinue. Some ethanol production for export might continue for a
                            while without the federal tax incentives.


                            17
                              See appendix IV for further discussion of the effect of the incentives on the ethanol industry.



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                             We were unable to estimate the size of the benefit that ethanol producers
                             receive. We could not make this estimate because we did not have
                             information (1) on the responsiveness of ethanol supply and demand to
                             price changes or (2) on whether ethanol producers control their prices,
                             and, if so, how much control they have over their prices. The ethanol
                             industry is dominated by a few large firms. Sixty-five percent of capacity is
                             owned by the three largest firms, and the largest firm, Archer Daniels
                             Midland, owns 50 percent of capacity. We did not have information on
                             how prices are determined in an industry with this level of concentration.
                             Consequently, we could not estimate how much of the value of the
                             incentives is shifted from the blenders to the producers. We also did not
                             have information on economies of scale or technological, managerial, or
                             marketing advantages that individual ethanol producers may possess.
                             Without any of this information, we did not know the extent, if any, to
                             which the prices these producers were able to charge exceeded their
                             production costs.


Ethanol Tax Incentives Are   The tax incentives benefit farmers who grow corn and likely benefit
Likely to Benefit Farmers    farmers who produce other crops, such as soybeans, by increasing the
Who Grow Corn and            prices that they receive for these products. Conversely, the tax benefits
                             may cause farmers who raise livestock to pay higher feed prices. The new
Soybeans                     farm policy, established in the Federal Agricultural Improvement and
                             Reform (FAIR) Act of 1996, has not been in effect long enough to provide
                             the information needed to make reliable quantitative estimates of the size
                             of the tax incentives’ effect on farm prices and income.

                             Corn farmers benefit from the tax incentives, according to analysts at USDA
                             and CBO, because the tax incentives create a demand for corn by ethanol
                             producers that raises the price of corn and the income derived from corn
                             sales. In 1995, the industry used approximately 500 million bushels of corn
                             to produce 1.3 billion gallons of ethanol. This usage represented about
                             6 percent of the total corn crop. Soybean farmers also likely benefit
                             because the higher corn prices due to the incentives make growing corn
                             more attractive than it would have been without the incentives, thereby
                             reducing the acreage planted with soybeans, which is likely to raise
                             soybean prices. However, livestock farmers may be adversely affected by
                             the incentives because the higher corn and soybean prices may increase
                             the cost of feeding their livestock.

                             In 1995, before the significant changes in farm policy introduced by the
                             FAIR Act, we estimated, using various assumptions about ethanol use and




                             Page 11                                               GAO/GGD-97-41 Tax Policy
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how the old farm policy would be implemented, that corn prices would
decline by 6 to 9 percent and soybean prices by 3 to 5 percent if the
incentives were removed.18 We also estimated that net farm income, which
combines the effect on crop and livestock farmers, would decline by 1 to
2 percent under the old policy.19 The size of these price declines and the
effect on net income is likely to be different under the FAIR Act. We have
not estimated the effect of the tax incentives on farm income and prices
because the FAIR Act has not been in place long enough to provide the
information on how farmers respond to prices under the new policy. This
information would be needed to make reliable estimates.

The FAIR Act affects (1) farm incomes by removing the link between
income support payments and farm prices and (2) farm prices by giving
farmers greater flexibility in making planting decisions. Before the FAIR
Act, farmers received payments that depended on farm prices. That is, as
prices dropped below a legislated level, farm payments increased. In
addition, farmers were required to plant corn if they wanted to participate
fully in the federal corn program. Under the FAIR Act, farmers receive
annual, fixed but declining, payments regardless of farm prices. The FAIR
Act gives farmers greater flexibility to make planting decisions because
the act eliminates the requirement that farmers must plant corn to qualify
for full payments under the federal corn program. The remaining farm
program linked to prices under the FAIR Act is a program of government
loans that may moderate the decline in farm incomes if market price
declines are severe.

If the tax incentives were removed under the FAIR Act, corn prices would
fall. However, the effect of removing the tax incentives on the size of the
price decline may differ from the effect under the old farm policy. The
increased planting flexibility under the FAIR Act makes it difficult to
predict the size of the price decline. In addition, under the FAIR Act, farm
support payments cannot increase in response to price declines to mitigate
the effect on farm incomes. If the price falls far enough, farmers may
offset some of the effect of the price decline through government loans.
However, USDA believes that the price of corn is unlikely to fall far enough
for the loans to be used to mitigate the effect of the price decline on farm
incomes. USDA projects no outlays under the loan program in its current
long-term budget projections.


18
 GAO/RCED-95-273R. We noted in this report that our assumptions about how farm policy would be
implemented did not include the full range of policy alternatives that were available at that time. Under
some of these alternatives, the decline in corn and soybean prices may have been smaller.
19
 See appendix IV for a description of how prices and incomes were estimated under the old farm
policy.


Page 12                                                                   GAO/GGD-97-41 Tax Policy
                          B-271977




Ethanol Tax Incentives    The tax incentives may benefit consumers of substitute fuels, such as
May Benefit Consumers     gasoline and MTBE, and disadvantage producers of these fuels because the
and Disadvantage          incentives increase the production of ethanol, which may cause a small
                          decrease in the price of a gallon of the substitute fuels. This benefit to
Producers of Substitute   consumers from lower fuel costs may be partially offset by small increases
Fuels                     in the prices of some food products due to the incentives.

                          If there were no tax incentives for ethanol, the fuel would no longer be
                          used and other fuels would be used as substitutes. According to analysts at
                          DOE, the oxygenate MTBE is likely to serve as a substitute for ethanol that is
                          used as an oxygenate—i.e., mixed with gasoline to help meet air quality
                          standards. According to these analysts, MTBE also may substitute for
                          ethanol used as an octane enhancer in gasoline.20 For ethanol that is used
                          as a gasoline extender, the analysts said that more gasoline and less
                          ethanol are likely to be used21

                          The effect of the tax incentives on the price of a gallon of MTBE is likely to
                          be small. We have not estimated this effect, but the available evidence
                          suggests that, if the incentives were removed, the increased demand for
                          MTBE would cause only a slight increase in price. EIA estimates that, over
                          the long term, removing the tax incentives would increase the difference
                          in price between RFG, which would be made only with MTBE, and
                          conventional gasoline by about 1 cent per gallon.

                          The effect of the tax incentives on the price of a gallon of gasoline also is
                          likely to be small. Because most consumers consider ethanol blends close
                          substitutes for gasoline, removing tax incentives would increase demand
                          for gasoline by causing consumers to switch from ethanol blends to
                          gasoline. Since ethanol currently makes up less than 1 percent of the total
                          U.S. motor fuel consumption, removing the ethanol tax incentives is
                          unlikely to have a large impact on prices. In 1988, the American Petroleum
                          Institute estimated that the tax incentives for ethanol reduced the price of
                          conventional gasoline by 0.27 percent.

                          The benefit to consumers from lower gasoline prices could be offset by
                          any higher food prices due to the incentives. As previously discussed, the
                          tax incentives may cause the prices of certain crops to be higher, which

                          20
                            However, refiners have alternatives other than the addition of an oxygenate to increase the octane
                          level of gasoline. The route chosen by each refiner will depend on the most cost-effective option that
                          fits with their refinery’s specific configuration, product slate, environmental requirements, and
                          numerous other variables.
                          21
                           Table III.3 in appendix III shows the amounts of gasoline, MTBE, and ethanol that are consumed
                          within and outside of air quality nonattainment areas.



                          Page 13                                                                   GAO/GGD-97-41 Tax Policy
                         B-271977




                         could lead to slightly higher prices to consumers for some food products.
                         However, the effect on food prices is likely to be small. For example, the
                         increased price that farmers receive for their corn may represent a much
                         smaller price increase for consumers because, in many cases, the corn is
                         only a part of the product purchased by the consumer and the farmer’s
                         price is only a part of the product’s retail cost to the consumer.
                         Furthermore, the effect of the increased corn price on the consumer’s total
                         food costs is likely to be small because spending on corn and products
                         derived from corn represents only a part of the consumer’s food budget.


                         The tax incentives for biomass alcohol fuels are likely to have had little
Tax Incentives for       effect on the environment. If there were no tax incentives for these fuels,
Ethanol Fuel Are         the price of ethanol would be higher compared with substitute fuels.
Likely to Have Had       Analysts we contacted or whose work we read believe little, if any, ethanol
                         fuel would likely be used in the United States without these incentives. As
Little Effect on         previously mentioned, the fuels that would likely replace ethanol differ
Environmental            according to which ethanol use one is considering. Replacing ethanol with
                         other fuels would result in differences in the emissions from fuel
Quality                  production, combustion, and evaporation. However, on the basis of our
                         analysis of the data as well as on discussions with analysts at DOE and EPA,
                         it seems that, with current technologies, there would likely be only slight
                         changes in emissions. Consequently, little change in air quality or global
                         environmental quality would be expected.

                         The net emissions changes from replacing ethanol with other fuels are
                         likely to be small for several reasons provided us by environmental and
                         energy analysts. These reasons are that (1) ethanol represents only a small
                         portion of the total fuel used; (2) the production of ethanol creates
                         emissions that are not much less polluting than those created by the
                         production of other oxygenates; (3) likely ethanol substitutes such as MTBE
                         are as clean-burning as ethanol; and (4) in certain areas of the United
                         States at certain times of the year, ethanol has greater emissions than
                         conventional gasoline because of its higher volatility.


No Effect Likely Where   Because tax incentives are only likely to cause substitution among equally
Gasoline Containing      clean fuels in areas where the use of gasoline containing oxygenates is
Oxygenates Is Required   mandated, it is unlikely that eliminating the tax incentives would affect air
                         quality in these locations. In areas that do not meet existing air quality
                         standards for the pollutants associated with transportation fuels, the use
                         of gasoline containing oxygenates is required during part or all of the year.



                         Page 14                                                GAO/GGD-97-41 Tax Policy
                             B-271977




                             Because the use of clean-burning fuel is mandated in these areas, without
                             the ethanol incentives, the next cheapest clean-burning fuel, most likely
                             MTBE, would have been used instead of ethanol. In 1995, in areas where the
                             use of gasoline containing oxygenates was required, gasoline oxygenated
                             with MTBE, which does not receive tax incentives, had more than a
                             50-percent share of the market for gasoline containing oxygenates.
                             Because they have similar effects on air quality—they both meet existing
                             standards for clean fuels—little change in the composition of emissions
                             and no change in overall air quality in these locations would be expected
                             from a substitution between ethanol and MTBE.


Little Effect Likely Where   If eliminating the tax incentives for ethanol fuel caused its replacement by
Gasoline Containing          gasoline in the areas where the use of gasoline containing oxygenates is
Oxygenates Is Not            not required, there likely would be little effect on air quality. According to
                             the best available estimate, if ethanol were entirely replaced with gasoline,
Required                     the average increase in gasoline use would be about 0.5 percent in these
                             areas. In the state with the greatest percentage increase, gasoline use
                             would increase by less than 4 percent.

                             As previously noted, ethanol traditionally has been used in midwestern
                             corn-producing states, where it is produced for use as a gasoline extender
                             and octane enhancer. These areas generally meet existing air quality
                             standards for the pollutants associated with transportation fuels, and the
                             use of gasoline containing oxygenates is not required. Because there
                             generally is no mandate to use a clean-burning fuel in these areas, analysts
                             believe that if there were no tax incentives, ethanol’s use as a gasoline
                             extender would disappear. Consumers would then use the next cheapest
                             fuel, which would most likely be conventional gasoline. Ethanol’s use as
                             an octane enhancer also would likely disappear if there were no tax
                             incentives and substitute octane enhancers would be used, mainly MTBE.22

                             According to DOE, conventional gasoline generally has more carbon
                             monoxide and toxic components emissions than ethanol-blended gasoline.
                             Therefore, switching from using an ethanol blend to using conventional


                             22
                               Ethanol’s disappearance as a gasoline octane enhancer may lead to the increased use of
                             methylcyclopentadienyl manganese tricarbonyl (MMT) as a substitute. EPA has found the use of MMT
                             to be a cause for concern because of possible adverse effects on human health. However, even if MMT
                             were to entirely replace ethanol as an octane enhancer, the growth in MMT use would likely not be
                             large for these reasons. First, MMT cannot be used in reformulated gasoline. Second, even in states
                             where reformulated gasoline use is not required, MMT use would be limited to its role as an octane
                             enhancer. If MMT were to entirely replace ethanol in these states, its share in total fuel use would not
                             be large. As previously noted, in the most ethanol-intensive state, ethanol currently represents only
                             4 percent of all gasoline plus gasoline blended with ethanol fuel used.



                             Page 15                                                                   GAO/GGD-97-41 Tax Policy
                            B-271977




                            gasoline would likely increase these emissions. However, environmental
                            analysts believe air quality would be unlikely to decline to the point that
                            these areas would not meet existing air quality standards for these
                            pollutants. The areas in which ethanol traditionally has been sold as a
                            gasoline extender generally are not areas where gasoline containing
                            oxygenates is required. In these areas, motor vehicle emissions are not
                            concentrated enough to create air quality problems. Furthermore, under
                            certain conditions,23 ethanol-blended fuel has a higher volatility than
                            conventional gasoline and its use releases more ozone-precursor
                            compounds than the use of conventional gasoline.24 In these
                            circumstances, switching from an ethanol blend to conventional gasoline
                            would be expected to decrease emissions of volatile organic compounds.25



No Significant Effect       Eliminating the use of ethanol in alternative-fuel vehicles would likely not
Likely Through the Use of   significantly affect air quality because, to date, ethanol has been little-used
Alternative-Fuel Vehicles   as an alternative fuel. In 1995, the share of total alternative fuel
                            (gasoline-equivalent gallons of fuel used in alternative-fuel vehicles)
                            represented by ethanol was less than 0.08 percent. EIA has projected that
                            ethanol used in alternative-fuel vehicles will account for only 0.28 percent
                            of the total transportation fuel market by 2015.

                            The number of alternative-fuel motor vehicles, particularly those fueled by
                            ethanol, is small and expected to remain so, even if tax incentives for
                            ethanol remain in place. In 1995, fewer than 1,000 alternative-fuel vehicles
                            were fueled by neat ethanol. Fuel used in these special vehicles
                            represented only 0.0002 percent of the total transportation fuel
                            consumption and only 0.02 percent of the total ethanol fuel consumption.
                            Energy analysts expect ethanol’s use as an alternative motor fuel to
                            increase. However, even with anticipated improvements in technology
                            during the next two decades and retention of the tax incentives, EIA
                            projects that ethanol use in alternative-fuel vehicles will represent a
                            negligible amount of the total fuel used.



                            23
                              When ethanol is simply blended with gasoline in a 10-percent, 90-percent ratio rather than used as an
                            ingredient in specially reformulated gasohol or used as a gasoline alternative in 85- to 100-percent
                            ethanol-gasoline blends, the resulting blend can have higher volatility than conventional gasoline under
                            conditions of high ambient air temperature, such as in the summer.
                            24
                              For example, ethanol-blended fuel does not meet the stringent summertime fuel volatility restrictions
                            in ozone nonattainment areas without adjustments to the gasoline fraction.
                            25
                              However, some ethanol-producing states have suggested that ethanol’s higher volatility is offset by its
                            lower reactivity with sunlight in producing ozone, compared with conventional gasoline. Currently, the
                            National Academy of Sciences is studying this issue at EPA’s request.
                            Page 16                                                                   GAO/GGD-97-41 Tax Policy
                           B-271977




No Significant Effect Is   The production, evaporation, and combustion of different fuels produce
Likely on Global           different levels and types of greenhouse gas emissions, depending on
Environmental Quality      whether the fuels are derived from biomass or from fossil fuel materials.26
                           On the basis of a review of the scientific literature and discussions with
                           EPA and other energy and environmental analysts, we conclude that
                           ethanol fuel use likely has had no significant net effect on greenhouse gas
                           emissions or on global environmental quality. According to the EPA analyst
                           we interviewed, the net effect on greenhouse gas emissions from the
                           corn-based ethanol fuel cycle is such that the possible global-warming
                           effects of using ethanol are likely no better than those of conventional
                           gasoline.27 Moreover, even if ethanol did reduce greenhouse gas emissions,
                           relative to gasoline, ethanol is such a small part of worldwide fuel use that
                           global environmental quality is not likely to be significantly affected.

                           The EPA analyst’s assessment is based on inferences from studies
                           comparing the net energy use and, in some cases, the greenhouse gas
                           emissions of different fuels. The exact net effect on the quantity of
                           greenhouse gases from using ethanol made with current corn-based
                           technologies instead of conventional gasoline is difficult to determine, and
                           we are not aware of any direct estimate of this net effect. In addition, the
                           results of the studies that provide indirect evidence are sensitive to
                           assumptions made by the researchers. The EPA analyst also noted that the
                           greenhouse gases emitted during the ethanol fuel cycle have so much
                           greater global-warming potential than those emitted during the
                           conventional gasoline fuel cycle that the global-warming picture may be
                           worsened by using ethanol. The greenhouse gases released during the
                           ethanol fuel cycle contain relatively more nitrous oxide and other potent
                           greenhouse gases. In contrast, the greenhouse gases released during the
                           conventional gasoline fuel cycle contain relatively more of the less potent
                           type, namely, carbon dioxide.


                           26
                             For example, when a fossil fuel such as gasoline is burned, the greenhouse gases that would have lain
                           buried in oil fields are released into the atmosphere, possibly contributing to global warming. In
                           contrast, when a fuel derived from biomass is burned, only the greenhouse gases that were taken up by
                           the plant material as it grew are released—the emissions from combustion, net of the carbon dioxide
                           absorbed during growing, are zero. Of course, some greenhouse gases are released during the
                           production of both the fossil fuel and the biomass-derived fuel. However, in contrast to the fossil fuel,
                           if the biomass fuel had no production emissions, the effect of its use on greenhouse gases would be
                           zero.
                           27
                             To completely evaluate the emission effects of alternative transportation technologies, one must
                           consider emissions and energy use from upstream fuel production processes as well as from vehicle
                           operations. This “full fuel cycle” approach is especially important when comparing technologies that
                           employ fuels with distinctly different primary energy sources and fuel production processes—such as
                           corn-based ethanol and conventional gasoline—for which upstream emissions and energy use are
                           significantly different. In the case of corn-based ethanol, one must also assume the share of emissions
                           from ethanol plants and upstream corn production that will be allocated to ethanol’s byproducts.



                           Page 17                                                                   GAO/GGD-97-41 Tax Policy
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EPA has not yet evaluated the most recent DOE study of ethanol’s
greenhouse gas emissions.28 USDA infers from this new study that replacing
corn-based ethanol fuel with gasoline would increase the quantity of
greenhouse gases emitted over the entire fuel cycle. However, the study
focused on the net greenhouse gas effect of using neat and near-neat
ethanol (in alternative-fuel vehicles) in place of gasoline oxygenated with
MTBE. The study did not estimate the net greenhouse gas effect of
eliminating the ethanol in use today, which is almost always ethanol and
gasoline mixtures that are mainly gasoline and are used in conventional
vehicles. Furthermore, because of the different assumptions made by
modelers regarding upstream energy conversion efficiencies, technology
pathways, emission control intensities, and vehicular emissions, different
studies of the same technology may generate significantly different
emissions results.

If sufficient breakthroughs in the technologies used to make ethanol from
biomass other than corn were to occur, then the use of ethanol instead of
fossil fuels possibly could cause a net reduction in greenhouse gas
emissions.29 DOE believes that, if the technological breakthroughs in
ethanol production over the next 20 years were significant enough, ethanol
produced from cellulosic biomass feedstocks could conceivably achieve a
market share of 10 to 15 percent of all U.S. transportation fuel.30 In that
event, the environmental benefits could far exceed those of the current
corn ethanol industry. However, neither EIA, nor anyone else to our
knowledge, has forecasted future levels of production of ethanol from
cellulosic biomass.




28
 M. Q. Wang, GREET 1.0 — Transportation Fuel Cycles Model: Methodology and Use, Argonne
National Laboratory, U.S. Department of Energy, ANL/ESD-33, June 1996.
29
  Ethanol can be derived from plant materials other than corn, such as wood, wood and other crop
waste, weeds, and municipal solid waste. Because crop and municipal waste have very low-valued
alternative uses compared with the alternative uses for corn, ethanol from these materials is expected
to be considerably cheaper to produce than corn-based ethanol, when (and if) manufacturing
breakthroughs occur.
30
 The constraints of engine- and fueling-system design limit the use of ethanol in conventional motor
vehicles to no more than about 15 percent of the total fuel used.



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                         Tax incentives for alcohol fuels are unlikely to have significantly increased
Tax Incentives for       U.S. energy independence because, despite the tax incentives, ethanol use
Ethanol Fuel Are         has not significantly reduced the United States’ reliance on imported
Unlikely to Have         energy. Nor is it likely that ethanol tax incentives have significantly
                         lessened U.S. susceptibility to oil price shocks. Vulnerability to oil price
Significantly Affected   shocks depends on the nation’s level of oil consumption as a proportion of
U.S. Energy              total fuel consumed, on the oil dependence of the transportation sector,
                         and on the difficulty of substituting other fuels for oil in case of a crisis.
Independence or          Many energy analysts believe that the percentage of the nation’s oil that is
Energy Security          imported is not a major cause of vulnerability to oil price shocks. The
                         alcohol-fuel tax incentives could only have been successful at enhancing
                         energy security if they had decreased oil’s proportion of total fuel
                         consumed or if the tax incentives had caused the supply of ethanol fuel to
                         be capable of rapid expansion in case of a crisis. According to DOE, it is
                         possible that with continuing tax subsidies for ethanol, future
                         technological breakthroughs may permit ethanol production at costs so
                         low that ethanol use would become more widespread.

                         Despite the tax incentives available since the late 1970s for ethanol, which
                         is produced almost entirely from domestically grown corn, U.S. fuel
                         imports as a percent of total energy consumption have not declined.
                         Imports today account for about 20 percent of the total U.S. energy
                         consumption, and about 48 percent of the oil consumption. In contrast,
                         ethanol31 currently accounts for less than 1 percent of U.S. motor vehicle
                         fuel consumption. Oil imports account for the same share of domestic
                         energy consumption that the imports did in 1978, before the ethanol fuel
                         tax incentives were implemented.32 EIA projections indicate that oil
                         imports, as a percentage of U.S. consumption, will continue to rise through
                         2015,33 even if the ethanol tax incentives remain in place.

                         In addition, tax incentives for alcohol fuel use have not been a factor in
                         deterring or moderating potential price shocks in the energy sector. For
                         this reason, the tax incentives do not increase the United States’ energy


                         31
                          This includes the ethanol used in gasoline blends as well as the ethanol used to make the gasoline
                         oxygenate, ethyl tertiary butyl ether (ETBE). ETBE is an ether produced from ethanol and used in
                         making oxygenated gasoline.
                         32
                          Appendix I contains more details about the events and legislation that have encouraged ethanol fuel
                         use.
                         33
                           Oil imports are projected to grow through 2015 in EIA’s reference case, as well as under most of the
                         alternative scenarios that they model. (EIA’s reference case represents the midlevel of EIA’s
                         alternative assumptions about the growth of the domestic economy and world oil market conditions.)
                         However, under the special case assumption of more rapid technology improvement, projected oil
                         imports begin to decline after 2005.



                         Page 19                                                                  GAO/GGD-97-41 Tax Policy
                       B-271977




                       security. As we recently reported,34 vulnerability to oil price shocks
                       depends on the nation’s level of oil consumption, including the oil
                       dependence of the transportation sector. The economic effects of oil price
                       disruptions are largely the same, regardless of the level of oil imports. The
                       rapid oil price increases of 1973 and 1979 disturbed U.S. economic stability
                       because there were (and are) few good substitutes for oil. Following these
                       crises, legislation encouraging alcohol fuel use was enacted in part to
                       diversify the sources of fuel beyond the consumption of petroleum to
                       guard against the potential impact of future shocks.

                       The greater the share of nonpetroleum-based fuels in total U.S. fuel
                       consumption, the smaller would be the impact of any oil price increase. To
                       the extent that ethanol is substituted for petroleum-based fuels, it can
                       mitigate the effects of any oil supply disruption or rapid increase in oil
                       prices, which could threaten U.S. economic stability. However, ethanol
                       currently comprises less than 1 percent of total U.S. fuel consumption and,
                       according to EIA projections, even if tax incentives for ethanol remain in
                       place, will still comprise less than 1 percent in 2015. Therefore, ethanol
                       use would not significantly mitigate the effects of oil price increases.
                       Alternatively, if ethanol’s supply were capable of rapid expansion, it could
                       mitigate the effects of any oil supply disruption or rapid increase in oil
                       prices. However, given existing technologies of production, the U.S.
                       ethanol-fuel supply cannot be greatly and cheaply expanded whenever
                       necessary. If a sufficient future breakthrough were to occur in the
                       technology used to make ethanol from biomass other than corn, then
                       ethanol/gasoline blends could become more widely used.


                       We estimated that the partial exemption for alcohol fuels reduced motor
The Partial            fuels excise tax revenues by about $7.1 billion from fiscal years 1979 to
Exemption Reduced      1995 (see table II.2 in app. II).35 We also estimated that about 108 billion
Highway Trust Fund     gallons of alcohol-fuel mixtures were sold over that same period and that
                       about $7.5 billion of motor fuels excise tax revenues were collected on the
Revenues From Fiscal   sales of this fuel. The amount of tax that would have been paid on an
Years 1979 to 1995     equivalent gallonage of gasoline is about $14.6 billion. In 1995, Treasury
                       projected that the partial exemption for alcohol fuels would reduce excise
                       tax receipts by $3.3 billion from fiscal years 1996 to 2000 (see table II.3 in
                       app. II).


                       34
                         GAO/RCED-97-6.
                       35
                        Unless otherwise noted, all revenue figures presented in this report are stated in constant 1996
                       dollars.



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Virtually all of the motor fuels excise tax revenue that has been forgone
due to the partial exemption would otherwise have been earmarked for
the Highway Trust Fund. Only a negligible amount of that forgone revenue
would have been earmarked for the Leaking Underground Storage Tanks
Trust Fund. In 1995, the gross federal highway user tax receipts for the
Highway Trust Fund were $23.1 billion.36 We estimated that, without the
partial exemption for alcohol fuels, an additional $617 million of revenue
would have been allocated to the fund for fiscal year 1995.

The income tax credits for alcohol, alcohol mixtures, and small ethanol
producers are offset against the Treasury’s General Fund and, therefore,
do not affect the amount of revenue allocated to the Highway Trust Fund.
Past estimates by Treasury indicate that these tax credits have reduced
general fund revenues by less than $0.2 billion from fiscal year 1981, when
the credits were first introduced, to fiscal year 1995. Although both the
partial exemption and the income tax credit for alcohol mixtures provide a
subsidy of 54 cents per gallon of alcohol blended as a fuel, there are
several reasons why the exemption may be preferable to taxpayers. First,
the benefit of the exemption can be realized immediately, while the benefit
of the credit is realized no earlier than when the taxpayer files a quarterly
estimated income tax return.37 Second, a blender must have a positive
precredit income tax liability to use the credit. Third, the benefit of the
income tax credits can be constrained by the general business tax credit
limitation and by the alternative minimum tax.38 Treasury projects that
about $50 million of alcohol fuels tax credits will be claimed against the
income tax from fiscal years 1996 to 2000.

The net effect that the partial excise tax exemption has had on total
federal revenues may be less than the $7.1 billion previously cited because
the excise tax exemption may increase the amount of real income that is
subject to the federal income tax. By convention, when the Joint
Committee estimates the amount of revenue that is attributable to an
excise tax, it reduces the estimated gross revenue gain from the tax by 25
percent to account for offsetting declines in income tax revenue.39

36
  This amount includes receipts from excise taxes on highway motor fuels, vehicles, and tires.
37
 Credits for overpayments of excise taxes are distinct from the income tax credit. See appendix II for
details.
38
  The general business tax credit is the combination of the alcohol fuels credits and 11 other tax
credits. The amount of general business credit that a taxpayer may claim cannot exceed the taxpayer’s
net regular income tax liability minus the greater of (1) the taxpayer’s tentative alternative minimum
tax liability or (2) 25 percent of the net regular tax liability above $25,000.
39
  See appendix II for the rationale behind this 25-percent offset.



Page 21                                                                  GAO/GGD-97-41 Tax Policy
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                            Conversely, when the Joint Committee estimates the amount of revenue
                            forgone due to an excise tax exemption, it reduces the gross revenue
                            forgone by 25 percent to account for offsetting increases in income tax
                            revenue. The Joint Committee projected that the net revenue cost of the
                            partial exemption will be $2.6 billion from fiscal years 1996 to 2000.


                            At our request, officials representing the heads of the Department of
Agency Comments             Energy, the Department of Agriculture, the Environmental Protection
and Our Evaluation          Agency, the Department of the Treasury, and the Internal Revenue Service
                            provided comments on a draft of this report. Generally, their concerns
                            centered on (1) the benefits and costs of the tax incentives, (2) the
                            potential future benefits from an expanded ethanol industry, (3) the
                            short-term economic effects of eliminating the incentives, (4) the effects of
                            unstable government subsidy policies, (5) oxygenate security, (6) the
                            energy balance40 of ethanol compared with other fuels, and (7) the effect
                            of the incentives on federal outlays. The following is a summary of the
                            agencies’ principal comments, accompanied by our responses.


Benefits and Costs of the   Both USDA and DOE officials expressed concern that the draft report would
Tax Incentives              be viewed by some readers as an assessment of the costs and benefits of
                            the ethanol tax incentives. In their view, the draft report did not provide a
                            balanced cost-benefit analysis because it quantified the excise tax revenue
                            loss due to the incentives but did not quantify the benefits received by
                            farmers, consumers, and others. The USDA and DOE officials were
                            concerned that readers would think that the benefits of the tax incentives
                            are small relative to their cost because the draft report described the
                            benefits that various groups receive in terms of small percentage changes
                            in prices or incomes. For example, the draft report suggested that the
                            effect of the tax incentives on gasoline consumers is likely to be small
                            because the incentives lower the price of a gallon of gasoline by an
                            estimated 0.27 percent. Both USDA and DOE officials pointed out that this
                            price decline, when multiplied by total gallons of gasoline consumed,
                            represents a yearly saving of over $200 million in consumer spending on
                            gasoline. USDA officials also commented that a balanced presentation of
                            the costs and benefits of the tax incentives for ethanol would include a
                            discussion of the tax benefits provided to petroleum and other energy
                            industries.


                            40
                              The energy balance of ethanol compares its energy contribution as a motor fuel component with the
                            net energy consumed in the production of ethanol, including the energy consumed in the production of
                            feedstocks.



                            Page 22                                                                GAO/GGD-97-41 Tax Policy
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Our response to the agencies’ comments involves several parts. First, we
agree that our report should not be viewed as an overall cost-benefit
analysis of the incentives. It was not intended to provide such an analysis,
and we have added statements to this report clarifying this point.

Second, we did not make dollar estimates of the benefits and costs to
particular groups because, in most cases, we did not have sufficient
information to make reliable estimates.41 Moreover, if we had quantified
the benefits to various groups, as USDA and DOE officials suggested, it
would not be appropriate to include either those estimates or our revenue
cost estimate in a cost-benefit analysis of the tax incentives. Inclusion
would not have been appropriate because benefits to specific groups in
society do not represent a net benefit to society. A benefit to one
group—higher incomes for farmers—is typically a cost to another
group—higher prices for consumers of certain foods. Similarly, the tax
revenue forgone due to the incentives does not represent a net cost to
society; it is a transfer from one group to another.

Third, in preparing an overall cost and benefit analysis, the real benefits of
a government program should be measured in terms of the extent to which
the program expands the total production potential of society.42 Similarly,
the cost of a program should be measured in terms of the lost opportunity
to increase production under an alternative allocation of resources. A
program would have a net benefit if it leads to a resource allocation that
increases production and consumption above what they would have been
under the best alternative resource allocation.

Fourth, sufficient information for completing a reliable, overall
cost-benefit analysis of the tax incentives is not available at this time. For
example, given the uncertainties regarding how farmers would respond to
a decline in the demand for corn under the new farm policy, we would be
unable to determine how the allocation of resources without the
incentives would differ from the current allocation of resources.

Finally, regarding the USDA and DOE officials’ point about the benefits
provided to petroleum and other energy industries, we agree that a proper
cost-benefit analysis of the alcohol fuels tax incentives should take


41
  We presented a dollar estimate of the excise tax revenues forgone because the requester is interested
in the effect that the incentives have had on the amount of revenue available to the Highway Trust
Fund. We did not present the estimate as part of a cost-benefit comparison.
42
  Total production includes the production of intangibles, such as energy security, and improvements
in environmental quality.



Page 23                                                                  GAO/GGD-97-41 Tax Policy
                             B-271977




                             account of pre-existing distortions in resource allocation, such as those
                             caused by other tax provisions.


Potential Future Benefits    USDA and DOE officials also said that a balanced assessment of the tax
From Cellulosic Biomass      incentives requires consideration of (1) the potential economic and
Ethanol                      environmental benefits of the much larger and cost-effective ethanol
                             industry, based on cellulosic biomass, that may emerge in the future and
                             (2) the role the existing ethanol industry would play as a launching
                             platform for this new technology. They said that our draft report did not
                             discuss these potential benefits. Representatives of both departments said
                             that government incentives would play an important role in the future
                             development of the ethanol industry. The officials expressed the opinion
                             that, if ethanol use can be increased significantly over time by using new
                             technologies and biomass feedstocks other than corn, then fossil energy
                             use and emissions of greenhouse gases, ozone, and particulates could be
                             reduced substantially. USDA officials pointed out that U.S. energy security
                             would be enhanced if the nation could reduce its heavy reliance on a
                             single transportation fuel, fossil-based gasoline.

                             In response to the agencies’ assertion that the existing ethanol industry
                             could play a significant role as a launching platform for the new
                             technology, we note that cellulose-based ethanol remains an experimental
                             rather than an economically viable technology. We clarified our report to
                             acknowledge that, if sufficient breakthroughs in the technologies used to
                             make ethanol from biomass other than corn were to occur, then the use of
                             ethanol in place of fossil fuels could possibly cause a net reduction in
                             greenhouse gas emissions. However, we also added that neither EIA, nor
                             anyone else to our knowledge, has forecasted future levels of production
                             of ethanol from cellulosic biomass.


Short-Term Economic          The USDA and DOE officials noted that the draft report did not discuss the
Effects of Eliminating the   economic effects that would occur under various scenarios for eliminating
Tax Incentives               the incentives. For example, the draft report did not include the effect on
                             prices of near-term market disruptions that would occur if the incentives
                             were eliminated quickly. The officials said that the short-term increase in
                             the price of MTBE would likely be significantly larger than the estimate of
                             the long-term increase that we report.

                             We agree; however, we chose not to discuss the short-term effects of
                             eliminating the incentives because such effects would depend on the



                             Page 24                                               GAO/GGD-97-41 Tax Policy
                      B-271977




                      specific scenario. Such short-term effects would be important for
                      computing the costs of different proposals for eliminating the incentives.


Effects of Unstable   DOE officials said that unstable government subsidy policies could be
Government Subsidy    devastating to the ethanol industry. They noted that investors need to plan
Policies              several years ahead when investing in plants that are based on new
                      technologies or when bringing production on-line for plants that take a
                      long time to build. If investors cannot count on a stable government
                      policy, they are unlikely to invest in new technologies. DOE officials noted
                      that one of our previous reports found this to be true in the alternative
                      fuels industries in several other countries.43

                      We agree that frequently changing levels of government support can cause
                      uncertainty that can negatively affect any industry. Our previously
                      mentioned report stated that “wavering government subsidies and
                      support” can discourage private investors from investing in an unproved
                      technology. However, the alcohol fuels tax incentives were enacted in the
                      late 1970s and early 1980s. Furthermore, we would not characterize the
                      history of the incentives to date as being one of “wavering government
                      subsidies and support.”


Oxygenate Security    DOE officials commented that the draft report did not note that if MTBE
                      were to replace ethanol as an oxygenate, the additional MTBE would likely
                      come almost entirely from foreign sources. They said that this could
                      reduce U.S. energy security by increasing the percentage of oxygenates
                      that is imported. DOE officials noted that the use of replacement fuels was
                      encouraged in the 1992 Energy Policy Act and that another of our recent
                      reports stressed that oxygenates are an important part of the whole
                      replacement fuel picture.44

                      We agree that we are on record in saying that oxygenates displace some
                      petroleum. However, as we explained above, ethanol’s potential for
                      substituting for petroleum is so small that it is unlikely to significantly
                      affect overall energy security. Furthermore, the United States’
                      vulnerability to disruptions in MTBE supply is not comparable to its
                      vulnerability to disruptions in oil supply. A disruption of MTBE supply is
                      probably less likely than an oil supply disruption because MTBE has more

                      43
                       Alternative Fuels: Experiences of Brazil, Canada, and New Zealand in Using Alternative Motor Fuels
                      (GAO/RCED-92-119, May 7, 1992).
                      44
                        GAO/RCED-96-121.



                      Page 25                                                                GAO/GGD-97-41 Tax Policy
                            B-271977




                            widely varied sources of supply. Moreover, in the event of a disruption of
                            MTBE imports, oxygenate regulations could be relaxed or suspended until
                            the disruption ended or until domestic production increased to fill the
                            shortage.


Energy Balance of Ethanol   USDA  officials said that the draft report understated the energy balance
Compared With Other         from ethanol made with current technology and did not mention the even
Fuels                       better energy balance that might be achieved if a cellulosic biomass
                            ethanol industry emerges in the future. The officials also noted that the
                            report failed to mention the large amounts of fossil fuel used in making
                            fossil-fuel products, such as gasoline and diesel fuel.

                            We agree that there is some evidence that ethanol use may have some
                            energy balance advantages relative to gasoline, in that the former may
                            involve lower levels of fossil energy and petroleum consumption.45 We
                            also acknowledge that, if sufficient breakthroughs in the technologies
                            used to make ethanol from biomass other than corn were to occur in the
                            future, then even better fossil energy and petroleum consumption
                            balances might be achieved through using ethanol in place of gasoline.
                            However, because so little ethanol fuel is used, our evaluation of energy
                            security benefits would not change even if no petroleum or other fossil
                            fuels were consumed in the production of ethanol. For this reason, we did
                            not compare the energy balance of ethanol with the energy balance of
                            gasoline. Our evaluation of the effects of ethanol use on greenhouse gas
                            emissions takes into account the latest research on full fuel-cycle
                            emissions.


Effect of the Tax           USDA officials noted that in a 1990 report, we estimated the savings in
Incentives on Federal       federal outlays for deficiency payments to corn farmers that result from
Outlays                     the partial exemption for ethanol.46 They said that we should include these
                            effects when discussing federal outlays before passage of the FAIR Act.

                            We disagree for several reasons. First, our 1990 report did not estimate the
                            impact of the partial exemption for ethanol on federal farm payments; it
                            simulated what would happen if ethanol production increased by a range
                            of assumed growth rates.


                            45
                             For example, see Wang, GREET 1.0 — Transportation Fuel Cycles Model: Methodology and Use,
                            pages 40 to 43 and 46.
                            46
                              Alcohol Fuels: Impact From Increased Use of Ethanol Blended Fuels (GAO/RCED-90-156, July 1990).



                            Page 26                                                              GAO/GGD-97-41 Tax Policy
                 B-271977




                 Second, as we noted in the “objectives, scope, and methodology” section
                 of this report, our objective relating to fiscal impact was limited to
                 estimating the effect that the tax incentives have had on the flow of
                 revenue into the Highway Trust Fund.

                 Third, while federal farm payments before the passage of the FAIR Act may
                 have been lower than they would have been in the absence of the tax
                 incentives, it is not possible to determine with certainty the size of any
                 federal outlay savings that may have occurred. Such savings would depend
                 on the unknown extent to which the Secretary of Agriculture would have
                 used the acreage reduction program to restrict corn supply in the absence
                 of the incentives. A sufficient restriction of corn acreage could have
                 mitigated or eliminated the effect of the reduced demand for corn on corn
                 prices. Therefore, such a restriction, if brought to bear, could also have
                 mitigated or eliminated any effect on federal outlays.

                 Finally, since the FAIR Act has now removed the link between income
                 support payments and farm prices, the tax incentives are not likely to have
                 any future effect on federal farm outlays.


Other Comments   USDA, DOE, EPA,Treasury, and IRS officials provided a number of
                 suggestions for rewording our discussion of technical details in the draft.
                 We made corrections and clarifications where appropriate. As a result of
                 our discussions with Treasury officials, we determined that the excise tax
                 data we used to make our revenue loss estimates did not reflect claims for
                 refunds or credits for excise tax overpayments on gasoline used to make
                 alcohol fuel mixtures. We obtained additional data from Treasury and IRS
                 and made the proper adjustments to our estimates.


                 Unless you publicly announce its contents earlier, we plan no further
                 distribution of this report until 30 days from the date of this letter. At that
                 time, we will send copies of this report to the Ranking Minority Member of
                 your committee, the Chairman and Ranking Minority Member of the
                 Senate Finance Committee, other appropriate congressional committees,
                 and other interested parties. Copies will also be made available to others
                 upon request.

                 This work was performed under the direction of James Wozny, Assistant
                 Director, Tax Policy and Administration Issues. Major contributors to this




                 Page 27                                                 GAO/GGD-97-41 Tax Policy
B-271977




report are listed in appendix V. If you have any questions, please contact
me on (202) 512-9110.

Sincerely yours,




James R. White
Associate Director, Tax Policy
  and Administration Issues




Page 28                                               GAO/GGD-97-41 Tax Policy
Page 29   GAO/GGD-97-41 Tax Policy
Contents



Letter                                                                                            1


Appendix I                                                                                       32

Chronology of the
Legislation and
Events Affecting
Ethanol Fuel Use
Appendix II                                                                                      35
                         Federal Tax Incentives for Alcohol Fuels                                35
Details and Estimates    Allocation of Excise Tax Revenues to the Highway Trust Fund             39
Relating to the Tax      Revenue Estimates for the Tax Incentives                                40
Incentives for Alcohol
Fuels
Appendix III                                                                                     45

Data on U.S. Fuel
Consumption and
Imports
Appendix IV                                                                                      49
                         The Factors Determining the Incidence of the Tax Incentives             49
Description of Groups    Description of the Markets and Consumers of Ethanol and                 51
in the Economy That        Related Products
the Ethanol Tax
Incentives Affect
Appendix V                                                                                       60

Major Contributors to
This Report
Tables                   Table II.1: Rates of Excise Taxes, Excise Tax Exemptions, and           36
                           Income Tax Credits for Selected Highway Motor Fuels




                         Page 30                                            GAO/GGD-97-41 Tax Policy
Contents




Table II.2: Estimates of the Amounts of Excise Tax Revenues            41
  Forgone Due to the Partial Exemptions for Alcohol Fuels,
  1979-95
Table II.3: Department of the Treasury and Joint Committee on          44
  Taxation Projections of Revenue Losses Attributable to the
  Excise Tax Exemptions for Alcohol Fuels, Fiscal Years 1996-2000
Table III.1: U.S. Transportation Fuel Consumed, 1992-96                45
Table III.2: Gasoline, MTBE, TAME, Ethanol, and ETBE Used in           46
  the United States in 1995, by Air Quality Area
Table III.3: U.S. Energy and Petroleum, Consumed and Imported          47
  (Actual and Projected), 1973-2015




Abbreviations

API        American Petroleum Institute
CBO        Congressional Budget Office
DOE        U.S. Department of Energy
EIA        Energy Information Administration
EPA        Environmental Protection Agency
ERS        Economic Research Service
ETBE       ethyl tertiary butyl ether
FAIR       Federal Agricultural Improvement and Reform Act of 1996
FAPRI      Food and Agriculture Policy Research Institute
GDP        gross domestic product
IRS        Internal Revenue Service
MMT        methylcyclopentadienyl manganese tricarbonyl
MTBE       methyl tertiary butyl ether
OPEC       Organization of Petroleum Exporting Countries
RFG        reformulated gasoline
USDA       U. S. Department of Agriculture


Page 31                                           GAO/GGD-97-41 Tax Policy
Appendix I

Chronology of the Legislation and Events
Affecting Ethanol Fuel Use


Year         Legislation/Event                           Ethanol summary
1967         Air Quality Act of 1967                     Regulated ambient air quality. Established emissions standards and a
             (P.L. 90-148)                               basic fuel and fuel additive registration program.
1970         U.S. production of crude oil peaked         Increased U.S. dependence on foreign sources of crude oil, primarily from
                                                         OPEC.
             Clean Air Amendments of 1970                Established the National Ambient Air Quality Standards and began
             (P.L. 91-604)                               regulating fuel additives for air pollution reduction. Section 211 gave EPA
                                                         the authority to regulate fuel and fuel additives, which included the
                                                         authority to control or prohibit the sale of any fuel or fuel additive that it
                                                         determined would endanger the public health or welfare.
1973         1973 Arab Oil Embargo                       Disrupted petroleum supply and escalated price. Was the beginning of
                                                         consumer efforts to conserve energy and reduce petroleum consumption.
             Emergency Petroleum Allocation              Established government controls on domestic petroleum price and
             Act of 1973                                 supply, replacing market forces.
             (P.L. 93-159)
1974         Supplier-Purchaser Rule, Buy-Sell           Below-market petroleum prices and allocated supplies caused lowered
             Program, and Crude Oil Entitlement          incentives for oil exploration and production, increased incentives to
             Program                                     import oil, and greater domestic oil demand.
             Unleaded motor gasoline was introduced      Began the transition to unleaded gasoline. Transition was enhanced by
             at gasoline stations                        the compatibility of unleaded gasoline with the catalytic converter, which
                                                         was developed to reduce tailpipe emissions.
1975         Energy Policy and Conservation              Established the Strategic Petroleum Reserve to deter and mitigate effects
             Act of 1975                                 of future oil supply disruptions.
             (P.L. 94-163)
1978         U.S. demand for petroleum peaked            Subsequent decline in demand contributed to lower oil imports.
             Powerplant and Industrial Fuel              Restricted construction of electric powerplants with petroleum or natural
             Use Act of 1978                             gas as their primary fuel.
             (P.L. 95-620)
             Energy Tax Act of 1978                      Established a 4 cents per gallon (then the entire amount of the federal
             (P.L. 95-618)                               gasoline excise tax) exemption from excise taxes for motor fuels blended
                                                         with biomass-derived alcohols (minimum of 10-percent alcohol).a
             1978 Iranian Revolution                     Declines in Iran’s crude oil production began a series of OPEC price
                                                         escalations between 1979 and 1981. A worldwide recession occurred and
                                                         oil consumption was depressed.
1980         Energy Security Act of 1980                 Authorized funds for building alcohol fuel production plants.
             (P.L. 96-294)
             Crude Oil Windfall Profit Tax Act of 1980   Extended the 4-cent exemption for gasohol to December 1, 1992, and
             (P.L. 96-223)                               established a blender’s tax credit of 40 cents per gallon of alcohol used in
                                                         the production of gasoline/alcohol mixtures.
             Omnibus Reconciliation Tax Act of 1980      Placed a tariff on imported ethyl alcohol to be used in the production of
             (P.L. 96-499)                               gasoline/alcohol mixtures.
1981         Petroleum Price and Allocation Decontrol    Reinstated market forces for petroleum prices. Domestic crude oil
             (E.O. 12287)                                production was revitalized. Deregulation of oil prices and the development
                                                         of futures markets reduced the economic cost of an oil price shock.
                                                         During an oil market shock, producers had the incentive to bring forth
                                                         additional energy supplies and consumers had an incentive to reduce
                                                         energy consumption because prices could adjust quickly and completely
                                                         to changing information about potential future oil supplies.
                                                                                                                            (continued)

                                           Page 32                                                          GAO/GGD-97-41 Tax Policy
                                        Appendix I
                                        Chronology of the Legislation and Events
                                        Affecting Ethanol Fuel Use




Year   Legislation/Event                              Ethanol summary
1982   Surface Transportation Assistance              Raised the gasoline tax rate from 4 to 9 cents per gallon and increased
       Act of 1982                                    the exemption for gasohol from 4 to 5 cents per gallon. Set a 9 cents per
       (P.L. 97-424)                                  gallon exemption for fuels containing 85 percent or more alcohol.
1984   Tax Reform Act of 1984                         Raised the exemption for gasohol from 5 to 6 cents per gallon. Increased
       (P.L. 98-369)                                  the blender’s tax credit from 40 to 60 cents per gallon of blend for
                                                      190-proof alcohol.
1986   Price of crude oil collapsed                   Domestic crude oil production declined, dependence on OPEC crude oil
                                                      increased, and lower petroleum prices stimulated economic growth.
       Tax Reform Act of 1986                         Reduced the exemption for 85-percent alcohol fuels from 9 to 6 cents per
       (P.L. 99-514)                                  gallon.
       Superfund Revenue Act of 1986                  Raised the gasoline excise tax rate from 9.0 to 9.1 cents per gallon.
       (P.L. 99-499)
1988   Alternative Motor Fuels Act of 1988            Addressed national energy policy concerns and created a program of
       (P.L. 100-494)                                 financial support for research, development, and demonstration of
                                                      alternative motor vehicles and alternative fuels.
       Technical and Miscellaneous                    Permitted gasohol blenders to purchase gasoline and alcohol at different
       Revenue Act of 1988                            locations and still get the 6 cent per gallon exemption without having to file
       (P.L. 100-647)                                 a claim for an excise tax refund.
1989   Reid Vapor Pressure Regulations                Reduced evaporative emissions of smog-producing compounds in
                                                      gasoline.
1990   Persian Gulf Crisis of 1990-91                 Unlike with previous oil supply disruptions, the impact from the sudden oil
                                                      price increase and supply cutoff was reduced. Reduction was attributable
                                                      to the deregulation of oil prices, to the development of futures markets, to
                                                      the achievement of greater efficiency and fuel-switching capabilities by oil
                                                      users, and to greater worldwide cooperation. Cooperation included the
                                                      use of worldwide strategic reserves, an OPEC increase in production, and
                                                      non-OPEC producer supply shifts.
       Omnibus Budget Reconciliation                  Raised the gasoline excise tax rate from 9.1 to 14.1 cents per gallon,
       Act of 1990                                    reduced the gasohol exemption from 6.0 to 5.4 cents per gallon, and
       (P.L. 101-508)                                 reduced the blender’s tax credit from 60 to 54 cents per gallon. Retained
                                                      the exemption for 85-percent alcohol fuels at 6 cents per gallon. Extended
                                                      these incentives to the year 2000. Provided an income tax credit of 10
                                                      cents per gallon for the first 15 million gallons of ethanol manufactured by
                                                      qualified small producers with annual outputs of less than 30 million
                                                      gallons.
       Clean Air Act Amendments of 1990               Initiated a mandated phaseout in the use of lead as a gasoline octane
       (P.L. 101-549)                                 enhancer. Established the requirement that areas with the worst
                                                      ground-level air pollution should use the following cleaner-burning motor
                                                      fuels: oxygenated gasoline in carbon monoxide nonattainment areas
                                                      during winter months and reformulated gasoline in ozone nonattainment
                                                      areas. Reduced the sulfur content of diesel fuel.
1992   Energy Policy Act of 1992                      Extended gasohol excise tax exemption to blends containing less than
       (P.L. 102-486)                                 10-percent (7.7 and 5.7 percent) alcohol. To encourage the use of
                                                      alternatives to petroleum-based transportation fuels, set guidelines and
                                                      established incentives for (1) purchasing clean-fuel vehicles for federal,
                                                      state, and private fleets and (2) arranging refueling facilities for these
                                                      fleets.
       Oxygenated fuels program began                 Required oxygenated gasoline use in wintertime in air quality
                                                      nonattainment areas for carbon monoxide.
                                                                                                                        (continued)


                                        Page 33                                                         GAO/GGD-97-41 Tax Policy
                                  Appendix I
                                  Chronology of the Legislation and Events
                                  Affecting Ethanol Fuel Use




Year   Legislation/Event                          Ethanol summary
1993   Omnibus Budget Reconciliation              Raised gasoline excise tax rate from 14.1 to 18.4 cents per gallon.
       Act of 1993
       (P.L. 103-66)
1994   EPA mandated 30-percent minimum            Issued a ruling that at least 30 percent of each refinery’s annual
       renewable oxygenate content for            production of reformulated gasoline in 1996 and for each year thereafter
       reformulated gasoline                      should be derived from renewable oxygenates.
1995   Courts struck down 30-percent renewable    Struck down EPA’s ruling of June 1994 mandating the use of at least
       oxygenate mandate                          30-percent renewable alcohol in reformulated gasoline, which would have
                                                  significantly expanded demand for ethanol.
       Reformulated gasoline program began        Required reformulated gasoline use in the worst air quality nonattainment
                                                  areas for ozone.

                                  a
                                   Although under the Internal Revenue Code, blends of gasoline with any biomass-derived alcohol
                                  receive the exemption, the only economically feasible biomass-derived alcohol has been ethanol.

                                  Sources: U.S. Department of Energy, Energy Information Administration, The Energy Information
                                  Administration’s Assessment of Reformulated Gasoline, Volume 1, SR/OOG/94-02/1, October
                                  1994, pages 5 and 6; Volume 2, SR/OOG/94-02/2, October 1994, pages 132-134; U.S.
                                  Department of Energy, Energy Information Administration, The U.S. Petroleum Industry: Past as
                                  Prologue, 1970-1992, DOE/EIA-0572, September 1993, pages 2 and 3; U.S. Department of
                                  Energy, Energy Information Administration, Renewable Energy Annual 1995, DOE/EIA-0603(95),
                                  December 1995, pages 68-70; U.S. Department of Energy, Energy Information Administration,
                                  Estimates of U.S. Biomass Energy Consumption 1992, DOE/EIA-0548(92), May 1994, page 29;
                                  U.S. Department of Energy, Energy Information Administration, Alternatives to Traditional
                                  Transportation Fuels: An Overview, DOE/EIA-0585/O, June 1994, pages 33-38; U.S. Department
                                  of Energy, Energy Information Administration, Alternatives to Traditional Transportation Fuels
                                  1994, Volume 1, DOE/EIA-0585(94)/1, February 1996, pages 5-7; U.S. Senate, Committee on the
                                  Budget, Tax Expenditures: Compendium of Background Material on Individual Provisions, S.Prt.
                                  103-101, December 1994, pages 80-82; Congressional Research Service, Alcohol Fuels Tax
                                  Incentives and EPA’s Renewable Oxygenate Requirement, 94-785 E, October 7, 1994, pages 6
                                  and 7; Congressional Research Service, Federal Excise Taxes on Gasoline and the Highway
                                  Trust Fund: A Short History, 96-394 E, May 3, 1996, pages 5-8; Congressional Research Service,
                                  Alternative Transportation Fuels: Oil Import, Highway Tax, and Implementation Issues, IB93009,
                                  March 28, 1996, pages 3 and 4; Congressional Research Service, Alcohol Fuels Tax Incentives:
                                  Current Law and Proposed Options to Expand Current Law, 89-343 E, June 2, 1989, pages 4-7
                                  and 11-12.




                                  Page 34                                                              GAO/GGD-97-41 Tax Policy
Appendix II

Details and Estimates Relating to the Tax
Incentives for Alcohol Fuels

                         The partial exemptions from motor fuels excise taxes were adopted in the
Federal Tax              Energy Tax Act of 1978 and first became effective in 1979. Currently,
Incentives for Alcohol   motor fuels consisting of at least 10-percent biomass-derived ethanol are
Fuels                    exempt from 5.4 cents of the per-gallon federal excise taxes on gasoline,
                         diesel fuel, and other motor fuels that are earmarked for the Highway
                         Trust Fund. Table II.1 shows that the exemption is also available, at lower
                         rates per gallon of fuel, for blends that are at least 7.7- or 5.7-percent
                         ethanol.1 For all of these fuel blends, the exemptions provide a subsidy of
                         54 cents per gallon of ethanol used (i.e., if the lowest alcohol content
                         within a given range is used). Exemptions for alcohol fuel blends that
                         contain biomass methanol or other biomass alcohols, instead of ethanol,
                         provide a subsidy worth 60 cents per gallon of alcohol used.2 The alcohol
                         contained in any of these blends must be at least 190 proof. The Internal
                         Revenue Code refers to these blends collectively as “gasohol.”




                         1
                          The 5.7- and 7.7-percent blends correspond to oxygen content standards for gasoline sold in ozone
                         nonattainment areas and carbon-monoxide nonattainment areas under the Clean Air Act. The tax
                         incentives were extended to these additional blends by the Energy Policy Act of 1992.
                         2
                          In the Internal Revenue Code sections relating to motor fuels, the term “methanol” refers to any
                         alcohol other than ethanol.



                         Page 35                                                                  GAO/GGD-97-41 Tax Policy
                                           Appendix II
                                           Details and Estimates Relating to the Tax
                                           Incentives for Alcohol Fuels




Table II.1: Rates of Excise Taxes, Excise Tax Exemptions, and Income Tax Credits for Selected Highway Motor Fuels
                                            Combined motor                                                   Rates of alcohol
                                              fuels excise tax Rates of exemption Rates of exemption         fuels tax credits
                                             rates (cents per (cents per gallon of (cents per gallon of (cents per gallon of
Motor fuel                                     gallon of fuel)a               fuel)            alcohol)b            alcohol)b,c
Gasoline                                                18.3                      0.0                N/A                     N/A
           d
Diesel fuel                                             24.3                      0.0                N/A                     N/A
Gasohol from ethanol:
  At least 10-percent ethanol                           12.9                      5.4               54.0                     54.0
  At least 7.7-percent but less than
  10-percent ethanol                                   14.14                     4.16               54.0                     54.0
  At least 5.7-percent but less than
  7.7-percent ethanol                                  15.22                     3.08               54.0                     54.0
Gasohol from methanol:
  At least 10-percent methanol                          12.3                      6.0               60.0                     60.0
  At least 7.7-percent but less than
  10-percent methanol                                  13.68                     4.62               60.0                     60.0
  At least 5.7-percent but less than
  7.7-percent methanol                                 14.88                     3.42               60.0                     60.0
10-percent dieselhol
from ethanol                                            18.9                      5.4               54.0                     54.0
10-percent dieselhol
from methanol                                           18.3                      6.0               60.0                     60.0
Qualified ethanol fuels from other than
petroleum or natural gas                                12.9                      5.4               6.35                     54.0
Qualified methanol fuels (other than
ethanol) from other than petroleum or
natural gas                                             12.3                      6.0               7.06                     60.0
                                                                                                                                 e
Special motor fuels                                     18.3                      0.0                0.0
Partially exempt methanol and ethanol
fuels from natural gas                                  11.3                      7.0               8.24                     N/A

                                                                                                        (Table notes on next page)




                                           Page 36                                                    GAO/GGD-97-41 Tax Policy
Appendix II
Details and Estimates Relating to the Tax
Incentives for Alcohol Fuels




Legend: N/A = not applicable.
a
    The combined tax rates encompass the Highway Trust Fund taxes and the General Fund tax.
b
 The rates of exemptions and credits per gallon of alcohol as shown in the table are for blends
that meet the minimum alcohol content percentage. Blends that have higher contents than the
minimum for a given range receive a lower subsidy per gallon. For example, gasohol that is
6-percent ethanol receives a subsidy of 51.3 cents per gallon of alcohol.
c
 The credit rates shown are for alcohol fuels in which the alcohol is at least 190 proof; credit rates
for proofs between 150 and 190 are lower. No credit is given for alcohol that is less than 150
proof. The credit rates shown do not include the credit for small ethanol producers.
d
    There is a lower rate of tax for diesel fuel used for intercity buses.
e
 Alcohol fuels that qualify as special fuels are eligible for the separate “alternative fuels
production tax credit.”

Sources: Internal Revenue Code and GAO computations.



Neat alcohol fuels—those that contain at least 85-percent alcohol—also
qualify for partial excise tax exemptions, but the subsidies per gallon of
alcohol are less than 10 cents. These fuels are referred to in the tax code
and in table II.1 as “qualified” ethanol and methanol fuels. A lower-rate
exemption is also available for “partially exempt methanol or ethanol
fuel,” which, in the tax code, means any liquid fuel that is at least
85-percent alcohol produced from natural gas.

In fiscal year 1995, over 99.9 percent of the alcohol fuel reported in
Internal Revenue Service (IRS) excise tax summaries was gasohol that
contained ethanol. All of the other alcohol fuels were aggregated into a
single line in the IRS summaries and, together, these fuels accounted for
less than 0.1 percent of the alcohol fuel reported.

The partial excise tax exemption may be claimed by the blenders of
gasohol or by the distributors that sell them the gasoline used to make
gasohol. The partial exemption may be claimed when the blenders or
distributors file their quarterly federal excise tax returns,3 when blenders
file their annual income tax returns, or, if certain conditions are met, when




3
 According to IRS regulations, the “position holder,” with respect to the taxable fuel at a distribution
terminal, is the one liable for paying the excise tax. In some cases, this may be the blender; in other
cases, it may be the terminal operator.



Page 37                                                                      GAO/GGD-97-41 Tax Policy
Appendix II
Details and Estimates Relating to the Tax
Incentives for Alcohol Fuels




blenders file quarterly claims for refunds of excise taxes.4 Most of the
exemptions are scheduled to expire after September 30, 2000, which is 1
year after the scheduled expiration of the Highway Trust Fund motor fuel
excise taxes. The exemption for partially exempt methanol and ethanol
fuels expires after September 30, 1999.

In addition to the excise tax exemptions, the tax code provides income tax
credits for alcohol used or sold as a fuel, whether the alcohol is blended
with another motor fuel or used neat. These income tax credits were
enacted as part of the Crude Oil Windfall Profit Tax Act of 1980, and they
are scheduled to expire after December 31, 2000. The “alcohol mixture
credit” is available to “blenders”—businesses that mix alcohol with other
motor fuels and use the mixtures in a trade or business or sell it for use as
a fuel. The credit provides a subsidy of 54 cents per gallon of ethanol used,
if it is at least 190 proof, or 40 cents, if the ethanol is between 150 and 190
proof. The subsidy per gallon of alcohol other than ethanol is 60 cents, if it
is at least 190 proof, or 45 cents, if the alcohol is between 150 and 190
proof. No credit is available for alcohols that are less than 150 proof. The
“alcohol credit” is available to businesses that either use neat alcohol fuels
or sell them at the retail level. This credit provides the same subsidy per
gallon of alcohol as the alcohol mixtures credit.

The tax code also provides for an income tax credit for small ethanol
producers—those that produce no more than 15 million gallons of
qualified ethanol fuel per year. Qualified ethanol fuel is ethanol that is
produced by a small producer and used or sold for use as a motor fuel.
The credit is equal to 10 cents per gallon of qualified ethanol.

For the most part, to qualify for an excise tax exemption or an income tax
credit, alcohol used in a motor fuel cannot be produced from petroleum,
natural gas, coal, or peat. One exception is the partially exempt methanol
or ethanol fuel previously mentioned. The other exception is that certain
alcohol fuels that are derived from coal or lignite (falling under the
heading “special motor fuels” in table II.1) could qualify for the alternative
fuels production tax credit. Little, if any, alcohol fuel is produced from
coal or lignite.


4
 The credit that a gasohol blender may claim for excise taxes previously paid on gasoline is distinct
from the income tax credits described in the following paragraph. Even though this claim for
previously paid tax is filed with the annual income tax return, it is an offset against excise tax receipts,
not income tax receipts, and Treasury subtracts the claims from the Highway Trust Fund rather than
from the General Fund. Blenders may claim credits for, or refunds of, excess excise taxes paid on the
gasoline they blend with ethanol, even if they are not the ones who originally made the tax payments,
as long as the original taxpayer did not claim the partial exemption.



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                       Details and Estimates Relating to the Tax
                       Incentives for Alcohol Fuels




                       Taxpayers who claim the alcohol mixtures credit or the alcohol credit
                       must reduce their credits by the amount of the partial excise tax
                       exemption associated with the same fuel. The taxpayers must choose
                       between the exemptions and the credits. One of the reasons why Congress
                       supplemented the exemption with the alcohol fuels credits was to provide
                       incentives for the production and use of alcohol fuels in mixtures that
                       contained less than 10-percent alcohol. At the time the credits were
                       introduced, the excise tax exemption applied only to mixtures that were at
                       least 10-percent alcohol. Congress also wanted to give users who were
                       exempt from all fuel excise taxes, such as farmers, an incentive to use
                       alcohol-fuel blends instead of gasoline and diesel.

                       Final regulations promulgated by IRS in 1990 interpreted section 40 of the
                       tax code to say that blends of gasoline and ethyl tertiary butyl ether (ETBE)
                       could qualify for the alcohol mixtures credit.5 This interpretation was
                       made retroactive to sales or uses of the fuel blends after September 30,
                       1980. In 1994, IRS published proposed regulations saying that blends of
                       gasoline and ETBE could qualify for the partial exemption from excise tax,
                       effective January 1, 1993.6 This ruling was confirmed by final regulations
                       that became effective October 1, 1995.7 The final regulations also
                       contained a ruling that enables gasoline refiners to claim the partial
                       exemption for mixtures of gasoline and ETBE that are blended at a refinery
                       and then distributed through pipelines, even if the ETBE content of this fuel
                       becomes diluted as it passes through the pipelines.


                       The second column of table II.1 shows the current combined rates (per
Allocation of Excise   gallon of fuel) of federal excise taxes on highway motor fuels. Most of the
Tax Revenues to the    tax on these fuels is allocated to the Highway Trust Fund. In the case of
Highway Trust Fund     10-percent gasohol and dieselhol, 7.5 cents of the tax per gallon of fuel
                       remains in the Treasury’s General Fund. In the case of the other gasohol
                       blends, 6.9 cents of the tax per gallon remains in the General Fund and 4.3
                       cents of the tax per gallon of the remaining fuels shown in the table is left
                       in the General Fund. The remainder of the taxes collected on these fuels is
                       transferred to the Highway Trust Fund. The partial exemptions for alcohol
                       fuels reduce the excise tax revenues that are allocated to the trust fund;

                       5
                        T.D. 8291, RIN 1545-AN72, Alcohol Fuels Credit; Definition of Mixture, March 9, 1990, 55 Fed. Reg.
                       8946. ETBE is an ether produced from ethanol.
                       6
                       PS-66-93, RIN 1545-AS10, Gasoline and Diesel Fuel Excise Tax; Rules Relating to Gasohol, 59 Fed.
                       Reg. 52735; Tax on Compressed Natural Gas, October 19, 1994.
                       7
                        T.D. 8609, RIN 1545-AS10, Gasohol; Compressed Natural Gas, July 25, 1995, 60 Fed. Reg. 40079, Aug. 7,
                       1995.



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                         Appendix II
                         Details and Estimates Relating to the Tax
                         Incentives for Alcohol Fuels




                         they do not affect the portion of the tax that is allocated to the general
                         fund.

                         The federal Highway Trust Fund was established by the Highway Revenue
                         Act of 1956 as an accounting mechanism to finance anticipated
                         expenditures under the federal-aid highway program for the 16-year period
                         from fiscal years 1957 to 1972. Congress has subsequently passed laws
                         extending the fund and the excise taxes that are earmarked to it.8 The trust
                         fund excise taxes are currently scheduled to expire after September 30,
                         1999. The 4.3-percent general fund tax rate is permanent.9

                         During fiscal year 1995, the Highway Trust Fund excise taxes generated
                         about $23.1 billion for the fund, with 60 percent of these revenues coming
                         from the gasoline tax. However, the total tax collections were subject to
                         certain tax refunds, credits, and transfers, such as a tax rebate for
                         diesel-powered vehicles, totaling about $.7 billion. Therefore, the net taxes
                         generated amounted to about $22.4 billion in fiscal year 1995.


                         Table II.2 shows our estimates of the amounts of excise tax revenue
Revenue Estimates        forgone from fiscal years 1979 to 1995 due to the exemptions for alcohol
for the Tax Incentives   fuels. We estimated that approximately $7.1 billion of excise tax revenue,
                         in constant 1996 dollars, was forgone over that period due to the
                         exemptions.




                         8
                          In addition to excise taxes on motor fuels, excise taxes on certain tires, a use tax on heavy vehicles,
                         and a retail tax on heavy trucks are also earmarked for the fund.
                         9
                          Before expiring on January 1, 1996, there was also a small excise tax on motor fuels that was
                         allocated to the Leaking Underground Storage Tanks Trust Fund. This fund was established to help
                         finance the cost of cleaning up leaking, underground storage tanks for petroleum products. The rates
                         of the tax were 0.1 cent per gallon of fuel for all of the fuels shown in table II.1, except for the qualified
                         ethanol and methanol fuels. The rate for qualified ethanol and methanol fuels was 0.05 cent per gallon
                         of fuel.



                         Page 40                                                                       GAO/GGD-97-41 Tax Policy
                                          Appendix II
                                          Details and Estimates Relating to the Tax
                                          Incentives for Alcohol Fuels




Table II.2: Estimates of the Amounts of
Excise Tax Revenues Forgone Due to                                                          Excise tax revenues     Excise tax revenues
the Partial Exemptions for Alcohol                                                        forgone (in millions of forgone (in millions of
Fuels, 1979-95                            Fiscal year                                           current dollars) constant 1996 dollars)
                                          1979-86                                                             $1,436                        $2,049
                                          1987                                                                   489                           642
                                          1988                                                                   483                           612
                                          1989                                                                   465                           564
                                          1990                                                                   467                           543
                                          1991                                                                   510                           569
                                          1992                                                                   420                           455
                                          1993                                                                   518                           549
                                          1994                                                                   504                           524
                                          1995                                                                   605                           617
                                          Total                                                                  N/A                        $7,124
                                          Legend: N/A = not applicable.

                                          Sources: GAO estimates on the basis of excise tax collection data from IRS (for fiscal years
                                          1987-95) and gasohol production data from a publication entitled The Economics of Gasoline
                                          Ethanol Blends (for calendar years 1979-86).



                                          The data sources and methodologies used to estimate the revenues
                                          forgone for the period 1979 through 1986 in table II.2 differed from those
                                          used for the period 1987 through 1995 because of differences in the data
                                          available for each period. For fiscal years 1987 through 1995, IRS’ quarterly
                                          reports on excise tax receipts contained sufficient detail for us to
                                          determine the amount of tax receipts collected from sales of gasohol and
                                          from sales of gasoline that would later be used to produce gasohol. This
                                          information on tax receipts for each quarter, combined with information
                                          on tax rates in effect for each quarter, enabled us to estimate the number
                                          of gallons of gasohol that were sold in each fiscal year.10 Once we had
                                          estimated the number of gallons of gasohol sold, we multiplied the tax rate
                                          for gasoline by the number of gallons of gasohol to compute the amount of
                                          revenue that would have been collected if the gasohol had been taxed at
                                          the full rate. To obtain our estimate of the amount of excise tax revenue
                                          forgone, we subtracted the amount of revenue actually collected on
                                          gasohol from the amount that would have been collected if it had been
                                          subject to the full rate.


                                          10
                                            In the case of gasohol that was taxed directly, the gallonage of gasohol could be computed as: gallons
                                          = tax receipts / rate of tax per gallon of gasohol. In the case of gasoline sold for later use in gasohol,
                                          the gallonage of gasohol could be computed as: gallons = (tax receipts / rate of tax per gallon of
                                          gasoline used for gasohol) / gasoline content as a fraction of each gasohol gallon.



                                          Page 41                                                                    GAO/GGD-97-41 Tax Policy
Appendix II
Details and Estimates Relating to the Tax
Incentives for Alcohol Fuels




IRS’excise tax reports before 1987 do not contain sufficient detail to allow
us to estimate the gallons of gasohol sold each year. Instead, we relied on
published estimates of the amounts of gasohol produced in calendar years
1979 through 1986.11 We used the published estimates of gasohol
production and the applicable tax rates to estimate the amount of tax that
was collected on the sale of gasohol from 1979 to 1986 and the amount
that would have been collected if the gasohol had been taxed at the full
excise tax rate. By subtracting the former from the latter, we obtained our
estimate of the revenue excise tax revenue forgone each year.12

We also obtained data from the Department of the Treasury and IRS
relating to the amount of revenue subtracted from the Highway Trust Fund
when taxpayers claim refunds or credits for overpayments of excise tax on
gasohol. We included these revenue losses in our totals for each year.

In the absence of the exemption, the amount of excise tax forgone would
not necessarily have been exactly equal to the $7.1 billion shown in table
II.2. Without the exemption, the 108 billion gallons of gasohol that we
estimated were consumed from 1979 to 1995 might have been replaced by
a slightly smaller gallonage of other motor fuels that had been subject to
the full motor fuel excise tax rates. Since ethanol has less energy content
than gasoline or methyl tertiary butyl ether (MTBE), if these other fuels had
been used instead of ethanol, then less total gallonage of fuel would have
been needed to support a given mileage total. Another reason why less
motor fuel might have been consumed is that, without the exemption, the
price of motor fuels might have been slightly higher than it was with the
exemption, which might have caused the demand for motor fuels to be
slightly lower than it was.

The estimates that we present in table II.2 are “static” estimates in that
they do not take into account the potential changes in motor fuel
consumption in response to the elimination of the exemptions. In this
respect, our estimates are similar in concept to the projections that
Treasury and the Joint Committee on Taxation make each year for the
amounts by which excise tax receipts are reduced due to the existence of


11
 These estimates were published in Anderson, Robert C., Thomas J. Lareau and Roger D. Wollstadt,
The Economics of Gasoline Ethanol Blends, Research Study #045, (American Petroleum Institute,
Washington, D.C., 1988).
12
 We were not able to present our results for individual fiscal years in this period because the data
were available for complete calendar years only. However, we did make an adjustment to our 1986
data which, when combined with the fact that the exemption became effective at the beginning of
1979, makes our estimate for the 1979 through 1995 period equivalent to the sum for the fiscal years
during that period.



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Details and Estimates Relating to the Tax
Incentives for Alcohol Fuels




the exemption.13 These projections do not represent the amount of
revenue that would be saved if the exemption were eliminated because
they do not account for the potential behavioral responses that might alter
the total gallonage of motor fuels consumed in the future.

When Treasury or the Joint Committee make revenue-savings projections
or revenue-cost projections for policy changes, they do take potential
behavioral responses into account. The Joint Committee has made
projections of the amount of revenue that would be saved if the exemption
were eliminated. These projections are virtually identical (after the
assumed effective date for the tax law change) to the Joint Committee’s
static projections of the amount of revenue that will be forgone, due to the
exemption, if it is not eliminated. This equality indicates that the
estimators believe behavioral responses to the elimination of the
exemption would be negligible. Treasury has not made public any
revenue-savings estimate for the elimination of the alcohol fuels
exemptions in recent years.

The estimates that we have made and the projections that Treasury has
made are of the reduction in excise tax revenues due to the exemptions. In
contrast, the projections that the Joint Committee has made are of the
reduction in total federal revenues due to the exemptions, net of income
tax effects. By convention, when the Joint Committee estimates the
amount of revenue that is attributable to an excise tax, it reduces the
estimated gross revenue gain from the tax by 25 percent to account for
offsetting declines in income tax revenue.14 Conversely, when the Joint
Committee estimates the amount of revenue forgone due to an excise tax
exemption, it reduces the gross revenue forgone by 25 percent to account
for offsetting increases in income tax revenue.

13
 Treasury’s projections are published each year in the “Tax Expenditure” section of the President’s
Budget. The Joint Committee’s projections are published each year in its “Estimates of Federal Tax
Expenditures.”
14
  When the Joint Committee produces revenue estimates for an existing or proposed tax law provision,
it assumes that the adoption or elimination of the provision will not affect aggregate economic
variables, such as the gross domestic product (GDP), total employment, and the overall price index.
The Joint Committee expects that the imposition of an excise tax would raise the prices of the taxed
goods and, thereby, increase nominal GDP by the amount of tax collected. However, to maintain its
assumption that GDP remains fixed, the Joint Committee assumes that aggregate income would fall by
an amount equal to the excise tax collected so as to offset the tax-induced increase in GDP. This
decline in income would reduce income tax receipts by an amount equal to the excise tax collected
multiplied by the average marginal income and payroll tax rate on all income. The average marginal
income tax rate is assumed to be about 25 percent. Therefore, the Joint Committee estimates that the
excise tax’s net effect on federal revenues would be equal to only 75 percent of the amount of excise
tax collected. (See Congressional Budget Office, Budget Estimates: Current Practices and Alternative
Approaches, Jan. 1995 and Bruce F. Davie, “Tax Expenditure in the Federal Excise Tax System,”
National Tax Journal, Vol. XLVII, No. 1, Mar. 1994, pp. 39-62), and Joint Committee on Taxation,
Discussion of Revenue Estimation Methodology and Process (JCS-14-92), August 13, 1992.



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                                           Appendix II
                                           Details and Estimates Relating to the Tax
                                           Incentives for Alcohol Fuels




                                           The projections made by Treasury and the Joint Committee are presented
                                           in table III.3. The Joint Committee’s projection of total federal revenues
                                           that will be forgone due to the partial tax exemption in fiscal years 1996
                                           through 2000—about $2.6 billion—is significantly lower than Treasury’s
                                           projections of excise tax revenues forgone—about $3.3 billion.

                                           Treasury projects that the alcohol fuels income tax credits will cost a total
                                           of about $50 million in forgone income tax revenue from fiscal years 1996
                                           to 2000. The Joint Committee has not made precise projections of the
                                           revenue costs of the credits; they simply project that the cost will be less
                                           than $50 million in each of the fiscal years from 1996 to 2000.


Table II.3: Department of the Treasury and Joint Committee on Taxation Projections of Revenue Losses Attributable to the
Excise Tax Exemptions for Alcohol Fuels, Fiscal Years 1996-2000
                                                                                                             Joint Committee
                                        Treasury projections Treasury projections      Joint Committee     projections of total
                                                 of excise tax        of excise tax  projections of total     net tax revenue
                                         revenue losses (in    revenue losses (in        net tax revenue losses (in millions of
                                           millions of current millions of constant losses (in millions         constant 1996
Fiscal year                                           dollars)        1996 dollars)   of current dollars)              dollars)
1996                                                     $645                      $645                       $600                         $600
1997                                                      665                        651                       600                          587
1998                                                      685                        656                       500                          479
1999                                                      705                        660                       500                          468
2000                                                      730                        668                       500                          458
Total                                                  $3,430                    $3,280                     $2,700                    $2,592
                                           Sources: Treasury projections are published in Analytical Perspectives: Budget of the United
                                           States Government for Fiscal Year 1997, Table 5-1, “Total Revenue Loss Estimates for Tax
                                           Expenditures in the Income Tax,” pages 62-64. The Joint Committee’s projections are from the
                                           Committee’s print Joint Committee on Taxation Staff Estimates of Federal Tax Expenditures for
                                           Fiscal Years 1996-2000, issued September 5, 1995, Table 1, “Tax Expenditure Estimates By
                                           Budget Function, Fiscal Years 1996-2000,” pages 12-19. We put the projections into constant
                                           dollars using the GDP deflator published in the fiscal year 1997 budget.




                                           Page 44                                                               GAO/GGD-97-41 Tax Policy
Appendix III

Data on U.S. Fuel Consumption and Imports


Table III.1: U.S. Transportation Fuel
Consumed, 1992-96                                                        Fuel consumption (millions of gasoline-equivalent gallons)
                                        Fuel type                              1992            1993               1994          1995        1996
                                        Traditional:
                                              Gasoline                     108,259         108,494         110,279           111,716     113,673
                                              Diesel                         23,866          24,297         26,422            26,740      27,316
                                        Total                              132,125         132,791         136,701           138,456     140,989
                                        Oxygenates:
                                              Ethanolb                          701             760               846            919         914
                                                      c
                                              MTBE                            1,175           2,069           2,019            2,973       3,330
                                              TAMEd + ETBEe                     N/A             N/A                N/A           201         N/A
                                        Total                                 1,876           2,829           2,865            4,093       4,244
                                        Alternative fuels:
                                              E-85f                           0.021           0.048           0.080            0.105           1
                                              E-95g                           0.085           0.080           0.140            0.140       0.140
                                              M-85h                                1               2                2              2           4
                                              M-100i                               3               3                3              3           3
                                              Liquified Petroleum
                                              Gases (propane)                   208             265               249            260         263
                                              Compressed
                                              Natural Gas (CNG)                   17              22               24             44          48
                                              Liquified Natural
                                              Gas (LNG)                            1               2                2              3           3
                                              Electricity                     0.374           0.309           0.430                1           1
                                        Total                                   230             294               281            313         323
                                        Legend: N/A = not available.
                                        a
                                            Projected.
                                        b
                                         Represents the ethanol used in all fuel blends that are 10-percent or less ethanol and 90-percent
                                        or more gasoline.
                                        c
                                            MTBE is methyl tertiary butyl ether, derived from fossil materials.
                                        d
                                            TAME is tertiary amyl methyl ether, derived from fossil materials.
                                        e
                                            ETBE is ethyl tertiary butyl ether, derived from biomass.
                                        f
                                            E-85 is a fuel mixture of 85-percent ethanol and 15-percent gasoline.
                                        g
                                            E-95 is a fuel mixture of 95-percent ethanol and 5-percent gasoline.
                                        h
                                            M-85 is a fuel mixture of 85-percent methanol and 15-percent gasoline.
                                        i
                                            M-100 is a fuel consisting of 100-percent methanol.

                                        Source: U.S. Department of Energy, Alternatives to Traditional Transportation Fuels, Vol. 1,
                                        DOE/EIA-0585(94)/1, February 1996, page 37.




                                        Page 45                                                                          GAO/GGD-97-41 Tax Policy
                                           Appendix III
                                           Data on U.S. Fuel Consumption and Imports




Table III.2: Gasoline, MTBE, TAME, Ethanol, and ETBE Used in the United States in 1995, by Air Quality Area
                                                                                                  Quantity of
                                                                                         gasoline-equivalent              Percent of total
                            Percent of that fuel   Quantity of fuel  Gasoline energy         fuel (millions of                  gasoline-
                              type used in area   used (millions of        equivalent gasoline-equivalent                 equivalent fuel
Fuel/Source material                  (percent)           gallons)          (percent)                gallons)              used (percent)
All areas meeting air quality standards:
  Gasolinea                                 58%                  63,802                  100%                   63,802                55.0%
  MTBE                                          0                      0                  82                         0                      0
  TAME                                          0                      0                  88                         0                      0
  Ethanol                                   38                       495                  67                      332                      0.3
All air quality nonattainment areas:
  Gasolinea                                 42                   47,057                  100                    47,057                40.7
  MTBE                                     100                     4,745                  82                     3,891                     3.4
  TAME                                     100                       123                  88                      108                      0.1
  Ethanol                                   62b                      742                  67                      497                      0.4
  ETBE                                     N/A                        63                  85                        54                0.05
All areas:
  Gasolinea/Fossil                         100                  110,859                  100                   110,859                95.8
  MTBE/Fossil                              100                     4,745                  82                     3,891                     3.4
  TAME/Fossil                              100                       123                  88                      108                      0.1
  Ethanol/Biomass                          100                     1,237                  67                      829                      0.7
  ETBE/Biomass                             100                        63                  85                        54                0.05
                                           Legend: N/A = not applicable.
                                           a
                                            Gasoline category does not include MTBE, TAME, ethanol, or ETBE.
                                           b
                                               Includes the ethanol used to make ETBE.

                                           Sources: Urbanchuk, John M., Ethanol: Fueling An Economic Engine: Macroeconomic and Fiscal
                                           Impacts of Ethanol Production Under the 1996 Farm Bill, April 19, 1996, AUS Consultants, page
                                           10; U.S. Department of Energy; and GAO.




                                           Page 46                                                              GAO/GGD-97-41 Tax Policy
                                            Appendix III
                                            Data on U.S. Fuel Consumption and Imports




Table III.3: U.S. Energy and Petroleum, Consumed and Imported (Actual and Projected), 1973-2015
                                           Energyb consumed                              Petroleumc consumed
                                  (quadrillion Btu)              (percent)              (quadrillion Btu)               (percent)
Yeara                               Total             Imported       Imported             Total         Imported            Imported
1973                                74.28                12.68               17           34.84               12.98                 37
1974                                72.54                12.19               17           33.46               12.66                 38
1975                                70.55                11.75               17           32.73               12.51                 38
1976                                74.36                14.65               20           35.18               15.20                 43
1977                                76.29                18.02               24           37.12               18.24                 49
1978                                78.10                17.32               22           37.97               17.06                 45
1979                                78.90                16.75               21           37.12               16.93                 46
1980                                75.96                12.25               16           34.20               13.50                 39
1981                                73.99                 9.65               13           31.93               11.38                 36
1982                                70.85                 7.46               11           30.23                9.05                 30
1983                                70.52                 8.31               12           30.05                9.08                 30
1984                                74.14                 8.96               12           31.05                9.89                 32
1985                                73.98                 7.87               11           30.92                8.95                 29
1986                                74.30                10.38               14           32.20               11.53                 36
1987                                76.89                11.91               15           32.87               12.53                 38
1988                                80.22                13.15               16           34.22               14.01                 41
1989                                81.33                14.18               17           34.21               15.33                 45
1990                                81.27                14.08               17           33.55               15.29                 46
1991                                81.12                13.36               16           32.85               14.22                 43
1992                                82.14                14.63               18           33.53               14.96                 45
1993                                83.86                17.18               20           33.84               16.40                 48
1994                                88.74                18.59               21           34.77               17.28                 50
1995                                90.93                17.93               20           34.92               16.87                 48
2000                                97.85                24.18               25           37.92               22.41                 59
2005                               103.36                27.43               27           40.46               25.59                 63
2010                               107.89                29.33               27           42.24               27.48                 65
2015                               110.67                30.53               28           43.26               28.60                 66

                                                                                                             (Table notes on next page)




                                            Page 47                                                         GAO/GGD-97-41 Tax Policy
Appendix III
Data on U.S. Fuel Consumption and Imports




Note: Imports are net of exports.
a
 Figures for 2000 and later years are Energy Information Administration (EIA) projections. Ethanol
preferences expire after 2000; however, EIA projections assume the preferences will be renewed
and continue at current levels through 2015.
b
Energy includes natural gas, coal, nuclear, and renewable, in addition to petroleum.
c
 Petroleum includes crude oil, lease condensate, petroleum products, unfinished oils, pentanes
plus, and gasoline-blending components.

Sources: 1973-1993: U.S. Department of Energy, Monthly Energy Review, DOE/EIA-0035(96/06),
June 1996, pages 7 and 9. 1994-2015: U.S. Department of Energy, Annual Energy Outlook 1997:
With Projections to 2015, DOE/EIA-0383(97), December 1996, page 96.




Page 48                                                                 GAO/GGD-97-41 Tax Policy
Appendix IV

Description of Groups in the Economy That
the Ethanol Tax Incentives Affect

                       The ethanol tax incentives benefit or disadvantage different groups in the
                       economy by changing the prices these groups pay and the income they
                       receive. By lowering the after-tax price of ethanol, the tax incentives
                       change the price of ethanol relative to the prices of other goods and,
                       thereby, change the supply and demand for these goods. The incentives
                       may cause the groups that buy and sell these goods to pay different prices
                       and receive different incomes than they would receive in the absence of
                       the incentives.

                       Determining the groups that the tax incentives benefit or
                       disadvantage—what economists call the “incidence” of the incentives—
                       requires analyzing how prices and incomes would be different in the
                       absence of the incentives. The groups that benefit from the incentives are
                       those that would pay higher prices or receive lower incomes in the
                       absence of the incentives. This appendix explains the factors that
                       determine the incidence of the incentives and describes the economic
                       groups that may be affected by the incentives.


                       The groups that bear the burden of a tax or receive the benefit of a tax
The Factors            incentive are not necessarily those who legally must pay the tax. Levying a
Determining the        tax may change the price of one good relative to another and, thereby, may
Incidence of the Tax   change prices and the allocation of resources. In this way, the tax may be
                       shifted to other households and firms in the economy through price
Incentives             changes.

                       The groups that legally must pay the excise tax on gasoline do not receive
                       the full benefit of the ethanol tax incentives. In some cases, those who
                       legally must pay the tax may be the blenders; in other cases, they may be
                       the gasoline distributors. In either case, the tax incentives reduce the
                       blenders’ after-tax cost of using ethanol because they are the ones who
                       undertake the activity of blending ethanol and gasoline that gives rise to
                       the tax reduction. If the blenders pay the tax, they can also claim the tax
                       reduction. If gasoline distributors pay the tax and claim the tax reduction,
                       they will reduce the price that they charge the blenders by virtually the full
                       amount of the tax benefit. The reasons for this are: (1) the gasoline
                       distributors are just as well off selling gasoline to be blended with ethanol
                       at the lower price and receiving the tax reduction as they are selling
                       gasoline for other uses at the higher price and receiving no tax reduction
                       and (2) the blenders have the option of not telling the distributors that the
                       gasoline will be blended with ethanol, in which case the distributors would




                       Page 49                                                GAO/GGD-97-41 Tax Policy
Appendix IV
Description of Groups in the Economy That
the Ethanol Tax Incentives Affect




not claim the tax reduction, and the blenders could later claim refunds of
the overpayment of tax.

However, the blender does not receive the full benefit of the incentives
because the reduction in the after-tax cost of ethanol increases the
blenders demand for ethanol, and thereby raises its price. Therefore, a
part of the benefit that the blenders could receive is offset due to the
increase in the pre-tax cost of ethanol. A part of the benefit is shifted back
to ethanol producers and may be shifted to other groups in the economy
through price and income changes.

How prices and incomes are altered by the shifting of the incentives
among groups depends on how responsive market supply and demand are
to price changes and on market conditions that affect a firm’s ability to
control prices. The responsiveness of supply and demand to price changes
is called the “price elasticity.” Determining the incidence of the incentives
requires (1) information on price elasticities for all of the markets
potentially affected by the incentives and (2) information on the
conditions in the markets that determine whether firms control prices and,
if so, how much control firms have over the prices they can charge to
consumers.

In competitive markets where firms do not control the prices they charge,
the incidence of the incentives depends on the elasticity of supply and
demand. In general, the less elastic is supply and the more elastic is
demand, the more suppliers benefit from the incentives. For example, if
the supply of corn by farmers is less responsive to price changes than the
demand for corn by ethanol producers, more of the value of the incentives
would be shifted back to farmers as higher corn prices. These elasticities
also make it likely that the short-term effect on prices of removing tax
incentives will be greater than the long-term effect because the supply of
products and resources is less elastic over shorter periods of time. For
example, fuel producers may need time to adjust their production levels
when a tax is removed, and, therefore, the short-term effect on their prices
is likely to be greater than the long-term effect.

Except in the case of a monopoly, the factors governing the incidence of
the tax incentives in noncompetitive markets are more difficult to
determine. The incidence of the tax incentives in a market with a few firms
that can influence market price depends on the behavior of these firms.
Whether a firm shifts the tax incentives forward to consumers will depend
on whether it believes other firms in the industry will also lower prices.



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                       Appendix IV
                       Description of Groups in the Economy That
                       the Ethanol Tax Incentives Affect




                       The incidence of the tax incentives may also depend on whether firms are
                       maximizing profits, total revenues, or market share.


                       The tax incentives, by altering supply and demand conditions in the
Description of the     ethanol market, can affect prices in markets throughout the economy. For
Markets and            example, the increased demand for ethanol increases demand and price in
Consumers of Ethanol   the corn market, while it lowers demand and price in markets for
                       substitute fuels. In this section, we describe the groups for whom the
and Related Products   incentives have a nonnegligible effect on prices. We do not describe the
                       groups such as workers for whom the effect is likely to be negligible.
                       Although the tax incentives increase the demand for workers in the
                       ethanol industry, this increased demand merely shifts labor from other
                       sectors in the economy and does not produce a net increase in
                       employment. Furthermore, the ethanol industry is relatively small and
                       increased demand in this industry is unlikely to have any net effect on
                       wage rates in the economy.


Ethanol Blenders and   The blending and distribution of the ethanol blends usually are not
Distributors           integrated with ethanol production. Ethanol and gasoline usually have
                       been blended by businesses that purchase gasoline at wholesale from
                       refiners and purchase ethanol at wholesale from ethanol producers. Most
                       fuel ethanol is sold in the open market rather than through integrated
                       distribution channels. The ethanol is sold primarily to wholesalers beyond
                       the refinery gate so that ethanol competes directly with wholesale gasoline
                       and other blending agents. Most petroleum pipelines will not carry ethanol
                       because the ethanol can suffer water contamination or cross
                       contamination with other petroleum products, and because of ethanol’s
                       corrosive properties. Therefore, ethanol is usually transported by truck or
                       rail and blended with gasoline, which arrives by pipeline at the distribution
                       points.

                       However, in the future, gasoline refiners may begin to account for a larger
                       share of alcohol fuel-blending than they have in the past. New IRS
                       regulations (effective Oct. 1, 1995) allow ETBE, which is an ether derived
                       from ethanol, to qualify for both the partial excise tax exemption and the
                       income tax credits. ETBE (like the ether MTBE) can be blended with gasoline
                       and transported via pipelines without serious problem.




                       Page 51                                               GAO/GGD-97-41 Tax Policy
                    Appendix IV
                    Description of Groups in the Economy That
                    the Ethanol Tax Incentives Affect




Ethanol Producers   The ethanol industry is dominated by a few firms. Sixty-five percent of
                    capacity is owned by the three largest firms, and the largest firm, Archer
                    Daniels Midland, owns 50 percent. In 1994, total capacity of the industry
                    was about 1.6 billion gallons per year, and total output was about 1.3
                    billion gallons. A few large plants account for the bulk of capacity, with 50
                    percent of industry capacity accounted for by four large plants owned by
                    Archer Daniels Midland. The average capacity of these plants was about
                    215 million gallons per year.

                    Economies of scale are difficult to quantify because of diverse plant
                    configurations in the industry. However, some estimates are that plants
                    need an annual capacity of 50 to 100 million gallons per year to take
                    advantage of economies of scale. In 1995, the four large plants owned by
                    Archer Daniels Midland accounted for about 70 percent of the capacity of
                    plants in the industry that can produce more than 50 million gallons per
                    year.

                    The ethanol is produced using dry-milling and wet-milling technologies.
                    Both processes convert a bushel of corn into approximately 2.5 gallons of
                    ethanol. The technologies differ in the byproducts produced and capital
                    costs. Generally, wet milling has higher capital costs but produces more
                    valuable byproducts than dry milling. The byproducts of the wet-milling
                    process include corn gluten meal, corn gluten feed, corn oil, and carbon
                    dioxide. The principal byproduct of dry milling is direct distillers grains,
                    which is a high protein livestock feed. Wet milling accounts for about
                    60 percent of the total ethanol production.

                    The net cost of producing ethanol depends on the price of corn; the value
                    of the byproducts generated in the production process; the costs of
                    energy, chemicals, and labor; the size of the plant; and the technology used
                    to produce the ethanol. The estimates of total costs can vary significantly
                    depending on variations in these components of costs. A 1988 report15 by
                    the American Petroleum Institute (API) estimated the total cost of ethanol
                    production in a wet-milling plant with a capacity of about 50 million
                    gallons per year at $1.14 per gallon with corn prices at $1.80 per bushel
                    and at $1.38 per gallon with corn prices at $2.75 per bushel. API estimated
                    dry-milling costs in a plant with the same capacity at $1.25 and $1.48 using
                    the same variation in corn prices. A 1992 analysis by the U.S. Department




                    15
                      Anderson, Lareau, and Wollstadt, The Economics of Gasoline Ethanol Blends.



                    Page 52                                                               GAO/GGD-97-41 Tax Policy
                               Appendix IV
                               Description of Groups in the Economy That
                               the Ethanol Tax Incentives Affect




                               of Agriculture’s (USDA) Economic Research Service (ERS)16 estimated the
                               total cost, in 1992, for a wet-milling plant with 100-million gallon capacity
                               at $1.24 per gallon of ethanol produced. This estimate was based on
                               average corn prices and byproduct prices from 1981 to 1991. ERS reported
                               estimates by other researchers that range from $1.08 to $1.95 per gallon.

The Effect on the Ethanol      Without the tax incentive, fuel ethanol production would largely
Industry of Removing the Tax   discontinue. This conclusion is based on estimates of ethanol production
Incentives                     costs, the opinions of industry analysts, and the results of simulation
                               models estimating the effect of removing the exemptions.

                               The cost of producing ethanol exceeds the price of the alternatives, given
                               the current technology and recent prices of substitute fuels. The wholesale
                               price of gulf coast regular gasoline at the rack averaged about $0.55 per
                               gallon in the second half of 1995, and the price of the methanol-based
                               additive, MTBE, averaged about $0.81 per gallon. The estimates of ethanol
                               production costs reported above all exceed the prices of these alternative
                               products. On the basis of these cost estimates, ethanol could not be priced
                               to match the prices of the alternative products and cover the cost of
                               producing ethanol and the additional costs of distributing ethanol to
                               blenders.

                               The economic viability of the ethanol industry depends on the size of state
                               subsidies as well as the federal incentives. States provide incentives for
                               ethanol in the form of tax exemptions and production subsidies. As of
                               December 1995, according to one industry survey, eight states had
                               production subsidies that ranged from 20 to 40 cents per gallon of ethanol,
                               and nine states had a sales tax or motor fuels tax exemption for ethanol.
                               These exemptions range from 10 cents per gallon of ethanol in
                               Connecticut and Iowa to 80 cents per gallon in Alaska. These state tax
                               incentives, combined with the federal exemption of 54 cents per gallon,
                               allow ethanol to compete profitably with substitute fuels.

                               However, ethanol producers may be able to price ethanol competitively
                               without the incentives if the price of corn were lower and the price of the
                               substitute fuels were higher, or if significant cost savings were made
                               through technological improvements. In 1988, API estimated that corn
                               would need to cost as little as $1.80 per bushel and wholesale gasoline
                               would have to sell for as much as $1.25 per gallon for producers to price
                               ethanol competitively with gasoline and cover their production cost.

                               16
                                Hohman, Neil and C. Matthew Rendleman, “Emerging Technology in Ethanol Production,”
                               Agriculture Information Bulletin, No. 663, (Economic Research Service, U.S. Department of
                               Agriculture, January 1993), pages 1 to 17.



                               Page 53                                                                GAO/GGD-97-41 Tax Policy
                           Appendix IV
                           Description of Groups in the Economy That
                           the Ethanol Tax Incentives Affect




                           Estimates made in 1993 of cost savings from improvements in technology
                           show short-term gains (in the next 2 to 5 years) of 5 to 7 cents per gallon
                           and long-term gains (in the next 5 to 10 years) of an additional 4 to 8 cents
                           per gallon.

                           In addition to the cost analysis, the views of analysts of the ethanol
                           industry also lead us to conclude that the ethanol production would
                           largely discontinue if the incentives were removed. For our 1995 report,
                           we interviewed ethanol and gasoline industry trade groups, ethanol
                           producers, and government officials.17 We concluded from the interviews
                           that, without the incentives, large-scale ethanol producers having the
                           lowest production costs may continue to produce ethanol, at least in the
                           short term, but that the amount of ethanol used would decline
                           dramatically. Some ethanol production for export may continue for a
                           while, although the amount of U.S. exports of ethanol varies a great deal
                           from year to year.18 In our 1995 report, we used declines of 50 and
                           90 percent with no expected future growth in ethanol use in the
                           simulations used to assess the effect of eliminating the exemption on farm
                           prices and incomes.

                           Simulations by the Energy Information Agency (EIA) also led to the
                           conclusion that the ethanol fuel production would largely discontinue if
                           the incentives were removed. According to EIA, ethanol would represent
                           about 21 to 33 percent of the oxygenate content of gasoline through 2015 if
                           the exemption were continued at current levels, while the rest of the
                           oxygenate content would be MTBE and other ethers. The EIA model projects
                           that ethanol-blending would discontinue if the exemptions actually were
                           to expire after 2000, but it would recover slightly by 2015 to cover about
                           2 percent of the oxygenate market. The recovery would occur because the
                           prices of other blending components would rise more rapidly than the
                           price of ethanol throughout the forecast period.


Producers of Alternative   Substitutes for ethanol as an octane enhancer are hydrocarbon aromatics,
Gasoline Additives         such as benzene, toluene, and xylene. The chief substitute for ethanol as
                           an oxygenate is MTBE, which is produced using methanol. MTBE also
                           enhances octane but to a smaller extent than ethanol. MTBE is a less costly
                           source of oxygen in blended fuels than ethanol. MTBE is currently derived

                           17
                             GAO/RCED-95-273R.
                           18
                             The export market for ethanol is volatile because the foreign demand for U.S. ethanol depends on the
                           price of sugar. Because ethanol production involves the fermentation of sugar, when sugar prices are
                           low, more ethanol is produced abroad and demand for U.S. ethanol is less.



                           Page 54                                                                 GAO/GGD-97-41 Tax Policy
          Appendix IV
          Description of Groups in the Economy That
          the Ethanol Tax Incentives Affect




          from natural gas and, therefore, it does not benefit from the federal tax
          preferences. These preferences are sufficient to make ethanol competitive
          with MTBE as an oxygenate. Ethanol and ethanol-based additives had
          35 percent of the oxygenate market in 1994, while MTBE had about
          65 percent.

          If the tax incentives were removed, MTBE is likely to supply nearly all of the
          oxygenate and octane enhancer markets. According to EIA simulations,
          MTBE would almost entirely replace ethanol if the incentives were
          removed. EIA also measured the impact of eliminating the incentives on the
          price of reformulated gasoline. The differential between the price of
          reformulated gas and conventional gasoline would increase from about 4
          cents per gallon to 5 cents per gallon after 2000 if the exemption is
          eliminated.


Farmers   Corn is the principal feedstock used for ethanol production. About 95
          percent of the ethanol sold for gasoline in the United States is made from
          corn; the rest is made from wheat, barley, and potato waste. In 1995,
          approximately 500 million bushels of corn were used to produce about
          1.3 billion gallons of ethanol. Corn used in ethanol production represented
          about 6 percent of the total corn output in 1995. Most ethanol production
          is in corn-growing states.

          Ethanol production increases the supply of high-protein animal feed and
          corn oil byproducts from the conversion of corn into ethanol. The
          dry-milling process generates distilled dried grains, while the wet-milling
          process produces gluten meal, gluten feed, corn oil and carbon dioxide.
          The increased supply of these byproducts may reduce the demand for and
          price of oil seeds, such as soybeans, cottonseed, and sunflower seeds. The
          increased supply of byproducts may reduce demand for soybeans because
          the byproducts compete with soybean meal in the high protein meal
          markets and with soybean oil in the vegetable oil markets. However, the
          effect of reduced demand on soybean prices may be offset by a reduction
          in supply as farmers switch to more profitable corn production following
          an increase in the price of corn. Corn is a primary competitor for soybean
          acreage, and as farmers substitute corn for soybean acreage, soybean
          supply may fall and its price increase, offsetting the effect on soybean
          prices of the drop in soybean demand due to increased production of
          ethanol byproducts.




          Page 55                                                GAO/GGD-97-41 Tax Policy
                                Appendix IV
                                Description of Groups in the Economy That
                                the Ethanol Tax Incentives Affect




                                Farmers use corn and other feed grains for their livestock. The higher corn
                                prices due to the ethanol tax incentives may increase the feed costs of
                                some livestock producers, such as those who raise cattle. However, to the
                                extent that the increased supply of ethanol byproducts lowers the price of
                                high protein animal feed, other producers, such as those who raise
                                poultry, may face lower costs. Although, as a group, grain producers may
                                increase their income, the total effect on farmers’ incomes depends on the
                                net effect of the price changes on grain, oilseed, and livestock producers.19


The Effect of the Ethanol Tax   In our 1995 report, we estimated the effect of removing the tax incentives
Incentives on Farm Prices and   on farm prices and income assuming that all agricultural policies set forth
Incomes                         in the 1990 farm bill would be maintained. We used an econometric model
                                developed by the Food and Agriculture Policy Research Institute (FAPRI) to
                                estimate the effect of the removing the incentives, assuming that the
                                demand for ethanol would decline by 50 percent and 90 percent.20 Each of
                                these scenarios was estimated for the period 1995 through 2000, assuming
                                alternatively no corn acreage reduction and that corn acreage would be
                                reduced as modeled in the 1995 FAPRI baseline.21 Under both sets of
                                assumptions, we concluded that corn prices, soybean prices, and net farm
                                income would decline if the tax incentives were removed. We found that
                                the average decline in the price of corn over the period 1995 through 2000
                                would range from 5.9 to 9.3 percent for a 50- and 90-percent decline in
                                ethanol use. We also found that, for a 50-and 90-percent decline in ethanol
                                use, the average decline in the price of soybeans would range from 3.0 to
                                4.8 percent, and the average decline in net income for all farmers would
                                range from 1.4 to 2.4 percent.

                                We did not estimate the effect on prices and incomes of removing the
                                incentives under the new policies introduced by the Federal Agricultural
                                Improvement and Reform (FAIR) Act of 1996. According to analysts at USDA

                                19
                                  In cases where farmers do not own the land they work, in theory, the benefit of higher farm prices
                                could be shifted back to the owners in terms of higher land prices or rents. In these cases, the effect of
                                the incentives on farm incomes would include the effect on the income of land owners as well as the
                                farmers who work the land.
                                20
                                  FAPRI uses a set of integrated models to determine the consequences of policies and programs that
                                affect U.S. and world agriculture. The FAPRI modelling system consists of U.S. domestic crop models;
                                U.S. livestock models; world trade models for feed grains, wheat and soybeans; a model that estimates
                                the cost of domestic government agricultural programs; and a model that estimates net farm income.
                                21
                                  The FAPRI baseline assumes that the acreage that farmers can plant with corn and still be eligible for
                                federal farm payments would be reduced by 7.5 percent in the first year and 5 percent thereafter. CBO
                                suggested that a reasonable alternative is to assume that the Secretary of Agriculture would have
                                reduced the acreage that farmers were allowed to plant with corn to remain eligible for federal
                                payments sufficiently to offset the effect of the reduced demand for corn on corn prices.



                                Page 56                                                                    GAO/GGD-97-41 Tax Policy
            Appendix IV
            Description of Groups in the Economy That
            the Ethanol Tax Incentives Affect




            and the Congressional Budget Office (CBO), corn and net farm income
            would decline under the FAIR Act if the incentives are removed. The FAIR
            Act, by eliminating the barriers to shifting acreage among crops, also
            increased the likelihood that the drop in ethanol production would result
            in a decrease in soybean prices if the incentives were removed. However,
            our estimates of the size of these price and income declines would be
            different because the estimates would reflect these new policies and
            changed market conditions since our report. For example, the decline in
            farm incomes may be different under the FAIR Act because the act removed
            the link between farm payments and farm prices so that lower market
            incomes from corn would not be offset by increasing deficiency payments.
            Our 1995 analysis assumed that government deficiency, or income
            support, payments would be made as corn prices declined, somewhat
            compensating corn farmers for lower market receipts from corn. The FAIR
            Act retained a program of government loans, which may moderate the
            decline in farm incomes if market price declines are severe.22 However,
            USDA believes that the price of corn is unlikely to fall far enough for the
            loans to be used to mitigate the effect of the price declines on farm
            income.


Consumers   Consumer demand for ethanol is based on its characteristics as a motor
            fuel and on environmental regulations. Ethanol is used in gasohol in
            unregulated markets as a gasoline extender and octane enhancer. Over
            76 percent of all gasohol is sold in midwestern states where it is
            competitive in price with gasoline because of the states’ proximity to
            ethanol producers and because of state tax incentives for gasohol. Ethanol
            is also used as an oxygenate to meet environmental regulations. According
            to estimates that are based on ethanol industry data, in 1995, ethanol
            represented 28 percent of the oxygenates used in the oxygenated fuels
            market and 7 percent of the oxygenates used in the reformulated gasoline
            market. By 2002, these ethanol shares are estimated to increase to
            38 percent and 13 percent of the respective markets, if the tax incentives
            are continued at the current levels.


            22
              Farmers may receive a loan from the government at a designated rate per unit of production (loan
            rate) by pledging and storing a crop as collateral. The farmers have the option either to repay their
            loans with interest at any time or, at the end of the loan period, to forfeit their crop to the government
            and have their interest payments forgiven. Farmers who raise certain crops, such as oilseeds, wheat,
            and feedgrains, may repay the loans at alternative repayment rates that are based on price data from
            USDA when these rates are lower than the loan rates. Because the farmers keep the difference
            between the loan rate and the alternative payment rate, they can sell their crops at market prices
            without reducing their returns. Farmers who do not take out loans may also receive amounts called
            loan deficiency payments that are equal to this difference between the loan rate and the alternative
            payment rate.



            Page 57                                                                     GAO/GGD-97-41 Tax Policy
Appendix IV
Description of Groups in the Economy That
the Ethanol Tax Incentives Affect




Consumers benefit if the tax incentives are passed on in the form of lower
motor fuel prices. Price-shifting depends on the price elasticity of demand
for ethanol-blended fuels. The more inelastic is demand, the more the
consumer would benefit from the incentives. The price elasticity for
ethanol blends is affected by the availability of substitute fuels with similar
characteristics and by environmental regulations requiring the use of
additives, such as ethanol. Demand would be less responsive to price
changes to the extent that the use of ethanol is required to meet
environmental standards and to the extent the ethanol blend is perceived
to have characteristics different from other motor fuels.

Consumers are not likely to benefit much from the tax incentives in the
regulated markets because the regulations do not require the use of
ethanol. The environmental regulations have increased demand for
ethanol for use as an oxygenate. Since the Clean Air Act Amendments of
1990, demand for ethanol and MTBE has more than doubled. However,
these regulations do not specify that ethanol be used as the oxygenate.
MTBE, which is less costly to produce than ethanol, already has about
65 percent of these regulated markets. The demand for ethanol blends in
these markets is likely to be highly elastic because consumers will respond
to any price differences by purchasing the lower-priced fuel.

Consumers also are not likely to benefit much from the tax incentives in
unregulated markets because the fuel characteristics of ethanol blends
make them a close substitute for gasoline. Ethanol blends have higher
octane levels than gasoline, which improves driveability by reducing
engine knock. However, the blends also have higher volatility than
gasoline, which reduces driveability by causing vapor lock in hot weather,
and the blends get fewer miles per gallon because ethanol has about
two-thirds the energy content of gasoline. API concluded from its review of
driveability studies that the octane, volatility, and mileage tradeoffs turn
out to be about equal, and that most consumers view ethanol blends as
close substitutes for gasoline.

Because the ethanol blends are viewed as close substitutes for gasoline by
most consumers, the effect of the incentives on gasoline prices would be
limited by the size of ethanol production relative to the total market for
motor fuels. Since ethanol makes up only 1 percent of the motor fuel
supply, removing the incentives is unlikely to have a large impact on price.
In 1988, API estimated that the tax incentives lowered the price of motor
fuels by 0.27 percent.




Page 58                                                 GAO/GGD-97-41 Tax Policy
Appendix IV
Description of Groups in the Economy That
the Ethanol Tax Incentives Affect




MTBE blends are also close substitutes for ethanol blends for use as an
octane enhancer and gasoline extender in the unregulated markets.
Ethanol blends have a higher octane level but have lower mileage and
higher volatility. Removing the ethanol tax incentives would increase
demand for MTBE both as an oxygenate and as an octane enhancer. The
consumers are likely to respond to any difference in price by purchasing
the lower-priced fuel. As previously described, EIA has estimated that
removing the tax incentives would produce a small increase in the price of
reformulated gasoline produced with MTBE.

The ethanol tax incentives may also affect consumers as buyers of food.
As previously discussed, the incentives may cause the prices of some
crops to be higher, which could then lead to slightly higher prices to
consumers for some food products. The benefit to consumers from lower
gasoline prices could be reduced by the higher food prices due to the
incentives. However, like the effect on gasoline prices, the effect on food
prices is likely to be very small. For example, the increased price that
farmers receive for their corn may represent a much smaller price increase
for consumers because, in many cases, the corn is only a part of the
product purchased by the consumer, and the farmer’s price is only part of
the product’s retail cost to the consumer. Furthermore, the effect of the
increased corn price on the consumer’s total food costs is small because
spending on corn and products derived from corn represents only a part of
the consumer’s food budget.




Page 59                                              GAO/GGD-97-41 Tax Policy
Appendix V

Major Contributors to This Report


                        James A. Wozny, Assistant Director, Tax Policy and Administration Issues
General Government      Anne O. Stevens, Economist-in-Charge
Division, Washington,   Kevin E. Daly, Senior Economist
D.C.                    Charles C. Tuck, Senior Economist

                        Mary C. Kenney, Senior Economist
Resources,
Community and
Economic
Development
Division, Washington,
D.C.




(268734)                Page 60                                            GAO/GGD-97-41 Tax Policy
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