Drawbacks of a Tax Credit for Energy Efficiency

It seems that every year there are new tax credits being offered for any of a variety of ways that you can be more energy efficient.  Whether it is Energy Star compliant appliances, high efficiency windows, or credits for installing renewable energy sources, our elected leaders seem to have no end of ways that they want to use the tax code to influence us to be more efficient.  The benefits of these various tax credits are largely accepted: They influence the behavior of consumers at the margin to make decisions that will reduce our collective and individual consumption of energy.  Secondary effects include reducing the scale of energy imports, reducing carbon emissions from the energy used, and hopefully shifting patterns of behavior over the long run.

But as with almost any public policy decision, there are drawbacks to these credits which should be understood before we adopt them or extend them.

First, these credits tend to disrupt market efficiencies.  By their very nature, tax credits for discretionary spending such as these credits are designed to encourage people to engage in behavior that they would not otherwise engage in.  In the case of high efficiency appliances, for example, the credits were introduced because the benefits of high efficiency were not enough to get people to choose those appliances on their own merit.  Perhaps the added cost of high efficiency is too much, or perhaps the added benefits are not enough to outweigh the costs.  Whatever the exact calculus, a tax credit only becomes necessary when the desired behavior (energy efficient decisions) is not something that the market already rewards.  A natural response is “so what?”  The problem with intentionally intervening in the market is that it results in waste.  Nothing involving taxes involves free money.  Every dollar of a tax credit will be paid for by somebody: either in the form of increased taxes on some other activity, or in the form of debt that will be paid by future generations – all in the name of using tax policy to get people to do something that would not otherwise be worth their while.

Second, energy credits are almost guaranteed to be regressive tax policies.  A tax policy is considered regressive if it tends to provide outsize benefits to people at higher income and wealth levels.  There is nothing inherently wrong with regressive taxation, but the people who are most likely to benefit from credits on expensive energy efficient upgrades are people who can afford to buy the more efficient products.

Third, because of the operation of inefficiency and regression, these credits result in a windfall to unintended recipients.  Imagine that you are in the business of selling windows.  You have two models, the low efficiency window and the high efficiency window.   Along comes a tax policy that offers 30% back to the consumer for the high efficiency window.  Basic microeconomics will tell you that the entire tax credit will not be passed to the consumer.  The installer will naturally increase the price of the efficient window to take a share of the credit.  How much of a share depends on the elasticity of demand and response to price fluctuations.

None of these drawbacks need be fatal to efficiency credits.  But if we support the credits, we should do so with full understanding of the implications.  These largely result in tax benefits to two groups: the relatively wealthy consumer and the manufacturers of these efficient devices.  It is paid for either by all or by future generations, and is done to intentionally encourage behavior that is not otherwise efficient and results in waste.  That might be the intended effect or it might be unintended.  And perhaps the benefits that we seek outweigh these concerns.  We simply need to ensure that the drawbacks to tax credit for energy efficiency are understood and accounted for.