The Subsidy Debate: Oil vs. Ethanol

Direct, indirect and hidden subsidies and incentives benefit both industries, and need to be acknowledged
By Kate Bechen and Porter J. Martin | September 12, 2011

Much has been said and written about whether the ethanol industry is sustainable without tax credits and tariffs. But what often is missing in criticisms of ethanol is an acknowledgement that the oil industry significantly benefits from a variety of tax credits, incentives and other publicly-funded subsidies. Bloomberg New Energy Finance estimated that worldwide governments provided approximately $43 billion to $46 billion in direct subsidies to renewable energy and biofuel technologies, projects and companies in 2009. According to an International Energy Agency study in 2008, fossil fuels received an estimated $557 billion, not factoring in security and public health costs associated with fossil fuels. The oil and ethanol industries, as well as the energy sector more generally, are subsidized by taxpayers through state and federal subsidies, incentives, tax credits and other governmental policies. 

It is a significant challenge to compare oil subsidies and ethanol subsidies because there is no consensus on the definition of “subsidy,” “public financial support,” “incentives” or similar terms. For example, the oil industry would not characterize the tax benefits associated with oil and gas exploration and development expensing as a “subsidy,” even though it is the only major industry that benefits from these specific tax provisions. On the other hand, the ethanol industry may agree that the Volumetric Ethanol Excise Tax Credit (VEETC) is a subsidy, but disagree that it should be characterized as an “ethanol-only subsidy” because gasoline blenders (i.e. oil companies) are the ones who actually receive the credit, not ethanol producers. 

Ethanol Subsidies

The ethanol industry receives a variety of federal and state incentives. When state incentives are factored in, some estimates put ethanol subsidies at around $30 billion, though this number is only an estimate because there is an inherent difficulty in measuring state-level incentives. Given the multitude of state programs, this article focuses on the three federal programs: VEETC, the Small Producers Tax Credit and the import tariff, all of which are set to expire on Dec. 31. While our focus is on these three federal programs, it is important to note that state programs have played pivotal roles in the development of the ethanol industry. For example, Iowa’s retailer tax credit played a significant role in establishing E10 ethanol at pumps throughout the state and eventually across the country.

The VEETC (or the blenders credit) provides a tax incentive in the amount of 45 cents per gallon of pure ethanol blended with gasoline. Thus, while VEETC is a subsidy benefiting the ethanol industry, the credit actually goes entirely to oil industry blenders, not ethanol producers. The credit, calculated by the Congressional Budget Office to be about $6 billion in 2009, is first taken as a credit against the blender’s fuel tax liability, but any excess is claimed as a direct payment from the Internal Revenue Service. It is difficult to accurately measure what portion of VEETC benefits the oil industry versus ethanol, but most likely oil has been in the best position to retain the value of VEETC, especially since 2006 when the supply of ethanol exceeded the renewable fuel standard (RFS), allowing oil companies to be price setters and consume ethanol when the price is in their favor.

The small ethanol producer tax credit is a tax incentive in the amount of 10 cents per gallon of ethanol that is sold or used by a producer in an ethanol fuel mixture. Qualified facilities produce not more than 60 million gallons of any type of alcohol and the incentive applies to the first 15 million gallons produced.

The import duty for fuel ethanol has two features, a 2.5 percent ad valorem tariff on the import of ethanol for use in fuel and a duty of 54 cents per gallon of ethanol. It is important to note that the 54-cent duty applies to imports from most countries to offset VEETC, an important point often ignored by critics of ethanol subsidies. Ethanol imports from countries that are party to one of several international trade agreements with the U.S. are not subject to the 54-cent duty, as long as the ethanol is produced from feedstocks originating in those nations. The tariff is in place to ensure that the U.S. is not subsidizing foreign ethanol by allowing foreign companies to benefit from VEETC. 

The national RFS also has likely had a subsidizing effect on the ethanol industry. The RFS calls for 36 billion gallons of renewable fuel to be produced by 2022, although conventional biofuel will be capped at 15 billion gallons in 2015. Corn and sorghum growers also benefit from direct payments and crop insurance premium subsidies. 

Oil Subsidies

At the turn of the 20th century, the federal government realized the importance for national security in developing oil reserves. As such, the government created many beneficial taxation, subsidy and other incentive programs geared specifically to aid the then young and struggling oil industry. This close historical relationship between the oil industry and the federal government has resulted in significant benefits for the oil industry.

The oil industry benefits from longstanding tax incentives not enjoyed by ethanol or any other major industry. One example is the favorable taxation of oil and gas exploration and development expenses that allow the oil industry to pay about $1 billion less in taxes each year, roughly the equivalent of the industry’s research and development expenditures. This deduction allows for a majority of expenses that do not have a salvage value to be expensed in the year incurred, rather than amortizing the costs over a longer period of time. Historically, the federal government sought to entice a fledgling industry into locating and developing oil and gas reserves in the name of national security. Over 100 years later these incentives still exist.

In addition to exploration and development expense deductions, the oil industry, given its size and level of dependency upon equipment and leases, also significantly benefits from various accelerated depreciation provisions for equipment and leases. Estimates have placed oil’s tax benefit at $4 billion due to accelerated depreciation. While the same deductions are available to ethanol, oil utilizes these tax deductions to a greater extent because of its size and the prevalence of leasing arrangements in the oil industry. According to a 2010 article in the New York Times, “As Oil Industry Fights a Tax, It Reaps Subsidies,” a 2005 Congressional Budget Office study found that, “capital investments like oil field leases and drilling equipment are taxed at an effective rate of 9 percent, significantly lower than the overall rate of 25 percent for businesses in general and lower than virtually any other industry.”  Lower taxes due to preferential treatment of a particular industry is equivalent to a subsidy.
Oil also benefits from a domestic production activities deduction. Due to the large scale of oil companies, this deduction is significant, but it is also a deduction available to any U.S. manufacturer. In fact, the oil industry only receives a 6 percent deduction, while all other industries receive 9 percent. The oil industry also benefits significantly from foreign tax credit provisions and deferral of income from controlled foreign corporations.

Hidden Subsidies

The oil industry benefits from the U.S. strategic petroleum reserve, as a result of the federal government purchasing extra oil supplies to be used in emergency situations. Other less obvious benefits and incentives received by the oil industry include taxpayer support of the transportation infrastructure, public liability for plugging and remediating onshore wells, environmental costs associated with air pollution and environmental clean up costs associated with oil spills.

A University of California-Davis study by Mark Delucchi and James Murphy with the Institute of Transportation Studies concluded that “if the U.S. motor vehicles did not use petroleum, the U.S. would reduce its peace time and war time defense expenditures in the long run by roughly $1 [billion] to $10 billion per year.” Most oil proponents disagree that these types of government expenditures should be characterized as subsidies to the oil industry. Roughly half of the world’s daily consumption of oil flows through one of seven or eight narrow sea passages, including the Panama Canal, Bab el-Mendab, Strait of Malacca, Strait of Hormus, Suez Canal and Suez-Mediterranean Pipeline, Bosporms and Dardeanelles and Danish Straights. Ensuring the steady flow of oil through these diverse oil transit chokepoints is of considerable value to the oil industry, and many current measures to ensure stability would not be necessary if the passageways were not significant oil check points. Ethanol has no such check points and a U.S. military presence is not needed to protect ethanol shipping and distribution channels. 

Gas and ethanol production facilities also benefit from tax increment financing, enterprise zones, high-quality job creation incentives and new capital investment programs offered by states. The ethanol industry has benefited from a variety of state programs, especially in Corn Belt states. 

While the ethanol industry has not been as successful as the oil industry in securing and maintaining tax advantages at the federal level, it has, or will be, a beneficiary of stimulus spending directed at the renewable energy industry in general. The size of ethanol’s portion of the stimulus funds is not clear. The Biomass Crop Assistance Program, the clean cities portion of the stimulus money and various earmarks for advanced biofuels research all will directly or indirectly lend support to the ethanol industry.

It is very difficult to assign a portion of public expenditures to a particular industry. It is also difficult to quantify and compare the financial benefits of complex tax provisions. But, is there anything wrong with simply acknowledging that the oil industry derives significant economic benefit from public financing of infrastructure, the U.S. tax code, environmental cleanup initiatives and military protection of the foreign oil supply? These factors have been largely excluded from articles and commentary that criticize ethanol’s dependence on tax credits and tariffs. Simply acknowledging that a subsidy, benefit or incentive exists doesn’t mean that there are not good reasons to continue such support. We all drive cars and are heavily reliant on the oil industry. But this also doesn’t mean that there aren’t also good reasons to reevaluate certain subsidies that become out dated, ineffective or excessive.

Authors: Kate Bechen
Attorney, Energy & Sustainability Group, Michael Best & Friedrich LLP
(414) 225-4956

Porter J. Martin
Partner, Michael Best & Friedrich LLP
(608) 283-0116