Low-Energy Fridays: Are all these energy subsidies worth it? Not really.

The tax cuts adopted during the first Trump administration as part of the 2017 Tax Cuts and Jobs Act are set to expire by the end of next year, putting extra pressure on the next Congress to adopt another tax reform. Republicans will likely try to extend those cuts as part of a budget reconciliation bill, and making them permanent would cost $3.5 trillion. This means legislators will be looking for subsidies to cut to pay for an extension. A likely source of funds is the roughly $1.2 trillion in clean energy subsidies (mostly in the form of tax credits) under the Inflation Reduction Act (IRA). The major question for lawmakers will be which is more worthwhile—the IRA tax credits or a continuation of the Trump tax cuts? In that vein, it is worth understanding the cost of energy subsidies and under what conditions they can achieve their hoped-for benefits.

The most basic (and, unfortunately, universally underappreciated) element of tax policy is that every dollar of subsidy the government spends must be paid for by a dollar extracted from a taxpayer. If deficits are used to pay for the subsidy, then the taxpayer will pay a dollar later plus interest. And because that taxpayer has lost the opportunity to spend their dollar on something with more utility, the overall efficiency of capital allocation becomes distorted.

In other words, taxes carry an economic cost beyond the dollar directly levied to pay for a subsidy (called deadweight loss). This important fact is often lost among policymakers because the gross domestic product equation includes government expenditures, making it seem like tax-and-spend policies improve growth. In truth, they slow growth compared to an alternative economy that enjoys lower taxes.

While taxes and the ensuing spending have a cost, the typical objective of energy subsidies is to address “market failures,” or underinvestment in activities that improve the economy. Classic examples include addressing pollution or early-stage research, where the return on investment for novel scientific discovery stretches so far into the future that it doesn’t garner much private investment.

So, do clean energy subsidies under the IRA fit into these justifications? Not really.

The first common defense of clean electricity subsidies is that they’re necessary for the market uptake of clean electricity and their ability to propel cost reduction via economies of scale. Given that wind and solar are among the cheapest forms of electric power generation, such an argument doesn’t hold much weight. This was a more compelling position when such tax credits began in the 1990s; but after decades of mostly uninterrupted subsidy, it may be time to declare victory on this front.

The second common defense is that these subsidies garner an environmental benefit that may outweigh their cost. The problem is that even before the expansion of subsidies under the IRA, clean energy was purchased and built to a far greater degree than fossil fuels. Since the subsidies only induce a marginal additional uptake of clean electricity, they become expensive policies for only small changes in carbon dioxide levels. This is a point made in my testimony on the IRA to the Senate Finance Committee, which noted that even under generous assumptions about the effectiveness of subsidies, most of the expenditures would simply enrich investors who were planning to build clean energy anyway rather than further reduce pollution.

The third common argument is that because fossil fuels have been subsidized heavily in the past, it’s only fair that renewables also be heavily subsidized. (Note: R Street is a stalwart opponent of fossil fuel subsidies.) Ignoring the fact that renewable energy is subsidized to a far greater degree than fossil fuels, the idea that we should replicate bad policy from one U.S. industry to another as a matter of “fairness” is nothing more than a wealth transfer from American taxpayers to industry investors.

So, what should policymakers do about clean energy subsidies? If we seek to maximize economic outcomes and minimize pollution, the answer is to curtail subsidies for technologies that don’t need them to be cost effective in the market, which yield very little environmental benefit at a high cost.

Simultaneously, tax credits that do have applications to energy innovation by investing in technologies that can’t yet attract private investment are more likely to achieve policymakers’ future environmental objectives, and tax credits should be simplified into a broad technology-neutral treatment that focuses on outcomes over rewarding specific technology types (the proposed Energy Sector Innovation Credit is one example). Even this may not be as economically beneficial a policy as one that would entirely forgo energy subsidies, but it is at least an improvement over the status quo. Such a policy would end up cutting most of the energy-related tax expenditure while realizing a net increase in energy innovation expenditure. Of course, full expensing for research and development is important, too.

In practice, lawmakers are unlikely to pursue an economically optimal approach to tax credits. Industries that benefit from such credits are likely to lobby lawmakers heavily, and irrespective of such lobbying, it is natural that if large subsidies exist, some congressional districts will receive and therefore defend those subsidies. Even in the 2017 tax reform law, Republicans retained wind and solar tax credits. The main difference now is the sheer size of the IRA tax credits, as annual energy tax credits ballooned from $18.9 billion in 2022 to $58.1 billion in 2023. Coupled with this year’s $1.6 trillion deficit, the energy tax credits will be a tougher sell.

Republicans may address tax issues next Congress in any number of ways. Instead of ending credits, they may simply get an early sunset; and tax cuts may be extended rather than made permanent. Because energy subsidies represent a cost that Americans must bear, lawmakers should ensure that what we get out of those subsidies is really worth the cost.