“Tax reform” is becoming one of the key catchphrases this election season. With support from both Democrats and Republicans, actual work on legislation is likely to take place in 2013. Key elements of reform are likely to include simplifying the tax code and reducing marginal tax rates by eliminating many credits and deductions. Tax reform provides us with an opportunity to remove barriers to efficiency investments imbedded in the current tax code and to use the tax code as a tool to support energy efficiency in the future more than current provisions do. The challenge is in proposing policies that encourage energy efficiency while still keeping with the overall goal of tax reform—simplifying the tax code
ACEEE has begun a series of working papers on tax reform and energy efficiency. Today we released the second paper in the series entitled Modifying How Energy Costs Are Treated for Business Tax Purposes in Order to Remove Barriers and Increase Energy Efficiency.
The current tax code creates three disincentives to energy efficiency investments:
- Since energy bills count as a business expense and are subtracted from the total amount of taxable income, effectively, the federal government is typically “paying” 25% of business energy costs (based on the average effective business tax rate of about 25%) and sometimes as much as 35% of a business’s energy costs (the maximum business tax rate). Subsidizing energy costs enables higher energy consumption.
- When businesses do invest in energy efficiency, a portion of the energy savings goes to the federal government in the form of higher taxes (e.g., 25% for a business with the typical effective tax rate of 25%, before adjusting for the effects of depreciation). When the full value of the savings does not accrue to the firm, the incentive to make investments goes down.
- When a firm makes capital investments, these expenses must be depreciated, meaning they are only recovered gradually. In the meantime the firm must carry the un-depreciated value on its books, which can reduce the incentive to make investments.
We believe that the tax code can be structured to encourage businesses to reduce energy consumption in a cost-effective manner instead of encouraging energy waste. In this new paper, we focus on how energy costs are treated and suggest three possible new ways to treat business energy costs in the tax code. One is simple but radical—it would shift business taxes to focus on income, not expenses, just as the individual income tax does. With this approach, the corporate income tax rate could probably be reduced to 3-4% of revenue instead of the current tax that averages about 25% of profits. The second approach is also simple but more surgical in that it would eliminate deductibility for just energy costs, although partial deductions would still be allowed for firms with very high energy costs as a percent of revenues, in order to not put these firms at a disadvantage in international trade. The third, more complicated, approach would reward businesses that operate with below-average energy costs relative to the average in their industry, while penalizing businesses that consume large amounts of energy. The working paper includes extensive examples to illustrate how each of the options might work.
At this point we are not advocating for any one of these three options, but instead propose that they be subject to serious examination and discussion. The working paper is intended to begin this discussion.
While tax policies should not be the sole policies in place for addressing U.S. energy consumption, they can be an elegant tool for encouraging businesses to reduce energy waste. One of the primary goals of tax reform is the simplification of the tax code. Several of our options would simplify the code. Also, all three options could reduce the need for specialized tax incentives currently in place to encourage energy efficiency. Another goal of tax reform held by many is to reduce marginal tax rates by broadening the tax base—two out of our three options would do this.
ACEEE plans to produce a report on tax reform later in 2012, building on our working papers and comments we receive on them. The first working paper, Should the U.S. Consider a Modest Emissions Fee as Part of a Strategy to Lower Marginal Tax Rates? was published in January. The third one, on depreciation of business investments, will be issued in April.