Energy tax policy involves the use of the government's main fiscal instruments -- primarilytax subsidies (tax credits, deductions, exemptions, and lower tax rates) as financial incentives, andincreased taxes as financial disincentives -- to alter the allocation or configuration of energyresources and thereby achieve policy objectives. The idea of applying tax policy instruments to theenergy markets is not new, but until the 1970s energy tax policy had been little used, except topromote oil and gas development. (1) Recurrent energy-related problems since the 1970s -- oil embargoes, oil price and supplyshocks, wide petroleum price variations and price spikes, large geographical price disparities, tightenergy supplies, rising oil import dependence, as well as increased concern for the environment --have caused policymakers to look toward energy taxes and subsidies with greater frequency. In atypical Congress hundreds of bills are introduced that propose to amend energy tax policy directly,and hundreds of others have indirect effects that either reduce costs (energy tax incentives) orincrease costs (energy taxes) in the energy industry. In the 108th Congress, over200 such bills wereintroduced. More recently, energy tax incentives and subsidies (and also some reductions in energy taxes)have been the dominant part of comprehensive energy policy legislation -- dominant in the sense thatthe changes in taxes resulting from the incentives produce the greatest economic effects in terms ofcost reductions or increases. In the 107th and 108th Congresses, an emerging "energy crisis" -- fluctuating oil prices, spiking petroleum product prices, the California energy crisis, spiking naturalgas prices, the collapse of Enron in 2001, the northeast electricity blackout on August 14, 2003 --led to several comprehensive energy policy reform bills. These bills proposed to, among otherthings, stimulate additional production of oil and gas and reduce petroleum import dependence,expand electricity supply and infrastructure, promote energy conservation and efficiency, and expandthe supply of alternative (renewable and unconventional) fuels. (2) Sizeable energy tax subsidies(tilted more toward fossil fuel supply) were part of H.R. 6 , the comprehensive energypolicy bill of the 108th Congress. The conference version of that bill proposed a $23.5 billion tenyear energy tax cut. (3) Failure of the comprehensive energy legislation caused several energy tax incentives to expirein 2003, so the 108th Congress enacted retroactive extension of several of the provisions as part ofthe Working Families Tax Relief Act of 2004 ( P.L. 108-311 ). Those provisions, which reducedrevenues by about $1.3 billion over ten years, were enacted on enacted on October 4, 2004. About$5 billion in energy tax incentives -- mostly from the expansion and liberalization of the renewableelectricity tax credit -- were part of the American Jobs Creation Act of 2004 ( P.L. 108-357 ) enactedon October 22, 2004. That leaves roughly $17 billion in tax breaks embodied in the failedcomprehensive legislation H.R. 6 (108th Congress) that have not been enacted. Many of the energy tax incentives that have not been enacted over the past four or five yearshave been repackaged as H.R. 6 (109th Congress), which the House approved with itstax title on April 13, 2005. The tax provisions provide about $8.1 billion of energy tax cuts over tenyears as compared with $23.5 billion in H.R. 6 in the 108th Congress, and $33.5 billionin House version of H.R. 4 in the 107th. The Senate is expected to vote on an SenateFinance Committee approved bill that provides about $17 billion in energy tax subsidies. This billis tilted less toward fossil fuel production and more toward energy conservation and alternative fuelsthan the $8 billion tax incentives package in the House-passed energy bill. President Bush's FY2006budget request proposed a $6.7 billion, ten-year energy tax incentives package. Finally, not all of the recent actions in the area of energy tax policy have involved taxsubsidies or incentives -- some have involved taxation. For example, during the spike in gasolineand diesel prices of spring 2000, there were several proposals (e.g., S. 2285 , 106thCongress) to suspend the motor fuels excise taxes to relieve consumers the burden of high andspiking prices. (4) Morerecently, there are bills to reinstate the crude oil windfall profit tax of the 1980 to reduce the windfallprofits allegedly being earned by oil companies from high crude oil and petroleum product prices. Proposals to amend the current federal tax treatment of the energy industry, and to eitherimpose energy taxes or provide tax subsidies, raise several important economic and other publicpolicy issues: The nature and seriousness of the nation's energy problems, and the appropriatepolicy instruments to deal with them. What exactly are the problems in U.S. energy markets? Is theproblem one of excessive demand for, and consumption of, energy? Is it insufficient supply? Or isit both? Moreover, are the problems an inherent part of the market system -- that need a governmentsolution? Or does government interference worsen the situation? Are there market failures, or justsimply barriers that could be overcome by the market itself if the economic variables were alignedjust right? More specifically, what are the various problems in each of the energy markets,the petroleum, natural gas, and electricity markets? How serious is growing petroleum importdependence and what are the tax policy instruments that may be effectively used to address thisproblem? Assuming that energy tax policy instruments are the recommended policychoice, how should the specific change in tax burdens be achieved? Should energy tax burdens bechanged by a tax credit, tax deduction or exemption, or by reducing some energy tax rate? What isthe relative effectiveness of each of these tax subsidy instruments in achieving policy effectiveness(the most "bang-for-the-buck")? What is, and what should be the federal tax treatment of the energy industry,including the tax treatment of investments in oil and gas wells and coal mines, and the tax treatmentof other expenses such as exploration and development costs? Does the oil and gas industry receivefederal tax subsidies and if so how much? Do these subsidies adversely affect the production,consumption, and importation of energy? Do they also inhibit the development of renewable energy(such as solar, wind, and biomass) and investments in energy efficiency? Should federal taxsubsidies for oil and gas and other fossil fuels be increased to stimulate exploration and supply toaddress our energy problems or would budgetary resources be better used to reduce energy demandby providing tax incentives for energy efficiency and renewable energy? How should the tax code allow for depletion of mineral reserves and othermineral production expenses. For example, should it use cost depletion, adjusted cost depletion,percentage depletion, or complete expensing? How would the various tax reform proposals (forexample, a cash-flow tax or a consumption tax) affect the treatment of the oil and gas and otherenergy sectors? Is there an economic or policy rationale for energy taxes to raise revenue orenergy tax subsidies to encourage greater energy conservation or increased supply of alternativefuels? Further, assuming the policy objective is to promote fossil fuel conservation, would the moreeffective incentives target energy efficiency or the supply of alternative (including renewable) formsof energy? What are the economic effects -- the effects on allocational efficiency,distribution of income, macroeconomic effects, effects on energy supply, demand, and imports -- oftaxing or subsidizing energy? This report provides background on the theory and application of tax policy as it relates tothe energy sector, particularly with respect to the theory of market failure in the energy sector andthe possible policy remedies. More specifically, it provides an overview for policymakers on thetypes of energy tax policy interventions that are likely to improve the functioning of energy markets,and the efficiency with which the general economic system allocates resources (i.e., the generalwelfare). Table 1 summarizes the market failures discussion in the report. It lists the types of energymarket failures likely to cause economic inefficiencies and the tax policy remedy suggested byeconomists. It also cites examples in current law that are consistent with this theory -- energy taxprovisions that enhance economic efficiency. The text following the table discusses each of thesefailures in detail. (5) At the outset, it is important to address the notion that there is something inherently differentabout energy, or fuels from various energy resources, that requires government intervention throughthe tax code. Often energy tax proposals are premised on such arguments, that energy is tooimportant to be left to the unfettered private market system. Table 1. Energy Market Failures and Energy Tax Policy Remedies Source: Adaptation based on Fisher, Anthony and Michael H. Rothkopf. Market Failure and Energy Policy: The Rationale for Selective Conservation. Energy Policy, v.17, August, 1989. According to economists, energy is a commodity that is produced to provideutility to consumers or end users, and, in general, is no different than any othereconomic good. Three features of energy as an economic good, however, differentiateit from other commodities. First, most energy is derived from depletable mineralresources: Petroleum products are derived from crude oil, natural gas resides indepletable reservoirs or deposits (such as coal mines), and electricity is (currently)mostly derived from coal. While this does not necessarily impede the smoothfunctioning of the competitive market system, it does mean that production decisionshave to be made functioning of the competitive market system, it does mean thatproduction decisions have to be made in an inter-temporal framework. That raises theimportant inter-generational question: Do markets optimally deplete resources overtime, or do they exploit them for short run gain at the expense of the long-termbenefits of the future generation of consumers? The second distinguishing feature of energy is that the activities required toproduce it generate adverse environmental effects, and the process of transformingit to do work involves combustion, which also generates pollution from emissions. In the presence of such pollution -- or externalities as discussed below -- marketsgenerally fail to produce and use the optimal quantities of energy -- they produce anduse too much energy, i.e., more than the optimal amounts that maximize socialwell-being. Finally, energy is different from other commodities (say, e.g., food, clothingor housing) in that both at the micro and macroeconomic level it enters theproduction process of many firms and industries in an important extent -- it is a majorfactor of production, just as are labor, capital, and managerial ability. This hasimportant implications for the macro-economy: It means that changes in energyprices, particularly crude oil prices which are benchmarks for all energy prices, havethe potential to move the markets, and the macro-economy, in a major way. Fluctuations in energy prices could have major effects on the business cycle,affecting aggregate output (GDP), employment, interest rates, and prices (i.e.,inflation). Two examples of this are the recession of 1974-75, which was caused bythe 1973 oil embargo, and the stagflation of the late 1970s, which was caused by thesharp run-up of crude oil prices of the 1970s. Under generally accepted economic and accounting principles, producers ofdepletable resources (such as oil, gas, or coal), who attempt to maximize profits overa finite stock of a resource, should be taxed in the same manner as non-energyproducers not subject to the finite resource constraint. Under a pure income tax,depreciation deductions would be based on economic depreciation; exploration anddevelopment drilling expenditures would be subject to cost depletion (capitalized)instead of expensed (entirely deducted from current-year taxable income) as iscurrently done; and depletion allowances would be based on the actual decline ineconomic value of the mineral deposit (or approximated by indexed cost depletioninstead of percentage depletion). (6) A neutral tax system would also generally capitalizedry hole costs, the intangible costs of drilling unsuccessful wells, as such expensesmay be viewed as part of the cost of developing successful wells -- essentially thecosts of creating an asset of value. In the event that there are no successful wells, thena deduction for such costs in the year incurred is appropriate under a neutral incometax system. Such an income tax would be neutral; i.e., it would not distort resourceallocation, the optimal allocation that would otherwise result in a competitivemarket. (7) The current tax treatment of mineral producers -- which permits expensingof intangible drilling costs and dry hole costs, percentage rather than cost depletionfor smaller companies and for some royalty owners, exemption from passive losslimitation rules that apply to other industries, and special tax credits and othersubsidies (such as the tax credit for oil and gas produced from marginal wells) -- differs from this neutral tax treatment in that it provides several tax subsidies for oiland gas. (8) While the magnitude and value of the subsidies in the aggregate are not large relativeto the size of the oil and gas industry, this can still lead to increased investments inlocating reserves (increased exploration), more profitable production, and someacceleration of oil and gas production (increased rate of extraction) and excessivelyrapid depletion of the resource (i.e., they provide an unambiguous incentive todeplete sooner rather than later). It also would lead to a channeling of resources intothese activities that otherwise would be used for oil and gas activities abroad or forother economic activities in the United States. While a change from the present tax system of tax subsidies to a neutral taxsystem would have a heavy adverse effect on many smaller oil and gas companies,particularly those that concentrate on onshore exploration, if the theory is correct, itwould be more than offset by the positive welfare effect on the country generally asmarket distortions are reduced, and resources would be allocated more efficiently. Perhaps more than other markets, the energy markets have characteristicswhich can lead to market failure and thus a misallocation of resources. Production,importation, and use of energy frequently generate non-market costs or benefits notaccounted for by the producers, importers, or consumers (and therefore not measuredin the marketplace) that spill over to people who are not a party to the transaction. These spillovers -- or externalities -- are an energy market shortcoming because theyare uncompensated, not reflected in the equilibrium market prices for the fuel(because without government intervention there are no economic incentives to do so). With externalities operating, markets can fail to establish energy prices equalto marginal costs of supply. With inaccurate cost/price signals, a competitivefree-market system may fail to achieve the socially optimal mix -- the allocationallyefficient mix -- of output. The presence of externalities does not alter the economicargument that competitive mineral producers should be taxed under the same incometax rules as the competitive non-mineral producers, but it does suggest either aseparate energy tax (in the case of a negative production externality, whereproduction and use of energy generates costs) or an energy tax subsidy (in the caseof a positive production externality, where the firm's competitive free market outputgenerates benefits to third parties). Environmental damage is perhaps the major negative externality created asa result of energy production and consumption activities. This consists mostly of airpollution resulting from mining, transportation and transmission, and refining andindustrial use of oil, gas, and coal, but also includes discharges of effluents into thewater, runoff from streets, and damages to the land from mining. For example, coalmining can be the source of external costs such as black lung disease (fromunderground mining), destruction of landscape, and water pollution from aciddrainage. Combustion of coal in coal-fired powerplants produces large emissions ofharmful gases, fine particulate matter, and urban smog linked to a wide range ofhealth and environmental damages. (9) The use (or combustion) of fossil fuels at the finalconsumer level by households, motorists, and businesses is also a significant sourceof air pollution and other environmental damages that impose uncompensated costson society (those not paying for the use of the fuel directly). While much of the airpollution is from the combustion of fossil fuels (gasoline and diesel) intransportation, it also includes industrial and residential fuels such as natural gas,heating oil, and coal. The Emissions Tax. Most publicfinance and environmental economists argue that a market-based instrument such asa tax, e.g., an emissions tax in the case of air pollution from the combustion of fossilfuels, would be an economically preferred instrument to correct for the marketdistortions caused by the pollution externality. (10) The taxwould be equal to the monetary value, per unit of emissions, of the damages to thirdparties, and structures, and other damages resulting from the harmful emission. Whilecurrent federal tax law does not provide an example of a theoretically pure pollutiontax, the tax on ozone-depleting chemicals resembles such a tax. (11) This tax,which is part of Internal Revenue Code (IRC) Â§4681 and Â§4682, assesses a per-poundtax on the sale or use of a variety of chlorofluorocarbons (CFCs) and other chemicalsthat have been proven to be harmful to the Earth's ozone layer. The tax varies basedon the degree of harm of each of the taxed chemicals, being lowest for methylchloroform and highest for Halon-1301. (12) Another example might be the black-lung excisetax on domestically mined coal. (13) Energy Taxes Aa Pollution Taxes. Some have proposed energy taxes based on the assumption that there is roughly adirect proportional relationship between emissions and the quantity of the fuel used.This tax would be imposed on the quantity of polluting fuel used, with rates varyingdirectly with the amount of external cost generated by each fuel based on estimatesof the monetary value of the harm to third parties. Thus, it would be highest on coal,then oil, then gas, and any non-polluting renewable energy resources such ashydropower would be either taxed at very low rates or tax exempt, depending on thedegree of environmental damage. (14) Two example of such a tax are the carbon tax andthe British Thermal Unit or Btu tax. While a carbon tax in theory should be a chargeon the emissions of CO 2 , in practice this tax is conceived of as an energy tax on thequantity of three fossil fuels burned -- coal, petroleum, and natural gas -- with the taxrate based on the carbon content, in the ratio of 1.0 to 0.8 to 0.6 respectively. Anexample of an energy tax that approximates the effects of a theoretically pureenvironmental tax might be a tax on vehicle fuel as proxy for the pure tailpipeemissions tax. This could be implemented as an addition to the existing motor fuelsexcise tax (the taxes on gasoline and diesel fuel). This externality tax would be inaddition to the current excise taxes on these fuels that are mainly user charges for thebenefits received from federal highway infrastructure. (15) Clinton's Btu Tax. The Btu(British thermal unit) tax is a broadly-based energy tax based on the heat content orheating potential of a fuel, or energy content in the form of heat. The standard Btu tax-- the type considered by the Congress in the 1980s and again in 1990 and the ClintonAdministration in 1993 -- is a flat or unit excise tax on all forms of energy based onthe Btu. For example, one barrel of oil has, on average, about 5.8 million Btu's,meaning that it has 5.8 million units of heat capable of raising one pound of water atmaximum density by one degree Fahrenheit. One short ton of coal (2,000 lbs.)contains about 22 million Btu's, about four times the Btu's in one barrel of oil; onethousand cubic feet (mcf) of natural gas contains about 1 million Btu's, about 1/6ththat of oil. (16) One gallon of gasoline contains about 125,000Btu's. Thus, for example, a fixed rate Btu tax of $1.00 per million of Btu's wouldimpose the following taxes: $5.80 per barrel on oil (about 15% of the 2003 oilprice), $0.97 per mcf of natural gas (about 20% of natural gas prices paid bypipelines); $20 per ton of coal (about 114% of coal prices), and 12.5Â¢ per gallon ofgasoline (about 11% of recent average gasoline prices). (17) On the eve of the 1973 oil embargo, petroleum imports supplied 33.4% ofU.S. consumption. Import dependence increased to 44.9% of consumption in 1978,and remained relatively flat through 1992. Since then, however, petroleum importshave increased to over 60% of consumption. For example, during the four weekperiod ending on June 3, 2005, petroleum imports were 60.7% of total supplies. Table 2. A $1 Million BTU Tax on SelectedFuels as % of 2003 Fuel Price Source: All data from Monthly Energy Review, May 2005. Coal price data are fromthe Energy Information Administration's website. A variety of external costs may be associated with petroleum importation.These may result when petroleum importers fail to take into account the non-marketcosts of ("excessive") dependence on imported petroleum from countries that arepolitically unstable or perhaps unfriendly to the United States. These costs are: the weakened defense posture and greater military vulnerabilityin the event of an embargo or supply disruption; the cost of allocating greater resources to national defense inorder to maintain the level of national security preferred (compared with the quantitythat would be allocated with much lower oil imports); and the economic and social costs in terms of unemployment,inflation, and shortages that would result from an effective oil embargo, or oil pricespikes. (18) One economically efficient policy to correct for these distortions wouldimpose a tax (or tariff) on imported petroleum based on the per-barrel estimate ofthese costs (the so-called oil import "premium"). Such a tax, however, would likelyviolate trade agreements, and thus policymakers focus on alternative policies suchas tax incentives for domestic petroleum production, which also reduce the demandfor imported petroleum. The problem of vulnerability to embargoes and price shocks, which relatesto dependence on imported oil from the Organization of Petroleum ExportingCountries (OPEC) and other unstable foreign countries, is distinct from the problemof import dependence, and might be better addressed in a policy of stockpiling oil asis being done with the Strategic Petroleum Reserve. Some have argued that oil price volatility might be a possible source ofmarket failure because it raises the risks associated with investing in oil and gas andmay result in under-investment in domestic oil and gas extraction. For much of the first part of the 20th Century, crude oil prices declined in realterms and the energy markets were relatively stable. The price of oil varied duringthis period, but new discoveries kept the trend of prices downward; gasoline, naturalgas, and electricity prices were also essentially declining in nominal terms duringmuch of this period. (19) The 1973-74 Arab oil embargo against the UnitedStates reduced oil supplies by 10-15% and oil prices more than doubled in just twoyears. The 1978-79 political turmoil in Iran (and the resulting abdication of theShah) and the Iranian oil workers strike virtually shut off this source of oil suppliesfrom the world market. Iranian oil output dropped from 6 million bpd to 1.2 millionbpd in December 1978, although other OPEC producers made up Iran's shortfalls.This was followed by a war between Iran and Iraq, which also threatened world oilsupplies and supplies to the United States. Although the loss of imports to the United States was not that large (about500,000 bpd), the threat of another supply disruption, combined with oil pricecontrols, caused panic buying on the part of consumers and strategic behavior on thepart of oil producers, which resulted in substantial oil price hikes. Crude oil pricesmore than doubled during this period from about $10/barrel to over $24/barrel. By1980, the official OPEC price was $36/barrel, but spot market prices reached nearly$40/barrel. Thus, between 1970 and 1980 crude oil prices had increased from around$1.50/barrel to around $35/barrel, an increase of over 2,200%. In 1985-86 there wasa sharp decline in oil prices, which were welcomed by consumers and beneficial tothe general economy, but which hurt the domestic oil industry (particularly upstreamoperations), and oil producing regions of the United States (Texas, Louisiana,Oklahoma, and Alaska) From 1986-1999 oil prices averaged about $17.00 per barrel, but they fluctuated from between $12 and $20 per barrel. Domestic crude oil prices reacheda low of about $8/barrel in December 1998, among the lowest crude oil prices inhistory after correcting for inflation. By the summer of 1999, crude oil prices hadrecovered to about $20 per barrel; and by the summer of 2000 prices peaked at wellover $30 per barrel, due largely to output reductions by OPEC, but also due to theincreased energy demand accompanying increasing growth in the world (particularlythe Asian) economies. Crude prices were still high by November 2000 ($30.30/barrel), but they fellin December after OPEC, which in 2004 produced 42% of the world's oil, increasedproduction. OPEC's prodigious oil reserves, sizeable production capacity, and cartel-type behavior make it the swing producer, capable of affecting short-run prices ineither direction, thus making both world and domestic crude oil prices more volatilethan they otherwise would be. During the winter of 2002-2003, there was anothercrude oil price increase, this time due to the anticipated war with Iraq and politicalupheaval in Venezuela and Nigeria, which are major oil producers and suppliers tothe United States. Most recently, prices have reached $60/barrel and have remainedabove $50 for several months. Wide fluctuations in the market price of oil increase investor risk in theenergy industry (particularly for oil and gas investments), but it can also inhibitinvestments in the development of alternative energy resources, both unconventionaland renewable, and in energy efficiency. However, all prices fluctuate in a freemarket, although some more than others. And such fluctuations or risks are part ofbeing in business -- they are not necessarily market failures. Further, if oil and gasprices fluctuate "excessively" so that they generate unusual risks that may affectenergy, economic, or national security, the preferred approach from an economist'spoint of view would be to attempt to stabilize the price of oil -- this might be doneby a variable oil import tax -- rather than to provide tax subsidies. (20) Sometimes energy taxes may act as a quasi user fee, a charge for the benefitsreceived by taxpayers from the provision of a public good or quasi-public goodfinanced from the user fee revenues. This is the economic rationale for the gasolinetax, which charges motorists generally in proportion to their use of the interstatehighways and highway infrastructure and uses the revenues to build and maintain thatinfrastructure. To the extent that charges approximate individual benefits received,the tax would be efficient and equitable. (21) Such taxes, however, are less precise instrumentsthan tolls and other benefit charges because 1) they do not actually charge users forthe marginal cost of using the infrastructure (including pavement costs, congestioncosts, and environmental costs), and 2) some of the highway trust fund revenues --currently the revenues from 2.86Â¢ of the tax -- are allocated for mass transit, whichmeans that motorists are paying to subsidize users of mass transit. It is true that allmotorists benefit from reduced congestion, but the most efficient way of addressingthis problem is to price the use of the roads to account specifically for the congestionexternality. When the externalities or spillover effects are positive, i.e., when a markettransaction or activity confers unpriced benefits on third parties, the market systemwould Under supply the commodity or activity. The classic case of positiveexternalities is research and development (R&D) that leads to technologicalinnovations. An individual firm that undertakes R&D activities obviously incurs thecost of these efforts and activities, but it typically does not obtain the entire return,some of which accrues to other firms (free riders) that do not undertake theseexpenditures. Energy R&D engenders similar spillover effects, whether it is fromresearch in clean-coal technologies, photovoltaic solar systems, electric cars, fuelcells, or energy efficiency technologies. The manufacturer of building equipment andenergy-using technologies may not have adequate incentives to support sufficientlevels of research to improve building or equipment efficiency because some of thegains may accrue to firms not undertaking the expenditures. In cases of positive externalities, the social return exceeds the purely privatereturns to individual companies, and from an economic perspective a subsidy iswarranted to bring the marginal costs of production in balance with the marginalsocial benefit (private benefits + external benefits, at the margin). Such support hasproduced major innovations in the energy efficiency of various energyusing-equipment such as heat pumps and resulted in significant reductions in theprice of generating alternative energy such as photovoltaic solar energy. Such is therationale for the present tax subsidies for such technologies (the tax credit, andexpensing treatment of R&D expenditures) as well as government expenditures forenergy R&D. The amount of the subsidy on the product or activity would be the value ofthe benefits per unit of the commodity traded -- proportional to the spillover --conferred on the source of the external benefits. Energy R&D is unlikely, however,to require a differential subsidy -- above and beyond that provided for non-energyR&D -- since there is no a priori reason to believe that the external benefits fromenergy R&D are higher or lower than for non-energy R&D. Many of the incentives or subsidies that are proposed for oil and gas as wellas for alternative fuels appear to be based on the supposition that government oughtto support business, particularly when times are bad. Such, for example, was therationale for numerous proposals to help the domestic oil industry, particularly smallproducers, that were harmed by the downward trend in crude oil prices since the mid-1980s, and the sharp drop in those prices during 1998-99. The low prices of 1998-99 fostered proposals for economic relief through thetax code for the particularly small independent drillers and producers, which were theharbingers of current comprehensive energy bills. The 1998-99 proposals mainlyfocused on production tax credits for marginal or stripper oil, which were laterincluded in the American Jobs Creation Act of 2004, P.L. 108-357 , enacted onOctober 22, 2004 (also referred to as the "jobs bill"). A $500 million package of loanguarantees for small independent oil and gas producers, which became law ( P.L.106-51 ) in August 1999, was enacted in lieu of the tax incentives. The Economic Justification for Tax Subsidies asan Industrial Policy. There is no purely economic justification,either on efficiency or stabilization grounds, for using tax subsidies as an industrialor employment policy to help a distressed industry -- including the conventionalfossil fuels industry and the alternative fuels industry. An industrial policy is usuallythe context for government subsidies to businesses whenever those businessesexperience sustained or sharp economic hardships, due generally to any cause buttargeted toward industries experiencing declining prices, suffering cost/pricesqueezes, or competition from foreign firms. Economic theory does recognize that market failures such as barriers to entryinto markets, and other failures that inhibit market competition, may be used tojustify government intervention. Intervention may also be justified by "externalities"or spillovers, previously discussed. The U.S. and world crude oil markets arecertainly not perfectly competitive, as there are elements of market power particularlyin the world oil market, which is significantly affected by the OPEC. But thesemarkets are certainly more competitive today then they have ever been. It does notappear that the imperfections may be exhibited by either the U.S. or world crude oilmarkets, that they would justify tax subsidies to oil and gas producers on grounds ofeconomic efficiency. Depressed or volatile oil prices (or any other price) are notmarket failures. An industrial policy is an inefficient way to stimulate aggregateemployment. Some have argued that the competitive free-market system may establishinterest rates (or private discount rates) that are too high, which may lead producersto discount the future excessively and therefore deplete energy and other minerals toorapidly. Rapid depletion increases environmental damages for the current generationand reduces economic living standards (real income) for future generations whowould have a lower capital stock. In general, economic theory and empirical evidence refute the proposition thatcompetitive markets lead to excessive exploitation of mineral resources. Capitalmarkets are also believed to function fairly close to competition, and there is nomarket failure that results in interest rates higher than the competitive rates. Even ifthe argument were true, however, it would at the very least suggest policies to lowerinterest rates, elimination of all federal tax subsidies for nonrenewable resources, andthe imposition of a federal severance tax to reduce production of these resources. Energy taxes on producers and consumers that factor in the external costs ofenergy use, such as air pollution, would contribute significantly to energyconservation by raising energy prices and reducing the demand for energy. Thedemand for energy would decline both through a direct demand response, i.e.,curbing energy use through reductions in output, service, or utility levels (e.g., byreducing the number of miles driven, indoor temperatures during winter by turningdown the thermostat, etc.) and through substitution of more energy-efficient for lessenergy-efficient technologies. This would be true for all energy that generatesexternal costs, but is particularly true for fossil fuels, whose external costs aregenerally greater than for other energy types. However, energy taxes to encourage conservation should be unnecessary oneconomic grounds because over the longer term, as depletion gradually diminishesthe stock of exhaustible energy resources (such as petroleum), conventional energyprices would be expected to increase in real terms, all else (such as technologicaladvancements and innovations, and the degree of recycling) remaining thesame. (22) As a result, more of the energy efficient technologies would become profitable andinvestment in energy-efficient technologies would increase (for example, moreenergy efficient housing, automobiles with higher miles per gallon, and more energyefficient industrial equipment such as boilers). (23) Thus, aside from energy taxes or subsidies to correct for energy productionand consumption externalities, and aside from possible user charges, economists generally argue there is no economic justification for additional taxes or tax subsidiesto encourage greater energy conservation, or energy efficiency. This is because thereis generally no market failure in energy use (notwithstanding the environmentalexternalities discussed above, or the exceptions discussed below) or in investmentin energy-using technologies -- at either the household or business level -- thatrequires such tax subsidies. Just as the competitive market system, corrected forexternalities, automatically and efficiently leads to the optimal production and useof energy resources, it also leads to the optimal amount of investment in energyefficiency technologies. All this is done without the effect of subsidies, in terms ofrevenue losses and allocational distortions, which reduce aggregate output and thegeneral welfare. There are four market failures in energy use, however, that may be aneconomic justification for government intervention, but only one is a rationale forcertain types of conservation tax subsidies. In rental housing, the tenant and thelandlord lack strong financial incentives to invest in energy conservation equipmentand materials, even when the benefits clearly outweigh the costs, because thebenefits from such conservation may not entirely accrue to the party undertaking theenergy-saving expenditure and effort. Builders and buyers may also lack sufficientinformation, a problem which is also discussed below. As a general rule, tenants are not going to improve the energy efficiency ofa residence that does not belong to them, even if the unit is metered. They might ifthe rate of return (or payback) is sufficiently large, but most tenants do not occupyrental housing long enough to reap the full benefits of the energy conservationinvestments. Part of the problem is also that it is not always easy to calculate theenergy savings potential (hence, rates of return) from various retrofitting investments. Landlords may not be able to control the energy consumption habits of renters tosufficiently recover the full cost of the energy conservation expenditures, regardlessof whether the units are individually metered or not. If the units are individuallymetered, then the landlord would not undertake such investments since all thebenefits therefrom would accrue to the renters, unless a landlord could charge higherrents on apartments with lower utility costs. If the units are not individually metered,but under centralized control, the benefits of conservation measures may accruelargely to the landlord, but even here the tenants may have sufficient control overenergy use to subvert the accrual of any gains to the landlord. In such cases, from thelandlord's perspective, it may be easier and cheaper to forego the conservationinvestments and simply pass on energy costs as part of the rents. Individual meteringcan be quite costly and while it may reduce some of the distortions, it is not likely tocompletely eliminate these, because even if the landlord can charge higher rents, hemay not be able to recover the costs of energy conservation efforts or investments. These market failures may lead to Under investment in conservation measuresin rental housing and provide the economic rationale for Internal Revenue Code(IRC) Â§136, which allows the value of any energy conservation subsidy provided byelectric utilities to households to be excluded from gross income. Without suchexplicit exclusion, such subsidies would be treated as gross income and subject totax. This exclusion, however, applies to both owner-occupied and rental housing,and to a limited extent to business conservation subsidies. There are other types of market failures in energy use that may suggest eitherminimum efficiency standards or government-provided information such as energyefficiency labels. As suggested above, many homeowners may not know the precisepayback or rate of return of a particular energy-efficiency enhancing investment, ormay not know how to calculate it. This may be a particularly serious problem forolder homes, which are less energy efficient then newer models -- those built sincethe energy crisis of the 1970s. This market failure problem suggestsgovernment-provided information as a solution, however, rather than tax subsidies. A third energy market failure arises out of asymmetric information betweenenergy consumers and manufacturers of energy efficient equipment. The energyconsumer may have little incentive to become fully informed about the energyefficiency of a particular energy-using or -saving item, while the producer, who hascomplete and accurate information, doesn't have the incentive to produce a higherpriced and more energy efficient product, since it is might be more difficult to marketand sell such a product. Thus, while a particular energy-saving device may have ahigh rate of return, the market may not provide it. This problem suggests eithergovernment mandated efficiency standards or labeling as is currently being done withappliance energy labels and fuel economy labels. Finally, although capital markets are generally competitive and efficient, low-income consumers may have difficulty acquiring loans for conservation investments,even when such investments are profitable (the present value of the energyexpenditure savings is greater than the capital costs). This suggests that low or zerointerest rate loans for low income consumers or even weatherization grants couldaddress the problem. The higher energy prices that would result from taxes imposed onconventional energy to address external costs would also lead to more investment toincrease the supply of alternative fuels, which would, in time, lead to even moreconservation of (reduced demand for) conventional fuels. Over the longer term, thesupply of these alternatives would tend to increase as depletion of conventionalenergy raises its real price. Even without increases in conventional fuel prices,alternative energy could gain a price advantage through future technologicaladvances. As in the case of energy conservation, there are no externalities or marketfailures that cause under-investment in alternative energy technologies andunder-supply of alternative fuels. The private market system works effectively andefficiently in developing any form of energy and its technologies if there aresufficient profit incentives, i.e., if the rate of return on such investments is above theopportunity cost of capital. Moreover, the market ensures that the least-cost, mostefficient alternatives become commercialized first, and the market adjusts quicklyand efficiently to the changing dynamics of the marketplace. In general, in cases where alternative fuels have difficulty penetrating themarket, it is because they cannot be competitively priced, relative to conventionalfuels, generally because either oil prices are too low, capital costs of alternative fuelstechnologies are too high, or both. To illustrate, compare the estimated 30-yearlevelized costs, per unit of electrical output, and the capital costs of varioustechnologies for producing electricity using conventional fuels (primarily coal, butalso natural gas) and alternative fuels such as biomass and wind energy systems. (24) Electricutilities can upgrade existing coal-fired units at a cost of 2.0Â¢/kWh, or they can investin the latest efficient and cleaner technology (the advanced combined-cycle naturalgas unit) at a cost of about 3.5Â¢/KWh. These are substantially lower than someestimates of the cost/KWh of the following energy alternatives: 15.0Â¢ forphotovoltaics; 5-10Â¢ for small hydroelectric; 6-8Â¢ for solar thermal power; 4-7Â¢ forwind power; and 4-6Â¢ for biomass. Much of these cost differences are due to thesignificantly higher capital costs of generating electricity with alternative energyresources ($7,000/KW for photovoltaics, $1,500/KW for biomass, $1,000/KW forwind) as compared with conventional fuels ($400/KW for the combined cycle naturalgas and $200/KW for retrofitting existing coal-fired units). (25) Volatile oil prices can increase investor risk and inhibit the development ofalternative, renewable (solar, wind, etc.), and unconventional resources. This isbecause oil is the benchmark energy resource that sets the long-term price (andtherefore influences the profitability) of all other fuels. Hypothetically, if alternativefuels would be profitable at oil prices of $40 per barrel, but prices fluctuate between$20 per barrel and $60 per barrel, there will generally be less investment inrenewable and unconventional resources than if the price were stable at $40 everyyear. However, as discussed before, tax subsidies for alternative fuels are a costlyand inefficient policy to correct for such risks. It is sometimes argued that alternative fuels such as solar and wind energyand other 'renewables' are at a competitive disadvantage, vis-a-vis fossil fuels,because of the production tax subsidies -- expensing, percentage depletion, andothers -- bestowed on the oil and gas industry over decades, and that this justifiescountervailing subsidies to alternative fuels to "level the playing field." Historicallythe large tax subsidies for oil and gas -- which totaled tens of billions of dollars todate -- helped keep domestic and world oil prices low, encouraged consumption, anddiscouraged the development of alternatives fuels. Past subsidies, however, do notdetermine the economic viability of alternative fuels at the present time -- pastsubsidies do not significantly affect the current competitive structure of the energymarket. As to the current oil and gas tax subsidies, there are two reasons that thesesubsidies are unlikely to reduce the competitiveness of alternative fuels. First, currentoil and gas tax subsidies are smaller than they have been historically. Indeed, someevidence suggests that current oil and gas tax subsidies are smaller, in relationshipto industry size, than the tax subsidies for alternative fuels. (26) Second,and more importantly, the structure of the world crude oil market since the 1970s haschanged in a fundamental but critical way: Crude oil prices have since the 1970s beendetermined in a world oil market, a market which has become more competitive andin which U.S. domestic producers are price takers. In such a market, the subsidiesfor oil and gas have little if any effect on the market price of crude oil, hence little,if any, effect on the competitiveness of alternative fuels. Energy taxes have also been proposed for primarily fiscal reasons -- togenerate revenues for deficit reduction. The first federal gasoline tax was enacted in1932 (at 1Â¢/gal. for gasoline and 2Â¢ for diesel fuel) as a way of cushioning federaldeficits, which were mounting with the Great Depression. Energy tax proposals fordeficit reduction were commonplace during the 1982-1993 period as budget deficitsmounted due to huge tax cuts under the Economic Recovery Tax Act of 1981 ( P.L.97-34 ) and the nation experienced reduced inflation, economic recession, defensebuildups, and the federal inability to control spending. Several energy taxes wereproposed at that time: an increase in the excise taxes on gasoline, diesel, and othermotor fuels; a sizeable tax on imported oil (in addition to the customs dutiesthat are already imposed on imported petroleum); a tax on both imported and domestically produced crude oil;and a broadly-based or general energy tax on all or most types ofenergy consumption, either based on the heat content of the fuel (Btu tax), the carboncontent of the fuel (the carbon tax), or on the sales price (the ad valorem energy tax). Eventually, only the tax on gasoline and other motor fuels was increased (by 5Â¢ in1982, 5Â¢ in 1990, and by 4.3Â¢ in 1993). As a general economic principle there is no distinct fiscal rationale for afederal energy tax as a source of general fund financing of federal activities or fordeficit reduction. Economic principles suggest federal programs ought to be financedby general income or general consumption taxes. Such taxes, however, while lessdistortive and more equitable than energy taxes and other selective excise taxes (ordifferential commodity taxes) are also distortional. Income taxes, for instance, distortthe choice between work and leisure by raising the price of work relative to the priceof leisure, which tends to increase leisure and reduce work. Income taxes also distortthe choice between consuming and saving for the future by raising the price ofconsuming in the future (i.e., saving). If an efficiency enhancing tax, such as an externality correcting energy tax,could be substituted for a distortional tax in a revenue neutral way, not only wouldthere be no budgetary effect, but there would be a gain in efficiency (e.g., a reductionin pollution to the environment). (27) In some cases, the revenue gain -- hence thepossible efficiency gain -- could be substantial. For example, a $30/ton tax on carbonemissions, which would roughly stabilize carbon emissions at their 2000 levels,would generate about $40 billion annually; a $100 per ton tax could generate as muchas $100 billion annually. (28) Another example is the gasoline tax. Currently, the burden of the gasoline taxis largely offset or counterbalanced by the benefits received from highways andinfrastructure financed from the tax. This means that under current law, and indeedsince the inception of the gasoline tax, there has never been a tax on gasoline thataccounts for the external costs of driving: the environmental costs of oil productionand refining, the environmental costs from tailpipe emissions, the costs of oil importdependence, and the road congestion. A policy to impose a tax on gasoline as asubstitute for a distorting income tax would not only make drivers pay for theexternal costs of driving, it would reduce income tax distortions, and enhanceeconomic efficiency. Moreover, higher gasoline prices would promote petroleumconservation, reduce air pollution, and carbon emissions substantially, and wouldpromote the development of alternative fuels without a large cost, in terms of reducedrevenues from subsidization, to the federal budgetary. However, gasoline taxes ofthis magnitude could be, unless phased-in gradually, a significant shock to theeconomy. Energy taxes and subsidies, when used to correct for externalities and othermarket failures, offer an efficient alternative or supplement to regulations as aninstrument of environmental policy. Regulations prescribe the type of technology orequipment for environmental protection, the maximum permitted rate of emission fora particular pollutant, or a minimum energy-efficiency standard, and are part of the"command-and-control" approach to environmental protection. Regulations, suchas standards, give policymakers more assurance that environmental policy goals willbe achieved regardless of cost, but are often more costly and less economicallyefficient than taxes or tradeable emissions permits. To illustrate the fundamental reason why a standard would be economicallyless efficient than the tax, consider a regulation that prescribes that electric utilitygenerators must be at least 45% energy-efficient as a way of conserving energy andreducing power plant emissions. That is, every fossil-fuel-fired generator in usewould have to have an efficiency rate of 45%. In response to the standard, and givencurrent economics of alternative generation strategies, most utilities would invest inthe advanced combined-cycle natural gas system (ACCNG), which is the cheapestand most energy efficient technology, with an efficiency rate close to 50%. Subjecting all firms to the same regulatory standard essentially ensures the samebehavioral response regardless of differences in the marginal costs of reducing airemissions. But, while the ACCNG system is the least-costly technology among thosefeasible technologies that meet the 45% energy efficiency standard, it may not be theleast-cost energy conservation or air pollution control strategy for every single utility,in every single plant, every single generating unit, and for each of the various typesof emissions. Intuition suggests, and many studies have confirmed, that the marginal costsof pollution control (marginal abatement costs) vary for each type of pollutant andwith the type of technology that utilities use. With the regulation as described, noaccount would be taken of the differences among utilities, plants, and generatingunits in their capacity to reduce emissions. Yet, because of differences in sitecharacteristics, design, and utilization rate, current generating units differsignificantly with respect to the difficulty (or ease) and the cost of reducingemissions. As a result, those firms with the greater pollution abatement costs wouldhave to undertake the same level of abatement as those with lower marginalabatement costs. Because of these cost differences, there are many different strategies andoptions that utilities might use to reduce exhaust emissions from power plants. Forexample, some utilities might just reduce output, others might invest in pollutioncontrol equipment, and still others might replace their coal-fired units with advancedtechnologies. If there are enough differences among utilities and their marginalabatement costs, then the total costs of reducing emissions with the regulatorystandard would be greater (less efficient) than any of the market-based approaches. In contrast, a tax would provide the incentive for each polluter to reducepollution in the least costly way -- up to the point at which the tax just equals themarginal abatement costs. In the above illustration, the utility with the lowermarginal abatement costs of reducing pollution would undertake more pollutionabatement than the utility with higher marginal abatement costs. In that way the totalcost of abatement would be minimized. Tax revenues could be used to compensatethe parties that are harmed by the emissions. The total costs of emissions controlfrom utilities would be much lower if utilities were permitted to use varioustechnologies and control options that are the least cost for that particular utility, thatparticular plant, and that particular generating unit, to address different emissions,which is how a tax would work. By using a tax instead of a standard, all thoseanti-pollution activities that cost less than the tax will, in theory, be undertaken. An alternative market-based approach for environmental protection -- anefficient alternative to emissions taxes or their practical equivalent, energy taxes -- is the tradeable emission permit or allowance, also known as "pollution rights," "cap-and-trade," or marketable pollution permits. Under this approach, thegovernment (the Congress and the environmental authorities) requires each emitterof a particular pollutant to have a legal permit to emit a fixed amount of thatpollutant. The authorities establish a target level for aggregate emissions of aparticular pollutant (say so many hundreds of thousand of tons per year), and thepollution equivalence of the tradeable permits (one permit equals one ton of Xpollutant). It also allows these permits to be traded in the marketplace among sourceemitters (or among anyone), who can either buy and use them (if the costs of a permitare less than the marginal abatement costs), save them for future use (if they expectmarginal abatement costs to rise above the cost of each permit) or sell them (if theirmarginal abatement costs per ton are less than the price of a permit). The ideaunderlying this approach is that it achieves any given level of pollution at lowercosts, and is thus economically efficient. Those firms with relatively low marginalabatement costs will choose abatement over permits; those with relatively highabatement costs will choose to purchase permits rather than control pollution. Theaggregate level of pollution is fixed, however. While in theory allowances are equivalent to an emissions tax -- and thus alsomore efficient than standards -- in practice there are differences that may maketradeable permits generally more appealing to the policymaker in certain situationswhile the emissions tax approach is more appealing in others. (29) First,tradeable permits fix the level of aggregate pollution and let the price adjust, whereasthe tax fixes the price (the statutory tax rate per unit) and lets the quantity of pollutant(or its equivalent amount of energy) adjust. Thus, tradeable permits appear to givethe authorities greater certainty of control over the level of pollution, and thereforecontrol over air and water quality. Tradable permits are considered by many asuperior instrument when pollution is reaching some critical level and thegovernment needs to control the quantity of the emissions. Another advantage oftradeable permits is that they avoid the information problem associated withemissions taxes, which would require authorities to know both the marginal externalcosts (the monetary value of the damages) and the marginal abatement costs per unitof pollution. This information, none of which is required with tradeable permits, isdifficult and costly to estimate and in some cases not available at all. None of thisis required with tradeable permits. Finally, taxes may be eroded by inflation andaffected by the entry and exit of firms. This is not a problem for tradeable permits. Under a tradeable permit system the authorities must establish a system formonitoring the emissions of the polluter. This is relatively simple when the numberof polluters is relatively small in relationship to the magnitude of the emissions,which is the case with SO 2 emitted by electric utilities. As the number of pollutersincreases, the complexity of emissions monitoring and program administrationincreases exponentially, which raises the transactions costs of the permit system tosuch levels that it would no longer make tradeable permits efficient. Such is the casewith CO 2 emissions which have millions of sources. In such a case an emissions taxis more appealing. The economic efficiency advantages of market-based approaches toenvironmental protection are suggested by the documented evidence on the successof the tradeable permit system -- mandated by title IV of the Clean Air Act -- incontrolling emissions of sulfur dioxide (SO 2 ) by electric utilities while loweringcompliance costs as compared to initial or regulatory costs. (30) Accordingto the Environmental Protection Agency: "Both the Acid Rain Program's rate-basedapproach to NO x reduction and cap-and-trade approach to SO 2 reduction have beenvery successful." (31) Tradable permits are also being discussed as aninstrument of controlling greenhouse gases worldwide, part of an internationalframework to control emissions of CO 2 and other greenhouse gases. The level of, and changes to, energy taxes and subsidies can affect energyprices and output, economic growth rates, income distribution, and internationaltrade. Thus, they can be a very powerful energy and economic policy instrument. As was discussed above, energy taxes and subsidies can be a usefulinstrument to correct for pre-existing distortions in the allocation of resources andsimultaneously generate tax revenues, if they are imposed on activities orcommodities such as energy resources whose production and use generate externalcosts, or if they are imposed as user fees for the services of a public good. Otherwise,selective energy excise taxes for either greater production, improved technical energyefficiency, or increased supply of alternative fuels reduce the efficiency of theeconomy. Reduced efficiency implies reduced output and lower standards of living. With respect to energy taxes on supply, there is generally no separate equitycase that can be made for taxing energy at a higher rate than other commodities. Dueto nonrenewable resources' finite stock, economic rents (also called scarcity rents) arecreated when these resources are produced. Under competitive conditions such rentswould be expected to rise at the rate of interest so as to achieve asset or capital market equilibrium. Such rents are not excessive under competitive supply and neednot be taxed away on equity grounds. (32) Energy taxes on consumers (e.g., gasoline taxes,oil taxes, or general energy taxes) also frequently have negative distributionalconsequences because the incidence of such taxes often falls disproportionately onlower incomes. Finally, energy tax subsidies frequently also have adversedistributional effects. One example -- there are others -- is the income tax credit (theÂ§29 tax credit) for non-conventional energy resources, which in addition to distortingresource allocation, losing tax revenues, and not reducing oil import dependence(since it has basically increased the supply of methane gas rather than alternatives topetroleum) is also questionable on tax equity grounds. Supporters of the creditcontend that it encourages domestic energy production, however, and could becomemore important in the future. They also note that domestic methane resulting fromthe credits helps offset the growing U.S. need for natural gas imports. Increases in energy taxes are basically a contractionary fiscal policy thatwould tend to reduce aggregate output and employment, and produce a temporaryincrease in the rate of inflation above the baseline. Increases in taxes on final energydemand, such as a hike in the gasoline tax, tend to be (dollar for dollar) lesscontractionary than energy taxes on industry (such as an oil tax) although these, too,reduce household income, consumer spending, and to some extent business costs andprofits. Sizeable taxes on oil increase the price of all energy and can trigger relativelylarge cutbacks in industrial energy use and energy used as inputs into production. Such taxes, including an oil import tax, can produce macroeconomic effects akin toan oil price shock, resulting in a temporary but sharp slowdown in the economy'sgrowth.

Summary: This report provides background on the theory and application of tax policy as it relates tothe energy sector, particularly with respect to the theory of market failure in the energy sector andsuggested policy remedies. Economic theory suggests that producers of energy-related minerals be taxed no differentlythan non-mineral producers: Exploration and development costs and other investments in a deposit(including geological and geophysical costs and delay rentals) should be capitalized. In general,competitive mineral producers subject to a pure income tax would not exploit resources as fast(compared with the rate of exploitation under the present system of subsidies). Over the longer term,depletion of fossil fuels and mineral resources leads to higher real energy prices, which wouldeventually promote the optimal amount of investment in energy efficiency and alternative fuelssupply. Under principles of neutrality of tax policy, there is no purely economic rationale for energytaxes or tax subsidies to (1) raise revenues; (2) conserve energy (with one exception); (3) promotealternative fuels; (4) compensate for any extra market risk; or (5) promote, as an industrial policy,specific industries such as the fossil fuels industry. However, even under a pure income tax,economic efficiency suggests a system of energy taxes (in addition to the income taxes) to correctfor any environmental externalities caused by the production, importation, and use of each fuel, andenergy taxes in the form of user charges for benefits received, such as the highway trust fund. In thecase of energy conservation, market failures in the use of energy in rental housing provide anefficiency rationale for the current gross income exclusion for conservation subsidies provided byelectric utilities. There are other market failures in energy use that suggest efficiency standards,energy labeling, or government-provided information, but not necessarily tax subsidies. Tax subsidies for domestic oil production tend to stimulate domestic supply of petroleum andreduce demand for petroleum imports. This may enhance national and economic security in the shortrun, but it might damage national and economic security in the long run as domestic energy resourcesare depleted faster than they otherwise would be. The economically efficient policy to reduce importdependence would impose a tax (or tariff) on imported petroleum based on the per-barrel estimateof these costs (the so-called oil import "premium"). The problem of vulnerability to embargoes andprice shocks, which relates to dependence on imported oil from the Organization of PetroleumExporting Countries (OPEC) and other potentially unstable or unfriendly foreign countries, is moreeffectively addressed in a policy of stockpiling oil, as is being done with the Strategic PetroleumReserve. In terms of environmental protection and management, energy taxes can be a cost-effectiveand efficient market-based instrument, and they are economically superior to the command andcontrol approach. In sum, energy taxes are generally distortional (except to correct for externalities,or when imposed as user fees for benefits received) and regressive, and may have adversemacroeconomic consequences, particularly sizeable taxes on energy production or oil imports.