Measuring the “Subsidy” Component of Biofuel Tax Exemptions and Credits

1. Measuring the “Subsidy” Component of Biofuel Tax Exemptions and Credits David R. Just, Erika M. Kliauga and Harry de Gorter Cornell University

2. Defining a Subsidy • Agreement on Subsidies and Countervailing Measures • Government contribution to industry or region • Displaces or impedes the export of like products • May have effects in a third market • Loss of market share • Modeling or detecting trade disruption in biofuels policy can be difficult • Linkages between several markets

3. Measuring Subsidy Effects • Must measure impact of policy on • World oil prices (or other traditional fuel) • World biofuel prices • World agricultural prices • Consider tax exemptions: If oil prices relatively unaffected by marginal production of biofuels, traditional analysis may overstate the subsidy component. • Ignores the perfect substitutability in production and consumption

4. The Economics of a Tax • Consumer willingness to pay for ethanol: where λ≈ 0.7 (lower mileage than gasoline) • With a volumetricfuel tax or,

5. The Economics of a Tax Credit • With a tax credit or, (1 - λ)t represents a penalty on biofuel production (e.g., $1.02/gal. in UK) Requires a tax credit equal to penalty to maintain a distortion free economy Requires a much higher tax credit in Brazil than in the United States

6. 5.6 times higher in Brazil 2.7 times higher in Brazil 10.2 times higher in Brazil 0.3 times lower in Brazil 6

7. 7

8. 8

9. How is the world market price of a biofuel established? • Without taxes or subsidies fuel is fuel – demand and supply for BTUs (interacting with food markets) • Now suppose one country offers a net subsidy to blend ethanol • Ethanol (or it’s inputs) will gravitate there and will force a wedge between producer prices of ethanol and other fuel • The world price of biofuel is linked to the world gasoline/diesel (oil) price by the tax exemption or blender’s tax credit in the country with the largest net subsidy. • This appears to be the United States for ethanol and the European Union for biodiesel.

11. So how is ethanol price determined in Brazil? • The U.S. imposes a tariff on ethanol imports (with some exceptions) • Linked directly to oil, unless the net subsidy in U.S. is large enough to make export profitable for some amount of ethanol. • Net external subsidy must exceed transportation costs • In this case, Brazil’s market price of ethanol equals U.S. market price minus tariff and transportation costs

13. So what does tax exemption do in Brazil? • Brazil’s tax exemption subsidizes ethanol consumption • Decreases ethanol exports (raises the opportunity cost of exports) • Brazil’s tax exemption has no direct effect on market price (unless change in ethanol supply impacts world oil price)

14. Figure 6b: Biofuel Tax Exemptions United States Brazil SE PG+t SE PG+tc PG+t SG PG D'F DF DF QF QE QE QF Imports Exports

15. Figure 7b: New Trade Model of a Biofuel Import Tariff United States Brazil SE PG+t SE PG+tc tariff PG+t SG PG DF DF QF QE QE QF Q'E ∆ Exports

16. Biodiesel is opposite case for the U.S. • Europe establishes market price • U.S. price equals EU price minus tariff and transportation costs • U.S. blender’s tax credit can subsidize biodiesel production • Has no direct effect on world market price (only if impact oil price)

17. Traditional Classification of Biofuel Policies (1) Discriminate against trade: • Production subsidies • Biofuel (e.g., tax write-offs, etc.) • Farm (e.g., corn) • Import tariffs (import quota) • Sustainability thresholds • -20% reduction in CO2 relative to oil in USA (2) Do NOT discriminate against trade: • Blender’s tax credits/tax exemptions and consumption mandates

18. Same policies in each country can have different effects • 3 different kinds of tax exemptions/credits: • Tax exemption at the pump (EU, Brazil and Canada prior to April 2008) • Blender’s tax credit (U.S.) • Biofuel producers tax credit (Canada post April 2008) – biofuel production subsidy • Prices of biofuel, biofuel feedstock and gasoline/diesel are still linked within a country and across countries through international trade • Without the largest net external subsidy, should have minimal impacts

19. Case of Canada and Biodiesel Canada ‘triple dipped’ because benefited from: • own biofuel producer tax credit (only available to domestic production) • U.S. blender’s tax credit (available to U.S. production and imports) • high EU price due to a combination of the latter’s diesel price, fuel tax and biodiesel tax exemption (available to EU production and imports) If all three countries had a tax exemption (or a blender’s tax credit), then producers in each country could only benefit from one country’s policy

20. Case of Canada and Biodiesel (cont’d) • No wonder Canada exports all biodiesel production • Furthermore, Canada has now established a domestic consumption mandate • this will tax gasoline to pay for the higher price of ethanol established in world markets • domestic biofuel producers will be unaffected

21. Concluding remarks • Volumetric fuel tax penalizes biofuels • Market price determined by country with combination of lowest fuel tax and highest tax credit/exemption and gasoline/diesel price paid by consumers (largest net subsidy) • Tax credits/exemptions in all other countries: • do not directly affect world oil prices and hence biofuel prices (& so do not directly help farmers) • Increase/decrease imports/exports if a tax exemption

22. Concluding remarks (cont’d) • Ethanol production in Brazil not supported by tax exemption (or mandates) because: • Ethanol market price linked to U.S. price • If not, would still need to adjust for penalties due to volumetric fuel taxes • Need to model net subsidies to determine impacts of : • import tariffs • actionable subsidies