U.S. Ethanol Subsidies: A Bad Policy That Refuses to Die

U.S corn farmers and ethanol distillers are among those celebrating passage of last week's tax bill. A little-noticed provision of the law extends ethanol tax credits ($.45 per gallon, plus a bonus for small producers) and tariffs on ethanol imports ($.54 per gallon), previously set to expire at the end of 2010. Should the rest of us also celebrate? I think not.

U.S. ethanol policy contradicts every principle of sound economics. It encourages use of fuels whose opportunity costs are high while discouraging use of those whose costs are low. It promotes trade flows that run opposite to comparative advantage. It creates new market failures instead of correcting those that already exist.

First consider opportunity costs. Economists use this term to mean the full costs of goods and services, taking into account all opportunities sacrificed to produce and use them. The opportunity costs of petroleum, ethanol, and other transportation fuels include costs of production, most of which are reflected in market prices, plus other costs, which are not. The effects of pollution, including both climate impacts and harm to local air quality, are one reason that opportunity costs exceed market prices. National security risks arising from dependence on foreign energy suppliers are a further important opportunity cost. The ostensible purpose of ethanol policy is to offset these costs by encouraging substitution of low-carbon domestic fuel for high-carbon foreign fuel, but in reality, the policy makes the situation worse, not better.

One problem is that corn-based ethanol, the kind produced in the United States, saves little if any carbon and produces little if any net gain in energy compared with petroleum. Measuring the exact carbon and energy efficiency of corn ethanol is not easy. Different assumptions regarding technologies, fuels consumed in farming and distilling, energy value of byproducts like cattle feed, land use impacts, and so on, give answers ranging from small net carbon and energy gains to small net losses. But even the most optimistic studies give corn ethanol only a tiny advantage over petroleum, nowhere near large enough to justify the scale of current subsidies.

What is more, even if corn ethanol were much more carbon- and energy-efficient than petroleum, subsidies would be the wrong way to bring prices into line with opportunity costs. Instead of subsidies, every type of fuel, including but not limited to ethanol and oil, should bear a surcharge equal to its external costs, calculated to account for climate change, local local air pollution, national security, and any other external effects of production and consumption. Gasoline, ethanol, biodiesel, compressed natural gas, and electricity would each bear a larger or smaller charge. Whereas ethanol subsidies act only to encourage substitution between ethanol and gasoline, a broader system would encourage many kinds of substitution. It would spur use of low-carbon, domestic energy sources like natural gas and electricity at the expense of both gasoline and gasoline-ethanol blends. At the same time, it would encourage across the board reduction in transportation fuel use by giving people incentives to buy smaller cars, move closer to work, use more local goods, and make other life-style changes. The fuel surcharges would be likely to generate considerable revenue, which could be used to reduce the marginal rates of other taxes or used to reduce the government's deficit.

Let's turn next to trade and comparative advantage. In the case of ethanol, comparative advantage belongs, hands down, to sugarcane-based ethanol from Brazil. The net energy yield from sugarcane-based Brazilian ethanol is about 8:1, compared to barely more than, or perhaps less than, 1:1 for the U.S. corn-based product. Unfortunately, Brazilian ethanol is saddled with a prohibitive $.54 per gallon tariff, just renewed. The result is an enormous loss of potential gains from trade in the form of a cleaner environment and lower consumer costs--gains that far outweigh the added profits of U.S. corn farmers and ethanol distillers. Need I add that Brazil is a friendly, democratic country, unlike the often corrupt, hostile, or authoritarian regimes from which we import much of our petroleum?

Comparative advantage in ethanol trade takes another kick in the face from a quirk of policy under which some Caribbean sugarcane producers can export ethanol to the United States duty free. For years they did not do so. Their inefficient sugar industries instead catered to the European Union, which granted them the same subsidized prices set for even less efficiently produced European beet sugar. Now the EU has reformed its sugar regime, and that particular free ride has ended. Rather than look for something they can produce efficiently, the Caribbean sugar producers are closing sugar mills and opening distilleries that cater to the sheltered U.S. ethanol market.

The trade effects of ethanol policy would be bad enough if they only involved the closing of U.S. markets to imports, but in reality, matters are even worse. When the effects of tax credits are added to those of import tariffs, they are, together, enough not just to block imports, but to turn the United States into a net exporter of ethanol. Ethanol exports are officially expected to run a record 315 million gallons this year, more than double the 2009 figure. True exports might be half again that if ethanol blended with exported gasoline is included. Exactly how do subsidized ethanol exports promote U.S. energy independence? Go figure.

The bottom line? Yes, there are market failures in transportation fuels. Yes, this is an area where government intervention in markets could actually make us better off. But current policy does not do so. Instead of mitigating market failures arising from pollution and national security effects, U.S. ethanol policy exacerbates them. A 2008 study by Robert W. Hahn of the AEI-Brookings Joint Center estimated that the costs of U.S. ethanol policy exceeded its benefits by more than $3 billion per year. Letting ethanol subsidies and tariffs expire as scheduled would have been a fine holiday gift for the U.S. economy. The next step would be a comprehensive rationalization of energy policy that took into account all opportunity costs of all fuels. Would this mean the end of ethanol as a motor fuel? Not necessarily. Some might still be imported from Brazil and elsewhere, boosting national security by diversifying energy sources. Research into cellulose-based ethanol would continue, although that potential clean domestic energy source has been slower to come on line than some have  hoped. But our goal need not be a world free of ethanol--just one free of bad ethanol policy.

Follow this link to view or download a short slideshow on the economics of ethanol.