Rising gas prices and environmental concerns have generated an assortment of tax proposals. What factors help CPAs determine if any are appropriate for our tax system and environment?
September 11, 2008
by Annette Nellen, CPA/Esq.
Both higher gas prices and tax credits increased demand for hybrid cars. The hybrid car credit (§30B(d)) enacted in 2005 helped promote sales, but has expired for many models. Yet, in 2008, dealers had waiting lists of interested buyers ("Hybrid Sales Are Zooming," Los Angeles Times, May 2008).
High demand for hybrid cars, even without a tax credit, begs the question of whether the credit was needed. Should the government have encouraged consumers to purchase hybrids by increasing the gasoline excise tax rather than by offering a credit? Or was the credit needed to encourage manufacturers to produce hybrids despite their high cost?
These are difficult questions. The answers are significant to the federal budget, the economy and the environment.
Below, we’ll look at some noteworthy green proposals and considerations for evaluating them.
Green Tax Proposals
Many of the tax proposals designed to help the environment use the "carrot" approach, such as a tax credit to encourage certain actions. Other proposals use the "stick" approach of increasing taxes on actions that harm the environment. Following is a sampling of proposals of the 110th Congress:
Cars: H.R. 6441 offers a credit of up to $2,000 for taxpayers who replace a car with one getting at least 20 percent better mileage. In addition, the buyer may deduct state and local taxes on the purchase and any interest on a loan used to buy the car.
R&D: H.R. 6552 allows a larger research tax credit for research involving clean-burning fuel.
Both carrots and sticks have economic justification. For example, when a person consumes less gasoline, everyone benefits from cleaner air and preserved oil supply. Paying the conservationist, such as with a tax credit, can therefore be justified. When new approaches for solving problems are needed, such as using alternative energy sources, research and production costs can be high and financial assistance to businesses may be warranted.
A tax on activities that harm the environment can also be justified. For example, gas-burning cars pollute, emit greenhouse gases and reduce a non-renewable resource. These costs can be paid for with a tax so that the polluter pays rather than everyone.
While tax law is frequently the approach of choice for changing behavior, non-tax approaches should also be considered to determine the best approach. Non-tax approaches include:
Tax Carrot or Stick
Determining whether it is best to change behavior with an incentive versus a tax is challenging. Behavioral studies should be considered. Generally, incentive approaches are preferred as they generate fewer outcries relative to a new tax or lost deduction.
Once policymakers determine that the tax law is the appropriate approach for reaching an environmental goal — whether by incentive or tax, there are many factors to consider in designing an appropriate provision.
Cost: Tax credits and deductions reduce government revenues. Legislators must find money for them by cutting spending or subsidies or raising taxes.
Equity: When the government gives tax breaks to some, it indirectly gives tax hikes to others. Also, credits and deductions do not provide universal benefits. For example, a nonrefundable credit is useless to a taxpayer who owes no tax. Deductions pose equity issues because they are worth more to taxpayers in higher tax brackets.
Value: Consideration should be given as to whether a tax incentive may result in rewarding behavior that would have occurred anyway.
Design: Which party in a transaction should get the tax incentive? A rationale behind the hybrid car credit was that high manufacturing costs would lead to high prices and low sales. The tax break though, could have been for the manufacturer rather than the buyer.
Tax credits and deductions are complex due to the need for special definitions. Simplification considerations are important because a provision may not achieve its goal if complexity deters taxpayers from pursuing the benefit.
How much reward is needed to change behavior? Compliance costs should also be considered in answering this question because they reduce the incentive's value.
Which activities should be subsidized through a tax incentive? There are often multiple technologies for reaching a particular goal. For example, once Congress decides there is a need to subsidize greater use of renewable energy, it must consider whether it targets one energy source or all. If the provision is too narrow, there is a risk that better technologies won't get developed.
Finally, the life of the incentive must be considered. Typically, special deductions and credits are enacted on a temporary basis due to budget effects and the hope that the incentive is not needed on a permanent basis. Usually, taxpayers cannot change their behavior immediately so incentive provisions should include lead time. For example, a manufacturer will need time to reconfigure its processes before replacing machinery with more energy-efficient models.
Tax Increase Considerations
Equity: An environmental tax, such as a carbon tax, is regressive in that it poses a greater burden on low-income individuals relative to higher income taxpayers. Also, some taxpayers may not be able to easily change their behavior to avoid the tax. For example, an individual might not be able to move closer to work or replace a car to avoid a tax on gas-guzzler cars. Thus, relief may be warranted for low-income taxpayers.
Revenue: Increased tax revenue poses issues for legislators of how best to use it. Should it be used for environmental subsidies, clean-up, research into new technologies or reducing other taxes?
Tax carrots and sticks, used appropriately, can be powerful tools for changing behavior and for enabling activities that help the environment. However, if they"re not well-designed, tax breaks can be useless spending initiatives and new taxes can have adverse effects on some taxpayers and industries.We are likely to continue to see numerous proposals at the state and federal levels that use the tax law for environmental purposes. Thoughtful analysis is needed to determine if action is warranted, whether a carrot or stick is best, and which level of government should act. Analysis is also needed to ensure that the provision does not unduly complicate the tax law, "incentivize" the wrong activity or create harmful side effects. The process will be challenging, but crucial to our tax system, as well as our fiscal and environmental well-being.
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Annette Nellen, CPA/Esq., is a tax professor and Director of the MST Program at San José State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the AICPA and ABA. She has several reports on federal and state tax reform and a blog.