Senate Budget Committee Releases Tax Expenditures Report

The Congressional Budget and Impoundment Control Act of 1974 (as amended) requires the Budget Committees to examine tax expenditures as they develop the Congressional Budget Resolution. Section 3(3) of the Budget Act of 1974 defines tax expenditures as those revenue losses attributable to provisions of the federal tax laws which allow a special exclusion, exemption, or deduction from gross income or provide a special credit, a preferential rate of tax, or a deferral of tax liability.

Tax expenditures are often enacted as permanent legislation and can be compared to direct spending on entitlement programs. There are over 200 separate tax expenditures in current law, costing the Treasury more than $1 trillion each year. Given the nation's unsustainable long-term budget outlook, all tax expenditures and spending deserve increased scrutiny. Recent deficit and debt reduction proposals included tax reform options that eliminated or scaled back tax expenditures in order to simplify the tax code, lower tax rates, and raise needed revenue.

This print was prepared by the Congressional Research Service (CRS) and was coordinated by Steve Bailey and Joel Friedman of the Senate Budget Committee staff. All tax code changes through the end of the 111^th Congress are included.

The CRS has produced an extraordinarily useful document which incorporates not only a description of each provision and an estimate of its revenue cost, but also a discussion of its impact, a review of its underlying rationale, an assessment which addresses the arguments for and against the provision, and a set of bibliographic references. Nothing in this print should be interpreted as representing the views or recommendations of the Senate Budget Committee or any of its members.

I am pleased to submit a revision of the December 2008 Committee Print on Tax Expenditures.

As in earlier versions, each entry includes an estimate of each tax expenditure's revenue cost, its legal authorization, a description of the tax provision and its impact, the rationale at the time of adoption, an assessment, and bibliographic citations. The impact section includes quantitative data on the distribution of tax expenditures across income classes where such data are relevant and available. The rationale section contains some detail about the historical development of each provision. The assessment section summarizes major issues surrounding each tax expenditure.

The revision was written under the general direction of Jane Gravelle, Senior Specialist in Economic Policy, Thomas Hungerford, Specialist in Public Finance, and Donald Marples, Section Research Manager. Contributors of individual entries include Andrew Austin, James Bickley, Jane Gravelle, Gary Guenther, Thomas Hungerford, Mark Keightley, Mindy Levit, Linda Levine, Steven Maguire, Donald Marples, Nonna Noto, and Molly Sherlock of the Government and Finance Division; Janemarie Mulvey, Christine Scott, David Smole and Scott Syzmendera of the Domestic Social Policy Division; and Jennifer Teefy of the Knowledge Services Group. Jennifer Scrafford and Jasmine Marcellus provided editorial review and prepared the document for publication.

With respect to each tax expenditure, this compendium provides:

Section 3(3) of the Congressional Budget and Impoundment Control Act of 1974 specifically defines tax expenditures as:

The listing of a provision as a tax expenditure in no way implies any judgment about its desirability or effectiveness relative to other tax or non-tax provisions that provide benefits to specific classes of individuals and corporations. Rather, the listing of tax expenditures, taken in conjunction with the listing of direct spending programs, is intended to allow Congress to scrutinize all federal programs relating to the same goals -- both non-tax and tax -- when developing its annual budget. Only when tax expenditures are considered will congressional budget decisions take into account the full spectrum of federal programs.

Because any qualified taxpayer may reduce tax liability through use of a tax expenditure, such provisions are comparable to entitlement programs under which benefits are paid to all eligible persons. Since tax expenditures are generally enacted as permanent legislation, it is important that, as entitlement programs, they be given thorough periodic consideration to see whether they are efficiently meeting the national needs and goals for which they were established.

Tax expenditure budgets which list the estimated annual revenue losses associated with each tax expenditure first were required to be published in 1975 as part of the Administration budget for fiscal year 1976, and have been required to be published by the Budget Committees since 1976. The tax expenditure concept is still being refined, and therefore the classification of certain provisions as tax expenditures continues to be discussed. Nevertheless, there has been widespread agreement for the treatment as tax expenditures of most of the provisions included in this compendium.²

As defined in the Congressional Budget Act, the concept of tax expenditure refers to the corporate and individual income taxes. Other parts of the Internal Revenue Code -- excise taxes, employment taxes, estate and gift taxes -- also have exceptions, exclusions, refunds and credits (such as a gasoline tax exemption for non-highway uses) which are not included here because they are not parts of the income tax.

The JCT acknowledged the criticisms of the use of a normal tax system and argued for modification of tax expenditure analysis so it will serve as an "effective and neutral analytical tool for policymakers."⁶ Their approach was to revise the classification of tax expenditures without reference to the normal tax system. The revised classification created two broad categories of tax expenditures: tax subsidies and tax-induced structural distortions.⁷

Tax subsidies are tax provisions that are "deliberately inconsistent with an identifiable general rule of the present tax law."⁸ Tax subsidies are further divided into three subcategories. The first is tax transfers, which are transfers to taxpayers regardless of their tax liability and would include the refundable portions of various tax credits (for example, the earned income credit (EIC) and the child tax credit). The second subcategory is social spending, which is designed to induce behaviors unconnected to the production of business income. Examples would include the charitable giving deduction, deductions and exclusions for individual retirement accounts (IRAs), and the nonrefundable portions of the EIC and child tax credit. The final subcategory is business synthetic spending, which includes subsidies designed to induce behaviors directly related to the production of business income (for example, various energy tax subsidies).

Tax-induced structural distortions contain the elements of the tax code that "materially affect economic decisions in a manner that imposes substantial economic efficiency costs."⁹ An example of this category of tax expenditure is the differential taxation of debt and equity financing. Since interest on debt is a deductible business expense, corporations may be encouraged to raise capital as debt rather than equity.

(1) exclusions, exemptions, and deductions, which reduce taxable income;

(2) preferential tax rates, which apply lower rates to part or all of a taxpayer's income;

(3) credits, which are subtracted from taxes as ordinarily computed; and

(4) deferrals of tax, which result from delayed recognition of income or from allowing deductions in the current year that are properly attributable to a future year.

The amount of tax relief per dollar of each exclusion, exemption, and deduction increases with the taxpayer's tax rate. A tax credit is subtracted directly from the tax liability that would otherwise be due; thus the amount of tax reduction is the amount of the credit -- which does not depend on the marginal tax rate. (See Appendix A for further explanation.)

         10 Largest Tax Expenditures, 2010: Individuals

        10 Largest Tax Expenditures, 2010: Corporations

These estimates were made for 12 tax expenditures. For other tax expenditures, a distributional estimate or information on distributional impact is provided, when such information could be obtained.

The following table shows the estimated distribution of returns by income class, for comparison with those tax expenditure distributions:

   Distribution by Income Class of Tax Returns at 2009 Income Levels

      Tax Expenditures as a Percentage of After-Tax Income, 2007

In calculating the revenue loss from each tax expenditure, it is assumed that only the provision in question is deleted and that all other aspects of the tax system remain the same. In using the tax expenditure estimates, several points should be noted.

First, in some cases, if two or more items were simultaneously eliminated, the combination of changes would probably produce a lesser or greater revenue effect than the sum of the amounts shown for the individual items. Thus, the arithmetical sum of all tax expenditures (reported below) may be different from the actual revenue consequences of eliminating all tax expenditures.¹³

Second, the amounts shown for the various tax expenditure items do not take into account any effects that the removal of one or more of the items might have on investment and consumption patterns or on any other aspects of individual taxpayer behavior, general economic activity, or decisions regarding other federal budget outlays or receipts.

Finally, the revenue effect of new tax expenditure items added to the tax law may not be fully felt for several years. As a result, the eventual annual cost of some provisions is not fully reflected until some time after enactment. Similarly, if items now in the law were eliminated, it is unlikely that the full revenue effects would be immediately realized.

These tax expenditure estimating considerations are, in many ways, similar to estimating considerations involving entitlement programs. First, like tax expenditures, annual budget estimates for each transfer and income-security program are computed separately. However, if one program, such as veterans pensions, were either terminated or increased, this would affect the level of payments under other programs, such as welfare payments. Second, like tax expenditure estimates, the elimination or curtailment of a spending program, such as military spending or unemployment benefits, would have substantial effects on consumption patterns and economic activity that would directly affect the levels of other spending programs. Finally, like tax expenditures, the budgetary effect of terminating certain entitlement programs would not be fully reflected until several years later because the termination of benefits is usually only for new recipients, with persons already receiving benefits continued under "grandfather" provisions.

The table below shows tax expenditure estimates by year for individuals and corporations. All revenue loss estimates are based upon the tax law enacted through December 15, 2010. As a result, they do not reflect the enactment of P.L. 111-312, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which extended dozens of expiring provisions. For a provision that was assumed to expire, its extension would typically add to its projected cost. On the other hand, P.L. 111-312 also continued lower individual income tax rates in 2011 and 2012, which would have the effect of lowering the cost of some tax expenditures in those years. Revenue estimates for these extenders presented in this document are from the Joint Committee on Taxation, JCX-54-10.

         Sum of Tax Expenditure Estimates by Type of Taxpayer,

Bartlett, Bruce. "The Flawed Concept of Tax Expenditures." National Center for Policy Analysis (http://www.ncpa.org), February 13, 2002.

Bosworth, Barry P. Tax Incentives and Economic Growth. Washington, DC: The Brookings Institution, 1984.

Brannon, Gerard M. "Tax Expenditures and Income Distribution: A Theoretical Analysis of the Upside-Down Subsidy Argument," The Economics of Taxation, ed. Henry J. Aaron and Michael J. Boskin. Washington, DC: The Brookings Institution, 1980, pp. 87-98.

Brixi, Hana Polackova, Christian M.A. Valenduc and Zhicheng Li Swift. Shedding Light on Government Spending Through the Tax System: Lessons from Developed and Transition Economies. Washington, DC, World Bank, 2004.

Browning, Jacqueline, M. "Estimating the Welfare Cost of Tax Preferences," Public Finance Quarterly, v. 7, no. 2. April 1979, pp. 199-219.

Burman, Leonard E. "Is the Tax Expenditure Concept Still Relevant?" National Tax Journal, v. 56 September 2003, pp. 613-628.

Burman, Leonard, Christopher Geissler, and Eric J. Toder. "How Big Are Total Individual Income Tax Expenditures, and Who Benefits from Them?" American Economic Review, papers and proceedings, v. 98, no. 2, May 2008, pp. 79-83.

The Century Foundation, Bad Breaks All Around, Report of the Working Group on Tax Expenditures, New York: The Century Foundation Press, 2002.

Craig, Jon and William Allan. "Fiscal Transparency, Tax Expenditures and Budget Processes: An International Perspective," Proceedings of the 94th Annual Conference 2001, Washington, D.C.: National Tax Association, 2002, 258-264.

Citizens for Tax Justice. "Judging Tax Expenditures: Spending Programs Buried Within the Nation's Tax code Need to be Reviewed," November 13, 2009.

Edwards, Kimberly K. "Reporting for Tax Expenditure and Tax Abatement," Government Finance Review, v. 4. August 1988, pp. 13-17.

Freeman, Roger A. Tax Loopholes: The Legend and the Reality. Washington, DC: American Enterprise Institute for Public Policy Research, 1973.

Fox, John O. "The Untold Story: Congress's Own Calculation of Its Revenue Losses from Special Provisions of the Tax Laws." Chapter 5 in If Americans Really Understood the Income Tax. Boulder, Colorado: Westview Press, 2001.

Gravelle, Jane G. "Tax Expenditures." The Encyclopedia of Taxation and Tax Policy, edited by Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle. Washington, DC: Urban Institute Press, 2005, pp. 379-380.

Gravelle, Jane G. and Thomas L. Hungerford, Corporate Tax Reform: Issues for Congress, Library of Congress, Congressional Research Service Report RL34229, July 24, 2008.

Hildred, William M., and James V. Pinto. "Estimates of Passive Tax Expenditures, 1984," Journal of Economic Issues, v. 23. March 1989, pp. 93-106.

Howard, Christopher. The Hidden Welfare State: Tax Expenditures and Social Policy in the United States. Princeton, NJ: Princeton Univ. Press, 1997.

Hungerford, Thomas L. "Tax Expenditures: Good, Bad, or Ugly?" Tax Notes, October 23, 2006, pp. 325-334.

__. Tax Expenditures: Trends and Critiques. Library of Congress, Congressional Research Service Report RL33641, Washington, DC: February 4, 2008.

__. "Tax Expenditures and Long-term Federal Budget Pressures," Tax Notes, December 22, 2008, pp. 1409-1417.

__. Tax Expenditures and the Federal Budget. Library of Congress, Congressional Research Service Report RL34622, Washington, DC: May 26, 2010.

King, Ronald F. "Tax Expenditures and Systematic Public Policy: An Essay on the Political Economy of the Federal Revenue Code," Public Budgeting and Finance, v. 4. Spring 1984, pp. 14-31.

Kleinbard, Edward D. "Tax Expenditure Framework Legislation," National Tax Journal, v. 63, no. 2. June 2010, pp. 353-382.

Klimschot, JoAnn. The Untouchables: A Common Cause Study of the Federal Tax Expenditure Budget. Washington, DC: Common Cause, 1981.

Ladd, Helen. The Tax Expenditure Concept After 25 Years. Presidential Address to the National Tax Association. Proceedings of the 86th Annual Conference 1994, Columbus, Ohio: National Tax Association, 1995, 50-57.

McLure, Charles E., Jr. Must Corporate Income Be Taxed Twice? Washington, DC: The Brookings Institution, 1979.

Mikesell, John L. "The Tax Expenditure Concept at the State Level: Conflict Between Fiscal Control and Sound Tax Policy," Proceedings of the 94th Annual Conference 2001, Washington, D.C.: National Tax Association, 2002, 265-272.

Neil, Bruce. "Tax Expenditures and Government Policy." Kingston, Ontario: John Deutsche Institute for the Study of Economic Policy, 1989.

Noto, Nonna A. "Tax Expenditures: The Link Between Economic Intent and the Distribution of Benefits Among High, Middle, and Low Income Groups." Library of Congress, Congressional Research Service Multilith 80-99E. Washington, DC: May 22, 1980.

Pechman, Joseph A., ed. Comprehensive Income Taxation. Washington, DC: The Brookings Institution, 1977.

__. Federal Tax Policy: Revised Edition. Washington, DC: The Brookings Institution, 1980.

__. What Should Be Taxed: Income or Expenditures? Washington, DC: The Brookings Institution, 1980.

__. Who Paid the Taxes, 1966-85. Washington, DC: The Brookings Institution, 1985.

Schick, Allen. "Controlling Nonconventional Expenditure: Tax Expenditures and Loans," Public Budgeting and Finance, v. 6. Spring 1986, pp. 3-19.

Schroeher, Kathy. Gimme Shelters: A Common Cause Study of the Review of Tax Expenditures by the Congressional Tax Committees. Washington, DC: Common Cause, 1978.

Simon, Karla, "The Budget Process and the Tax Law," Tax Notes, v. 40. August 8, 1988, pp. 627-637.

Steuerle, Eugene, and Michael Hartzmark. "Individual Income Taxation, 1947-79," National Tax Journal, v. 34, no. 2. June 1981, pp. 145-166.

Sugin, Linda. "What is Happening to the Tax Expenditure Budget?" Tax Notes, August 16, 2004.

Sunley, Emil M. "The Choice Between Deductions and Credits," National Tax Journal, v. 30, no. 3. September 1977, pp. 243-247.

Surrey, Stanley S. Pathways to Tax Reform. Cambridge, MA: Harvard University Press, p. 3.

U.S. Government Accountability Office. Tax Expenditures Represent a Substantial Federal Commitment and Need to be Reexamined, GAO-05-690, Washington, DC: 2005.

Other benefits include certain combat-zone compensation and combat-related benefits. In addition, any member of the armed forces who dies while in active service in a combat zone or as a result of wounds, disease, or injury incurred while in service is excused from all tax liability. Any unpaid tax due at the date of the member's death (including interest, additions to the tax, and additional amounts) is abated. If collected, such amounts are credited or refunded as an overpayment. (Medical benefits for dependents are discussed subsequently under the Health function.) Families of members of the armed forces receive a $100,000 death gratuity payment for deceased members of the armed forces. The full amount of the death gratuity payment is tax-exempt.

The personal use of an automobile is not excludable as a qualified military benefit.

The rule that the exclusion for qualified scholarships and qualified tuition reductions does not apply to amounts received that represent compensation for services no longer applies in the case of amounts received under the Armed Forces Health Professions Scholarship and Financial Assistance Program or the F. Edward Hebert Armed Forces Health Professions Scholarship and Financial Assistance Program. Recipients of these scholarships are obligated to serve in the military at an armed forces medical facility.

The value of the exclusion rises as income rises and, thus, reduces the progressivity of the income tax system. For example, the value of each $100 excluded from income is $10 for an individual in the 10-percent tax bracket (the lowest income tax bracket) and $35 for an individual in the 35-percent tax bracket (the highest income tax bracket). The effect of the exclusion, thus, counteracts the progressive rate structure of the income tax system, resulting in a less progressive overall system.

The exclusion of qualified medical scholarships will primarily benefit students, therefore most beneficiaries are likely to have low tax rates. As noted earlier, the tax benefit of an exclusion varies according to the marginal tax rate of the individual.

Prior to this court decision, the Treasury Department had held that the rental value of quarters, the value of subsistence, and monetary commutations were to be included in taxable income. This view was supported by an earlier income tax law, the Tax Act of August 27, 1894, (later ruled unconstitutional by the Courts) which provided a two-percent tax "on all salaries of officers, or payments to persons in the civil, military, naval, or other employment of the United States."

The principle of exemption of armed forces benefits and allowances evolved from the precedent set by Jones v. United States, through subsequent statutes, regulations, or long-standing administrative practices.

The Tax Reform Act of 1986 (P.L. 99-514) consolidated these rules so that taxpayers and the Internal Revenue Service could clearly understand and administer the tax law consistent with fringe benefit treatment enacted as part of the Deficit Reduction Act of 1984 (P.L. 98-369). Provisions added by the Military Family Tax Relief Act of 2004 (P.L. 108-121) in November 2003 clarified uncertainty concerning the U.S. Treasury Department's authority to add dependent care assistance programs to the list of qualified military benefits.

For some benefits, the rationale was a specific desire to reduce tax burdens of military personnel during wartime (as in the use of combat pay provisions); other allowances were apparently based on the belief that certain types of benefits were not strictly compensatory, but rather intrinsic elements in the military structure.

The Economic Growth and Tax Reconciliation Relief Act of 2001 (P.L. 107-16) simplified the definition of earned income by excluding nontaxable employee compensation, which included combat zone pay, from the definition of earned income. The amount of earned income that armed forces members reported for tax purposes was reduced and caused a net loss in tax benefits for some low-income members of the armed forces. The Working Families Tax Relief Act of 2004 (P.L. 108-311) provided that combat pay that was otherwise excluded from gross income could be treated as earned income for the purpose of calculating the earned income tax credit and the child tax credit, through 2005, a provision that was extended through 2006 by the Gulf Opportunity Zone Act of 2005 (P.L. 109-135), 2007 by the Tax Relief and Health Care Act of 2006 (P.L. 109-432), and made permanent by the Heroes Earnings Assistance and Relief Tax Act of 2008 (P.L. 110-245).

Some see the provision of compensation in a tax-exempt form as an unfair substitute for additional taxable compensation. The tax benefits that flow from an exclusion do provide the greatest benefits to high-rather than low-income military personnel. Administrative difficulties and complications could be encountered in taxing some military benefits and allowances that currently have exempt status; for example, it could be difficult to value meals and lodging when the option to receive cash is not available. By eliminating exclusions and adjusting military pay scales accordingly, a result might be to simplify decision-making about military pay levels and make "actual" salary more apparent and satisfying to armed forces personnel. If military pay scales were to be adjusted upward, it could increase the retirement income of military personnel. However, elimination of the tax exclusions could also lead service members to think their benefits were being cut, or provide an excuse in the "simplification" process to actually cut benefits, affecting recruiting and retention negatively.

Garrison, Larry R. "Tax Planning for Armed Forces Personnel (Part I)," The Tax Advisor, v. 30, December 1999, pp. 838-843.

__, "Tax Planning for Armed Forces Personnel (Part II)," The Tax Advisor, v. 31, January 2000, pp. 44-47.

Grefer, James E., Comparing Military and Civilian Compensation Packages, Center for Naval Analysis, March 2008.

Kapp, Lawrence A. and Charles A. Henning, Operations Noble Eagle, Enduring Freedom, and Iraqi Freedom: Questions and Answers About U.S. Military Personnel, Compensation, and Force Structure, Library of Congress, Congressional Research Service Report RL31334 (2006).

Kusiak, Patrick J. "Income Tax Exclusion for Military Personnel During War: Examining the Historical Development, Discerning Underlying Principles, and Identifying Areas for Change," Federal Bar News and Journal, v. 39, February 1992, pp. 146-151.

Ogloblin, Peter K. Military Compensation Background Papers: Compensation Elements and Related Manpower Cost Items, Their Purposes and Legislative Backgrounds. Washington, DC: Department of Defense, Office of the Secretary of Defense, September 1996, pp. 137-149.

Poulson, Linda L. and Ananth Seetharaman. "Taxes and the Armed Forces," The CPA Journal, April 1996, pp. 22-26.

Rousseau, Richard W. "Tax Benefits for Military Personnel in a Combat Zone or Qualified Hazardous Duty Area," The Army Lawyer, v. 1999, December 1999, pp. 1-29.

Steurle, Gene. "Tax Relief and Combat Pay," Tax Notes, v. 50, January 28, 1991, pp. 405-406.

U.S. Congress, Congressional Budget Office. Evaluating Military Compensation. Washington, DC, April 2010.

U.S. Congress, Congressional Budget Office. Military Family Housing in the United States. Washington, DC, September 1993, p. 67.

U.S. Congress,, House Committee on Ways and Means. Tax Benefits for Individuals Performing Services in Certain Hazardous Duty Areas; Report to Accompany H.R. 2778 including Cost Estimate of the Congressional Budget Office, 104th Congress, 2nd Session. Washington, DC: U.S. Government Printing Office, 1996, p. 14.

__, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, H.R. 3838, 99th Congress, Public Law 99-514. Washington, DC: U.S. Government Printing Office, 1987, pp. 828-830.

__, Joint Committee on Taxation. Technical Explanation of H.R. 3365, The Military Family Tax Relief Act of 2003," as Passed by the House of Representatives and the Senate. Washington, DC: U.S. Government Printing Office, 2003, pp. 1-19.

__, Joint Committee on Taxation. Technical Explanation of H.R. 6081, The "Heroes Earnings Assistance and Relief Act of 2008," as Scheduled for Consideration by the House of Representatives on May 20, 2008. Washington, DC: U.S. Government Printing Office, 2008.

U.S. Dept. of Defense. Report and Staff Analysis of the Seventh Quadrennial Review of Military Compensation. Washington, DC: 7 volumes, August 21, 1992.

U.S. Dept. of the Treasury, Internal Revenue Service. Publication 3: Armed Forces' Tax Guide. Washington, DC: U.S. Government Printing Office, 2008.

U.S. Dept. of the Treasury, Office of the Secretary. Tax Reform for Fairness, Simplicity, and Economic Growth; the Treasury Department Report to the President. Washington, DC: November 1984, pp. 47-48.

U.S. General Accounting Office, "Military Compensation: Active Duty Compensation and Its Tax Treatment," GAO Report GAO-04-721R (Washington, DC: April 2004).

__, "Military Personnel: DOD Has Not Implemented the High Deployment Allowance that Could Compensate Servicemembers Deployed Frequently for Short Periods," GAO Report GAO-04-805 (Washington, DC: June 2004).

__, "Military Personnel: Bankruptcy Filings Among Active-Duty Servicemembers," GAO Report GAO-04-465R (Washington, DC: February 2004).

__, "Military Compensation: Active-Duty Compensation and Its Tax Treatment," GAO Report GAO-04-721R (Washington, DC: April 2004).

U.S. Government Accountability Office, "Military Personnel: DOD Needs to Improve the Transparency and Reassess the Reasonableness, Appropriateness, Affordability, and Sustainability of Its Military Compensation System," GAO Report GAO-05-798, (Washington, D.C.: July 2005).

In the case of the percentage-of-disability method, the pension is the percentage of disability multiplied by the terminal monthly basic pay. These disability pensions are excluded from gross income.

In the years-of-service method, the terminal monthly basic pay is multiplied by the number of service years times 2.5. Only that portion that would have been paid under the percentage-of-disability method is excluded from gross income.

Members of the United States armed forces joining after September 24, 1975, and who retire on disability, may exclude from gross income Department of Defense disability payments equivalent to disability payments they could have received from the Department of Veterans Affairs. Otherwise, Department of Defense disability pensions may be excluded only if the disability is directly attributable to a combat-related injury.

Under the Victims of Terrorism Tax Relief Act of 2001 an exclusion from gross income for disability income is extended to any individual (civilian or military) when attributable to a terrorist or military action regardless of where the activity occurs (inside or outside the United States).

In 1976, the exclusion was repealed, except in certain instances. Congress sought to eliminate abuses by armed forces personnel who were classified as disabled shortly before becoming eligible for retirement in order to obtain tax-exempt treatment for their pension benefits. After retiring from military service, some individuals would earn income from other employment while receiving tax-free military disability benefits. Since present armed forces personnel may have joined or continued their service because of the expectation of tax-exempt disability benefits, Congress deemed it equitable to limit changes in the tax treatment of disability payments to those joining after September 24, 1975.

The exclusion causes the true cost of providing for military personnel to be understated in the budget.

Cullinane, Danielle. Compensation for Work-Related Injury and Illness. Santa Monica, CA: RAND, 1992. 60pp. (RAND Publication Series N-3343-FMP.)

Ogloblin, Peter K. Military Compensation Background Papers: Compensation Elements and Related Manpower Cost Items, Their Purposes and Legislative Backgrounds. Washington, DC: U.S. Government Printing Office, September 1996, pp. 545-556.

Poulson, Linda L. and Ananth Seetharaman. "Taxes and the Armed Forces," The CPA Journal, April 1996, pp. 22-26.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1976 (H.R. 10612, 94th Congress; Public Law 94-455). Washington, DC: U.S. Government Printing Office, 1976, pp. 129-131.

U.S. Department. of the Treasury, Office of the Secretary. Tax Reform for Fairness, Simplicity, and Economic Growth; the Treasury Department Report to the President. Washington, DC: November, 1984, pp. 51-57.

U.S. General Accounting Office. Disability Benefits: Selected Data on Military and VA Recipients; Report to the Committee on Veterans' Affairs, House of Representatives, GAO/HRD-92-106. Washington, DC: August 1992, pp. 19.

__. Disability Compensation: Current Issues and Options for Change. Washington, DC: 1982.

__. VA Disability Compensation: Comparison of VA Benefits with those of Workers' Compensation Programs, Report to the Chairman, Subcommittee on Benefits, Committee on Veterans' Affairs, House of Representatives. Washington, DC: General Accounting Office, February 14, 1997.

__. VA Disability Compensation: Disability Ratings May Not Reflect Veterans' Economic Losses, Report to the Chairman, Insurance and Memorial Affairs, Committee on Veterans' Affairs, House of Representatives. Washington, DC: Office, January 7, 1997.

__. Military and Veterans' Benefits: Observations on the Concurrent Receipt of Military Retirement and VA Disability Compensation, Testimony before the Subcommittee on Personnel, Committee on Armed Services, U.S. Senate, March 27, 2003.

This deduction is available to taxpayers regardless of whether they claim the standard deduction or itemize deductions when filing their income tax return. The deduction is not restricted by the overall limitation on itemized deductions.

An individual in the 10-percent tax bracket (federal tax law's lowest tax bracket) would not pay taxes equal to $10 for each $100 excluded. Likewise, an individual in the 35-percent tax bracket (federal law's highest tax bracket) would not pay taxes of $35 for each $100 excluded. Hence, the same exclusion can be worth different amounts to different military personnel, depending on their marginal tax bracket. By providing military compensation in a form not subject to tax, the benefits have greater value for members of the armed services with high income than for those with low income.

One of the benefits of an "above-the-line" deduction is that it reduces the taxpayer's adjusted gross income (AGI). As AGI increases, it can cause other tax deductions and credits to be reduced or eliminated. Therefore, deductions that reduce AGI will often provide a greater tax benefit than deductions "below-the-line" that do not reduce AGI.

In enacting the new deduction, Congress identified the increasing role that Reserve and National Guard members fulfill in defending the nation and a heavy reliance on service personnel to participate in national defense. Congress noted that more than 157,000 reservists and National Guard were on active-duty status -- most assisting in Operation Iraqi Freedom at the time of enactment.

Garrison, Larry R. "Tax Planning for Armed Forces Personnel (Part I)," The Tax Advisor, v. 30, December 1999, pp. 838-843.

__, "Tax Planning for Armed Forces Personnel (Part II)," The Tax Advisor, v. 31, January 2000, pp. 44-47.

Kusiak, Patrick J. "Income Tax Exclusion for Military Personnel During War: Examining the Historical Development, Discerning Underlying Principles, and Identifying Areas for Change," Federal Bar News and Journal, v. 39, February 1992, pp. 146-151.

Levin, Mark H. "Benefits for Servicemen and Women Under the Military Family Tax Relief Act of 2003," The CPA Journal, v. 76, no. 1, January 2006.

Ogloblin, Peter K. Military Compensation Background Papers: Compensation Elements and Related Manpower Cost Items, Their Purposes and Legislative Backgrounds. Washington, DC: Department of Defense, Office of the Secretary of Defense, September 1996, pp. 137-149.

Poulson, Linda L. and Ananth Seetharaman. "Taxes and the Armed Forces," The CPA Journal, April 1996, pp. 22-26.

U.S. Congress, House Committee on Veterans' Affairs, Subcommittee on Education, Training and Employment. Transition Assistance Program, Hearing, 102nd Congress, 2nd session, Serial no. 102-31. Washington, DC: U.S. Government Printing Office, 1992.

__, House Committee on Ways and Means. Tax Benefits for Individuals Performing Services in Certain Hazardous Duty Areas; Report to Accompany H.R. 2778 including Cost Estimate of the Congressional Budget Office, 104th Congress, 2nd Session. Washington, DC: U.S. Government Printing Office, 1996.

__, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, H.R. 3838, 99th Congress, Public Law 99-514. Washington, DC: U.S. Government Printing Office, 1987, pp. 828-830.

__, Joint Committee on Taxation. Technical Explanation of H.R. 3365, The "Military Family Tax Relief Act of 2003," as Passed by the House of Representatives and the Senate. Washington, DC: U.S. Government Printing Office, 2003, pp. 1-19.

U.S. Department of Defense. Report and Staff Analysis of the Tenth Quadrennial Review of Military Compensation. Washington, 2 volumes, 2008.

U.S. Department of the Treasury, Internal Revenue Service. Publication 3: Armed Forces' Tax Guide. Washington, DC: U.S. Government Printing Office, 2009.

__, Office of the Secretary. Tax Reform for Fairness, Simplicity, and Economic Growth; the Treasury Department Report to the President. Washington, DC: November 1984, pp. 47-48.

U.S. General Accounting Office, Military Compensation: Active Duty Compensation and Its Tax Treatment, GAO Report GAO-04-721R (Washington: May 2004), pp. 1-32.

U.S. Government Accountability Office. Military Personnel: Reserve Component Servicemembers on Average Earn More Income while Activated, GAO Report GAO-09-688R (Washington: June 2009), pp. 1-41.

U.S. Department of the Treasury, Internal Revenue Service, Publication 3, Armed Forces' Tax Guide, 2009.

U.S. Government Accountability Office, Military Personnel: Actions Needed to Strengthen Management of Imminent Danger Pay and Combat Zone Tax Relief Benefits, Report to Congressional Committees, GAO-06-1011. September 2006.

__, Military Personnel: DOD Needs to Improve the Transparency and Reassess the Reasonableness, Appropriateness, Affordability, and Sustainability of Its Military Compensation System, Report to Congressional Committees, GAO-05-798. July 2005.

To qualify for either the income or housing cost exclusion, a person must be a U.S. citizen or permanent resident, must have their tax home in a foreign country, and must either be a bona fide resident of a foreign country or have lived abroad for at least 330 days of any 12 consecutive months. Qualified income must be "earned" income rather than investment income. If a person qualifies for only part of the tax year, only part of the annual exclusion can be claimed. The housing cost exclusion is designed to offset higher housing costs of living abroad. According to the tax code, the housing exclusion is equal to the excess of actual foreign housing costs over 16 percent of the applicable year's earned income exclusion amount, but is capped at 30 percent of the taxpayer's maximum foreign earned income exclusion. In practice, however, the Treasury Department has the authority to raise the maximum housing exclusion to reflect actual housing costs in particular foreign cities. While a taxpayer can claim both the housing and income exclusions, the combined exclusions cannot exceed total foreign-earned income, including housing allowances.

Many employers offer their overseas employees "tax equalization" packages whereby the employer guarantees that the employees will not pay more taxes working overseas than they would pay if they were working in the U.S. The section 911 provisions relieve the employer from having to reimburse employees for U.S. tax on the amounts that are excluded under the income and housing exclusions. In this way, section 911 subsidizes employers sending employees overseas.

Data suggest that U.S. citizens who work abroad have higher real incomes, on average, than people working in the United States. If that is true, where it does reduce taxes, the exclusion reduces the progressivity of the income tax.

The effect of the exclusion on horizontal equity is more complicated. The U.S. tax liability of Americans working abroad can differ from the tax on people with identical real income living in the United States, because of differences in the cost of living and corresponding differences in nominal income. A person working in a high-cost country needs a higher nominal income to match the real income of a person in the United States. In contrast, an expatriate in a low-cost country needs a lower nominal income than in the U.S. Because tax brackets, exemptions, and the standard deduction are expressed in nominal dollars in the tax code, people living in low-cost countries, who have low nominal incomes, would consequently have a lower tax bill than people with identical real income living in the United States. And, if not for the foreign-earned income exclusion, U.S. citizens working in high-cost countries, with high nominal incomes, would likely pay higher taxes than their U.S. counterparts.

The maximum income exclusion for a particular year is a set dollar amount for all taxpayers and is not linked to the actual cost of living in a particular geographic location. For low-cost foreign locations, it may overcompensate. In that case, the exclusion may have the unintended effect of increasing horizontal inequity in the tax system. Some point out that the tax code does not take into account variations in living costs within the United States; they argue that the appropriate equity comparison would be between an expatriate and a person living in the highest cost area within the United States.

The Internal Revenue Code sets the limit on the housing cost exclusion based on a formula. However, legislation enacted in 2005 granted the Treasury Department authority to adjust the statutory housing cost exclusion cap upward to reflect unusually high costs in particular foreign real estate markets. For tax year 2007, more than 100 foreign cities or regions had housing cost allowances that exceeded the statutory maximum of $25,710 for that year (equal to 30 percent of the maximum income exclusion of $85,700 for 2007). For example, the maximum housing exclusion for Dubai was $42,452; for Paris, $87,200; and for Hong Kong, $114,300.

For 2006, approximately 335,000 taxpayers living abroad reported approximately $36.7 billion in foreign-earned income. Nearly $18.4 billion, or half of that, was claimed as a foreign-earned income exclusion on their tax returns. Roughly 57 percent of taxpayers who reported foreign-earned income had no U.S. tax liability for 2006, after claiming the foreign-earned income exclusion and the foreign tax credit.

The subsequent history of the exclusion shows a continuing attempt by policymakers to find a balance between the provision's perceived beneficial effects on U.S. trade and economic performance and perceptions of tax equity. In 1962, the Kennedy Administration recommended eliminating the exclusion in some cases and scaling it back in others in order to "support the general principles of equity and neutrality in the taxation of U.S. citizens at home and abroad." The final version of the Revenue Act of 1962 (P.L. 87-834) simply capped the exclusion in all cases at $20,000. The Tax Reform Act of 1976 (P.L. 94-455) would have pared the exclusion further (to $15,000), again for reasons of tax equity.

However, the Foreign Earned Income Act of 1978 (P.L. 95-615) completely revamped the exclusion such that the 1976 provisions never took effect. The 1978 Act sought to provide tax relief more closely tied to the actual costs of living abroad. It replaced the single exclusion with a set of separate deductions that were linked to various components of the cost of living abroad, such as the excess cost-of-living in general, excess housing expenses, schooling expenses, and home-leave expenses.

In 1981, the emphasis again shifted to the perceived beneficial effects of encouraging U.S. employment abroad; the Economic Recovery Tax Act (ERTA, P.L. 97-34) provided a large flat income exclusion and a separate housing exclusion. ERTA's income exclusion was $75,000 for 1982, but was scheduled to increase to $95,000 by 1986. However, concern about the revenue consequences of the increased exclusion led Congress to temporarily freeze the exclusion at $80,000 under the Deficit Reduction Act of 1984 (P.L. 98-369); annual $5,000 increases were to resume in 1988. In 1986, as part of its general program of broadening the tax base, the Tax Reform Act (P.L. 99-514) fixed the exclusion at $70,000. The Taxpayer Relief Act of 1997 (P.L. 105-34) provided the gradual increase in the exclusion to $80,000 by 2002, as well as indexing for U.S. inflation, beginning in 2008.

The Taxpayer Increase Prevention and Reconciliation Act of 2006 (TIPRA; P.L. 109-222) contained new restrictions on both the housing and earned income exclusions as a revenue-raising element designed to partly offset unrelated revenue-losing items in the act. The act contained four principal changes. First, it moved up from 2008 to 2006 the scheduled indexation of the exclusion. (While the combined, net impact of TIPRA's changes was expected to reduce the benefit's revenue loss, the indexation provision, taken alone, likely increases it.) Second, TIPRA changed the way tax rates apply to a taxpayer's income that exceeds the exclusion. Under prior law, if a person had income in excess of the maximum exclusion, tax rates applied to the additional income beginning with the lowest marginal rate. Under TIPRA, marginal rates apply beginning with the rate that would apply if the taxpayer had not used the exclusion. Third, TIPRA changed the "base amount" related to the housing exclusion. Under prior law, the housing exclusion applied to housing expenses exceeding 16 percent of the salary level applicable to the GS-14 federal grade level; TIPRA set the base amount at 16 percent of the foreign earning income exclusion amount ($91,500 for 2010). In addition, TIPRA capped the housing exclusion at 30 percent of the maximum excludable income; there was no cap under prior law. TIPRA also gave the Treasury Department the authority to adjust the 30 percent housing cost cap upward for individual cities around the world with unusually high housing costs.

Historically, the foreign-earned income and housing cost exclusions have been defended on the grounds that they help increase U.S. exports, because Americans working abroad play an important role in promoting the sale of U.S. goods abroad. The impact of the provision is uncertain, however. U.S. citizens do not need to be employed by a U.S.-based corporation in order to qualify for the exclusions; they can be employed by foreign corporations. Self-employed Americans working abroad also qualify for the exclusions. Recently, scholars have argued that the exclusions may actually work against U.S. domestic economic interests by encouraging highly compensated U.S. citizens to work overseas, thereby both expatriating U.S. intellectual capital and reducing U.S. tax revenue.

Bonache, Jaime, Juan I. Sanchez, and Celia Zarraga-Oberty. "The Interaction of Expatriate Pay Differential and Expatriate Inputs on Host Country Nationals' Pay Unfairness." The International Journal of Human Resource Management, vol. 20, no. 10 (October 2009), pp. 2135-2149.

Cluett, Ronald. "United States: Sound and Fury, Signifying What? The U.S. Foreign Earned Income Exclusion Debate." Tax Notes International, September 15, 2008, p. 943 ff.

Curry, Jeff, and Maureen Keenan Kahr. "Individual Foreign-Earned Income and Foreign Tax Credit, 2001." Internal Revenue Service (IRS), Statistics of Income Bulletin (Spring 2004), pp. 98-120.

Dhanda, Michelle. "International Taxation: A Guide for Academics Abroad." Suffolk Transnational Law Review, vol. 32, no. 3, September 22, 2009.

Evans, Jeffrey. "911: The Foreign Earned Income Exclusion -- Policy and Enforcement." Virginia Journal of International Law 37 (Summer 1997), pp. 891-918.

Gravelle, Jane G., and Donald W. Kiefer. U.S. Taxation of Citizens Working in Other Countries: An Economic Analysis. Library of Congress, Congressional Research Service Report 78-91 E. Washington, DC, 1978.

Hollenbeck, Scott, and Maureen Keenan Kahr. "Individual Foreign-Earned Income and Foreign Tax Credit. Internal Revenue Service, Statistics of Income Bulletin, vol. 28, no. 4 (Spring 2009), pp. 54-84.

Hrechak, Andrew, and Richard J. Hunter, Jr. "Several Tax Breaks Available for those Working Abroad." Taxation for Accountants 52 (May 1994), pp. 282-286.

Oliver, Joseph R. "The Foreign Earned Income Exclusion: An Update" CPA Journal 69 (August 1999), pp. 46-50.

U.S. Congress, Conference Committees, 2006. Tax Increase Prevention and Reconciliation Act of 2005. Conference report to accompany H.R. 4297. H. Rpt. 109-455, 109^th Cong., 2^nd sess. Washington, U.S. Government Printing Office, 2006, pp. 307-310.

U.S. Congress, Senate, Committee on Finance. Background Fact Sheet on Section 911 Prepared by Chairman Grassley's Finance Committee Staff. Washington, May 25, 2006. Posted on the committee's web site at [http://finance.senate.gov/newsroom/chairman/release/?id=caab3c6c-81c1-4edb-b6f9-7af28c32b25c]. (Visited October 15, 2010.)

U.S. Congress, Joint Committee on Taxation. Options to Improve Tax Compliance and Reform Tax Expenditures. Prepared by the Staff of the Joint Committee on Taxation. Publication JCS-02-05, 109^th Cong., 1^st sess. Washington, January 27, 2005, pp. 174-177.

U.S. Department of the Treasury. Taxation of Americans Working Overseas: the Operation of the Foreign Earned Income Exclusion in 1987. Washington, DC, 1993.

When the foreign-source income is repatriated, the U.S. parent corporation can claim a credit against its U.S. tax liability for any foreign taxes the subsidiary has paid on that income. The credit cannot exceed the U.S. tax due on the foreign-source income. It is intended to avoid double taxation of repatriated foreign income. Excess credits incurred in tax years beginning after October 22, 2004 may be carried back one year and then carried forward up to 10 years.

U.S. corporations with foreign-source income face an overall limitation on the foreign tax credit they may use in a tax year. The limitation is designed to prevent the credit from being used to lower U.S. tax liability on U.S.-source income. Under the limitation, the foreign tax credit cannot exceed a taxpayer's U.S. income tax liability multiplied by a fraction equal to the taxpayer's foreign-source taxable income divided by its worldwide taxable income. For tax years starting after 2006, this limitation must be calculated separately for two categories (or baskets) of foreign-source income: passive income and general income. In this case, passive income refers to investment income such as dividends and interest and income from what are known as qualified electing funds. Any foreign-source income not considered passive generally is treated as belonging to the general-income basket. In determining its taxable income for each basket, a taxpayer must take into account the expenses, losses, and deductions related to the gross income related to each basket.

Federal tax law requires U.S. multinational corporations to allocate deductible expenses that could be related to both foreign and domestic income, such as interest payments and spending on research and development (R&D), between U.S. and foreign earnings. This allocation is not necessarily inconsequential, as the more costs a firm can assign to U.S. sources, the greater its foreign-source income as a share of total income and the larger its foreign tax credit limitation. For firms subject to lower tax rates on their foreign-source income than on their U.S.-source income, a change in the allocation of a small amount of expenses would not affect the foreign taxes it could claim as a credit. But in the case of firms that have excess foreign tax credits because they pay relatively high taxes on foreign-source income, a shift in the allocation of a small amount of expenses could increase the foreign taxes that are creditable, and thus reduce their U.S. taxes.

This requirement does not apply to research expenses that are incurred to satisfy some legal requirement or government regulation.

While research expenses are capital in nature in that they create assets that earn future income, section 174 allows firms to deduct them as a current expense as an incentive to invest in R&D. Most expenses are allocated to U.S. or foreign income on the basis of their relationship to the sources of gross income. But this matching principle is of little use in allocating research expenses, as they are not closely related to gross income in the current tax year. So a different approach is needed.

The allocation of research expenses between foreign-source and U.S.-source income is governed by a set of regulations (Reg. § 1.861-17) issued by the Internal Revenue Service (IRS) in 1995. They proceed on the assumption that research expenses ordinarily deducted under section 174 are related to all income associated with broad product categories and can be allocated to all sources of that income, such as sales, royalties, or dividends.

The regulations set forth a two-step process for making this allocation. In the first step, research expenses are allocated to a particular class of income, such as sales, royalties, and dividends. Each class of income is then divided among product categories identified by three-digit standard industrial classification (SIC) codes.

The second step is more complicated. It involves apportioning the research expenses allocated to each product category between foreign-source income (or the statutory grouping) and U.S.-source income (or the residual grouping), using either the sales method or the gross-income method. Both methods allocate a fixed (or exclusive) percentage of the research expenses to the geographic location where more than 50 percent of the expenses were incurred. If that location is the United States, then 50 percent of the expenses are apportioned to U.S.-source income under the sales method, and 25 percent are apportioned to U.S. income under the gross-income method. (If that location happens to be another country, then the same percentages would apply to foreign-source income.) A larger fixed allocation can be made if a taxpayer can demonstrate the R&D related to the expenses is likely to have limited or long-delayed commercial applications outside the United States. If a taxpayer chooses the sales method, the amount of research expenses apportioned to foreign-source income for each product category, after subtracting the 50 percent of expenses assigned to U.S. income, is determined by multiplying the remaining expenses by a fraction equal to the taxpayer's foreign sales divided by its total sales for that category. If the taxpayer chooses the gross-income method, the apportionment is done the same way for each product category, except that gross income is used in lieu of sales in the fraction. An allocation using the gross-income method may not reduce the amount of research expenses allocated to foreign-source income to less than 50 percent of the foreign-source allocation produced by the sales method.

The tax expenditure associated with the regulations lies in the larger foreign tax credits that some corporations can use as a result of the required allocation of research expenses to foreign-source income.

The current regulations under sections 861 to 863 trace their origin to a set of final regulations (Reg. § 1.861-8) issued by the IRS in 1977. They required that a multinational firm's research expenses be allocated according to either the proportion of sales that occurred in each country or the proportion of gross income that had its source in each country. This meant, for example, that if a firm received 25 percent of its worldwide revenue from the sale of a product in the United States, then it had to allocate 25 percent of the research costs associated with that product to U.S.-source income and the remaining 75 percent to foreign-source income. The regulations also contained a so-called "place-of-performance" option that allowed a taxpayer to allocate 30 percent of its research expenses to any location where it performed over half of its R&D, before applying the sales formula for the allocation of its remaining research expenses.

The 1977 regulations proved controversial from the start. Critics charged that they reduced domestic R&D spending and encouraged U.S. firms to transfer some of their R&D activities to foreign locations.

Congress responded to these criticisms by adopting a two-year suspension of the regulations through the Economic Recovery Tax Act of 1981 (ERTA). During that period, U.S. firms were allowed to allocate all of their U.S. research costs as they saw fit.

In a report on the regulations mandated by ERTA and issued in 1983, the Treasury Department recommended that the suspension be extended an additional two years to allow more time to assess their likely effects. Congress agreed with the recommendation and suspended the regulations for another two years through the Deficit Reduction Act of 1984. In extending the suspension, it noted that its assessment of the regulations would focus on whether a repeal would be more effective than other options in boosting domestic business R&D investment.

But when Congress passed the Tax Reform Act of 1986, it indicated that the issue of whether to retain, repeal, or modify the regulations still needed more time for analysis and discussion. So the act extended the suspension through 1987. It also altered the regulations to permit taxpayers using the place-of-performance option to allocate 50 percent of its research expenses to the location where more than half of its R&D was done, and to use the gross-income method to allocate the remaining expenses.

The Technical and Miscellaneous Revenue Act of 1988 temporarily replaced the regulations with a set of more liberal rules that applied in 1988 only. Under the act, firms were required to allocate 64 percent of their domestic research expenses to U.S. income and 64 percent of their foreign research expenses to foreign income for the first four months of the year. The remaining 36 percent of expenses could be allocated using either the gross-income or sales method. For the remaining eight months of 1988, taxpayers were required to use the allocation methods specified in the 1977 regulations.

From 1988 to 1991, Congress passed three measures that retained the requirement that 64 percent of research expenses be allocated to U.S. income: the Omnibus Budget Reconciliation Act of 1989, the Omnibus Budget Reconciliation Act of 1990, and the Tax Extension Act of 1991. This treatment expired on August 1, 1992.

Under the Omnibus Budget Reconciliation Act of 1993, taxpayers were allowed to allocate up to 50 percent of research expenses to U.S. income, and they could allocate the remaining 50 percent between U.S. and foreign income using either the sales or gross-income method. This provision expired on December 31, 1994.

In December 1995, the IRS issued proposed regulations that made three significant changes in the 1977 regulations. First, the proposed regulations would allow taxpayers to identify product categories by using three-digit SIC codes instead of two-digit codes. Second, the percentage of research expenses that could be exclusively allocated to a location under the sales method would rise from 30 percent to 50 percent. Third, a decision to use the sales or gross-income method would be treated as a binding election to use the same method in future tax years. The current regulations emerged from these proposed regulations.

Proponents argue the regulations are justified mainly because R&D performed by U.S.-based firms in the United States leads to the development of goods and services that they sell profitably at the same time in the United States and in other countries through subsidiaries. Under these circumstances, the accurate measurement of the foreign taxable income of these firms requires that part of their U.S. research expenses be deducted from foreign income.

Critics say this view of the process through which U.S.-based multinational companies earn foreign income from goods and services developed largely through their U.S. R&D activities is unrealistic. In their view, technological innovations generally are exploited commercially first in the country where they were developed, and only after a lengthy and often unpredictable delay are they then sold or used in other countries. Under this scenario, the regulations cannot be justified, as the accurate measurement of U.S. income requires that all (or nearly all) U.S. research expenses be deducted from U.S. income.

A policy issue raised by these differing perspectives relates to the geographic spread of the spillover benefits of R&D investments. If the spillover is primarily international in scope, then the argument made by proponents of the regulations would appear to have merit. But if the spillover is primarily local in scope, then critics would appear to be justified in calling for the repeal of the regulations and their replacement with a set of rules more favorable to the allocation of research expenses to U.S. income.

Another major source of controversy is the impact of the regulations on domestic business investment in R&D and the incentives for U.S. firms to transfer R&D activities overseas.

Critics have long argued that the regulations have the effect of lowering this investment and encouraging U.S. companies to transfer some of their R&D to foreign locations with higher tax rates than U.S. tax rates. Such an undesirable outcome, critics say, results from the impact of the regulations on the worldwide tax liabilities of U.S. multinational corporations, especially those with excess foreign tax credits. Most foreign governments do not allow a deduction for the cost of R&D conducted in the United States. Therefore, allocating a U.S. business expense to foreign rather than U.S. income has the same effect on a firm's net tax liability under federal tax law as denying it a deduction for this expense. If a foreign government allows a deduction for this expense, a U.S. firm's foreign taxes would decline but its total tax liability would remain about the same. But if the foreign government disallows a deduction, the increase in the firm's U.S. taxes would not be offset by a reduction in its foreign taxes. In this case, both the U.S. and foreign governments are taxing income equal in amount to the denied deduction.

According to critics, this double taxation could be a problem for U.S. companies with excess foreign tax credits. It could lead them to reduce domestic business R&D investment and a shift of investment funds to less productive uses. For such companies, the regulations create a tax incentive for shifting R&D operations abroad that is equal to the difference between U.S. tax rates and the tax rates in foreign locations.

In contrast, supporters of the regulations see no compelling reason for the U.S. government to get rid of them and instead permit taxpayers to deduct the entire amount of their U.S. research expenses from U.S. income. They point out that doing so could create a situation that U.S. tax law tries mightily to avoid: the use of foreign tax credits against a firm's tax liability on U.S.-source income. In the view of supporters, if action should be taken to eliminate any double taxation caused by the regulations, it should be taken by foreign governments that disallow a deduction for U.S. research expenses. They also dispute the claim that few foreign governments (if any) permit such a deduction. To the extent that these governments do allow those expenses to be deducted, supporters say that allocating the entire amount of U.S. research expenses to U.S. income would be tantamount to allowing a double deduction and creating a tax subsidy for domestic R&D investment, not a tax penalty as critics charge.

A policy issue raised by these opposing arguments concerns the net effect of current tax law on the incentive to invest in domestic R&D. There seems to be lingering uncertainty over how the regulations have affected this incentive. So additional research on this issue seems warranted. Lawmakers may also wish to know how the regulations have affected the incentive to undertake domestic R&D investment provided by the research tax credit under section 41 and the expensing of eligible research costs under section 174. Given the compelling economic rationale for providing government support for domestic R&D investment, it might be useful to find out if the regulations tend to bolster or undercut the stimulative effect of these two research tax incentives.

Some specialists in international tax policy argue that the rules for the sourcing of income and the allocation of research expenses should be designed to accomplish three aims: 1) to avoid the double taxation of income; 2) to avoid imposing too little tax on income; and 3) to achieve an equitable distribution of tax revenue from the operations of multinational companies among sovereign governments. In their view, the only way to accomplish all three objectives simultaneously is to come to an international consensus on a set of such rules. A harmonization of tax systems among countries that are major players in the global economy would probably be needed to achieve such an understanding. Lawmakers may want to explore such an option in finding a solution to the problems posed by the current regulations for allocating research expenses for U.S.-based multinational corporations.

Bishcel, Jon E. "Optimizing the Benefits From R&D Expenses Under the Allocation and Apportionment Regs." Journal of Taxation, vol. 48, no. 6, p. 332.

Brumbaugh, David L. Allocation of Research and Development Costs and the U.S. Foreign Tax Credit. Library of Congress, Congressional Research Service Report 89-220 E. Washington, DC: April 4, 1989.

Goodman, Mark E. "IRS Issues Proposed Regulations on Allocation and Apportionment of Research and Experimental Expenditures." The Tax Adviser, vol. 27, no. 9, September 1996, pp. 533-534.

Gravelle, Jane G. and Donald J. Marples. The Foreign Tax Credit's Interest Allocation Rules. Library of Congress, Congressional Research Service Report RL34494. Washington, DC: September 29, 2008.

Hines, James R Jr. and Adam B. Jaffe. "International Taxation and the Location of Inventive Activity." in International Taxation and Multinational Activity, James R. Hines, Jr., ed. University of Chicago Press, 2001, pp. 201-229.

Rashkin, Michael D. Practical Guide to Research and Development Tax Incentives. CCH, Chicago, IL: 2007, pp. 43-47.

U.S. Congress, Committee on Ways and Means, Subcommittee on Oversight. The Research and Experimentation Tax Credit and the Allocation of Research Expenses Under Internal Revenue Code Section 861. Hearing, 104^th Cong., 1^st Sess., GPO, Washington, DC: 1996.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Economic Recovery Tax Act of 1981. JCS-71-81, GPO, Washington, DC: 1981, pp. 141-142.

Specifically, section 912 excludes certain amounts received under provisions of the Foreign Service Act of 1980, the Central Intelligence Act of 1949, the Overseas Differentials and Allowances Act, and the Administrative Expenses Act of 1946. The allowances are primarily for the higher cost of living abroad, housing, education, and travel. Section 912 also excludes cost-of-living allowances received by federal employees stationed in U.S. possessions, Hawaii, and Alaska. Travel, housing, food, clothing, and certain other allowances received by members of the Peace Corps also are excluded. However, special allowances for hardship posts are not eligible for the exclusion.

Section 912's impact on horizontal equity (the equal treatment of equals) is more ambiguous. Without section 912 or a similar provision, federal employees in high-cost countries would likely pay higher taxes than persons with identical real incomes who work in the United States. The higher nominal income needed to offset higher living costs abroad would place federal employees stationed abroad in a higher tax bracket. It would also reduce the value of personal exemptions and the standard deduction, which are set at the same nominal dollar amount, regardless of where the taxpayer lives or works.

The complete exclusion of cost-of-living allowances probably overcompensates for this effect. U.S. citizens employed abroad in the private sector are permitted to exclude up to $91,500 in 2010, rather than an amount explicitly linked to cost-of-living allowances. Given the flat amount, whether the tax treatment of federal workers is more or less favorable than that of private-sector workers depends on the size of the federal worker's cost-of-living allowance.

Some have argued that because no tax relief is provided for people who work in high-cost areas in the United States, horizontal equity requires only that persons abroad be taxed no more heavily than a person in the highest-cost area in the U.S. It might also be argued that the cost-of-living exclusion for employees in Alaska and Hawaii violates horizontal equity, since private-sector workers in those states do not receive a tax exclusion for cost-of-living allowances.

Rationale

The section 912 exclusions were first enacted by the Revenue Act of 1943. Apparently the costs of living abroad were rising. Congress determined that federal personnel overseas were engaged in "highly important" duties and that the allowances merely offset the extra costs of working and living abroad. Congress determined that the Government should bear the full burden of the excess living costs, including any income taxes that would otherwise be imposed on cost-of-living allowances.

The Foreign Service Act of 1946 expanded the list of excluded allowances beyond cost-of-living allowances to include housing, travel, and certain other allowances. In 1960, the exclusions were further expanded to include allowances received under the Central Intelligence Agency Act. In 1961, certain allowances received by Peace Corps members were added to the list of exclusions.

Assessment

The benefit from the section 912 exclusions is largest for federal employees abroad who receive a substantial part of their income as cost-of-living, housing, education, or other allowances. Beyond this, the effects of the exclusions are uncertain. The exclusions may encourage employees to request that a greater portion of their compensation be paid in the form of these tax-favored benefits.

It could be argued that the federal agency that employs a person who claims a section 912 exclusion does not directly bear the cost of the exclusion. That is, the exclusion reduces the income tax revenue of the federal government in general, but that revenue cost is not reflected in the budgets of the particular federal agencies with overseas employees. As a consequence, section 912 may enable individual federal agencies to employ more U.S. citizens abroad than they otherwise would or could if they were held accountable for the full cost of those employees, including the income tax forgiven on qualifying allowances.

U.S. Internal Revenue Service. U.S. Government Civilian Employees Stationed Abroad. Publication 516. Washington, DC, Government Printing Office, February 2010.

Subpart F of the Internal Revenue Code (sections 951-964) provides an exception to the general deferral principle. Under its provisions, certain income earned by foreign corporations controlled by U.S. shareholders is deemed to be distributed whether or not it actually is, and U.S. taxes are assessed on a current basis rather than deferred. Income subject to Subpart F is generally income related to passive investment rather than income from active business operations. Also, certain types of sales, services, and other income whose geographic source is relatively easily shifted is included in Subpart F.

While U.S. tax (less foreign tax credits) generally applies when tax-deferred income is ultimately repatriated to the United States, a provision of the American Jobs Creation Act of 2004 (P.L. 108-357) provided a temporary (one-year) 85% deduction for repatriated dividends. For a corporation subject to the top corporate tax rate of 35%, the deduction had an effect similar to a reduction in the tax rate on repatriations to 5.25%. The deduction applied to a one-year period consisting (at the taxpayer's election) of either the first tax year beginning on or after P.L. 108-357's date of enactment (October 22, 2004) or the taxpayer's last tax year beginning before the date of enactment.

The one-year deduction for repatriations enacted in 2004 likely increased the repatriation of funds from foreign subsidiaries. However, at least part of the increase likely consisted of a shift in the timing of repatriations from future periods towards the present, as firms took advantage of the one-year window. While the provision was intended, in part, to increase domestic investment -- its supporters argued that repatriated funds would be invested in the United States -- firms' disposition of the repatriations is not certain.

In 1975, Congress again considered eliminating deferral, and in 1978 President Carter proposed its repeal, but on both occasions the provision was left essentially intact. Subpart F, however, was broadened by the Tax Reduction Act of 1975, the Tax Reform Act of 1976, the Tax Equity and Fiscal Responsibility Act of 1982, the Deficit Reduction Act of 1984, the Tax Reform Act of 1986, and the Omnibus Reconciliation Act of 1993 (OBRA93). OBRA93 added section 956A to the tax code, which expanded Subpart F to include foreign earnings that firms retain abroad and invest in passive assets beyond a certain threshold.

In recent years, however, the trend has been incremental restrictions of Subpart F and expansions of deferral. For example, the Small Business Job Protection Act of 1996 repealed section 956A. And the Tax Relief Extension Act of 1999 (P.L. 106-170) extended a temporary exemption from Subpart F for financial services income. In 2004, the American Jobs Creation Act relaxed Subpart F in the area of shipping income and provided a one-year temporary tax reduction for income repatriated to U.S. parents from overseas subsidiaries.

Defenders of deferral argue that the provision is necessary to allow U.S. multinationals to compete with firms from foreign countries; they also maintain that the provision boosts U.S. exports. However, economic theory suggests that a tax incentive such as deferral does not promote the efficient allocation of investment. Rather, capital is allocated most efficiently -- and world economic welfare is maximized -- when taxes are neutral and do not distort the distribution of investment between the United States and abroad. Economic theory also holds that while world welfare may be maximized by neutral taxes, the economic welfare of the United States would be maximized by a policy that goes beyond neutrality and poses a disincentive for U.S. investment abroad.

Supporters of a "territorial" tax system would permanently exempt U.S. tax on repatriated dividends, thus eliminating U.S. tax even on a postponed basis. Several arguments have been made in support of territorial taxation. One is based on the notion that changes in the international economy have made economic theory's traditional notions of efficiency and neutrality obsolete. (This analysis, however, is not the consensus view of economists expert in the area.) This argument maintains that efficiency is promoted if taxes do not inhibit U.S. multinationals' ability to compete for foreign production opportunities or interfere with their ability to exploit the returns to research and development. Another argument holds that the current tax system produces so many distortions in multinationals' behavior that simply exempting foreign-source business income from tax would improve economic efficiency.

Ault, Hugh J., and David F. Bradford. "Taxing International Income: An Analysis of the U.S. System and Its Economic Premises." In Taxation in the Global Economy, ed. Assaf Razin and Joel Slemrod, 11-52. Chicago: University of Chicago Press, 1990.

Bergsten, C. Fred, Thomas Horst, and Theodore H. Moran. "Tax Issues." In American Multinationals and American Interests. Washington, DC: The Brookings Institution, 1977.

Desai, Mihir, Fritz Foley, and James Hines, "The Demand for Tax Haven Operations," Journal of Public Finance v90 (February 2006), pp. 513-531.

Desai, Mihir, and James Hines, "Old Rules and New Realities: Corporate Tax Policy in a Global Setting," National Tax Journal 57 (December 2004), pp. 937-960.

Engel, Keith. "Tax Neutrality to the Left, International Competitiveness to the Right, Stuck in the Middle with Subpart F." Texas Law Review 79 (May 2001), pp. 1525-1606.

Frisch, Daniel J. "The Economics of International Tax Policy: Some Old and New Approaches." Tax Notes 47 (April 30, 1990), pp. 581-591.

Gourevitch, Harry G. Anti-Tax Deferral Measures in the United States and Other Countries. Library of Congress, Congressional Research Service Report 95-1143 A, (1995).

Graetz, Michael J., and Paul W. Oosterhuis, "Structuring an Exemption System for Foreign Income of U.S. Corporations," National Tax Journal 54 (December 2001), pp. 771-786.

Gravelle, Jane G. Reform of U.S. International Taxation: Alternatives. Library of Congress, Congressional Research Service Report RL34115, (2008).

_. Tax Havens: International Tax Avoidance and Evasion. Library of Congress, Congressional Research Service Report R40623, (2010).

_. "Issues in International Tax Policy." National Tax Journal 57 (September 2004), pp. 773-778.

Grubert, Harry and Rosanne Altshuler. "Corporate Taxes in the World Economy: Reforming the Taxation of Cross-border Income," in Fundamental Tax Reform: Issues, Choices, and Implications, John W. Diamond and George R. Zodrow, eds. (Cambridge, MA: MIT Press, 2008), pp. 319-354.

Grubert, Harry, "Comment on Desai and Hines, 'Old Rules and New Realities: Corporate Tax Policy in a Global Setting," National Tax Journal, vol. 58, Jun. 2005, pp. 263-278.

_. and John Mutti, Taxing International Business Income: Dividend Exemption versus the Current System (Washington: American Enterprise Inst., 2001), 67 pp.

Hartman, David G. "Deferral of Taxes on Foreign Source Income," National Tax Journal 30 (December 1977), pp. 457-462.

--. "Tax Policy and Foreign Direct Investment." Journal of Public Economics 26 (February 1985), pp. 107-121.

Marples, Donald J. U.S. Taxation of Overseas Investment and Income: Background and Issues. Library of Congress, Congressional Research Service Report RL32749, (2009).

Marples, Donald J. and Jane G. Gravelle. Tax Cuts on Repatriation Earnings as Economic Stimulus: An Economic Analysis. Library of Congress, Congressional Research Service Report R40178, (2010).

Rousslang, Donald. "Deferral and the Optimal Taxation of International Investment Income." National Tax Journal 53 (September 2000), pp. 589-601.

Slemrod, Joel. "Effect of Taxation with International Capital Mobility." In Uneasy Compromise: Problems of a Hybrid Income-Consumption Tax, ed. Henry J. Aaron, et al., 115-147. Washington, DC: The Brookings Institution, 1988.

U.S. Congress. Joint Committee on Taxation. Factors Affecting the International Competitiveness of the United States. Joint Committee Print. 102^nd Congress, 1^st session. Washington, DC: Government Printing Office, May 30, 1991.

U.S. Department of the Treasury, Office of Tax Policy. The Deferral of Income Earned Through U.S. Controlled Foreign Corporations. Washington, DC: December, 2002.

Yoder, Llowell D. "Subpart F in Turmoil: Low Taxed Active Income Under Siege." Taxes 77 (March 1999), pp. 142-166.

In general, the United States taxes U.S. corporations on their worldwide income. The United States also permits firms to credit foreign taxes they pay against U.S. taxes they would otherwise owe.

Foreign taxes, however, are only permitted to offset the portion of U.S. taxes due on foreign-source income. Foreign taxes that exceed this limitation are not creditable and become so-called "excess credits." It is here that the source of income becomes important: firms that have excess foreign tax credits can use these credits to reduce U.S. taxes if they can shift income from the U.S. to the foreign operation. This treatment effectively exempts such income from U.S. taxes.

The tax code contains a set of rules for determining the source ("sourcing") of various items of income and deduction. In the case of sales of personal property, gross income is generally sourced on the basis of the residence of the seller. U.S. exports covered by this general rule thus generate U.S. -- rather than foreign -- source income.

The tax code provides an important exception, however, in the case of sales of inventory property. Inventory that is purchased and then resold is governed by the so-called "title passage" rule: the income is sourced in the country where the sale occurs. Since the country of title passage is generally quite flexible, sales governed by the title passage rules can easily be arranged so that the income they produce is sourced abroad.

Inventory that is both manufactured and sold by the taxpayer is treated as having a divided source. Unless an independent factory price can be established for such property, half of the income it produces is assigned a U.S. source and half is governed by the title passage rule. As a result of the special rules for inventory, up to 50 percent of the combined income from export manufacture and sale can be effectively exempted from U.S. taxes. A complete tax exemption can apply to export income that is solely from sales activity.

Thus, the source-rule benefit is probably shared by U.S. capital in general, and therefore probably disproportionately benefits upper-income individuals. To the extent that the rule results in lower prices for U.S. exports, a part of the benefit probably accrues to foreign consumers of U.S. products.

The source rules remained essentially unchanged until the advent of tax reform in the 1980s. In 1986, the Tax Reform Act's statutory tax rate reduction was expected to increase the number of firms with excess foreign tax credit positions and thus increase the incentive to use the title passage rule to source income abroad.

Congress was also concerned that the source of income be the location where the underlying economic activity occurs. The Tax Reform Act of 1986 thus provided that income from the sale of personal property was generally to be sourced according to the residence of the seller. Sales of property by U.S. persons or firms were to have a U.S. source.

Congress was also concerned, however, that the new residence rule would create difficulties for U.S. businesses engaged in international trade. The Act thus made an exception for inventory property, and retained the title passage rule for purchased-and-resold items and the divided-source rule for goods manufactured and sold by the taxpayer.

More recently, the Omnibus Budget Reconciliation Act of 1993 repealed the source rule exception for exports of raw timber.

__. Tax Benefit for Exports: The Inventory Source Rules. Library of Congress, Congressional Research Service Report 97-414 E. (1997).

Hammer, Richard M., and James D. Tapper. The Foreign Tax Credit Provisions of the Tax Reform Act of 1986. Tax Adviser 18 (February 1987), pp. 76-80, 82-89.

Krugman, Paul R. and Maurice Obstfeld. "Export Subsidies: Theory," In International Economics: Theory and Policy, 3^rd ed. New York: Harper Collins, 1994.

Maloney, David M., and Terry C. Inscoe. A Post-Reformation Analysis of the Foreign Tax Credit Limitations. International Tax Journal 13 (Spring 1987), pp. 111-127.

Marples, Donald J.. Taxes and International Competitiveness. Library of Congress, Congressional Research Service Report RS22445 (2008).

Rousslang, Donald J. "The Sales Source Rules for U.S. Exports: How Much Do They Cost? Tax Notes International 8 (February 21, 1994), pp. 527-535.

--, and Stephen P. Tokarick. The Trade and Welfare Consequences of U.S. Export-Enhancing Tax Provisions. IMF Staff Papers 41 (December 1994), pp. 675-686.

U.S. Congress, Joint Committee on Taxation. Factors Affecting the International Competitiveness of the United States. Joint Committee Print. 98th Congress, 2^nd session. Washington, DC: May 30, 1991.

__. "Determination of Source in Case of Sales of Personal Property." In General Explanation of the Tax Reform Act of 1986. Joint Committee Print, 100th Congress, 1st session. May 4, 1987.

U.S. Congressional Budget Office. "Options to Increase Revenues: Eliminate the Source-Rules Exception for Exports." In Budget Options. Washington, DC: 2007.

U.S. Department of the Treasury. Report to the Congress on Earnings Stripping, Transfer Pricing and U.S. Income Tax Treaties. Washington, DC: 2007.

U.S. Department of the Treasury. Report to the Congress on the Sales Source Rules. Washington, DC: 1993.

The deferral benefit is circumscribed by several tax code provisions; the broadest in scope is provided by the tax code's Subpart F. Under Subpart F, certain types of income earned by certain types of foreign subsidiaries are taxed by the United States on a current basis, even if the income is not actually remitted to the firm's U.S. owners. Foreign corporations potentially subject to Subpart F are termed Controlled Foreign Corporations (CFCs); they are firms that are more than 50% owned by U.S. stockholders, each of whom own at least 10% of the CFC's stock. Subpart F subjects each 10% shareholder to U.S. tax on some (but not all) types of income earned by the CFC. In general, the types of income subject to Subpart F are income from a CFC's passive investment -- for example, interest, dividends, and gains from the sale of stock and securities -- and a variety of types of income whose geographic source is thought to be easily manipulated.

Ordinarily, income from banking and insurance could in some cases be included in Subpart F. Much of banking income, for example, consists of interest; investment income of insurance companies could also ordinarily be taxed as passive income under Subpart F. Certain insurance income is also explicitly included in Subpart F, including income from the insurance of risks located outside a CFC's country of incorporation. However, Congress enacted a temporary exception from Subpart F for income derived in the active conduct of a banking, financing, or similar business by a CFC predominantly engaged in such a business. Congress also enacted a temporary exception for investment income of an insurance company earned on risks located within its country of incorporation.

In short, Subpart F is an exception to the deferral tax benefit, and the tax expenditure at hand is an exception to Subpart F itself for a range of certain financial services income. Prior to enactment of the Tax Increase Prevention and Reconciliation Act of 2006 (TIPRA; P.L. 109-222), the exception was scheduled to expire at the end of 2006. TIPRA extended the provision for two years, through 2008. The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) subsequently extended the provision through 2009. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, (P.L. 111-312) extended this provision through 2011.

The provision only poses an incentive to invest in countries with tax rates lower than those of the United States; in other countries, the high foreign tax rates generally negate the U.S. tax benefit provided by deferral. In addition, the provision is moot (and provides no incentive) even in low-tax countries for U.S. firms that pay foreign taxes at high rates on other banking and insurance income. In such cases, the firms have sufficient foreign tax credits to offset U.S. taxes that would be due in the absence of deferral. (In the case of banking and insurance income, creditable foreign taxes must have been paid with respect to other banking and insurance income. This may accentuate the importance of the exception to Subpart F.)

The exceptions for banking and insurance were removed as part of the broad Tax Reform Act of 1986 (Public Law 99-514). In removing the exception (along with several others), Congress believed they enabled firms to locate income in tax haven countries that have little "substantive economic relation" to the income. As passed by Congress, the Taxpayer Relief Act of 1997 (Public Law 105-34) generally restored the exceptions with minor modifications. In making the restoration, Congress expressed concern that without them, Subpart F extended to income that was neither passive nor easily movable. However, the Act provided for only a temporary restoration, applicable to 1998. Additionally, the Joint Committee on Taxation identified the exceptions' restoration as a provision susceptible to line-item veto under the provisions of the 1996 Line-Item Veto Act because of its applicability to only a few taxpaying entities, and President Clinton subsequently vetoed the exceptions' restoration. The Supreme Court, however, ruled the line-item veto to be unconstitutional, thus making the temporary restoration effective for 1998, as enacted.

The banking and insurance exceptions to Subpart F were extended with a few modifications for one year by the Tax and Trade Relief Extension Act of 1998. (The Act was part of Public Law 105-277, the omnibus budget bill passed in October, 1998.) The modifications include one generally designed to require that firms using the exceptions conduct "substantial activity" with respect to the financial service business in question and added a "nexus" requirement under which activities generating eligible income must take place within the CFC's home country. In 1999, Public Law 106-170 extended the provision through 2001. In 2002, Public Law 107-147 extended the provision for five additional years, through 2006. The American Jobs Creation Act of 2004 (P.L. 108-357) added rules permitting, in some circumstances, certain qualifying activities to be undertaken by related entities. TIPRA (P.L. 109-222) extended the provision for two years, through 2008, and the Emergency Economic Stabilization Act of 2008 (P.L. 110-343) extended the provision through the end of 2009. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act (P.L. 111-312) extended the provision through 2011.

It should be noted that traditional economic theory questions the merits of the deferral tax benefit itself. Its tax incentive for investment abroad generally results in an allocation of investment capital that is inefficient from the point of view of both the capital exporting country (in this case the United States) and the world economy in general. Economic theory instead recommends a policy known as "capital export neutrality" under which marginal investments face the same tax burden at home and abroad. From that vantage, then, the exceptions to Subpart F likewise impair efficiency.

Sullivan, Martin A. "Economic Analysis: Large U.S. Banks Keeping More Profits in Tax Havens." Tax Notes, 14 June, 2004, 1340.

U.S. Congress, Joint Committee on Taxation. "Extension and Modification of Exceptions under Subpart F for Active Financing Income." In General Explanation of Tax Legislation Enacted in the 107^thCongress. Joint Committee Print. 107^th Congress, 2nd session. Washington, DC: U.S. Government Printing Office, 2003, pp. 279-283.

U.S. Department of the Treasury, Office of Tax Policy. The Deferral of Income Earned Through U.S. Controlled Foreign Corporations. Washington, DC: December, 2002.

Yoder, Lowell D. "The Subpart F Exception for Active Financing Income." Tax Management International Journal 31 (June 14, 2002) : 283-303.

Rousslang, Donald J., "Foreign Tax Credit," in Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds., The Encyclopedia of Taxation and Tax Policy (Washington: The Urban Institute, 1999), pp.137-9.

U.S. Department of Treasury, Internal Revenue Service, Foreign Tax Credit for Individuals, Publication 514, (2007).

In order to protect its domestic tax base, the U.S. imposes a limitation on the foreign tax credit. In effect, the tax code only allows foreign tax credits to offset the U.S. tax on foreign source-income. Any foreign taxes paid in excess of the limit become "excess credits" and can be carried back one year and carried forward up to 10 years. When a firm is in an excess credit position, the rules surrounding the sourcing of fungible sources of income, such as interest, become important.

Current law applies the fungibility principle to interest allocation in a manner sometimes referred to as "water's edge" allocation. Under this system, foreign subsidiaries are not explicitly included in the allocation. This has two implications for the allocation formula. First, only a domestic parent's equity stake in its foreign subsidiary is counted as an asset -- excluding the foreign subsidiary's assets financed by debt. The parent's assets, in contrast, are all included in the calculation -- whether financed by equity or debt. Secondly, the subsidiary's interest expense is automatically allocated to foreign sources. This occurs since the subsidiary's interest expense reduces dividend payments to the parent, which are all allocated to foreign source income.

Under current law, beginning in 2021, the U.S. will allocate interest expense using a "worldwide"allocation regime. Under a "worldwide" allocation, the borrowing of foreign subsidiaries would be taken into account. The switch to a "worldwide" regime was originally scheduled to take place in 2009 as a result of the American Jobs Creation Act of 2004 (P.L. 108-357). The implementation was then first delayed until 2011 by the Housing and Economic Recovery Act of 2008 (P.L. 110-289), and then until 2018 by the Worker, Homeownership, and Business Assistance Act of 2009 (P.L. 111-92), and finally to 2021 by the Hiring Incentives To Restore Employment Act (P.L. 111-147).

Current law contains a subgroup election for firms that are banks. This election allows the interest allocation rules to be applied separately to the bank and non-bank subsidiaries of a U.S. corporation. Beginning in 2021, this election is available to a wider range of financial intermediaries, including finance companies and insurance firms.

In contrast, the basic result of the worldwide interest allocation formula, if elected, is to increase the weight given to foreign assets in the allocation formula. This should in turn result in a greater proportion of the interest expense being allocated to U.S.-source income under the foreign tax credit formula, leading to higher foreign source income and a higher foreign tax credit for firms with excess credits.

The availability of subgroup elections runs counter to the principle of fungibility that is embodied by the interest allocation rules. This result follows from the fact that firms could distribute their borrowing among related subsidiaries to minimize foreign allocations of interest. The expansion of this election beginning in 2021, under current law, could move the U.S. system further from the principle of fungibility.

The Tax Reform Act of 1986 (P.L. 99-514) modified the interest allocation rules by adopting a one-taxpayer rule to address concerns that prior law allowed affiliated corporations to reduce U.S. tax on U.S. income by borrowing money through one corporation rather than another.

The American Jobs Creation Act of 2004 (P.L. 108-357) modified the interest allocation rules significantly. The Act mandated a switch from a waters edge to a worldwide view on the fungibility starting in 2009 and created a financial institution group election. Congress enacted these changes in response to concerns that the prior view left taxpayers excessively exposed to double taxation of foreign-source income and reduced their incentive to invest in the United States. As mentioned above, the switch to a worldwide view is currently delayed to until 2021.

The subgroup election provisions in the interest allocation rules do not appear consistent with the general objective of the interest allocation rules. The subgroup election may permit firms to reduce the current domestic interest allocation costs, while achieving foreign interest allocation benefits.

__ and Jack Mintz, "U.S. Interest Allocation Rules: Effects and Policy," International Taxation and Public Finance, vol. 2, no. 1, (1995), pp. 7-35.

Collins, Julie H., and Douglas A. Shackelford, "Foreign Tax Credit Limitations and Preferred Stock Issuances." Journal of Accounting Research 30 (Supplement), (1993), pp.103 - 24.

Froot, Kenneth A., and James R. Hines, Jr., "Interest Allocation Rules, Financing Patterns, and the Operations of U.S. Multinationals," in The Effects of Taxation on Multinational Corporations, Martin Feldstein, James R. Hines, Jr., and R. Glenn Hubbard, eds., (Chicago: University of Chicago Press, 1995), pp. 277 - 307.

Gravelle, Jane G. and Donald J. Marples, The Foreign Tax Credit's Interest Allocation Rules, Library of Congress, Congressional Research Service Report RL 34494. Washington, D.C., 2008.

U.S. Congress, Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 108th Congress, JCS-5-05, (Washington: GPO, 2005).

IC-DISC shareholders may defer up to $10 million that is attributable to qualified export sales. An interest charge is imposed on shareholders, however, based on the distribution that would have occurred had deferral not been elected. The $10 million deferral restriction was intended to limit the benefit of IC-DISC activity to smaller businesses.

The budgetary impact IC-DISC is relatively small when compared to recent and existing export subsidies. For example, the revenue loss in 2010 from the inventory property sales source rule exception is estimated at $7.2 billion, compared to an estimated $0.5 billion loss stemming from IC-DISC. In 2006, the exclusion of extraterritorial income (ETI) provision, which has been repealed, resulted in an estimated $4.0 billion revenue loss.

The provision allowing the formation of Domestic International Sales Corporations (DISCs) was enacted as part of the Revenue Act of 1971. Shortly after enactment, several European countries argued that the DISC provision violated the General Agreement of Tarriffs and Trade (GATT) by allowing unlimited tax deferral. A GATT panel concluded that DISC was a prohibited export subsidy. The United States never formally recognized the illegality of DISC.

In response to the GATT panel ruling on DISC, the Tax Reform Act of 1986 enacted a provision allowing for the creation of Interest Charge Domestic International Sales Corporations (IC-DISC) and Foreign Sales Corporations (FSC). A FSC was similar to a DISC in that exporters were required to establish a specially qualified subsidiary corporation to which they sold their products. Unlike DISC, FSC was designed to provide a GATT compliant export benefit by classifying FSC income as foreign-source income not connected with US trade or business, effectively exempting it from U.S. income tax. Although FSCs were foreign-chartered corporations they were allowed a 100% dividends-received deduction, as well as having their income exempted from Subpart F's anti-deferral rules.

In early 2000, the WTO Appellate Body confirmed an earlier ruling that FSC were a prohibited export subsidy. As a result, the FSC provision was repealed and a provision excluding extraterritorial income (ETI) was included in the FSC Repeal and Extraterritorial Income Exclusion Act of 2000 enacted later in the year. The ETI provision provided US exporters with a similar tax benefit offered by FSC, while no longer requiring the FSC foreign management requirement. The benefit, however, was based on "extraterritorial income," and therefore not based solely on exports, making the ETI provision WTO compliant.

Amid complaints from the European Union and another finding that the ETI provision violated WTO rule, the ETI provision was repealed by the American Jobs Creation Act of 2004. A year earlier, the Jobs and Growth Tax Relief Reconciliation Act of 2003 had cut taxes on dividend and capital gains, re-establishing the attractiveness of IC-DISC, which had been introduced nearly two decades earlier.

Economic theory also highlights the inefficiencies that IC-DISC may introduce into the allocation of productive economic resources within the U.S. economy, as only domestic exporters may benefit from the subsidy. Additionally, because the tax benefit is related to the production of exported goods and services, domestic consumers receive no direct consumption benefit. Foreign consumers, on the other hand, benefit from lower priced goods.

Brumbaugh, David L. A History of Extraterritorial Income (ETI) and Foreign Sales Corporation (FSC) Export Tax-Benefit Controversy. Library of Congress, Congressional Research Service Report RL31660. September 22, 2006.

__ DISC: Effects, Issues, and Proposed Replacements. Library of Congress, Congressional Research Service Report 83-69. April 5, 1983.

Gravelle, Jane, Kent Hughes, and Warren E. Farb. The Domestic International Sales Corporation (DISC) and its Effect on U.S. Foreign Trade and Employment. Library of Congress, Congressional Research Service Report 76-92. May 4, 1976.

U.S. Congress, Joint Committee on Taxation. "Foreign Sales Corporations." in General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984. Committee Print, 98^th Congress, 2^nd Session. Washington, DC: Government Printing Office (1984), pp. 1037-1070.

FIRPTA also requires income tax withholding for the disposition of a U.S. real property interest by a foreign person. The withholding is a deposit towards expected taxes arising from the sale of U.S. real property. In general, the purchaser is responsible for withholding equal to 10% of the purchase price of the property. The 10% withholding is then paid to the Internal Revenue Service. Some foreign entities, for example, partnerships, trusts, and estates, may be subject to a higher withholding. Failure to withhold the tax may result in the purchaser being liable for the tax.

A number of exemptions from the withholding requirement exist. The most common applies to U.S. buyers that purchase a principal residence with a sales price of less than $300,000.

The quantitative impact on the budget of taxing the disposition of U.S. real property by foreigners appears to be small, as indicated by the estimated negative tax expenditures listed in the table above.

The FIRPTA tax withholding requirement reduces the ability of foreign investors to avoid paying taxes on the sale of appreciated U.S. property. The required withholding amounts to a deposit on the expected tax liability. Prior to the passage of FIRPTA it was possible for foreign investors to avoid paying taxes through U.S. tax treaties, nonrecognition provisions, or by structuring investments through corporations.

Sakai, Marcia and James Mak. "Taxation of Foreign Real Property Investments in The U.S.: A State Perspective," University of Hawaii at Manoa, Working paper, no. 90-30, 1990.

U.S. Congress, Joint Committee on Taxation. Description of Selected Federal Tax Provisions that Impact Land Use, Conservation, and Preservation. JCX-68-99, Washington, DC, September 28, 1999.

Corporations involved in shipping trade and business operations may, as an alternative to the conventional corporate income tax, elect to pay the "tonnage tax". The tonnage tax is a tax on a notional shipping income (rather than on corporate income); the tax rate is equal to the highest corporate income tax rate, which is currently 35%. Notional shipping income is calculated as daily notional shipping income multiplied by the number of days a vessel operates in U.S. foreign trade. Daily notional income is $0.40 per 100 tons of a ship's weight up to 25,000 net tons, and then $0.20 per 100 tons in excess of 25,000 tons. Corporations electing to pay the tonnage tax are allowed no deductions against notional shipping income, and no credits against tonnage taxes paid.

While the expected tax burden is reduced under the tonnage tax, the actual tax burden may not be. Corporations that suffer losses or that are less profitable than expected may end up paying a tonnage tax that is higher than they would have under the corporate income tax. Again, this is because the tonnage tax is not directly related to profitability.

The direct benefit of a higher after tax return to investment accrues to the owners and shareholders of domestic shipping operators involved in U.S. foreign trade. Owners and shareholders also benefit from increased certainty and clarity with respect to a company's future tax liabilities. U.S. consumers also benefit indirectly in the form of lower priced traded goods. The estimated revenue losses reported in the table above indicate a relatively small budgetary impact from this provision.

Finally, because notional shipping income per ton decreases above the 25,000 ton threshold, the tonnage tax is more beneficial to larger vessels.

With respect to the tonnage tax's effect on employment, Section 46 of the United States Code (pertaining to manning requirements) generally requires the officers of U.S. registered ships and most other crew members to be U.S. citizens. Therefore, any increase in the number of U.S. registered vessels that is the result of the tonnage tax could have a positive effect on employment among corporations involved in shipping trade and business. The net effect on aggregate employment within the U.S. economy, however, will be determined by the amount to which the increase in shipping trade and business employment represents new job creation.

Marples, Donald. U.S. Taxation of Overseas Investment and Income: Background and Issues. Library of Congress, Congressional Research Service Report RL32749. May 21, 2008.

U.S. Congress, Conference Committees, American Jobs Creation Act of 2004, conference report to accompany H.R. 4520, 108^th Cong. 2^nd sess. H.Rept. 108-755 (Washington: GPO, 2004).

Selkou, Evangela, and Michael Roe. "UK Tonnage Tax: Subsidy or Special Case?," Maritime Policy and Management, v. 29, no. 4, 2002, pp. 393-404.

There are a few exceptions to this general rule, however. Under section 174, a business taxpayer may deduct, as a current expense, certain research expenditures that are paid or incurred in connection with the taxpayer's trade or business. This treatment is available even though eligible expenditures are likely to produce intangible assets (especially patents) with useful lives that extend far beyond a single tax year. Alternatively, a taxpayer may treat these expenditures as deferred expenses and amortize them on a straight-line basis over 60 or more months, beginning in the month that benefits from the expenditures are first realized; or amortize the expenditures over 10 years, starting with the tax year in which they are paid or incurred. If a taxpayer fails to account for research expenditures using one of these methods, it generally is required to capitalize the expenditures. A taxpayer is deemed to have begun to realize benefits from research expenditures when the asset(s) derived from them are first used to earn income.

In general, non-corporate taxpayers (e.g., partnerships or S corporations) must amortize over 10 years research expenditures that were deducted as a current expense, in computing their alternative minimum taxable income. For tax years after 1990, this adjustment is not required for expenses paid or incurred in the conduct of research in which a taxpayer "materially participates." A taxpayer may also avoid the adjustment by choosing to amortize the expenditures over 60 or more months.

Treasury regulations define the expenditures eligible for the section 174 deduction as "research and development costs in the experimental or laboratory sense." The regulations also specify that eligible research expenditures include all costs related to "the development of an experimental or pilot model, a plant process, a product, a formula, an invention, or similar property, and the improvement of already existing property."

Still, not all costs arising from research projects may be deducted under section 174. Most notably, expenditures for the acquisition or improvement of land or depreciable or depletable property to be used in connection with research, do not qualify. Outlays for structures and equipment used in research and development (R&D) must be recovered over 15 years and 3 years, respectively, using the appropriate depreciation schedules under section 167. In addition, expenditures to determine the existence, location, extent, or quality of mineral deposits, including oil and gas, may not be deducted under section 174.

To prevent business taxpayers from receiving a double tax benefit for the same research expenditures, the deduction allowed under section 174 must be reduced by the amount of any credit claimed under section 41 for increases in qualified research expenditures. Taxpayers have the option of taking a reduced credit equal to 65% of the credit that could be taken in lieu of lowering their deduction of research expenditures.

The main beneficiaries of the section 174 deduction are larger manufacturing corporations primarily engaged in developing, producing, and selling technically advanced products. As a corporate tax deduction, the benefits of expensing any capital cost are likely to accrue mainly to upper-income individuals (see discussion in the Introduction).

The Tax Equity and Fiscal Responsibility Act of 1982 modified the individual alternative minimum tax to allow individuals to amortize research, mining exploration and development, and magazine circulation expenses over 10 years in computing their alternative minimum taxable income. Individuals who choose this option avoid having those expenditures treated as a preference item.

And the Omnibus Budget Reconciliation Act of 1989 clarified the reasonableness requirement for the deduction of research expenditures as current expenses under section 174. Specifically, the act specified that such expenditures should be held to the same requirement for reasonableness that applies to salaries and other compensation under section 162(a)(1). In drawing this parallel, Congress was intending to prevent taxpayers from disguising dividends, gifts, loans, or other similar payments as research expenditures.

While these considerations may present a strong case for subsidizing business R&D investments on economic grounds, they do not necessarily call for the use of a tax preference like section 174. A principal shortcoming with tax subsidies like section 174 is that they do not target the R&D investments that are likely to generate the largest social benefits.

Bernstein, Jeffry I., and M. Ishaq Nadiri. "Interindustry R&D Spillovers, Rates of Return, and Production in High Tech Industries," American Economic Review, v. 76. June 1988, pp. 429-434.

Cordes, Joseph J. "Tax Incentives for R&D Spending: A Review of the Evidence," Research Policy, v. 18. 1989, pp. 119-133.

__. "Expensing." The Encyclopedia of Taxation and Tax Policy, edited by Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle. Washington, D.C.: Urban Institute Press, 2005. pp. 128-130.

Goldbas, Michael and Greg Alan Fairbanks. "The Final Step in Computing the R&E Credit." Tax Adviser, vol. 36, no. 3, March 1, 2005, p. 136.

Guenther, Gary. Research and Experimentation Tax Credit: Current Status and Selected Issues for Congress. Library of Congress, Congressional Research Service Report RL31181. Washington, updated September 1, 2010.

Hall, Bronwyn H. and John van Reenen, "How Effective are Fiscal Incentives for R&D? A Review of the Evidence. Working Paper 7098. National Bureau of Economic Research, Cambridge, MA, April 1999.

Hudson, David S. "The Tax Concept of Research or Experimentation." Tax Lawyer, v. 45, Fall 1991, pp. 85-121.

Kiley, Michael T. Social and Private Rates of Return to Research and Development in Industry. Library of Congress, Congressional Research Service Report 93-770. Washington, DC: August 27, 1993.

Landau, Ralph, and Bruce Hannay, eds. Taxation, Technology and the U.S. Economy. New York: Pergamon Press, 1981. See particularly George Carlson, "Tax Policy and the U.S. Economy" (a version of which was published as Office of Tax Analysis Paper 45, U.S. Treasury Department, January 1981), pp. 63-86, and Joseph J. Cordes, "Tax Policies for Encouraging Innovation: A Survey," pp. 87-99.

Lee, Andrew B., "Section 174: "Just in Time" for Deducting Costs of Developing New or Improved Manufacturing Processes," The Tax Adviser, July 1996, p. 401.

Mansfield, Edwin, et al. "Social and Private Rates of Return from Industrial Innovations," Quarterly Journal of Economics, v. 41. March 1977, pp. 221-240.

McClelland, David Huston, "Deductibility of Contract Development Costs Under Section 174," The Tax Adviser, January 2000, p. 19.

McConaghy, Mark L. and Richard B. Raye. "Congressional Intent, Long-Standing Authorities Support Broad Reading of Section 174," Tax Notes, Feb. 1, 1993, pp. 639-653.

Mamureas, T., and M.J. Nadiri. "Public R&D Policies and Cost Behavior of the U.S. Manufacturing Industries," Journal of Public Economics, v. 63, no. 1, pp. 57-83.

Rashin, Michael. D. Practical Guide to Research and Development Tax Incentives: Federal, State, and Foreign. CCH, Inc. Chicago: 2007, pp. 61-97.

Tobin, Brian F., "New Regulations Clarify R&E Definition," The Tax Adviser, May 1995, p. 287.

U.S. Congress, Congressional Budget Office. Federal Support for R&D and Innovation, April 1984.

U.S. Government Accountability Office. The Research Tax Credit's Design and Administration Can Be Improved. Publication GAO-10-136. Washington, 2009.

The regular credit is equal to 20 percent of a business taxpayer's qualified research expenditures for the current tax year above a base amount. Computing this amount hinges on whether a business taxpayer is regarded as an established or startup firm under the rules governing the use of the credit. For an established firm, which is a firm that had taxable income and qualified research expenditures in at least three of the four years from 1984 to 1988, the base amount is the product of its "fixed-base percentage (FBP)"and its average gross receipts in the past four tax years; its FBP is the ratio of its total research expenditures to total gross receipts in that period. Under no circumstances can the base amount fall below 50 percent of current-year qualified research expenditures (QREs), nor can the FBP exceed 0.16. Startup firms, which are firms whose first tax year occurred after 1983 or had fewer than three tax years from 1984 to 1988 with both gross receipts and QREs, are assigned an initial FBP of 0.03 during their first five tax years in which they earn gross receipts and invest in qualified research.

Firms had the option of claiming the AIRC instead of the regular credit. The AIRC was equal to the sum of 3 percent of a firm's qualified research expenditures above 1 percent but below 1.5 percent of its average gross receipts in the four previous years, 4 percent of its qualified research expenditures above 1.5 percent but below 2.0 percent of the same receipts, and 5 percent of its qualified research expenditures above 2.0 percent of the same receipts. Under the Emergency Economic Stabilization Act of 2008 (P.L. 110-343), the AIRC was not available in 2009and it was not included in the extension of the research credit in P.L. 111-312. In general, firms were likely to benefit more from the AIRC than the regular credit if their qualified research expenditures in the current tax year are slightly above their base amounts for the regular credit.

Firms may claim the ASIC, which is equal to 12 percent of expenses that exceed 50 percent of spending in the last three years, or 6 percent if there are no expenditures in at least one of those years. In 2009, the maximum rate for the ASIC rose to 14 percent.

Payments for basic research conducted by universities and non-profit scientific research organizations are eligible for a basic research tax credit. The credit is equal to 20 percent of such payments above a base amount, which is equal to the sum of 1 percent of a taxpayer's in-house and contract research spending in the base period and any excess of its average non-basic research contributions to qualified organizations in the base period, adjusted for increases in the cost of living, over its contributions in the current tax year. Research expenditures used to compute the basic research credit may not also be used to compute the regular credit or the AIRC or ASIC.

Firms may also claim a 20 percent credit for the entire amount of payments for contract research they make to an energy research consortium.

The definition of qualified research has been a contentious issue since the credit first entered the tax code in July 1981. As it now stands, research must satisfy three criteria in order to qualify for the credit. First, the research must involve activities that can be expensed under section 174, which is to say that the research must be "experimental" in the laboratory sense. Second, the research must be done to discover information that is "technological in nature" and useful in the development of a new or improved product, process, computer software technique, formula, or invention that is to be sold, leased, licensed, or used by the firm performing the research. Finally, the research must entail a process of experimentation whose goal is the development of a product or process with a "new or improved function, performance, or reliability or quality."

Not all spending on qualified research qualifies for the incremental or alternative credits. Specifically, only outlays for the following purposes can be used to compute the credit:

If a taxpayer claims both the research tax credit and a deduction for research expenditures under section 174, the deduction must be reduced by the amount of the credit. This reduction, which is also referred to as a basis adjustment, has the effect of including the credit in a firm's taxable income, thereby lowering the marginal effective rate of the credit. Alternatively, a taxpayer can elect to take a reduced credit, one that is 65% of the credit it could otherwise claim.

The credit may not be claimed for eligible expenses paid or incurred after June 30, 1995 and before July 1, 1996, as the credit had expired for that period and has not been renewed retroactively to cover it.

A 50 percent nonrefundable investment tax credit is available for investments in qualifying therapeutic discovery projects. The amounts are awarded by certificate and were $1 billion during the two-year period 2009 through 2010. The credit is available only to companies having 250 or fewer employees.

So because of its design, the credit does not benefit all firms undertaking increasing amounts of qualified research. For instance, it is of no benefit to firms whose research intensity (i.e., research expenditures as a share of gross receipts in a certain period) is declining. If the decline in research intensity is due to faster growth in sales than research expenditures, then the credit could conceivably operate as a minor implicit tax on sales growth.

By contrast, in a sign that the credit may be serving its intended purpose, it provides the largest subsidies to firms whose investment in research and development (R&D) is rising faster than their sales revenue.

Individuals to whom the credit is properly allocated from a partnership or subchapter S corporation may use the credit in a particular year to offset only the tax on their taxable income derived from that business. This is to say that owners of partnerships or S corporations cannot use research tax credits earned by these entities to offset the tax on income from other sources.

The credit is claimed mostly by large C corporations, while its direct tax benefits accrue largely to higher-income individuals (see discussion in the introduction).

Section 41 first entered the federal tax code through the Economic Recovery Tax Act of 1981. Under the act, the credit rate was initially set at 25 percent, there was no basis adjustment, and the base amount was equal to average research expenditures in the previous three tax years. Such a design was intended to serve two purposes: (1) to give U.S.-based firms a robust incentive to invest more in R&D than they otherwise would, and (2) to offset some of the significant costs associated with initiating or expanding business R&D programs.

The original credit was supposed to expire at the end of 1985, to give Congress an opportunity to evaluate its effects before deciding whether or not to extend it. It was extended retroactively through 1988, at a reduced rate of 20 percent, by the Tax Reform Act of 1986. The Technical and Miscellaneous Revenue Act of 1988 extended the credit for another year and a half and added a basis adjustment equal to 50 percent of the credit.

Additional changes were made in the credit through the Omnibus Reconciliation Act of 1989. Specifically, the act extended the credit through 1990, allowed the base amount to increase in step with rises in gross receipts rather than research expenditures, expanded the credit to apply to research intended to explore future lines of business as well as to develop current ones, and instituted a full basis adjustment.

The Omnibus Reconciliation Act of 1990 extended the credit through the end of 1991, and the Tax Extension Act of 1991 further extended it through June 1992. After the credit expired and remained in abeyance for about one year, the Omnibus Budget Reconciliation Act of 1993 retroactively extended it through June 1995.

After the credit again expired and lapsed for about one year, the Small Business Job Production Act of 1996 reinstated it retroactively to July 1, 1996 and extended it through May 31, 1997, leaving a one-year gap in coverage that remains intact. The act also introduced a three-tiered alternative credit and allowed 75 percent of payments to non-profit research consortia to qualify for the credit.

The Taxpayer Relief Act of 1997 further extended the credit through June 1998, and the omnibus budget bill passed in 1998 (P.L. 105-277) extended the credit through June 1999. After expiring yet again, the credit was extended to June 30, 2004 by the Ticket to Work and Work Incentives Improvement Act of 1999 (P.L. 106-170). In October 2004, President Bush signed into law a tax bill (the Working Families Tax Relief Act of 2004, P.L. 108-311) that included an extension of the credit through December 31, 2005.

H.R. 6111, adopted in December 2006, extended the credit through 2007, increased the alternative rates for 2007, and added the ASIC.

The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) retroactively renewed the credit through 2009. It also increased the rate for the ASIC to 14 percent and abolished the AIRC for the 2009 tax year.

The therapeutic research credit was adopted in the Patient Protection and Affordable Care Act of 2010, P.l. 111-148. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312) extended the credit for two years, through 2011, but did not extend the AIRC.

Since its enactment in 1981, the research tax credit has provided over $1 billion a year in tax subsidies for business R&D investment. The credit's effectiveness hinges on the sensitivity of this investment to declines in its real after-tax cost. Available evidence suggests that in the 1980s, a decline in this cost of one dollar was associated with an increase in business R&D investment of one to two dollars. Because this sensitivity may shift over time, it is not clear whether R&D investment remains as responsive to cost declines today.

Although the credit can be justified on economic grounds and is thought to be cost-effective, it has been the target of several criticisms. First, some question whether a tax subsidy is the most efficient way to encourage increased investment in basic research; in their view, an open-ended subsidy like the credit is not likely to target research with the greatest social returns. Second, the lack of a clear and widely accepted definition of the qualified research makes it possible for firms to claim the credit for expenses that may have little or nothing to do with such research. Third, the credit's incentive effect may be insufficient to boost business R&D to levels commensurate with its purported social benefits. Fourth, some critics of the credit contend that it mostly subsidizes research that would be performed in the absence of the credit. Finally, the credit's lack of permanence is thought to deter some R&D investment by compounding the uncertainty surrounding the expected after-tax returns on prospective research projects.

Atkinson, Robert D. The Research and Experimentation Tax Credit: A Critical Policy Tool for Boosting Research and Enhancing U.S. Economic Competitiveness. Information Technology and Innovation Foundation. Washington, D.C.: September 4, 2006.

Baily, Martin Neil, and Robert Z. Lawrence. "Tax Policies for Innovation and Competitiveness," Paper Commissioned by the Council on Research and Technology. Washington, DC, April 1987.

__. "Tax Incentives for R&D: What do the Data Tell Use?" Study Commissioned by the Council on Research and Technology. Washington, DC, 1992.

Berger, Philip G. "Explicit and Implicit Tax Effects of the R&D Tax Credit." Journal of Accounting Research, v. 3, August 1993, pp. 131-71.

Bernstein, Jeffry I. and M. Ishaq Nadiri. "Interindustry R&D Spillovers, Rates of Return, and Production in High Tech Industries," American Economic Review, v. 76. June 1988, pp. 429-434.

Billings, B. Anthony and Randolph Paschke, "Would H.R. 463 Improve the Competitiveness of U.S. R&D Tax Incentives?," Tax Notes, June 9, 2003, pp. 1509-1524.

__. "Permanent Research Tax Credit Could Reverse Offshoring of Jobs," Tax Notes, March 29, 2004, pp. 1655-1666.

Brown, Kenneth M., ed. The R&D Tax Credit. Issues in Tax Policy and Industrial Innovation. Washington, DC: American Enterprise Institute for Public Policy, 1984.

Busom, Isabel. An Empirical Evaluation of the Effects of R&D Subsidies. Burch Working Paper No. B99-05. Berkeley, CA, University of California, Berkeley, May 1999.

Cordes, Joseph J. "Tax Incentives for R&D Spending: A Review of the Evidence," Research Policy, v. 18. 1989, pp. 119-133.

__. "Research and Experimentation Tax Credit." The Encyclopedia of Taxation and Tax Policy, edited by Joseph J. Cordes, Robert O. Ebel, and Jane G. Gravelle. Washington, DC: Urban Institute Press, 2005. pp. 330-332.

Cox, William A. Research and Experimentation Credits: Who Got How Much? Library of Congress, Congressional Research Service Report 96-505, June 4, 1996.

Ernst & Young. Supporting Innovation and Economic Growth: the Broad Impact of the R&D Credit in 2005. April 2008.

Gravelle, Jane G. The Tax Credit for Research and Development: An Analysis. Library of Congress, Congressional Research Service Report 85-6. Washington, DC, January 25, 1985.

Grigsby, McGee and John Westmoreland, "The Research Tax Credit: A Temporary and Incremental Dinosaur." Tax Notes, December 17, 2001, pp. 1627-1640.

Guenther, Gary. Research and Experimentation Tax Credit: Current Status and Selected Issues for Congress. Library of Congress, Congressional Research Service Report No. RL31181. Washington, D.C., September 10, 2010.

Guinet, Jean, and Hroko Kamata. "Do Tax Incentives Promote Innovation?" OECD Observer, no. 202, October-November, 1996, pp. 22-25.

Hall, Bronwyn H. "R & D Tax Policy During the 1980s," in Tax Policy and the Economy 7, ed. James M. Poterba. Cambridge, MA: MIT Press, 1993.

__, and John van Reenen. How Effective Are Fiscal Incentives for R&D? A Review of the Evidence. Working Paper 7098. Cambridge, MA, National Bureau of Economic Research, April 1999.

Hines, James R. "On the Sensitivity of R&D to Delicate Tax Changes: The Behavior of U.S. Multinationals in the 1980s." In Studies in International Taxation in the 1980s," Ed. Alberto Giovanni, R. Glenn Hubbard, and Joel Slemrod. Chicago: The University of Chicago Press, 1993.

Kiley, Michael T. Social and Private Rates of Return to Research and Development in Industry. Library of Congress, Congressional Research Service Report 93-770. Washington, DC: August 27, 1993.

Landau, Ralph, and Bruce Hannay, eds. Taxation, Technology and the US. Economy. NY: Pergamon Press, 1981. See particularly George Carlson, "Tax Policy and the U.S. Economy," (a version of which was published as Office of Tax Analysis Paper 45, U.S. Treasury Department, January 1981), pp. 63-86, and Joseph Cordes, "Tax Policies for Encouraging Innovation: A Survey," pp. 87-99.

Mamureas, Theofaris P. and M. Ishaq Nadiri. "Public R&D Policies and Cost Behavior of the U.S. Manufacturing Industries." National Bureau of Economic Research Working Paper 5059, Cambridge, MA, March 1995.

Mansfield, Edwin, et al. "Social and Private Rates of Return from Industrial Innovations," Quarterly Journal of Economics, v. 41. March 1977, pp. 221-240.

McIntyre, Bob. Proposed Extension of Corporate Tax Credit: Throwing Good Money After Bad, Citizens for Tax Justice. Washington, D.C.: May 12, 2006.

Office of Technology Assessment, The Effectiveness of Research and Experimental Tax Credits, OTA-BRITC-174, September 1995.

Ohmes, Christopher J., David S. Hudson, and Monique J. Migneault, "Final Research Credit Regulations Expected to Immediately Affect IRS Examinations," Tax Notes, February 23, 2004, pp. 1015-1024.

Rashkin, Michael D. Practical Guide to Research and Development Tax Incentives: Federal, State, and Foreign. Chicago: CCH Inc., 2007.

Tillinger, Janet W. "An Analysis of the Effectiveness of the Research and Experimentation Tax Credit in a Q Model of Valuation." The Journal of the American Taxation Association, Fall 1991, pp. 1-29.

U.S. Congress, House Committee on Ways and Means. Research and Experimentation Tax Credit Hearing, 98th Congress, 2nd session. August 2, 1984.

__, Joint Committee on Taxation. Description and Analysis of Tax Provisions Expiring in 1992. January 27, 1992: pp. 59-68.

__, Joint Economic Committee. The R&D Tax Credit: An Evaluation of Evidence on Its Effectiveness, 99th Congress, 1st Session. Senate Report 99-73, August 23, 1985.

U.S. General Accounting Office. Additional Information on the Research Tax Credit. Testimony of Natwar Gandhi Before the House Ways and Means Subcommittee on Oversight. Publication GGD-95-162, Washington, 1995.

__. Studies of the Effectiveness of the Research Tax Credit. Publication GGD-96-43. May 1996.

__. The Research Tax Credit's Design and Administration Can Be Improved. Publication GAO-10-136. Washington, 2009.

Watson, Harry. "The 1990 R&D Tax Credit: A Uniform Tax on Inputs and a Subsidy for R&D." National Tax Journal, v. 49, March 1996, pp. 93-103.

In order to qualify as "energy-efficient commercial building property," several criteria must be met. First, the costs must be associated with depreciable or amortizable property that is installed in a domestic building that is within the scope of Standard 90.1-2001 of the American Society of Heating, Refrigerating, and Air Conditioning Engineers and the Illuminating Engineering Society of North America (as in effect on April 2, 2003). Second, the property in question must be installed as part of: (1) the interior lighting system, (2) the heating, cooling, ventilation and hot water systems, or (3) the building envelope. Third, the property must be installed pursuant to a plan intended to reduce the total annual energy and power costs of the building (with respect to interior lighting, heating, cooling, ventilation and hot water supply systems) by 50% or more in comparison to a reference building that meets the minimum requirements of Standard 90.1-2001.

Note finally, that the basis or the depreciable cost of any property generating a deduction must be reduced by the amount deducted. Thus, depreciation may not be claimed on any amount that is deducted under the provision.

A qualified professional must certify that the property reduces the total annual energy and power costs of the building's heating, cooling, ventilation, hot water, and interior lighting systems by 50% or more when compared to a similar reference building that meets minimum specified energy standards described in Standard 90.1-2001, Energy Standard for Buildings Except Low-Rise Residential Buildings, of the American Society of Heating, Refrigerating, and Air Conditioning Engineers and the Illuminating Engineering Society of North America. If the overall 50% energy reduction standard is not satisfied, but improvements to one of the three energy efficient commercial building property types described above reduce energy usage by 16 2/3%, then the cost of the improvements to that particular subsystem may also be deducted in the tax year placed in service, but the deduction is limited to 60¢ per square foot of building space less total deductions claimed in prior tax years.

The taxpayer must receive a certificate with respect to the property before the deduction may be claimed. The required certification, which includes a statement that the applicable energy reduction requirement has been satisfied, must be provided by a professional engineer or contractor who is unrelated to the taxpayer and has represented in writing to the taxpayer that he or she has the qualifications necessary to provide the certification. The engineer or contractor must be licensed in the jurisdiction in which the building is located. The certification must also include a statement that field inspections conducted after the building was placed in service confirm that the building has met, or will meet, the energy-savings targets. The certification must include a list identifying the components of the interior lighting systems, heating, cooling, ventilation, and hot water systems, and building envelope installed on or in the building, the energy efficiency features of the building, and its projected annual energy costs. This list may aid in the identification of the property that qualifies for the deduction. However, the list is not required to specify the cost of the property. This information may need to be obtained separately from the contractor or a cost segregation study. The certification need not be included with the taxpayer's return but should be retained.

Qualification for the deduction for energy efficiency improvements to commercial buildings also requires calculation of energy savings attributable to the interior lighting systems, heating, cooling, ventilation, and hot water systems, and building envelope. The energy savings calculations must be made using IRS approved software that utilizes the performance rating method.¹⁴ The energy-efficient commercial building deduction is claimed by the person who is entitled to depreciate the property (e.g., the owner of the building or a lessee who pays for and installs the property). Also, under IRS regulations, if more than one taxpayer installs qualifying property on or in the same building, the aggregate amount of deductions claimed by all taxpayers may not exceed the limit based on square footage.¹⁵. However, in the case of a federal, state, or local government building -- in which case the owners of such buildings are tax-exempt entities and cannot therefore benefit from tax incentives -- the person who designs the energy efficient commercial building property may claim the deduction (IRC § 179D(d)(4)). Improvements to a tax-exempt property (other than a government building), such as a church, which is not depreciable, do not qualify for the deduction. Improvements to a residential rental building qualify for the deduction if it has four or more stories above ground level.

The business profit maximizing (and cost minimizing) objective is generally sufficient to promote an economically efficient level of investment in energy-saving capital when the rate of return on such investments is above the opportunity cost. From an economic perspective, allowing special tax benefits for certain types of investment or consumption can result in a misallocation of resources. There are, however, cases where the market outcome may result in an underinvestment in commercial building energy efficiency. Specifically, if consumption of energy results in negative effects on society, such as pollution, the deduction under IRC § 179D might be justified . In general, however, it would be more economically efficient to directly tax energy fuels than to subsidize a particular method of achieving conservation.

The commercial sector may underinvest in energy efficiency in cases where the person choosing the energy equipment for the building is not the same as the person paying the energy bills. In the case where building owners are not responsible for energy bills, building owners may install less efficient building components to minimize up-front capital costs, since the owner does not realize the energy savings directly. If, however, the building owner is able to recoup the higher installation costs associated with energy-efficient building components through higher rents, the market should determine the economically efficient level of investment in commercial building energy efficiency.

There may be a market failure in tenant-occupied homes, if the tenant pays for electricity while the landlord makes choices regarding the building's energy efficiency. In rental housing, the tenant and the landlord lack strong financial incentives to invest in energy conservation equipment and materials, even when the benefits clearly outweigh the costs, because the benefits from such conservation may not entirely accrue to the party undertaking the energy-saving expenditure and effort.

Tenants oftentimes lack the economic incentive to improve the energy efficiency of a residence that does not belong to them. Tenants might make energy-efficiency improvements if the rate of return (or payback) is sufficiently large, but most tenants do not occupy rental housing long enough to reap the full benefits of the energy conservation investments. Part of the problem is also that it is not always easy to calculate the energy savings potential (hence rates of return) from the various retrofitting investments. Landlords may not be able to control the energy consumption habits of renters to sufficiently recover the full cost of the energy conservation expenditures, regardless of whether the units are individually metered. If the units are individually metered, then the landlord would generally not undertake such investments since all the benefits therefrom would accrue to the renters, unless a landlord could charge higher rents on apartments with lower utility costs. If the units are not individually metered, but under centralized control, the benefits of conservation measures may accrue largely to the landlord, but even here the tenants may have sufficient control over energy use to subvert the accrual of any gains to the landlord. Tenants tend to engage in less energy conservation when utility bills are paid by landlords. In such cases, from the landlord's perspective, it may be easier and cheaper to forgo the conservation investments and simply pass on energy costs as part of the rents. Individual metering can be quite costly, and while it may reduce some of the distortions, it is not likely to completely eliminate them, because even if the landlord can charge higher rents, he may not be able to recover the costs of energy conservation efforts or investments.

These market failures may lead to underinvestment in conservation measures in rental housing and provide the economic rationale for gross income exclusion under Internal Revenue Code (IRC) § 136, as discussed elsewhere in this compendium. Without such explicit exclusion, such subsidies would be treated as gross income and subject to tax. This exclusion, however, applies both to owner-occupied and to rental housing.

Brown, Marilyn. "Market Failures and Barriers as a Basis for Clean Energy Policies," Energy Policy, v. 29. November 2001, pp. 1197-1207.

Deru, M. Energy Savings Modeling and Inspection Guidelines for Commercial Building Federal Tax Deductions, 2nd Ed., National Energy Renewable Laboratory Technical Report NREL/TP-550-40467, May 2007.

Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17. August 1989, pp. 397-406.

Hahn, Robert W. "Energy Conservation: An Economic Perspective." American Enterprise Institute, October 2005.

Hassett, Kevin A., and Gilbert E. Metcalf. "Energy Conservation Investment: Do Consumers Discount the Future Correctly?" Energy Policy, v. 21. June 1993, pp. 710-716.

Howarth, Richard B. and Bo Anderson. "Market Barriers to Energy Efficiency." Energy Economics, October 1993. pp. 262-292.

International Energy Agency. Mind the Gap: Quantifying Principal-Agent Problems in Energy Efficiency. 2007.

Levinson, Arik and Scott Niemann, "Energy Use by Apartment Tenants when Landlords Pay for Utilities." Resource and Energy Economics, v. 26. 2004. pp. 51-75.

Loskamp, Wendy. "Energy, Water Efficiencies and Savings Come From Meter Data Management." Energy Pulse. Insight Analysis and Commentary on the Global Power Industry. 2006 Metcalf, Gilbert E. "Economics and Rational Conservation Policy." Energy Policy, v. 22. October 1994, pp. 819-825.

National Science and Technology Council. Net-Zero, High-Performance Green Buildings. October 2008.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

Sutherland, Ronald J. "Energy Efficiency or the Efficient Use of Energy Resources?" Energy Sources, v. 16. April 1994, pp. 257-268.

__. "The Economics of Energy Conservation Policy." Energy Policy, v. 24. April 1996, pp. 361-370.

U.S. Congress. House. Committee on Energy and Commerce. National Energy Policy: Conservation and Energy Efficiency. Hearings Before the Subcommittee on Energy and Air Quality. Washington, DC: U.S. Government Printing Office, June 22, 2001.

U.S. Department of Energy. Lawrence Berkeley National Laboratory. "Energy Efficiency, Market Failures, and Government Policy." Levine, Mark D., et al. March 1994.

__. Energy Information Administration. Annual Energy Review 2009. August 2010.

As is discussed elsewhere in this compendium, businesses may be eligible for an investment tax credit (ITC) for qualified investments in renewables or a production tax credit (PTC) for electricity production using a renewable resource.

Chirinko, Robert S., Steven M. Fazzarri, and Andrew P. Meyer. "How Responsive is Business Capital Formation to its User Cost? An Exploration with Micro Data?" Journal of Public Economics vol. 74 (1999), pp. 53-80.

Cummins, Jason G., Kevin A. Hassett, and R. Glen Hubbard, "A Reconsideration of Behavior Using Tax Reforms as Natural Experiments." Brookings Papers on Economic Activity, 1994, no. 1, pp. 1-72.

Hungerford, Thomas L., and Jane G. Gravelle. Business Investment and Employment Tax Incentives to Stimulate the Economy. Library of Congress, Congressional Research Service Report R41034. Washington, DC: July 21, 2010.

Gravelle, Jane. Economic Effects of Taxing Capital Income. MIT Press, 1994.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

A notable exception to Sec. 7704 occurs if 90 percent of the gross income of a PTP is passive-type income, such as interest, dividends, real property rents, gains from the disposition of real property, and similar income or gains. In these cases, the PTP is exempt from corporate level taxation, thus allowing it to claim pass-through status for tax purposes.

Qualifying income includes interest, dividends, real property rents, gain from the disposition of real property, income and gains from certain natural resource activities, gain from the disposition of a capital asset (e.g., selling stock), or certain property held for the production of income, as well as certain income and gains from commodities. In addition, gains related to the marketing of certain alternative fuels are treated as qualifying income for publicly traded partnerships. Qualifying income does not include income derived from the production of power, or trading and investment activity.

The Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647) clarified the definition of qualified income to include income from the transport of oil and gas and from depletable natural resources. Income from the marketing of oil and gas to retail customers was excluded from qualified income. The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) expands the definition of qualified income to include income or gains from the transport or storage of certain biofuels.

Gentry, William M., "Taxes, Financial Decisions and Organizational Form: Evidence from Publicly Traded Partnerships," Journal of Public Economics, vol. 53, no. 2, (1994), pp. 223-244.

Marples, Donald J. Taxation of Private Equity and Hedge Fund Partnerships: Characterization of Carried Interest. Library of Congress, Congressional Research Service Report RS22717. Washington, DC: June 3, 2010.

Martin, John D., and John W. Kensinger, "Valuation Effects of Rollout Publicly Traded Partnerships in the Oil and Gas Industry," Managerial and Decision Economics, vol. 11, no. 3, (1990), pp. 143-153.

National Association of Publicly Traded Partnerships, "Facts & Answers about Publicly Traded Partnerships," 2010, 4 p.

Schisler, Dan L. and James M. Lukawitz. "The Impact of the Omnibus Budget Reconciliation Act of 1987 on Shareholders of Publicly Traded Partnerships," Advances in Taxation, vol. 7, (1995), pp.141-159.

U.S. Congress, House Committee on the Budget, Omnibus Budget Reconciliation Act of 1987, 100th Congress, 1st Session., October 26, 1987 (Washington, GPO, 1987).

U.S. Congress, Joint Committee on Taxation, Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interest and Related Issues, Part I, JCX-62-07, 110th Congress, 1st Session. (Washington, GPO, 1987).

There are two methods of calculating this deduction: cost depletion and percentage depletion. Cost depletion allows for the recovery of the actual capital investment -- the costs of discovering, purchasing, and developing a mineral reserve -- over the period during which the reserve produces income. Each year, the taxpayer deducts a portion of the adjusted basis (original capital investment less previous deductions) equal to the fraction of the estimated remaining recoverable reserves that have been extracted and sold. Under this method, the total deductions cannot exceed the original capital investment.

Under percentage depletion, the deduction for recovery of capital investment is a fixed percentage of the "gross income" -- i.e., revenue -- from the sale of the mineral. Under this method, total deductions typically exceed, despite the limitations, the capital invested to acquire and develop the reserve.

Section 613 states that mineral producers must claim the higher of cost or percentage depletion. The percentage depletion rate for oil and gas is 15% and is limited to average daily production of 1,000 barrels of oil, or its equivalent in gas, and only for wells located in the United States. For producers of both oil and gas, the limit applies on a combined basis. For example, an oil producing company with 2006 oil production of 100,000 barrels, and natural gas production of 1.2 billion cubic feet (the equivalent of 200,000 barrels of oil) has average daily production of 821.92 barrels (300,000 / 365 days). Percentage depletion is not available to integrated major oil companies -- it is available only for independent producers and royalty owners. An independent producer is one that does not have refinery operations that refine more than 75,000 barrels of oil per day, and does not have retail oil and gas operations grossing more than $5 million per year. Beginning in 1990, the percentage depletion rate on production from marginal wells -- oil from stripper wells (those producing no more than 15 barrels per day, on average), and heavy oil -- was raised. This rate starts at 15% and increases by one percentage point for each whole $1 that the reference price of oil for the previous calendar year is less than $20 per barrel (subject to a maximum rate of 25%). This higher rate is also limited to independent producers and royalty owners, and for up to 1,000 barrels, determined as before on a combined basis (including non-marginal production). However, for 2009, high market crude oil prices limited the percentage depletion rate to 15%. Small independents operate about 400,000 (320,0000) small stripper wells in about 28 states, which produce about 800,000 barrels of marginal oil/day (1.7 trillion cubic feet of annual gas production), about 20% (9%) of domestic lower 48 production.

Percentage depletion is limited to 65% of the taxable income from all properties for each producer. However, for tax years beginning after December 31, 2008 and before January 1, 2010, this limitation is suspended for marginal properties. A second limitation is the 100% net-income limitation, which applies to each individual property rather than to all the properties. From 1998-2011, the 100% net-income limitation was also suspended for marginal production. Since 1990, transferred properties have been eligible for percentage depletion. The difference between percentage depletion and cost depletion is considered a subsidy. It was once a tax preference item for purposes of the alternative minimum tax, but this was repealed by the Energy Policy Act of 1992 (P.L. 102-486).

The percentage depletion allowance is available for many other types of fuel minerals, at rates ranging from 10% (coal, lignite) to 22% (uranium). The rate for regulated natural gas and gas sold under a fixed contract is 22%; the rate for geo-pressurized methane gas is 10%. Oil shale and geothermal deposits qualify for a 15% allowance. The net-income limitation to percentage depletion for coal and other fuels is 50%, as compared to 100% for oil and gas. Under code section 291, percentage depletion on coal mined by corporations is reduced by 20% of the excess of percentage over cost depletion.

The combination of this subsidy and the deduction of intangible drilling and other costs (see previous entry) represented a significant boon to mineral producers who were eligible for both. The deduction of intangible drilling costs allows up to three-quarters of the original investment to be "written off" immediately, and under the percentage depletion allowance a portion of gross revenues can be written off for the life of the investment. It was possible for cumulative depletion allowances to total many times the amount of the original investment.

The 1975 repeal of percentage depletion for the major integrated oil companies, and declining oil production, means that the value of this tax subsidy has been greatly reduced in the last 30 years. The reduction in the depletion allowance to 15% in 1984 means that independent producers benefit from it much less than they used to, although independents have increased their share of total output, and they qualify for the higher depletion rate on marginal production. Most recently, high oil and gas prices may have raised somewhat the subsidy value of percentage depletion to the independents. In addition, cutbacks in other tax benefits and additional excise taxes have raised effective tax rates in the mineral industries, although independent oil and gas producers continue to be favored. However, the exemption for working interests in oil and gas from the passive loss limitation rules still creates opportunities for tax shelters in oil and gas investments. This rule allows losses incurred from exploring for and producing oil and gas to offset ordinary non-oil and gas income.

Undoubtedly, these cutbacks in percentage depletion contributed to the decline in domestic oil production, which peaked in 1970 and recently dropped to a 30-year low. Percentage depletion for other mineral deposits was unaffected by the 1975 legislation. Nevertheless, in an average year more than half the percent revenue loss is a result of oil and gas depletion. The value of this expenditure to the taxpayer is the amount of tax savings that results from using the percentage depletion method instead of the cost depletion method.

Percentage depletion has little, if any, effect on oil prices, which are determined by supply and demand in the world oil market. However, it may encourage higher prices for drilling and mining rights.

This system was in effect from 1913 to 1918, although in the Revenue Act of 1916, depletion was restricted to no more than the total value of output, and in the aggregate no more than capital originally invested or fair market value on March 1, 1913 (the latter so that appreciation occurring before enactment of income taxes would not be taxed).

The 1916 depletion law marked the first time that the tax laws mentioned oil and gas specifically. On the grounds that the newer discoveries that contributed to the war effort were treated less favorably, discovery value depletion was enacted in 1918. Discovery depletion, which was in effect through 1926, allowed deductions in excess of capital investment because it was based on the market value of the deposit after discovery. Congress viewed oil and gas as a strategic mineral, essential to national security, and wanted to stimulate the wartime supply of oil and gas, compensate producers for the high risks of prospecting, and relieve the tax burdens of small-scale producers.

In 1921, because of concern with the size of the allowances, discovery depletion was limited to net income; it was further limited to 50% of net income in 1924. Due to the administrative complexity and arbitrariness of the method, and due to its tendency to establish high discovery values, which tended to overstate depletion deductions, discovery value depletion was replaced in 1926 by the percentage depletion allowance, at the rate of 27.5%.

In 1932, percentage depletion was extended to coal and most other minerals. In 1950, President Truman recommended that the depletion rate be reduced to 15%, but Congress disagreed. In 1969, the top depletion rates were reduced from 27.5% to 22%, and in 1970 the allowance was made subject to the minimum tax.

The Tax Reduction Act of 1975 eliminated the percentage depletion allowance for major oil and gas companies and reduced the rate for independents to 15% for 1984 and beyond. This was in response to the Arab oil embargo of 1973-74, which caused oil prices to rise sharply. The continuation of percentage depletion for independents was justified by Congress on the grounds that independents had more difficulty in raising capital than the major integrated oil companies, that their profits were smaller, and that they could not compete with the majors.

The Tax Equity and Fiscal Responsibility Act of 1982 limited the allowance for coal and iron ore. The Tax Reform Act of 1986 denied percentage depletion for lease bonuses, advance royalties, or other payments unrelated to actual oil and gas production.

The Omnibus Budget and Reconciliation Act of 1990 introduced the higher depletion rates on marginal production, raised the net income limitation from 50% to 100%, and made the allowance available to transferred properties. These liberalizations were based on energy security arguments. The Energy Policy Act of 1992 repealed the minimum tax on percentage depletion. The Taxpayer Relief Act of 1997 suspended the 100% taxable income limitation for marginal wells for two years, and further extensions were made by the Ticket to Work and Work Incentives Improvement Act of 1999 and the Job Creation and Worker Assistance Act of 2002. The Working Families Tax Relief Act of 2004 retroactively suspended the 100% net-income limitation through December 31, 2005. The Energy Policy Act of 2005 (P.L. 109-58) increased the per-day limitation on refining, for purposes of determining who is an independent producer, from 50,000 barrels per day to 75,000 barrels per day. The Tax Relief and Health Care Act of 2006 (P.L. 109-432) extended the suspension of the 100% net-income limitation through 2007. The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) extended the 100% net-income limitation for marginal properties by one year, beginning on January 1, 2008. The Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010 (P.L. 111-312) extended the suspension of the 100% net-income limitation for marginal properties for an additional two years, through December 31, 2011.

Tax provisions that encourage investment in a specific industry may be justified in cases where they address a positive externality associated with either production or consumption of certain goods. For example, oil and natural gas prices do not reflect the environmental harm caused by the release of greenhouse gases in the atmosphere associated with oil and gas production and consumption. However, the percentage depletion tax subsidy for oil and gas production work against the goal of reducing the negative externalities associated with oil and gas production.

As a production subsidy, however, percentage depletion is economically inefficient. It incorrectly measures the income of qualifying independent oil and gas producers, and it encourages excessive development of existing properties -- the source of the depletion benefit -- over exploration for new ones, which will not produce a flow of depletion benefits until actual output results. This tax treatment contrasts with capital subsidies, such as accelerated depreciation for non-mineral assets. Although accelerated depreciation may lower effective tax rates by speeding up tax benefits, these assets cannot be used for depreciation deductions in excess of investment.

Percentage depletion for oil and gas subsidizes independent producers that are primarily engaged in exploration and production. To the extent that it stimulates oil production, it reduces dependence on imported oil in the short run, but it contributes to a faster depletion of the Nation's resources in the long run, which may increase long-term oil import dependence. Arguments have been made over the years to justify percentage depletion on grounds of unusual risks, the distortions in the corporate income tax, national security, uniqueness of oil as a commodity, the industry's lack of access to capital, and protection of small producers.

Volatile oil prices make oil and gas investments more risky, but this would not necessarily justify percentage depletion or other tax subsidies. The corporate income tax does have efficiency distortions, but from an economic perspective income tax integration may be a more appropriate policy to address this problem.

To address national security concerns, one alternative is an oil stockpile program such as the Strategic Petroleum Reserve.

Edmunds, Mark A. "Economic Justification for Expensing IDC and Percentage Depletion Allowance," Oil & Gas Tax Quarterly, v. 36. September 1987, pp. 1-11.

Energy Information Administration. Accelerated Depletion: Assessing the Impact on Domestic Oil and Natural Gas Prices and Production. SR/OIAF/2000-04. July 2000.

Fenton, Edmund D. "Percentage Depletion, RMFP, and the Exxon Cases," Oil and Gas Tax Quarterly, v.52. September 2003, pp. 1-17.

Frazier, Jessica, and Edmund D. Fenton. "The Interesting Beginnings of the Percentage Depletion Allowance," Oil and Gas Tax Quarterly, v. 38. June 1990, pp. 697-712.

Ghiselin, Dick. "Drilling Economics" Oil and Gas Investor, December 2005, pp.13-22.

Gravelle, Jane G. "Effective Federal Tax Rates on Income from New Investments in Oil and Gas Extraction," The Energy Journal, v.6. 1985, pp. 145-153.

Harberger, Arnold G. Taxation and Welfare. Chicago: Univ. of Chicago Press, 1974, pp. 218-226.

Hennessee, Patrick A. Percentage Depletion -- How Natural Gas Producers Can Avoid the Retailer Exclusion of 613A. The Journal of Taxation. July 2005, pp. 39-46.

__ . Energy Tax Policy: An Economic Analysis. Library of Congress, Congressional Research Service, Report RL 30406. Washington, DC: June 28, 2005.

Lucke, Robert, and Eric Toder. "Assessing the U.S. Federal Tax Burden on Oil and Gas Extraction," The Energy Journal, v. 8. October 1987, pp. 51-64.

Lyon, Andrew B. "The Effect of Changes in the Percentage Depletion Allowance on Oil Firm Stock Prices," The Energy Journal, v.10. October 1989, pp.101-116.

McDonald, Stephen L. Federal Tax Treatment of Income from Oil and Gas. The Brookings Institution, 1963.

Gilbert Metcalf, "Taxing Energy in the United States: Which Fuels Does the Tax Code Favor?" Center for Energy Policy and the Environment, 2009.

Rook, Lance W. "The Energy Policy Act of 1992 Changes the Effect of the AMT on Most Oil Producers," Tax Advisor, v. 24. August 1993, pp. 479-484.

Sherlock, Molly and Donald Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service, CRS Report R40999. Washington, DC: Updated 2010.

Thomas, Christopher, S. Charles Maurice, D. Larry Crumbley. Vertical Integration, Price Squeezing, and Percentage Depletion Allowance. The Quarterly Review of Economics and Business, v. 29. Winter 1989, pp26-37.

U.S. General Accounting Office. Additional Petroleum Production Tax Incentives Are of Questionable Merit, GAO/GGD-90-75. Washington, DC: July 1990.

U.S. Treasury Department. Tax Reform for Fairness, Simplicity, and Economic Growth, v. 2. Washington, DC: November 1984, pp. 229-231.

U.S. Treasury Department. Internal Revenue Service. IRS Audit Guide: Oil and Gas Industry, Market Segmentation Specialization Program. 2006.

In rental housing, the tenant and the landlord lack strong financial incentives to invest in energy conservation equipment and materials because the benefits from such conservation may not entirely accrue to the party undertaking the cost of the energy-saving expenditure and effort. Tenants do not generally have motivation to improve the energy efficiency of a residence that does not belong to them unless the rate of return (or payback) is sufficiently large. However, most tenants do not occupy rental housing long enough to reap the full benefits of the energy conservation investments. Alternatively, landlords may not be able to control the energy consumption habits of renters to sufficiently recover the full cost of the energy conservation expenditures.

If the units are individually metered and the tenant pays for electricity separately, the landlord may not undertake energy conservation investments since all the benefits would accrue to the renters unless higher rents could be charged on apartments with lower utility costs. If the units are under centralized control (rather than individually metered), the benefits of conservation measures may accrue largely to the landlord, but even here the tenants may have sufficient control over energy use to subvert the accrual of any gains to the landlord. In such cases, from the landlord's perspective, it may be easier and cheaper to forgo the conservation investments and simply pass on energy costs as part of the rents. Individual metering can be quite costly, and while it may reduce some of the distortions, it is not likely to completely eliminate them. Even if the landlord can charge higher rents, he may not be able to recover the costs of energy conservation efforts or investments.

These market failures may lead to underinvestment in conservation measures in rental housing and provide the economic rationale for this provision. Without such explicit exclusion, such subsidies would be treated as gross income and subject to tax. This exclusion, however, applies both to owner-occupied and to rental housing.

Hahn, Robert W. "Energy Conservation: An Economic Perspective." American Enterprise Institute, October 2005.

Howarth, Richard B. and Bo Anderson. "Market Barriers to Energy Efficiency." Energy Economics, October, 1993. pp. 262-292.

Loskamp, Wendy. Energy, Water Efficiencies and Savings Come From Meter Data Management. Energy Pulse. Insight Analysis and Commentary on the Global Power Industry. http\www.energypulse.net.

Metcalf, Gilbert E. "Economics and Rational Conservation Policy." Energy Policy, v. 22. October 1994, pp. 819-825.

Pauley, Patricia, et al. "The Energy Policy Act of 1992: Provisions Affecting Individuals." Taxes, February, 1993, pp. 91-96.

Sherlock, Molly F. and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: September 20, 2010.

Sutherland, Ronald J. "Energy Efficiency or the Efficient Use of Energy Resources." Energy Sources, v. 16, pp. 257-268.

Sutherland, Ronald J. "The Economics of Energy Conservation Policy." Energy Policy, v. 24. April 1996, pp. 361-370.

U.S. Congress, House. Report to Accompany H.R. 776, the Comprehensive Energy Policy Act. Washington, DC: U.S. Government Printing Office, Report 102-474, Part 6, pp. 35-37.

__ . House. Committee on Energy and Commerce. National Energy Policy: Conservation and Energy Efficiency. Hearings Before the Subcommittee on Energy and Air Quality. Washington, DC: U.S. Government Printing Office, June 22, 2001.

U.S. Department of Energy. Lawrence Berkeley National Laboratory. "Energy Efficiency, Market Failures, and Government Policy." Levine, Mark D., et al. March 1994.

U.S. Department of the Treasury. Internal Revenue Service. Gross Income v. Non-Gross Income: Energy Conservation Subsidies Provided by Utilities. Letter Ruling 200717010. January 19, 2007.

IDCs are amounts paid by the operator for fuel, labor, repairs to drilling equipment, materials, hauling, and supplies. They are expenditures incident to and necessary for the drilling of wells and preparing a site for the production of oil, gas, or geothermal energy. IDCs include the cost to operators of any drilling or development work done by contractors under any form of contract, including a turnkey contract. Amounts paid for casings, valves, pipelines, and other tangible equipment that have a salvage value are capital expenditures and they cannot be expensed; they are recovered through depreciation. (And as discussed in the subsequent entry on percentage depletion, amounts expended to purchase a property are depleted using either percentage or cost depletion.) Geological and geophysical (G&G) costs -- exploratory costs associated with determining the precise location and potential size of a mineral deposit -- are amortized by independents over two years and by major integrated oil companies over seven years.

The option to expense IDCs applies to domestic properties, which include certain off-shore wells (essentially those within the exclusive economic zone of the United States), including generally offshore platforms subject to certain restrictions. Except for IDCs incurred in the North Sea, IDCs on foreign properties must be either amortized (deducted in equal amounts) over 10 years or added to the adjusted cost basis and recovered through cost depletion. An integrated oil company, generally a large producer that also has refining and marketing operations, can expense only 70% of the IDCs -- the remaining 30% must be amortized over a five-year period. Dry hole costs for either domestic or foreign properties may be expensed or capitalized at the discretion of the taxpayer.

For integrated producers, the excess of expensed IDCs over the amortizable value (over a 10-year period) is a tax preference item that is subject to the alternative minimum tax to the extent that it exceeds 65% of the net income from the property. Independent (non-integrated) producers include only 60% of their IDCs as a tax preference item. As noted above, instead of expensing, a taxpayer may choose to amortize IDCs over a five-year period and avoid the alternative minimum tax. The amortization claimed under IRC section 59(e) is not considered a tax preference item for alternative minimum tax purposes. Prior to 1993, an independent producer's intangible drilling costs were subject to the alternative minimum tax, and they were allowed a special "energy deduction" for 100% of certain IDCs, subject to some limitations. If an operator has elected to amortize IDCs on a well that proves later to be a dry hole, the operator may deduct such costs as an ordinary loss. The taxpayer is not required to include these costs as an IDC tax preference item in computing alternative minimum tax. If a property is disposed of prior to its exhaustion, any expensed IDCs are recaptured as ordinary income.

Historically, expensing of IDCs was a major tax subsidy for the oil and gas industry, and, combined with other tax subsidies such as the depletion allowance, reduced effective tax rates significantly below tax rates on other industries. These subsidies provided incentives to increase investment, exploration, and output, especially of oil and gas. Oil and gas output, for example, rose from 16% of total U.S. energy production in 1920 to 71.1% in 1970 (the peak year). Coupled with reductions in corporate income tax rates, increased limits on expensing, and the alternative minimum tax, the value of this subsidy has declined over time. And, since the early 1970s, domestic crude oil production has fallen substantially. However, the subsidy still keeps effective marginal tax rates on oil and gas (especially for independent producers) somewhat below the marginal effective tax rates on other industries in most cases.

Unlike percentage depletion, which may only be claimed by independent producers, this tax expenditure is shared by both independents and by the integrated oil and gas producers. However, independent oil producers, many of which are large, drill 80-90% of the wells and undertake the bulk of the expenditures for exploration and development, thus receiving the bulk of the benefits from this tax expenditure. The at-risk, recapture, and minimum tax restrictions that have since been placed on the use of the provision have primarily limited the ability of high-income taxpayers to shelter their income from taxation through investment in mineral exploration. However, the exemption for working interests in oil and gas from the passive loss limitation rules still creates opportunities for tax shelters in oil and gas investments.

In 1931, a court ruled that IDCs were capital costs, but permitted expensing, arguing that the 15-year precedent gave the regulation the force of a statute. In 1942, Treasury recommended that expensing be repealed, but Congress did not take action. A 1945 court decision invalidated expensing, but Congress endorsed it (on the basis that it reduced uncertainty and stimulated exploration of a strategic mineral) and codified it as section 263(c) in 1954. Continuation of expensing has been based on the perceived need to stimulate exploratory drilling, which can increase domestic oil and gas reserves, and (eventually) production, reduce imported petroleum, and enhance energy security. However, none of the four economic rationales for intervention in the energy markets (the market failures rationales) justify expensing treatment of IDCs.

The Tax Reform Act of 1976 added expensing of IDCs as a tax preference item subject to the minimum tax. Expensing of IDCs for geothermal wells was added by the Energy Tax Act of 1978. The Tax Equity and Fiscal Responsibility Act of 1982 limited expensing for integrated oil companies to 85%; the remaining 15% of IDCs had to be amortized over 3 years.

The Deficit Reduction Act of 1984 limited expensing for integrated producers to 80% of IDCs. The Tax Reform Act of 1986 established uniform capitalization rules for the depreciation of property, but IDCs (as well as mine development and other exploration costs) are exempt from those rules. The Tax Reform Act further limited expensing for integrated producers to 70% of costs, and also repealed expensing of foreign properties.

In 1990, a special energy deduction was introduced, against the alternative minimum tax, for a portion of the IDCs and other oil and gas industry tax preference items. For independent producers, the Energy Policy Act of 1992 limited the amount of IDCs subject to the alternative minimum tax to 60% (70% after 1993) and suspended the special energy deduction through 1998. The Energy Policy Act of 2005 (P.L. 109-58) included a provision to amortize geological and geophysical (G&G) costs over two years. The Tax Increase Prevention and Reconciliation Act of 2006 (P.L. 109-222) raised the amortization period for geological and geophysical costs to five years for major integrated oil companies. The Energy Independence and Security Act of 2007 (P.L. 110-140), enacted on December 19, 2007, further raised the amortization period for geological and geophysical expenditures incurred by major integrated oil companies from five to seven years.

Immediate expensing of IDCs provides a tax subsidy for capital invested in the mineral industry, especially for oil and gas producers, with a relatively larger subsidy for independent producers. Technological innovation has reduced the percentage of dry holes in both exploratory and development drilling, thus reducing the tax benefits from immediate expensing of dry hole costs.

Expensing rather than capitalizing IDCs allows taxes on income to be effectively eliminated. As a capital subsidy, however, expensing is economically inefficient because it promotes investment decisions that are based on tax considerations rather than inherent economic considerations.

To the extent that IDCs stimulate drilling of successful wells, they reduce dependence on imported oil in the short run, but contribute to a faster depletion of the nation's resources in the long run. Arguments have been made over the years to justify expensing on grounds of unusual risks, national security, uniqueness of oil as a commodity, the industry's lack of access to capital, and protection of small producers.

Volatile oil prices make oil and gas investments very risky, but this would not necessarily justify expensing. The corporate income tax does have efficiency distortions, but economists argue that income tax integration may be a more appropriate policy to address this issue; sustained high oil and gas prices increase profits and provide sufficient financial incentives for exploration and drilling, making expensing unnecessary. For the goal of enhancing energy security, one alternative approach is through an oil stockpile program such as the Strategic Petroleum Reserve.

Eicher, Jeffrey D. And Leo N. Hitt. "The Alternative Minimum Tax System: A Stealth Tax," Taxes, v. 84 July 2006, pp. 37-45.

Friske, Karyn Bybee. "Alternative Minimum Tax Credit and the Consolidated Regulations: Is Simplification Possible?" The Oil and Gas and Energy Quarterly, September 2001, pp.139-145.

Ghiselin, Dick. "Drilling Economics" Oil and Gas Investor, December 2005, pp.13-22.

Gravelle, Jane G. "Effective Federal Tax Rates on Income from New Investments in Oil and Gas Extraction," The Energy Journal, v. 6 (1985), pp. 145-153.

Lazzari, Salvatore . Energy Tax Provisions in the Energy Policy Act of 1992. Library of Congress, Congressional Research Service, Report 94-525 E. Washington, DC: June 22, 1994. (Archived: Available upon request from the author.)

Lucke, Robert, and Eric Toder. "Assessing the U.S. Federal Tax Burden on Oil and Gas Extraction," The Energy Journal, v. 8. October 1987, pp. 51-64.

Rook, Lance W. "The Energy Policy Act of 1992 Changes the Effect of the AMT on Most Oil and Gas Producers," Tax Adviser, v. 24 (August 1993), pp. 479-484.

Sherlock, Molly and Donald Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service, CRS Report R40999. Washington, DC: Updated 2010.

U.S Congress, Senate Committee on Finance. JCT Description of Federal Energy Tax Provisions, Hearings, 107th Congress, 1st session. Washington, DC: U.S. Government Printing Office, July 10th and 11, 2001.

U.S. General Accounting Office. Additional Petroleum Production Tax Incentives Are of Questionable Merit, GAO/GGD-90-75. July 1990. Washington, DC: U.S. Government Printing Office, July 1990.

U.S. Department of Energy. Energy Information Administration. Performance Profiles of Major Energy Producers. DOE/EIA-0206(06). December 2007.

U.S. Department of Energy. Energy Information Administration. Federal Interventions and Subsidies in Energy Markets. SR/CNEAF/2008-01. April 2008.

U.S. Treasury Department. Tax Reform for Fairness, Simplicity, and Economic Growth, v. 2. November 1984, Washington, DC: 1984, pp. 229-231.

U.S. Treasury Department. Internal Revenue Service. Publication 535: Business Expenses. 2005.

Zlatkovich, Charles P., and Karl B. Putnam. "Economic Trends in the Oil and Gas Industry and Oil and Gas Taxation," Oil and Gas Quarterly, v. 41. March, 1993, pp. 347-365.

These bonds may be issued to finance the construction of hydroelectric generating facilities at dam sites constructed before March 18, 1979, or at sites without dams that require no impoundment of water. Bonds may also be issued to finance solid waste disposal facilities that produce electric energy. These exempt facility bonds generally are subject to the state private-activity bond annual volume cap. Bonds issued for government-owned solid waste disposal facilities, a different category of private activity bond, are not, however, subject to the volume cap.

Some of the benefits of the tax exemption also flow to bondholders. For a discussion of the factors that determine the shares of benefits going to bondholders and users of the energy facilities, and estimates of the distribution of tax-exempt interest income by income class, see the "Impact" discussion under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

The definition of solid waste plants eligible for tax-exempt financing was expanded by the 1980 Act because the Treasury regulations then existing denied such financing to many of the most technologically efficient methods of converting waste to energy. This expansion of eligibility included plants that generated steam or produced alcohol. Tax exemption for steam generation and alcohol production facilities bonds were eliminated by the 1986 Tax Act.

Even if a case can be made for a federal subsidy of energy production facilities based on underinvestment at the state and local level, it is important to recognize the potential costs. As one of many categories of tax-exempt private-activity bonds, those issued for energy production facilities increase the financing cost of bonds issued for other public capital. With a greater supply of public bonds, the interest rate on the bonds necessarily increases to lure investors. In addition, expanding the availability of tax-exempt bonds increases the range of assets available to individuals and corporations to shelter their income from taxation.

___. Private Activity Bonds: An Analysis of State Use. Library of Congress, Congressional Research Service Report RL34159.

___. Tax-Exempt Bonds: A Description of State and Local Government Debt. Library of Congress, Congressional Research Service Report RL30638.

U.S. Congress, Joint Committee on Taxation, Present Law and Background Related to State and Local Government Bonds, Joint Committee Print JCX-14-06, March 16, 2006.

U.S. Congress, Joint Committee on Internal Revenue Taxation. General Explanation of the Crude Oil Windfall Profits Tax Act of 1980. 96th Congress, 2nd session, 1980.

U.S. Department of Treasury, Internal Revenue Service. Tax-Exempt Private Activity Bonds, Publication 4078, June 2004.

Zimmerman, Dennis. Electricity Restructuring and Tax-Exempt Bonds: Economic Analysis of Legislative Proposals, Library of Congress, Congressional Research Service Report RL30411.

___. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activity. Washington, DC: The Urban Institute Press, 1991.

Both the credit and the phase-out range are adjusted for inflation (multiplied by an inflation adjustment factor) since 1979. For 2009 the reference price of oil is $56.39. The inflation adjustment factor is 1.1343 and the nonconventional source fuel credit prior to phase out is $3.40 ($3 x 1.1343) barrel-of-oil equivalent of qualified fuels.

Qualifying fuels include synthetic fuels (either liquid, gaseous, or solid) produced from coal, and gas produced from either geopressurized brine, Devonian shale, tight formations, or biomass. Synthetic fuels from coal, either liquid, gaseous, or solid, are also qualifying fuels provided that they meet the statutory and regulatory requirement that they undergo a significant chemical transformation, defined as a measurable and reproducible change in the chemical bonding of the initial components. In most cases, producers apply a liquid bonding agent to the coal or coal waste (coal fines), such as diesel fuel emulsions, pine tar, or latex, to produce the solid synthetic fuel. The coke or coke gas made from coal and used as a feedstock, or raw material (e.g., coke used in steel-making) also qualifies as a synthetic fuel as does the breeze (which are small pieces of coke) and the coke gas (which is produced during the coking process). However, coke or coke gas made from petroleum does not qualify for the tax credit. Depending on the precise Btu content of these synfuels, the section 45K tax credit could be as high as $26/ton or more, which is a significant fraction of the market price of coal. Qualifying fuels must be produced within the United States. The credit for coke and coke gas is also $3/barrel of oil equivalent and is also adjusted for inflation, but the credit is set to a base year of 2004, making the nominal unadjusted tax credit less than for other fuels.

The section 45K credit for gas produced from biomass, and synthetic fuels produced from coal or lignite, was available through December 31, 2007, provided that the production facility was placed in service before July 1, 1998, pursuant to a binding contract entered into before January 1, 1997. Thus, generally, the credit has expired. The credit for coke and coke gas was available through December 31, 2009, for plants placed in service before January 1, 1992, and after June 30, 1998. The section 45K credit used to apply to oil produced from shale or tar sands, and coalbed methane (a colorless and odorless natural gas that permeates coal seams and that is virtually identical to conventional natural gas). But for these fuels the credit terminated on December 31, 2002 (and the facilities had to have been placed in service (or wells drilled) by December 31, 1992).

The section 45K credit is part of the general business credit. It is not claimed separately; it is added together with several other business credits, and is also subject to the limitations of that credit. The section 45K credit is also offset (or reduced) by other types of government subsidies that a taxpayer may benefit from: government grants, subsidized or tax-exempt financing, energy investment credits, and the enhanced oil recovery tax credit that may be claimed with respect to such project. Finally, the credit is nonrefundable and cannot be used to offset a taxpayer's alternative minimum tax liability. Any unused section 45K credits generally may not be carried forward or back to another taxable year. (However, under the minimum tax section 53, a taxpayer receives a credit for prior-year minimum tax liability to the extent that a section 45K credit is disallowed as a result of the operation of the alternative minimum tax.)

However, to date, the credits have not stimulated production of fuels, such as shale oil or heavy oil, that would substitute for petroleum. These and other non-conventional fuels are still generally too costly to be profitably produced. With the exception of coalbed methane, tight sands gas, and "synfuels" from coal, the credit's effects have, generally, not been sufficient to offset the disincentive effects of previously low and unstable oil prices, and the high cost of non-conventional fuels mining and production. High crude oil prices can render some of the non-conventional petroleum fuels (such as oil shale and tar sands) competitive, which might stimulate production even without a tax credit. However, variable oil prices add to the risk of these and other types of energy ventures and investments, and undermine profitability and investments in these areas.

The primary supply effects of the section 45K tax credit have been on non-conventional gases, particularly of coalbed methane, tight sands gas, and shale gas. The credit has increased drilling for these gases, and added to total natural gas reserves. In the case of coalbed methane, the combined effect of the large tax credit (the credit of $1.00 per mcf was, at times, 100% of natural gas prices) and declining production costs (due to technological advances in drilling and production techniques) has helped boost production from 0.1 billion cubic feet in 1980 to 1.6 trillion cubic feet in 2003. More recently, favorable rulings by the Internal Revenue Service have increased the production of solid "synthetic" fuels from coal, increasing the supply of these fuels for use as a feedstock in steel-making operations and in electricity generation. The credit for coalbed methane benefits largely oil and gas producers, both independent producers and major integrated oil companies, and coal companies. Many oil and gas companies, such as DTE Energy, Phillips Petroleum, and the Enron Corporation, used section 45K tax credits to help reduce their effective tax rates.

The final version of the Energy Tax Act did not include the production tax credit. The original concept was resuscitated in 1979 by Senator Talmadge as S. 847 and S. 848, which became part of the Crude Oil Windfall Profit Tax Act of 1980 (P.L. 96-223).

The purpose of the credits was to provide incentives for the private sector to increase the development of alternative domestic energy resources because of concern over oil import dependence and national security. The United States has a large resource base of unconventional energy resources, including shale oil and unconventional gases such as tight sands gas and coalbed methane. According to the U.S. Geological Survey and the Minerals Management Service, estimated U.S. recoverable reserves of unconventional gases exceed those of any other category of gas, including estimates of conventional reserves, comprising 35% of the total.

The section 45K credit's "placed-in-service" rule has been amended several times in recent years. The original 1980 windfall profit tax law established a placed-in-service deadline of December 31, 1989. This was extended by one year to December 31, 1990, by the Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647). That deadline was extended to December 31, 1991, as part of OBRA, the Omnibus Budget Reconciliation Act of 1990 (P.L.101-508). The Energy Policy Act of 1992 (P.L.102-486) extended coverage for facilities for biomass and fuels produced from coal through 1997 and extended the credit on production from these facilities through 2007. The Small Business Jobs Protection Act of 1996 (P.L. 104-188) further extended the placed-in-service rule by an additional eighteen months. In Rev. Proc. 2001-30 and 2001-34, the Internal Revenue Service implemented regulations that permitted greater production of solid synthetic fuels from coal to qualify for the section 45K credit. Some have questioned the scientific validity of these rules and have christened the process "spray and pray."

The American Jobs Creation Act of 2004 (P.L. 108-357) provided a production tax credit for refined coal. The production tax credit's provisions were inserted in section 45 of the tax code, the section that provides a tax credit for electricity produced from renewable energy resources. (A discussion of the section 45 tax credit appears elsewhere in the Energy section of this compendium.)

The Energy Policy Act of 2005 (P.L. 109-58) made several amendments to the section 45K tax credit. First, the credit's provisions were moved from section 29 of the tax code to new § 45K. Before this, this credit was commonly known as the "section 29 credit." Second, the credit was made available for qualified facilities that produce coke or coke gas that were placed in service before January 1, 1993, or after June 30, 1998, and before January 1, 2010. Coke and coke gas produced and sold during the period beginning on the later of January 1, 2006, or the date the facility is placed in service, and ending on the date which is four years after such period begins, would be eligible for the production credit, but at a reduced rate and only for a limited quantity of fuel. The tax credit for coke and coke gas would be $3.00/barrel of oil equivalent, but the credit would be indexed for inflation starting with a 2004 base year as compared with a 1979 base year for other fuels. A facility producing coke or coke gas and receiving a tax credit under the previous section 29 rules would not be eligible to claim the credit under the new section 45K. The new provision also requires that the amount of credit-eligible coke produced not exceed an average barrel-of-oil equivalent of 4,000 barrels per day. Third, the 2005 Act provided that, with respect to the IRS moratorium on taxpayer-specific guidance concerning the credit, the IRS should consider issuing rulings and guidance on an expedited basis to those taxpayers who had pending ruling requests at the time that the IRS implemented the moratorium. Finally, the 2005 legislation made the general business limitations applicable to the tax credit. Any unused credits could be carried back one year and forward 20 years, except that the credit could not be carried back to a taxable year ending before January 1, 2006. These new rules were made effective for fuel produced and sold after December 31, 2005, in taxable years ending after such date.

The Tax Relief and Health Care Act of 2006 (P.L. 109-432) eliminated the phase out limit for coke and coke gas, and clarified that petroleum based coke or coke gas does not qualify.

In general, much of the added gas output has substituted for domestic and imported (i.e., Canadian) conventional natural gas rather than for imported petroleum, meaning that the credit has basically not achieved its underlying energy policy objective of enhancing energy security by reducing imported petroleum. More recently, additional supplies of domestic unconventional gases may be substituting for imported LNG (liquefied natural gas). Declining conventional natural gas production in Texas, New Mexico, Oklahoma, Louisiana, and the Gulf of Mexico has been partially offset by increases in Colorado and Wyoming, reflecting the growing prominence of unconventional sources such as tight sands, shales, and coalbeds.

Economists see little justification for such a credit on grounds of allocative efficiency, distributional equity, or macroeconomic stability. From an economic perspective, although tax incentives are generally less distortionary than mandates and standards, critics maintain that the section 45K tax credit compounds distortions in the energy markets, rather than correcting for preexisting distortions due to pollution, oil import dependence, "excessive" market risk, and other factors. Such distortions may be addressed by other policies: Pollution and other environmental externalities may be dealt with by differential taxes positively related to the external cost; excessive dependence on imported petroleum and vulnerability to embargoes and price shocks have led to calls for either an oil import tax or a petroleum stockpile such as the Strategic Petroleum Reserve.

The credit has not encouraged the collection of coalbed methane from active coal mines, which continues to be vented and which contributes a potent greenhouse gas linked to possible global warming. Hydraulic fracturing of coal beds, and other environmental effects from the production of coalbed methane and other unconventional gases, is coming under greater scrutiny.

In recent years, much of the benefits of the tax credits has accrued to coal producers and users, who spray the coal with a fuel and sell it as a solid "synthetic fuel." The coal industry has also benefitted from the expansion of the credit to coke and coke gas. Under the original statute and regulations, such conversion of coal into a synthetic fuel was premised on a significant chemical transformation that would increase the energy content of the resulting fuel.

Bryner, Gary C. "Coalbed Methane Development: The Costs and Benefits of an Emerging Energy Resource." Natural Resource Journal, v. 43, Spring 2003. pp. 519-560.

Clark, Judy. "Geopolitics, Unconventional Fuels to Reshape Industry," Oil and Gas Journal, April 25, 2005, pp 44-44

Crow, Patrick, and A.D. Koen. "Tight Gas Sands Drilling Buoying U.S. E & D Activity." Oil and Gas Journal, v. 90. November 2, 1992, pp. 21-27.

Fletcher, Sam. "Major U.S. Supply Role Seen for Unconventional Gas," Oil and Gas Journal, December 20, 2004, pp. 32-34.

Kuuskraa, Vello A., and Charles F. Brandenburg. "Coalbed Methane Sparks New Energy Industry," Oil and Gas Journal, v. 87. October 9, 1989, pp. 49-56.

Lazzari, Salvatore. Economic Analysis of the Section 29 Tax Credit for Unconventional Fuels, Library of Congress, Congressional Research Service Report 97-679 E. Washington, DC: July 7, 1997.

___. "Energy Taxation: Subsidies for Biomass," Encyclopedia of Energy Technology and the Environment, John Wiley & Sons, 1995, pp. 1238-1245.

___. Energy Tax Policy: History and Current Issues. Library of Congress, Congressional Research Service Report RL33578, Washington, D.C. July 28, 2006.

___. Energy Tax Policy: An Economic Analysis. Library of Congress, Congressional Research Service Report RL 30406. Washington, DC: June 28, 2005.

Lemons, Bruce N. and Larry Nemirow. "Maximizing the Section 29 Credit in Coal Seam Methane Transactions," The Journal of Taxation. April 1989, pp. 238-245.

Matlock, Judith M. and Laurence E. Nemirow. "Section 29 Credits: The Case Against Requiring an NGPA Well-Category Determination," Journal of Taxation, v. 85. August 1996, pp. 102-107.

McIntire Robert, and T.D. Coo Nguyen. Corporate Income Taxes in the 1990s. Citizens for Tax Justice. October 2000.

McKinnon, John D. "Washington Alchemy Turns Coal Products Into Big Tax Credits." The Wall Street Journal, v. 238, July 12, 2001.

Morgan, Dan. "Coal State Senators Question Tax Audits: IRS Reviews Use of Synthetic Fuel Credits." The Washington Post, September 13, 2003. p. A-3.

Schraufnagel, D., G. Hill and R. A. McBane. Coalbed Methane: A Decade of Success. Paper Presented at the Conference of the Society of Petroleum Engineers. 1994.

Sherlock, Molly and Donald Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service, CRS Report R40999. Washington, DC: Updated 2010.

U.S. Treasury Department. Internal Revenue Service. IRS Notice 2008-44 on Section 45K Inflation Adjustment Factor, Reference Price for Nonconventional Source Fuel Credit. March 31, 2008.

Wills, Irene Y, and Norman A. Sunderman. "Section 29 Tax Credit Still Available," Oil and Gas Tax Quarterly, v. 40. December 1991.

Credits are only awarded for domestic production that exceeds prior levels and are subject to per manufacturer limits. Specifically, each manufacturer is only eligible for credits for domestic production of energy-efficient units in excess of average production over the past two years. Beginning in 2011, each manufacturer is limited to $25 million in credits, or 4% of the taxpayer's average annual gross receipts for the preceding three tax years (prior to 2011 each manufacturer was limited to $75 million in credits or 2% of annual gross receipts).

The appliance credit is part of the general business credit. It is claimed in concert with a variety of other business tax credits, and it is subject to the limits of those credits as well. This provision became effective for appliances produced after December 31, 2005 and is set to expire December 31, 2011.

As the tax credit decreases the costs of manufacturing energy-efficient appliances relative to less efficient alternatives, manufacturers will shift their resources towards manufacturing energy-efficient models. As the supply of energy-efficient models increases, the price is expected to fall. As energy-efficient models become cheaper relative to other appliances, the quantity demanded of energy-efficient models is expected to increase.

Tax incentives for energy-efficient appliances can be provided either to the producers (supply side) or consumers (demand side) of energy-efficient appliances. According to economic theory, the effect will be the same, regardless of which party initially receives the incentive. If tax credits are provided to producers, it is expected that these credits will be shared with consumers in the form of lower prices. If tax credits or other subsidies (i.e. rebates) are provided to consumers, it is expected that producers will increase their prices, thereby capturing some of the benefit.

Providing credits to suppliers rather than consumers may be appealing for a number of reasons. First, it is easier to process claims for tax credits from a handful of manufacturers as opposed to hundreds of thousands of individual taxpayers. Second, providing tax credits to manufacturers may also be attractive as it reduces prices of energy-efficient appliances equally for all consumers. Tax credits awarded to individuals are only available for those with a positive tax liability. Further, evidence on the effect of energy-efficient appliance rebates on market share is mixed, indicating that demand side incentives may not consistently increase purchases of energy-efficient models.

Overall, a relatively small share of the appliance market is eligible for the tax credits awarded under section 45M. Further, it is not clear that the tax credits are fully responsible for increased manufacturing of energy-efficient appliances. Some of the tax credits being claimed benefit manufacturers that would have increased production of qualifying energy-efficient appliances without the credit. Manufacturers may increase the number of energy-efficient appliances produced in response to general market trends or in response to anticipated increases in appliance standards or Energy Star criteria. Credits awarded to manufacturers that would have increased production without the incentive are economically inefficient, as they provide a windfall benefit to the taxpayer.

Finally, from an economic perspective, allowing special tax credits for certain targeted activities distorts the allocation of resources. Targeted tax credits encourage companies to undertake certain types of investments and production that would not otherwise be economical at current and expected prices and rates of return. In the case of energy-efficient appliances, the credits are targeted to include dishwashers, clothes washers, and refrigerators. Other appliances with higher energy consumption, such as clothes dryers, are excluded.

Dale, Larry and K. Sydney Fujita, An Analysis of the Price Elasticity of Demand for Household Appliances, Lawrence Berkeley National Laboratory, Berkeley, CA, February 2008.

Datta, Souvik and Sumeet Gulati, "Utility Rebates for Energy Star Appliances: Are They Effective," University of British Columbia Working Paper, July 2010.

Davis, Lucas W., Evaluating the Slow Adoption of Energy Efficient Investments: Are Renters Less Likely to Have Energy Efficient Appliances? National Bureau of Economic Research, Working Paper 16114. June 2010.

Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17. August 1989, pp. 397-406.

Hahn, Robert W. "Energy Conservation: An Economic Perspective." American Enterprise Institute, October 2005.

Hassett, Kevin A., and Gilbert E. Metcalf. "Energy Conservation Investment: Do Consumers Discount the Future Correctly?" Energy Policy, v. 21. June 1993, pp. 710-716.

Howarth, Richard B. and Bo Anderson. "Market Barriers to Energy Efficiency." Energy Economics, October, 1993. pp. 262-292.

International Energy Agency. Mind the Gap: Quantifying Principal-Agent Problems in Energy Efficiency. 2007.

Levinson, Arik and Scott Niemann, "Energy Use by Apartment Tenants when Landlords Pay for Utilities." Resource and Energy Economics, v. 26. 2004. pp. 51-75.

Loskamp, Wendy. "Energy, Water Efficiencies and Savings Come From Meter Data Management. Energy Pulse." Insight Analysis and Commentary on the Global Power Industry. http\www.energypulse.net.

Metcalf, Gilbert E. "Economics and Rational Conservation Policy." Energy Policy, v. 22. October 1994, pp. 819-825.

Pimental, D., A. Pleasant, et al. "U.S. Energy Conservation and Efficiency." Energy, Development, and Sustainability. V. 6, September 2004. pp. 279-306.

Scafidi, Catina M., and Anthony P. Curatola. "ETIA of 2005 and New Energy-Efficient Appliances." Strategic Finance. V. 87, June 2006. Montvale: pp. 16-18.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

Sutherland, Ronald J. "Energy Efficiency or the Efficient Use of Energy Resources." Energy Sources, v. 16, 1994. pp. 257-268.

___. "The Economics of Energy Conservation Policy." Energy Policy, v. 24. April 1996, pp. 361-370.

U.S. Department of Energy. Lawrence Berkeley National Laboratory. "Energy Efficiency, Market Failures, and Government Policy." Levine, Mark D., et al. March 1994.

Young, Denise. "When Do Energy-Efficient Appliances Generate Energy Savings? Evidence from Canada." Energy Policy, v. 36. January 2008. pp.157-173.

To qualify for the tax credit, eligible property must be installed in the United States in a dwelling used as a residence by the taxpayer. For fuel cell power plants to qualify, they must be installed in connection with the taxpayer's principal residence.

The tax credit is nonrefundable, but unused credits may be carried forward to offset future tax liability. The credit may also be claimed against the alternative minimum tax.

The credit is available for property placed in service through December 31, 2016.

Residential installed solar photovoltaics (PV) capacity doubled between 2008 and 2009. The large increase in solar PV installations between 2008 and 2009 may be partially attributable to the removal of the $2000 cap previously associated with the tax credit under § 25D. The removal of the $2000 cap, however, was not associated with a dramatic increase in solar water- and space-heating capacity.

Residential energy efficiency tax credits are disproportionately claimed by higher-income households. In 2008, 228,000 taxpayers claimed the § 25D residential energy-efficient property credit. The average credit received was $966. Nearly 72% of those claiming credits in 2008 had an adjusted gross income (AGI) above $50,000. Of all taxpayers, approximately 35% had an AGI in excess of $50,000 in 2008.

The credit for residential energy efficient property was extended through the end of 2008 by the Tax Relief and Healthcare Act of 2006 (P.L. 109-432). The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) extended the credits again, through December 31, 2016, and added small wind and geothermal heat pumps to the list of eligible property. P.L. 110-343 also included provisions allowing the credit to be claimed against the alternative minimum tax (AMT). The American Recovery and Reinvestment Act of 2009 (P.L. 111-5) removed the credit caps associated with various technologies (except for the limits associated with fuel cells) for property placed in service after 2008. The Recovery Act also removed credit limitations previously placed on projects receiving subsidized energy financing.

Enhancing residential energy efficiency is consistent with the long-term energy policy goals of reducing energy consumption, increasing energy security, and addressing environmental concerns. Policies designed to promote residential energy efficiency are consistent with these objectives.

The economic efficiency of a tax incentive can be evaluated based on how much additional investment is generated by the incentive. If, in this case, the tax credit goes to consumers that would have invested in energy efficient property without the tax credit, the tax credit would be a windfall benefit to the taxpayer, and not result in additional energy efficiency.

Clinch, J. Peter, and John D. Healy. "Cost-Benefit Analysis of Domestic Energy Efficiency." Energy Policy, v. 29. January 2000. pp.113-124.

Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17. August 1989, pp. 397-406.

Gillingham, Kenneth, Richard G Newell, and Karen Palmer. "Energy Efficiency Economics and Policy," Annual Review of Resource Economics, v. 1. June 2009. pp. 597-620.

Hassett, Kevin A., and Gilbert E. Metcalf. "Energy Conservation Investment: Do Consumers Discount the Future Correctly?" Energy Policy, v. 21. June 1993, pp. 710-716.

Hassett, Kevin A., and Gilbert E. Metcalf. "Energy Tax Credits and Residential Conservation Investment: Evidence From Panel Data," Journal of Public Economics, v. 57. 1995. pp. 201 - 217.

Howarth, Richard B., and Bo Anderson. "Market Barriers to Energy Efficiency." Energy Economics, October, 1993. pp. 262-292.

Internal Revenue Service (IRS), Statistics of Income (SOI), 2009 and IRS SOI Bulletin, Winter 2010.

Metcalf, Gilbert E. "Economics and Rational Conservation Policy." Energy Policy, v. 22. October 1994, pp. 819-825.

Metcalf, Gilbert E. and Kevin A. Hassett, "Measuring the Energy Savings from Home Improvement Investments: Evidence From Monthly Billing Data," The Review of Economics and Statistics, v. 81. August 1999. pp. 516-528.

Pimental, D., A. Pleasant, et al. "U.S. Energy Conservation and Efficiency: Benefits and Costs." Energy, Development, and Sustainability. v. 6, September 2004. pp. 279-306.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

Sherwood, Larry. U.S. Solar Market Trends 2009. Interstate Renewable Energy Council. July 2010.

Stern, Paul C. "Blind Spots in Policy Analysis: What Economics Doesn't Say About Energy Use." Journal of Policy Analysis and Management, v.5. April 1986, pp. 200-227.

Sutherland, Ronald J. "Energy Efficiency or the Efficient Use of Energy Resources." Energy Sources, v. 16, 1996. pp. 257-268.

Sutherland, Ronald J. "The Economics of Energy Conservation Policy." Energy Policy, v. 24. April 1996, pp. 361-370.

Qualifying energy efficiency improvements include certain improvements to a building's envelope; heating, cooling, and water-heating equipment; and other energy efficiency property. Building envelope components may include qualifying energy-efficient property such as insulation, exterior windows and doors, metal roofs designed to reduce heat gain, and asphalt roofs with cooling granules. For building envelope components, labor costs are not eligible for a tax credit.

Eligible heating, cooling, and water-heating equipment includes natural gas, propane, or hot water boilers with an annual fuel utilization efficiency (AFUE) rate of at least 95. Qualified natural gas, propane, or oil furnaces are those with an AFUE rate of at least 95. Electric heat pumps may qualify if they achieve the highest efficiency tier of Consortium for Energy Efficiency, as in effect on January 1, 2009. Electric heat pump water heaters may qualify if they have an energy factor of at least 2.0. Natural gas, propane, or oil water heaters with an energy factor of 0.82 or a thermal efficient of at least 90% also qualify. For a central air conditioner to qualify, it must have at least the highest efficiency tier as established by the Consortium for Energy Efficiency as in effect on January 1, 2009. Biomass fuel stoves and water heaters may also qualify. Finally, advanced main air circulating fans with an annual electricity use of no more than 2% of the total annual energy use of a furnace may also qualify for the tax credit. For heating, cooling, and water-heating equipment, labor and installation costs may be included as qualified expenditures.

In 2011, the allowable credit is limited for certain qualifying property. The tax credit for advanced main air circulating fans may not exceed $50. The credit limit for qualified natural gas, propane, or oil furnaces or hot water boilers is $150. The tax credit for each qualifying item of energy efficient property is $300. The tax credit for windows is limited to $200.

To be eligible for the credit, energy efficiency improvements must be made to property located in the United States serving as the taxpayer's primary residence. No credits are available for property placed in service after December 31, 2011.

The tax credit amount for residential energy property expenditures was fixed according to each type of property. Advanced main air circulating fans were eligible for a $50 credit, qualified natural gas, propane, or oil furnaces or hot water heaters were eligible for $150 credit, and qualifying electric heat pump water heaters, electric heat pumps, geothermal heat pumps, central air conditioners, and natural gas, propane or oil water heaters were eligible for a $300 credit. Once again, the maximum credit that could be claimed during the 2006 and 2007 tax years, combined, for any and all improvements under IRC § 25C, for each dwelling was $500. The tax credit was allowed to expire after 2007 and was not available in the 2008 tax year.

The passage of the Emergency Economic Stabilization Act of 2008 (EESA; P.L. 110-343) reinstated and modified the tax credit for nonbusiness energy property under IRC § 25C for the 2009 tax year. EESA also added biomass fuel stoves to the list of property eligible for a $300 credit. Geothermal heat pumps were removed from the list of eligible property under IRC § 25C but were added to the list of eligible property under IRC § 25D (discussed elsewhere in this compendium). Before any claims for the credit could be made for the 2009 tax year, the American Recovery and Reinvestment Act of 2009 (ARRA; P.L. 111-5) again changed the tax credit for nonbusiness energy property provided under IRC § 25C.

While ARRA did not introduce additional tax credits for energy efficient home improvements, ARRA expanded upon the credits first made available by EPACT and extended by EESA in a number of ways. For improvements made to a building's envelope, ARRA increased the credit rate to 30% of qualified expenditures. The credit for other noncommercial energy property also became 30% of expenditures, rather than making property subject to fixed credit amounts. ARRA also significantly increased the maximum credit amount, to $1,500 combined for the 2009 and 2010 tax years. ARRA also changed the qualifying standards for various types of energy property.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312) extended the IRC § 25C tax credits for residential energy efficient property through 2011, but reduced the credit amounts to pre-2009 levels. P.L. 111-312 also reinstated the rule that expenditures made from subsidized energy financing are not qualified expenditures, increased certain efficiency standards for boilers and furnaces, and modified the efficiency standards for windows and doors to be consistent with Energy Star criteria.

Residential energy use for heating and cooling constitutes a significant fraction of total U.S. energy consumption. Some believe that residential efficiency improvements are the "low hanging fruit" when it comes to enhancing overall energy efficiency and reducing the nation's energy use. Congress enacted the residential energy efficiency tax credits in 2005 in response to the belief that many existing homes were not adequately insulated, and generally inefficient. The credits were expanded and extended as Congress continued to believe that residential energy efficiency represented an opportunity for cost-effective energy consumption reductions.

There are additional market barriers that may prevent investment in residential energy efficiency, and may help explain the so-called "energy paradox." The energy paradox describes the observation that individuals oftentimes pass on energy efficiency investments that have very high expected rates of return. One possible barrier to energy-efficient investments is the high first cost associated with such investments. If consumers are unable to obtain credit, or if there are credit market failures, the result may be an underinvestment in energy efficiency. Other barriers to energy efficiency investments include a lack of information about energy efficiency options or behavioral issues that lead consumers to choose inefficient technologies, as those technologies are what is most familiar to the consumer. While these market barriers may explain low levels of energy efficient product adoption, they do not necessitate a tax policy solution.

The economic efficiency of a tax inventive can be evaluated based on how much additional investment is generated by the incentive. If, in this case, the tax credit goes to consumers that would have invested in energy-efficient property without the tax credit, the tax credit would be a windfall benefit to the taxpayer, and not result in additional energy efficiency. Hasset and Metcalf (1995) present evidence that tax credits for energy efficiency do increase the probability that a taxpayer makes an energy efficiency investment. While it appears that tax credits for residential energy efficiency may lead to some additional investments, it is not clear how much of the tax credit rewards taxpayers who would have made investments without the tax incentive.

Clinch, J. Peter, and John D. Healy. "Cost-Benefit Analysis of Domestic Energy Efficiency." Energy Policy, v. 29. January 2000. pp.113-124.

Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17. August 1989, pp. 397-406.

Gillingham, Kenneth, Richard G Newell, and Karen Palmer. "Energy Efficiency Economics and Policy," Annual Review of Resource Economics, v. 1. June 2009. pp. 597-620.

Hassett, Kevin A., and Gilbert E. Metcalf. "Energy Conservation Investment: Do Consumers Discount the Future Correctly?" Energy Policy, v. 21. June 1993, pp. 710-716.

Hassett, Kevin A., and Gilbert E. Metcalf. "Energy Tax Credits and Residential Conservation Investment: Evidence From Panel Data," Journal of Public Economics, v. 57. 1995. pp. 201 - 217.

Howarth, Richard B., and Bo Anderson. "Market Barriers to Energy Efficiency." Energy Economics, October, 1993. pp. 262-292.

Internal Revenue Service (IRS), Statistics of Income (SOI), 2009 and IRS SOI Bulletin, Winter 2010.

Metcalf, Gilbert E. "Economics and Rational Conservation Policy." Energy Policy, v. 22. October 1994, pp. 819-825.

Pimental, D., A. Pleasant, et al. "U.S. Energy Conservation and Efficiency: Benefits and Costs." Energy, Development, and Sustainability. v. 6, September 2004. pp. 279-306.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

Stern, Paul C. "Blind Spots in Policy Analysis: What Economics Doesn't Say About Energy Use." Journal of Policy Analysis and Management, v.5. April 1986, pp. 200-227.

Sutherland, Ronald J. "Energy Efficiency or the Efficient Use of Energy Resources." Energy Sources, v. 16, 1996. pp. 257-268.

Sutherland, Ronald J. "The Economics of Energy Conservation Policy." Energy Policy, v. 24. April 1996, pp. 361-370.

The alcohol mixture credit is typically claimed as an instant excise tax credit. Excess credits may be claimed as an income tax credit or received as a direct payment. For 90/10 mixtures (90% gasoline, 10% ethanol) the excise tax credit is 4.5¢ per gallon of the blend. The current 4.5¢ credit, which is equivalent to 45¢ per gallon of ethanol, is generally claimed up front on sales of gasoline loaded onto tanker trucks. Blenders prefer to claim the excise tax credit, rather than the income tax credit, because its benefits accrue immediately upon the purchase of the fuels for blending rather than when the tax return is filed. Also, the excise tax credit is not treated as taxable income, whereas the income tax credits have to be reported as taxable income, and are thus taxed.

For small ethanol producers, current law also provides for a production tax credit in the amount of 10¢ per gallon of ethanol produced and sold for use as a transportation fuel. This credit, called the "small ethanol producer credit," is limited to the first 15 million gallons of annual alcohol production for each small producer, defined as one with an annual production capacity of under 60 million gallons. This is in addition to any blender's tax credit claimed on the same fuel. A cooperative may pass through the small ethanol producer credit to its patrons. The small ethanol credit is available only as an income tax credit, not as an excise tax credit or direct payment.

Biodiesel is eligible for tax credits, similar in structure to those provided for ethanol. Essentially, there are three tax credits for biodisel: a credit for biodiesel fuel mixtures (blends of biodiesel and petroleum diesel), a credit for unblended (pure) biodiesel either used or sold at retail by the taxpayer, and a small biodiesel producer credit. Each gallon of biodiesel, including agri-biodiesel (biodiesel made from virgin oils), may be eligible for a $1.00 tax credit. The mixtures tax credit may be claimed as an instant excise tax credit against the 24.4¢ per gallon tax on diesel blends. The mixtures credit is proportionate to the fraction of biodiesel in the mixture -- a blend of 80% diesel with 20% virgin biodiesel would qualify for a 20¢ per-gallon tax credit against the 24.4¢ tax.

Additionally, an eligible small agri-biodiesel producer credit of 10¢ is available for each gallon of "qualified agri-biodiesel production." An eligible "small agri-biodiesel producer" is defined as any person who, at all times during the taxable year, has annual productive capacity for agri-biodiesel not in excess of 60,000,000 gallons. The term "qualified agri-biodiesel production" would be defined as any agri-biodiesel, not to exceed 15,000,000 gallons, that: (1) the producer sells during the taxable year for use by the purchaser (a) in the production of a qualified biodiesel mixture in the purchaser's trade or business, (b) as a fuel in a trade or business, or (c) for sale at retail to another person who places the agri-biodiesel in that person's fuel tank; or (2) the producer uses or sells for any of such purposes. Aggregation rules are provided for determining the 15,000,000 and 60,000,000 gallon limits, for applying the limits to passthrough entities, and for allocating productive capacity among multiple persons with interests in one facility, and authorize anti-abuse regulations. The eligible small agri-biodiesel producer credit is effective for taxable years ending after August 8, 2005 and sunsets after December 31, 2011.

Beginning on January 1, 2009, a new provision was introduced under IRC § 40: the cellulosic biofuel producer credit. This credit is a nonrefundable income tax credit for each gallon of qualified cellulosic fuel production of the producer for the taxable year. The amount of the credit per gallon is $1.01, except in the case of cellulosic biofuel that is alcohol. In the case of cellulosic biofuel that is alcohol, the $1.01 credit amount is reduced by (1) the credit amount applicable for such alcohol under the alcohol mixture credit as in effect at the time cellulosic biofuel is produced and (2) in the case of cellulosic biofuel that is ethanol, the credit amount for small ethanol producers as in effect at the time the cellulosic biofuel fuel is produced. The reduction applies regardless of whether the producer claims the alcohol mixture credit or small ethanol producer credit with respect to the cellulosic alcohol.

Qualified cellulosic biofuel production is any cellulosic biofuel which is produced by the taxpayer and which is sold by the taxpayer to another person for use by such other person in the production of a qualified biofuel fuel mixture in such person's trade or business (other than casual off-farm production), for use by such other person as a fuel in a trade or business, or who sells such biofuel at retail to another person and places such biofuel in the fuel tank of such other person, or is used by the producer for any purpose described in (a), (b), or (c) above.

In 2009, anticipated revenue losses associated with the alcohol fuel mixture credit and the cellulosic biofuel producer credit increased substantially as the paper industry began to claim tax credits for "black liquor." Black liquor is a byproduct of the paper pulping process that is used as a fuel to power paper manufacturing facilities. In 2009, paper manufacturers were able to claim the alcohol fuel mixture credit (IRC § 6426) for using black liquor. In June 2009, the IRS ruled that when the alcohol fuel mixture credit expired at the end of 2009, black liquor would qualify for the cellulosic biofuel producer credit (IRC § 40). When the alcohol fuel mixture tax credit was introduced, it was expected to result in revenue losses of $100 million annually. In the first half of 2009, $2.5 billion in tax credits were claimed by the paper industry for use of black liquor. Under the Health Care and Education Reconciliation Act of 2010 (P.L. 111-152), black liquor can no longer qualify for the cellulosic biofuel producer credit.

Production of ethanol as a motor fuel, most of which is a gasoline blend, has increased in recent decades. In 1979, approximately 40 million gallons were produced. By 2001, production had increased to 1.7 billion gallons. Production continued to increase through the 2000s, reaching 2.8 billion gallons in 2003, 3.9 billion gallons in 2005, 6.5 billion gallons in 2007, and 10.6 billion gallons in 2009. Ethanol is currently blended in 80% of the nation's gasoline.

Throughout the 1980s, 1990s, and into the 2000s, the excise tax exemption for ethanol was an important incentive for alcohol fuels. This exemption was replaced with the current tax credits in 2005 (this change is discussed below). In recent years, however, the renewable fuel standards (RFS) may have been a more important factor in promoting renewable fuels than tax incentives. The RFS was adopted in 2005 under the Energy Policy Act of 2005 (P.L. 109-58) and greatly expanded in 2007 under the Energy Security and Independence Act (P.L. 110-140). In 2009, the renewable fuels mandate required 10.5 billion gallons of ethanol (10.8 billion gallons were consumed). If mandates are driving investments in alcohol fuels and biofuels, tax incentives may provide a windfall benefit to taxpayers without resulting in additional alcohol fuel or biofuel production.

The alcohol fuels mixture credit and the pure alcohol fuels credit were enacted as part of the Crude Oil Windfall Profit Tax Act of 1980 (P.L. 96-223), at the rate of 40¢ per gallon for alcohol that was 190 proof or more, and 30¢ per gallon for alcohol between 150 and 190 proof. The credits were increased in 1982 and 1984. The Omnibus Reconciliation Act of 1990 (P.L. 101-508) reduced the credits to 54¢ and 40¢ and introduced the 10¢ per-gallon small ethanol producer credit. The Transportation Equity Act for the 21^st Century (P.L. 105-178) reduced the blender's tax credit from 54¢ to its current rate of 52¢, and to 51¢ beginning in 2005.

The American Jobs Creation Act of 2004 (P.L. 108-357) reformed the tax incentives for fuel ethanol, by, in effect, treating the tax credits as if they were payments of excise tax liability. The rationale for the restructuring was to increase revenues for the Highway Trust Fund (HTF). Consumption of fuel ethanol blends results in revenue losses to the HTF in the amount of the 5.2¢ exemption times the quantity of fuel ethanol blends used. In addition, under tax code sections enacted in 1990, 2.5¢ of the taxable portion of the tax (the 13.2¢ for 90/10 fuel ethanol blends) was retained in the general fund. Thus, in total, the HTF lost, under previous law, 7.7¢/gallon of fuel ethanol blends (5.2¢ plus 2.5¢). Under the restructured incentives, tax revenue losses accrue to the general fund, rather than the HTF. The American Jobs Creation Act of 2004 also introduced the biodiesel fuel tax credits, and allowed, for the first time, the small ethanol producer's tax credit to flow through to members of a farmers' cooperative.

The Energy Policy Act of 2005 (P.L. 109-58) made several amendments to the tax subsidies for ethanol and biodiesel fuels. First, it raised the maximum annual alcohol production capacity for an eligible small ethanol producer from 30 million gallons to 60 million gallons. The provision also modified the election by a cooperative to allocate the credit to its patrons. Second, the Energy Policy Act of 2005 added the 10¢/gallon "eligible small agri-biodiesel producer credit" to the list of credits that comprise the biodiesel fuels credit. The 2005 Energy Policy Act also permitted cooperative organizations to elect to apportion the eligible small agri-biodiesel producer credit among their patrons, and set forth the election procedure. Another provision extended the existing income tax credit, excise tax credit, and payment incentives for biodiesel (which were enacted in 2004 under the "Jobs Bill") through December 31, 2010.

The Tax Relief and Health Care Act of 2006 (P.L. 109-432) 1) reduced the excise tax on ethanol and methanol fuels derived from coal; 2) extended the 54¢/gallon tariff on imported ethanol through January 1, 2009; and 3) allowed 50% of the capital costs of cellulosic ethanol plants to be expensed, deducted in the first year. The Food, Conservation, and Energy Act of 2008, (P.L. 110-234, also known as the "farm bill"), made several changes to the tax incentives for alcohol fuels: First, it reduced the 51¢ ethanol tax credit, and 5.1¢ excise tax equivalent to 45¢ per gallon (equivalent to 4.5¢ per gallon of the 90/10 mixture) when total ethanol use (including cellulosic ethanol) reaches 7.5 billion gallons. This begins in 2009, and there is a lag of one year: a determination in 2008 would reduce the tax credits beginning in 2009. Second, the farm bill created a new, temporary cellulosic biofuels production tax credit for up to $1.01 per gallon, available through December 31, 2012. Third, it extended the tariff on imported ethanol another two years, through December 31, 2010. Finally, the farm bill reduced the fraction of an ethanol fuel mixture consisting of a denaturant, which effectively increases the fraction of a mixture which must consist of ethanol. The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) expanded the 50% expensing of ethanol plant costs to include cellulosic biofuels generally, rather than only cellulosic ethanol. The law also 1) extends the $1.00 per gallon production tax credit for biodiesel and the 10¢/gallon credit for small biodiesel producers through 2009, 2) extends the $1.00 per gallon production tax credit for diesel fuel created from biomass, 3) eliminates the current-law disparity in credit for biodiesel and agri-biodiesel, and 4) eliminates the requirement that renewable diesel fuel must be produced using a thermal depolymerization process. As a result, the credit will be available for any diesel fuel created from biomass without regard to the process used, so long as the fuel is usable as home heating oil, as a fuel in vehicles, or as aviation jet fuel. Diesel fuel created by co-processing biomass with other feedstocks (e.g., petroleum) will be eligible for the 50¢/gallon tax credit for alternative fuels. Biodiesel imported and sold for export will not be eligible for the credit effective May 15, 2008.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312) extended current income tax credits for alcohol fuels along with excise tax credits and outlay payments for fuel mixtures. Under P.L. 111-312, the production tax credit for biodiesel, the small agri-biodiesel producer credit, and the production tax credit for biodiesel from biomass were extended through December 31, 2011.

Generally, tax subsidies are an economically inefficient mechanism for addressing environmental concerns. The use of petroleum as a fuel generates negative external costs by way of pollution, congestion, and energy security concerns. Since consumers generally do not consider these negative external costs when making petroleum consumption choices, the market will result in too much petroleum consumption. If petroleum prices were increased to fully reflect these negative external costs, petroleum consumption would fall to the economically efficient level. Policymakers often choose to subsidize alternatives to pollution generating activities, rather than directly taxing the polluting activity. While subsidies divert production and consumption toward the less-polluting alternative, subsidies that promote less-polluting alternatives are less economically efficient than taxes levied directly on polluting activities. Further, subsidies that promote certain fuels can distort market decisions and lead to an inefficient allocation of resources.

The alcohol fuel mixture credit and the cellulosic biofuel producer credit also provide a lesson in the potential for unintended consequences. The alcohol fuel mixture credit was introduced in 2005 to encourage the production of fuels from certain forms of biomass, not to reward paper companies for a practice that had been used for decades.

Congressional Budget Office. Using Biofuel Tax Credits to Achieve Energy and Environmental Policy Goals. July 2010.

Consumer Reports. The Ethanol Myth. Consumers Union of U.S., Inc. October 2006.

De Gorter, Harry and David R. Just. "The Welfare Economics of an Excise-Tax Exemption for Biofuels and Interaction with Farm Subsidies." American Journal of Agricultural Economics. Vol. 91 (May 2009). pp. 477-488.

Kaplow, Doug. Biofuels -- At What Costs? Government Support for Ethanol and Biodiesel in the United States. Prepared for the Global Studies Initiative of the International Institute for Sustainable Development. October 2006.

Metcalf, Gilbert E. "Using Tax Expenditures to Achieve Energy Policy Goals." American Economic Review: Papers and Proceedings. Vol. 98 (May 2008). pp. 90-94.

Organization for Economic Co-Operation and Development. Economic Assessment of Biofuels Support Policies. 2008.

The Renewable Fuels Association. Industry Outlook: 2010. February 2010.

Schnepf, Randy and Brent D. Yacobucci. Renewable Fuel Standard (RFS): Overview and Issues. Library of Congress, Congressional Research Service Report R40155. Washington, DC: October 14, 2010.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

Sullivan, Martin A. "IRS Allows New $25 Billion Tax Break for Paper Industry," Tax Notes. October 19, 2009. pp271-272.

U.S. Department of Energy. Breaking the Biological Barriers to Cellulosic Ethanol: A Joint Research Agenda. DOE/SC-0095. June 2006.

U.S. Government Accountability Office. Biofuels: Potential Effects and Challenges of Required Increases in Production and Use. GAO-09-446. August, 2009.

U.S. General Accounting Office. Biofuels: DOE Lacks A Strategic Approach to Coordinate Increasing Production With Infrastructure Development Vehicle Needs. GAO-07-713. June 2007.

Yacobucci, Brent. Fuel Ethanol: Background and Public Policy Issues. Library of Congress, Congressional Research Service Report RL33290, Washington, DC: April 8,, 2008.

___. Biofuels Incentives: A Summary of Federal Programs. Library of Congress, Congressional Research Service Report R40110, Washington, DC: September 15, 2010.

Generally, the credit is available to the taxpayer purchasing the vehicle for use. Lessors of a vehicle subject to a lease may also qualify for the tax credit. If the vehicle is purchased or leased by a tax-exempt organization, the seller of the vehicle may be able to claim the credit so long as the seller clearly discloses the amount of the allowable credit to the purchaser. For businesses, the portion of the credit attributable to vehicles of a character subject to depreciation allowances is treated as part of the general business credit.

Hybrid Vehicles and Advanced Lean-Burn Technology Vehicles. For hybrid and advanced lean-burn technology vehicles weighing less than 8,500 pounds (i.e., for passenger cars or light trucks), the total credit consists of two components: a fuel economy credit, which ranges from $400-$2,400 depending on the rated city fuel economy of the vehicle; and a conservation credit, which ranges from $250-$1,000 depending on estimated lifetime fuel savings. The conservation credit is based on the estimated lifetime fuel savings between the two vehicles assumed to travel 120,000 miles. For both components, the comparison is made with a comparable 2002 model year standard gasoline-powered vehicle. For advanced lean-burn vehicles, the amount of the credit is adjusted to account for the different BTU content of fuel if the fuel used is not gasoline.

In the case of hybrids and advanced lean-burn vehicles, there is a cumulative 60,000 limit imposed on the number of vehicles (all models of the hybrid or lean-burn type) sold by each manufacturer that are eligible for the credit. Once the cumulative limit is reached for either technology, the credit for that manufacturer begins to phase out during the second quarter after the limit is reached. The credit is completely phased out, such that no credit is available, after the sixth quarter (four quarters after the phase-out begins). The credit is available for imported vehicles, but no credit is allowed for any vehicle used predominately outside of the United States.

Hybrid vehicles are defined as motor vehicles that draw propulsion energy from two onboard sources of stored energy: an internal combustion or heat engine using consumable fuel, and a rechargeable energy storage system. A qualifying hybrid vehicle must meet the applicable regulations under the Clean Air Act. For a vehicle with a gross vehicle weight rating of 6,000 pounds or less (passenger cars and many light trucks), the applicable emissions standards are the Bin 5 Tier II emissions standards of the Clean Air Act. For a vehicle with a gross vehicle weight rating greater than 6,000 pounds and less than or equal to 8,500 pounds, the applicable emissions standards are the Bin 8 Tier II emissions standards.

A qualifying advanced lean-burn technology motor vehicle is one that incorporates direct injection, and achieves at least 125% of the 2002 model year city fuel economy. The 2004 and later model vehicles must meet or exceed certain Environmental Protection Agency emissions standards. The emissions standards for advanced lean-burn vehicles are the same as those for hybrids.

The tax credit for hybrid vehicles is available for vehicles purchased after December 31, 2005, and before January 1, 2010. Qualifying advanced lean-burn technology motor vehicles also must be placed in service before January 1, 2011 to qualify.

Hybrids weighing more than 8,500 pounds, or so-called heavy hybrids, may also be eligible for a tax credit under section 30B. The amount of the credit for heavy hybrids is determined according the estimated increase in fuel economy, relative to a comparable vehicle powered solely by a gasoline or diesel internal combustion engine, and the incremental cost of the hybrid vehicle.

Alternative-Fuel Vehicles. The credit for new qualified alternative fuel motor vehicles is generally equal to 50% of the incremental cost of the technology, relative to a conventionally powered vehicle of the same class and size. A maximum allowable incremental cost is determined according to the vehicle's weight. A bonus credit of 30% is also provided for alternative fuel vehicles meeting certain EPA emissions standards. In all cases, the credit cannot exceed $4,000-$32,000 per vehicle, with higher credits allowed for heavier vehicles.

A new qualified alternative-fuel motor vehicle is defined as a motor vehicle that is capable of operating on an alternative fuel, defined as compressed natural gas, liquefied natural gas, liquefied petroleum gas, hydrogen, and any liquid at least 85 percent of the volume of which consists of methanol. A reduced credit is available for mixed-fuel (flexible-fuel) vehicles.

The new credit for alternative-fuel vehicles applies to purchases made between January 1, 2006, and December 31, 2010.

Fuel Cell Vehicles. The credit for fuel cell vehicles ranges from $8,000 ($4,000 if placed in service after 2009) to $40,000, depending on vehicle weight. If the new qualified fuel cell motor vehicle is a passenger automobile or light truck, the amount of the credit is increased if certain fuel efficiencies are met based on the 2002 model year city fuel economy for specified weight classes.

A new qualified fuel cell motor vehicle is defined as a motor vehicle that (1) is propelled by power derived from one or more cells that convert chemical energy into electricity by combining oxygen and hydrogen fuel that is stored on board the vehicle in any form, and (2) in the case of a passenger automobile or light truck, receives an EPA certification.

The tax credit for fuel cell vehicles applies to purchases made between January 1, 2006 and December 31, 2014.

Plug-In Electric-Drive Motor Vehicles. Section 30D provides a tax credit for qualified plug-in electric-drive motor vehicles. Beginning in 2010, a vehicle which draws propulsion from a battery with a capacity of at least 5 kWh is eligible for a base credit of $2,500. This credit increases for vehicles propelled by batteries with a higher capacity. Specifically, an additional $417 credit is awarded for each kWh of capacity above 5 kWh. The maximum credit amount is $7,500 (prior to 2010 the credit limit was higher, up to $15,000, for qualifying heavy vehicles).

The plug-in electric-drive vehicle credit is subject to a 200,000 per manufacturer limitation. The credit begins to phase out in the second quarter after the quarter in which the manufacturer reaches the limit. The credit then phases out over four quarters, such that the credit is fully phased out by the sixth quarter after the manufacturer reaches the limit. Prior to 2010, there was a 250,000 credit-eligible vehicle limit. This was replaced with the per-manufacturer limit beginning in 2010.

To the extent that a vehicle is eligible for the plug-in electric-drive vehicle credit under section 30D, the same vehicle is not eligible for a tax credit as a hybrid vehicle under section 30B.

Electric Plug-In Conversion. Taxpayers converting a motor vehicle into a qualified plug-in electric drive vehicle may qualify for a 10% credit for the cost of conversions, up to $4,000. To be eligible for the credit, a qualified plug-in traction battery module must have a capacity of at least 4 kWh. The credit is available for conversions made after February 17, 2009, and before January 1, 2012.

Some manufacturers of hybrid vehicles have reached their 60,000-per-manufacturer limit and the tax credit is no longer available. Credits for Toyota and Lexus hybrids were fully phased out as of October 2007. Credits for Honda hybrids were fully phased out as of January 2009. Credits for Ford and Mercury hybrids were fully phased out as of April 2010. Thus, a number of popular hybrid models no longer qualify for tax incentives.

It is not expected that manufacturers of plug-in electric vehicles will meet the per-manufacturer limits of 200,000 prior to the credit's expiration. As of 2010, there are only two vehicles qualifying for the plug-in electric-drive vehicle credit: Tesla's roadster and the CODA sedan. Chevy's Volt, a plug-in electric hybrid, and the Nissan Leaf, an all electric vehicle, will both qualify for the maximum $7,500 credit when they go on sale at the end of 2010. Additional models eligible for the plug-in electric-drive vehicle credit are expected to enter the marketplace in the coming tax years.

The primary goal of tax credits for alternative-technology vehicles is to reduce petroleum use. Fuel consumed in conventional motor vehicles accounts for the largest fraction of total petroleum consumption in the United States and is a leading source of dependence on foreign oil. Hybrids and alternative-technology vehicles are generally less polluting, producing significantly lower fuel cycle emissions when compared to equivalently sized conventional vehicles. While the adoption of hybrids and other alternative-technology vehicles is associated with decreased gasoline consumption and reduced CO₂ emissions, the role of tax credits in driving this change is likely to be small. Relative to rising gas prices, federal tax incentives played a small role in increasing the market share of hybrid and alternative-technology vehicles.

Congress believed that further investments in hybrids and alternative technology vehicles are necessary to transform the mode of transportation in the United States toward clean, fuel-efficient vehicles, reducing reliance on imported petroleum. In this regard, hybrids and alternative-fuel vehicles (e.g., ethanol fueled vehicles) were viewed as short-term options; advanced lean-burn and fuel cell vehicles were viewed as long-term options.

The credits initially enacted in 2005 expanded upon previous incentives for hybrid and alternative-technology vehicles. The Energy Policy Act of 1992 (P.L. 102-486) introduced a $2,000 tax deduction for passenger vehicles that run on alternative fuels (up to a $50,000 for heavy-duty trucks), and also established a tax credit for electric vehicles. Under an administrative ruling by the Internal Revenue Service (Revenue Procedure 2002-42), purchasers of model year 2000-2006 hybrid vehicles were allowed to claim the clean-fuel vehicle deduction, which expired on January 1, 2006.

There are other barriers to adoption of hybrid and other alternative-technology vehicles a tax credit might address. These include, for example, (1) the high first cost associated with hybrid and alternative-technology vehicles, (2) the volatility of fuel prices, (3) technology risks associated with new, unfamiliar and unproven technologies, and (4) a lack of complementary infrastructure (such as electric charging stations or alternative-fuel refueling facilities).

Because tax credits for hybrid and alternative vehicles reduce the price of such vehicles relative to gasoline and diesel powered alternatives, such tax credits are intended to eliminate the previously noted market failures and market barriers. A tax credit approach, however, may not be the most economically efficient mechanism for addressing the negative externalities associated with gasoline consumption and market barriers to hybrid and alternative-technology vehicle adoption. Relative to tax credits, rising gas prices have played a larger role in increasing consumer demand for hybrids and alternative-technology vehicles. Additionally, taxing gasoline directly (taxing the activity associated with the negative externality) is more economically efficient than subsidizing the purchase of select vehicles.

There are also equity concerns associated with the credits for hybrid and alternative technology vehicles. These credits tend to be claimed by higher income taxpayers. Given the evidence suggesting that tax incentives play a relatively small role in determining hybrid sales, it is likely that many of these tax credits were received by individuals who would have purchased the vehicle without the tax incentive. This would represent a windfall gain to the higher income consumers who would have purchased without the tax incentive.

Concerns surrounding windfall gains to purchasers of hybrid and alternative-technology vehicles may be exacerbated by the incidence of the tax credit. Economic theory suggest that it does not matter whether consumers or producers bear the statutory incidence of a tax incentive, since economic incidence depends on each parties' relative responsiveness to changes in price. Producers can be expected to capture some of the tax benefit through higher prices. Some empirical evidence suggests that the economic incidence of the tax credit for hybrids was split between consumers and producers. There is also evidence that suggests that consumers were able keep more of the tax credit than theory would have predicted in the hybrid market. If tax benefits are already disproportionately benefitting high-income consumers, concerns over the equity attributes of the tax incentive remain.

Diamond, David, "The Impact of Government Incentives for Hybrid-Electric Vehicles: Evidence from US States," Energy Policy, vol. 37 (2009), pp. 972-983.

Chupp, Andrew B., Katie Myles, and E. Frank Stephenson, "The Tax Incidence of Hybrid Automobile Tax Preferences," Public Finance Review, vol. 38, no. 1 (January 2010), pp. 120 - 133.

Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17 (August 1989), pp. 397-406.

Graham, R. Comparing the Benefits and Impact of Hybrid Electric Vehicle Options. EPRI Report # 1000349. July 2001.

Hahn, Robert W. "Energy Conservation: An Economic Perspective." American Enterprise Institute, October 2005.

Hassett, Kevin A., and Gilbert E. Metcalf. "Energy Conservation Investment: Do Consumers Discount the Future Correctly?" Energy Policy, v. 21. June 1993, pp. 710-716.

Heutel, Garth and Erich Muehlegger. Consumer Learning and Hybrid Vehicle Adoption. Harvard University John F. Kennedy School of Government, Working Paper no. 10-013, April 2010.

Lazzari, Salvatore. Tax Credits for Hybrid Vehicles. Library of Congress, Congressional Research Service Report RS22558. Washington, DC: February 7, 2008.

Pimental, D., and A. Pleasant, et al. "U.S. Energy Conservation and Efficiency." Energy, Development, and Sustainability. v. 6, September 2004. pp. 279-306.

Sallee, James M., "The Surprising Incidence of Tax Credits for the Toyota Prius," American Economic Journal: Economic Policy (forthcoming).

Sallee, James M., "The Taxation of Fuel Economy," paper presented at the National Bureau of Economic Research Tax Policy and the Economy Conference, Washington, DC, September 23, 2010.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

Sutherland, Ronald J. "Energy Efficiency or the Efficient Use of Energy Resources." Energy Sources, v. 16, 1994. pp. 257-268.

Sutherland, Ronald J. "The Economics of Energy Conservation Policy." Energy Policy, v. 24. April 1996, pp. 361-370.

U.S. Department of Energy. TAFV Alternative Fuels and Vehicle Choice Model Documentation. Prepared for Oak Ridge National Laboratory (ORNL/TM-2001/134), by David L. Greene. July, 2001.

U.S. Department of the Treasury. Internal Revenue Service. IRS News Release: IR-2006-145. September 20, 2006.

U.S. Department of the Treasury. Internal Revenue Service. IRS Notice: 2006-78. Cumulative Bulletin 2006-41. October 10, 2006.

U.S. Department of the Treasury. Internal Revenue Service. IRS News Release: IR-2008-113 on Vehicles Certified as Qualified Advanced Lean-Burn Technology Vehicles. October 6, 2008.

Yacobucci, Brent. Alternative Fuels and Advanced Technology Vehicles: Issues in Congress. Library of Congress, Congressional Research Service Report R40168. Washington, DC: September 22, 2010.

__. Advanced Vehicle Technologies: Energy, Environment, and Developmental Issues. Library of Congress, Congressional Research Service Report RL30484. Washington, DC: December 6, 2007.

__. Tax Incentives for Alternative and Advanced Technology Vehicles. Library of Congress, Congressional Research Service Report RS22351. Washington, DC: December 19, 2005.

Nine tertiary recovery methods listed by the Department of Energy in section 212.78(c) of its June 1979 regulations qualify for the tax credit: miscible fluid displacement, steam-drive injection, micro-emulsion flooding, in-situ combustion, polymer-augmented water flooding, cyclic steam injection, alkaline (or caustic) flooding, carbonated water flooding, and immiscible carbon dioxide (CO) gas displacement. Another technique, immiscible non-hydrocarbon gas displacement, was added later.

Qualifying EOR costs include the following costs, which are associated with an EOR project: 1) the costs of tangible equipment -- equipment that would otherwise qualify for depreciation; 2) intangible drilling and development costs (i.e., labor, supplies and repairs); and 3) the costs of the injectants. For purposes of the credit, the costs of the injectants include expenditures related to the use of a tertiary injectant as well as expenditures related to the acquisition (whether produced or acquired by the purchaser) of the tertiary injectant. The project must be located in the United States, and involve the application of sound engineering principles (as certified by a petroleum engineer).

Effective January 1, 2005, the cost of constructing a natural gas processing plant in the Alaska North Slope qualifies for the 15% EOR credit. The plant must be capable of processing at least 2 trillion Btu's of Alaskan natural gas into the natural gas pipeline system every day, and must produce carbon dioxide for reinjection into a producing oil or gas field.

The EOR credit is allowable provided that the average wellhead price of crude oil (using West Texas Intermediate as the reference) in the year before credit is claimed, is below the statutorily established threshold price of $28 (as adjusted for inflation since 1990), in the year the credit is claimed. The EOR credit is phased out over a $6 range, proportionately as the average wellhead price -- this is referred to as the reference price -- rises from the inflation-adjusted threshold price plus $6/barrel. Thus, had the price of West Texas intermediate oil been above $36.27 (when the phase-out range would have been $36.27-$42.27), the EOR credit for 2004 would have been reduced by the proportion this excess represented to $6. To illustrate, had oil prices averaged $39.27/barrel in 2003, the EOR credit would have been reduced by 50% [($39.27 - $36.27)/$6]. For 2007, average wellhead oil price for oil at $66.52, and above $41.06 ($28 times the inflation adjustment factor of 1.4222 for 2007), the EOR credit is fully phased out in 2010.

The EOR credit is nonrefundable, which means that it is limited to the amount of a taxpayer's regular tax liability. In addition, because the EOR credit is claimed as part of the general business credit, it is also subject to those limits, which generally reduce the economic value of the tax credit. Thus, the EOR credit may not be greater than a taxpayer's net income tax in excess of 25% of net regular tax liability above $25,000, or the tentative minimum tax. The cost of the property that may otherwise be deducted as depreciation, depletion, or amortization (as the case may be) is reduced by the amount of the credit. Alternative fuel production credits attributable to the property are also reduced by the EOR credit. Finally, the EOR credit cannot be claimed against the alternative minimum tax.

U.S. production of oil by EOR methods has nearly doubled over the last 20 years, growing from about 450,000 barrels per day to nearly 800,000 barrels per day in 2003. At that level, EOR production comprises about 13% of total domestic production. While much of that output uses thermal techniques, the use of CO2 injection processes is projected to increase sharply, according to the U.S. Department of Energy: from 350,000 barrels per day in 2006, to 1.3 million barrels per day in 2030. The CO2 sequestration option for reducing global warming -- collecting the CO2 at its source and either storing it or using it to recover EOR oil -- may further increase oil production by EOR techniques. The smaller percentage decline in EOR oil output relative to conventional oil means that EOR oil output will grow somewhat over the next 10 years as a fraction of total domestic production. It is estimated, however, that nearly 400 billion barrels of oil (nearly half of the estimated total oil reserves in place and more than double cumulative U.S. production since the first oil well was discovered and produced) remain in abandoned reservoirs, significantly more than the known reserves of oil recoverable by conventional primary and secondary methods. Further, it is estimated that 10% of that oil consists of known recoverable reserves that could be produced with current EOR techniques if the financial incentives were there.

The incentive effect of the EOR credit should, in time, and assuming a decline in oil prices and the availability of the credit, increase the recovery of this oil, which would increase the domestic supply of oil and tend to reduce the level of imported oil. It is unlikely, however, to reverse the long-term slide in domestic production and growing dependence on imports. The United States is more dependent on imported oil, but is less vulnerable to supply disruptions and oil price shocks, due to the stockpiling of oil under the Strategic Petroleum Reserve, the diminished relative importance of petroleum in the general economy, the weakened market power of the Organization of Petroleum Exporting Countries (OPEC), and increased competitiveness in world oil markets. Increased domestic oil production lessens short-term dependency but encourages long-term dependency as domestic resources are depleted. EOR oil is more expensive to recover than conventional oil but is a relatively inexpensive way to add additional oil reserves.

Lazzari, Salvatore. Federal Tax Incentives for CO2 Pipelines. Library of Congress. Congressional Research Service. Washington, D.C. 2007.

Moritis, Guntis. "EOR Increases 24 Percent Worldwide; Claims 10 Percent of U.S. Production," Oil and Gas Journal, v. 90. April 20, 1992, pp. 51-79.

__. "EOR Weathers Low Oil Prices," Oil and Gas Journal, v. 98. March 20, 2000, pp. 39-61.

Price, John E. "Accounting for the Cost of Injection Wells and Injectants in Secondary and Tertiary Recovery Efforts," Oil and Gas Tax Quarterly, v. 37. March 1989, pp. 519-534.

McIntyre, Robert S., and T.D. Coo Nguyen. "Corporate Income Taxes in the 1990s," Institute on Taxation and Economic Policy. October 2000.

McAllister, Ted. "Impact of Unconventional Gas Technology in the Annual Energy Outlook 2000," Energy Information Administration, Annual Energy Outlook, 2000. DOE/EIA-0383 (2000), December 1999.

Norman, Chuck. "CO(2) for EOR is Plentiful But Tied to Oil Price," Oil and Gas Journal, v. 92. February 7, 1994, pp. 44-49.

Sherlock, Molly and Donald Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service, CRS Report R40999. Washington, DC: Updated 2010.

Soot, Peet M. "Tax Incentives Spur Development of Coalbed Methane," Oil and Gas Journal, v. 89. June 10, 1991, pp. 40-42.

"Special Report: Enhanced Oil Recovery -- 2002 Worldwide EOR Survey," Oil and Gas Journal, v. 100. April 15, 2002, pp. 71-83.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Crude Oil Windfall Profit Tax Act of 1980, 96th Congress, 2nd session. 1980: pp. 80-84.

U.S. Congress, Joint Committee on Taxation. Tax Expenditures for Energy Production and Conservation Hearings Before the Senate Finance Committee, 111st Congress, 1st session. Washington, DC: U.S. Government Printing Office, April 21, 2009.

U.S. Department of Energy. Energy Information Administration. Analysis of Selected Tax Provisions of the Conference Energy Bill of 2003. SR/OIF/2004-01, February 2004.

U.S. Department of Energy. Energy Information Administration. Annual Energy Outlook 2010 DOE/EIA-0383(2010), May 11, 2010. U.S. Department of Energy. Office of Fossil Energy. Enhanced Oil Recovery/CO2 Injection. October 22, 2003.

U.S. Department of the Interior. U.S. Geological Survey. The Significance of Field Growth and the Role of Enhanced Oil Recovery. U.S.G.S. Fact Sheet FS-115-00, October 2000.

Williams, Peggy. "Enhanced Oil Recovery," Oil and Gas Investor, v. 16. July 1996, pp. 22-30.

Solar equipment is defined as a system that generates electricity directly (photovoltaic systems), or that heats, cools, or provides hot water in a building. It also includes equipment that illuminates the inside of a structure using fiber-optic distributed sunlight. Solar property used for heating a swimming pool is not eligible for the solar credit.

Eligible geothermal property includes geothermal heat pumps and equipment used to produce, distribute, or use energy derived from a geothermal deposit. Electric transmission property does not qualify.

Generally, the investment tax credit (ITC), or energy credit, is available for property placed in service by December 31, 2016. For geothermal property, except geothermal heat pumps, there is no sunset date for the credit (the credit for geothermal heat pumps expires at the end of 2016). In 2017, the credit rate for solar property becomes 10%.

The energy credit is part of the general business credit. Unused credits may be carried back for one year and carried forward up to 20 years. The taxpayers basis in property eligible for the ITC must be reduced by one-half of the credit amount. For construction projects that are two or more years, credits may be claimed as construction progresses rather than at the time the property is placed in service.

Section 1603 Treasury Grants in Lieu of Tax Credits. Section 1603 of the American Recovery and Reinvestment Act of 2009 (P.L. 111-5) allows taxpayers installing ITC-eligible property to request a cash grant from the Treasury in lieu of the ITC. Grants are available for property placed in service during the 2009 or 2010 tax years. The Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010 (P.L. 111-312) extended this grant option through 2011. For projects with construction start dates in 2009 through 2011, grants may be available if the property is placed in service by the property's expiration date under the ITC. The cash grants are determined according to the ITC credit rate. As such, solar, fuel cell, small wind systems qualify for a grant equal to 30% of the basis in the property. Geothermal systems also qualify for a 30% grant (geothermal systems qualify for a 30% grant, rather than a 10% grant, since geothermal systems are PTC-eligible property). Geothermal heat pumps, microturbines, and CHP systems may be eligible for a grant equal to 10% of the property's basis.

In recent years, installations of renewable technologies have increased. Solar PV non-residential installation capacity grew rapidly between 2000 and 2008. In 2009, the growth rate of non-residential solar PV installation capacity slowed. Uncertainty surrounding the future of the ITC may have been responsible. As the ITC was set to return to 10% in 2009, developers rushed to complete installations before the end of 2008. While the 30% credit rate was ultimately extended by the Emergency Economic Stabilization Act of 2008 (P.L. 110-343), the investment climate had changed and obtaining financing for new projects was difficult. The American Recovery and Reinvestment Act of 2009 (P.L. 111-5) attempted to address financing difficulties by allowing taxpayers eligible for the ITC to receive a grant from the Treasury in lieu of tax payments. As of August 2010, 830 solar electricity projects had received nearly $328 million in Treasury grants. Another 82 solar thermal projects had been awarded an additional $2 million in Treasury grants. While the majority of projects funded under the Section 1603 grants programs are solar, these projects represent a relatively small share of total grant spending (6%) as solar installations tend to be smaller and less expensive than other grant-eligible technologies.

The geothermal heat pump industry has also experienced rapid growth in recent years. Between 2007 and 2008 alone, geothermal heat pump capacity shipped increased 43%, to 416, 105 tons. Approximately half of all geothermal heat pump shipments were for the commercial sector.

The 1980 Windfall Profit Tax Act extended the credit for solar and geothermal equipment, raised their credit rates from 10% to 15%, repealed the refundability of the credit for solar and wind energy equipment, and extended the credit beyond 1985 for certain long-term projects. The Tax Reform Act of 1986 (P.L. 99-514) retroactively extended the credits for solar, geothermal, ocean thermal, and biomass equipment through 1988, at lower rates.

The Miscellaneous Revenue Act of 1988 (P.L. 100-647) extended the solar, geothermal, and biomass credits at their 1988 rates -- ocean thermal was not extended. The Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239) extended the credits for solar and geothermal and reinstated the credit for ocean thermal equipment, through December 31, 1991. The credit for biomass equipment was not extended. The Tax Extension Act of 1991 (P.L. 102-227) extended the credits for solar and geothermal through June 30, 1992. The Energy Policy Act of 1992 (P.L. 102-486) made the credits for solar and geothermal equipment permanent.

Thus, the credits for solar and geothermal equipment are what remained of the business energy tax credits enacted under the Energy Tax Act of 1978. Prior to the Energy Policy Act of 2005, and with the reforestation credit and the rehabilitation credit, they were the sole exceptions to the repeal of the investment tax credits under the Tax Reform Act of 1986. The Energy Policy Act of 2005 raised the credit rate for solar equipment from 10% to 30%, and expanded it to fiber optic distributed sunlighting, fuel cells, and microturbines. The Tax Relief and Health Care Act of 2006 (P.L. 109-432) extended the 30% tax credit for solar and the 10% credit for microturbines by one year through 2008. The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) extends the 30% investment tax credit for solar energy property and qualified fuel cell property, as well as the 10% investment tax credit for micro turbines, for eight years (through 12-31-2016). Under the Energy Policy Act of 2005 (P.L. 109-58), the 30% rate for solar was temporary and would have reverted back to the permanent rate of 10% on January 1, 2009. P.L. 110-343 adds small commercial wind, geothermal heat pumps, and combined heat and power systems (at a 10% credit rate) as a category of qualified investment. That legislation also increases the $500 per half kilowatt of capacity cap for qualified fuel cells to $1,500 per half kilowatt and allows these credits to be used to offset the alternative minimum tax (AMT).

The American Recovery and Reinvestment Act of 2009 (P.L. 111-5) made additional modifications to the ITC. First, credit limitations for entities receiving subsidized financing were removed. Second, dollar limitations for specific types of property were eliminated. Previously, the 30% credit for small wind property was capped at $4,000, the 30% credit for solar water heating property had been capped at $2,000, and the 10% credit for geothermal heat pumps had been capped at $2,000.

Investment tax credits for renewable energy technologies may also be economically inefficient if such credits fail to directly lead users to adopt such technologies. If taxpayers would have installed solar panels, or other renewable technologies, without the tax credit, the tax credit provides a windfall benefit to the taxpayer without increasing installed renewable generation capacity.

Generally, investment tax incentives create economic distortions by directing investment and resources toward specific technologies that otherwise might not be economically viable. The ITC for renewable energy specifies eligible technologies and credit rates. If instead, the price of oil or other conventional energy resources were to increase, the market would select the most viable renewable or other energy alternatives.

Finally, high capital costs for renewable and alternative energy technologies and market uncertainty are not energy market failures. Nonetheless, high costs and technology uncertainty do act as barriers to the development and commercialization of renewable technologies. The incentive effects of the ITC might lead to technological innovations that reduce the cost of subsidized technologies, ultimately making such technologies more competitive.

Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17. August 1989, pp. 397-406.

Hasset, Kevin A., and Gilbert E. Metcalf. "The Whys and Hows of Energy Taxes." Issues in Science and Technology. Winter 2008, v. 24, pp. 45-51

Hoerner, J. Andrew and Avery P. Gilbert. Assessing Tax Incentives for Clean Energy Technologies: A Survey of Experts Approach. Center for a Sustainable Economy. Washington, DC: April 2000.

Inyan, S., L. Sunganthi, and Anand A. Samuel. "Energy Models for Commercial Energy Production and Substitution of Renewable Energy Resources." Energy Policy, v.34. November 2006, pp. 26-40.

Kobos, Peter H., Jon D. Erickson, and Thomas E. Drennen. "Technological Learning and Renewable Energy Costs: Implications for US Renewable Energy Policy." Energy Policy, v. 34, September 2006, pp.16-45.

Sav, G. Thomas. "Tax Incentives for Innovative Energy Sources: Extensions of E-K Complementarity," Public Finance Quarterly, v. 15. October 1987, pp. 417-427.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

Sherwood, Larry. U.S. Solar Market Trends 2009. Interstate Renewable Energy Council. July 2010.

U.S. Congress. House Committee on Ways and Means. Tax Credits for Electricity Production from Renewable Energy Resources. Hearing Before the Subcommittee on Select Revenue Measures, 109th Congress, 1st session, May 24, 2005.

--. Senate Committee on Energy and Natural Resources. Power Generation Resource Incentives and Diversity. Hearings, 109th Congress, 1st session. Washington, DC: U.S. Government Printing Office, March 8, 2005.

U.S. Department of Energy. Energy Information Administration. Geothermal Heat Pump Manufacturing Activities. November 2009.

Clean fuel refueling property is generally any tangible equipment (such as a pump) used to dispense a fuel into a vehicle's tank. Qualifying property includes fuel storage and dispensing units and electric vehicle recharging equipment. A clean fuel is defined as any fuel at least 85% of the volume of which consists of ethanol (E85) or methanol (M85), natural gas, compressed natural gas (CNG), liquefied natural gas, liquefied petroleum gas, and hydrogen, or any mixture of biodiesel and diesel fuel, determined without regard to any use of kerosene and containing at least 20% biodiesel. The taxpayer's basis in the property is reduced by the amount of the credit. No credit is available for property used outside the United States.

Only the portion of the credit attributable to property subject to an allowance for depreciation would be treated as a portion of the general business credit; the remainder of the credit would be allowable to the extent of the excess of the regular tax (reduced by certain other credits) over the alternative minimum tax for the year. This credit is effective for property placed in service after December 31, 2005, and in the case of property relating to hydrogen, before January 1, 2015; and in the case of any other property, before January 1, 2012.

To the extent that the credits are effective in increasing the supply of alternative fuels, and substitute for petroleum products (gasoline and diesel fuel), there is a decline in petroleum use and importation. Fuel consumed in conventional motor vehicles accounts for the largest fraction of total petroleum consumption and is a leading source of dependence on foreign oil. Alternative fuel vehicles are also generally less polluting, producing significantly lower total fuel cycle emissions when compared to equivalently sized conventional vehicles.

As of September 2010, approximately 2,200 of the nation's 120,000 fuel retailers dispense E85. Additionally, there are approximately 2,619 propane fuel stations, 842 compressed natural gas fuel stations, 595 electric charging stations, 58 hydrogen fuel stations, and 40 liquified natural gas stations. While the number of alternative fuel stations is increasing, such stations are represent a small share of fuel stations generally. The 30% tax credit for alternative fuel property at refueling stations could address this shortage and market problem to the development of alternative fuels. Given the current state of development of E85 and other alternative fuel refueling infrastructure required for their use, and given the many technological and cost barriers to this development, the tax credit might stimulate additional investment. Greater (and more convenient) supply of alternative fuels could then reduce their price, stimulate demand for alternative fuels, and reduce petroleum consumption and importation.

From an economic perspective, however, allowing special tax credits for selected technologies distorts the allocation of resources, and may create economic inefficiencies. Tax credits encourage investments in high cost technologies, ones that would not otherwise be economical at current and expected prices and rates of return. Economic theory suggests that taxes on conventional fuels and conventional fuels using vehicles, such as the gas-guzzler tax of IRC section 4064, is more effective and efficient in stimulating the development of the least cost alternatives to gasoline and diesel fuel. When conventional motor fuel prices are sufficiently high, many motorists have sufficient financial incentives to purchase more fuel efficient vehicles, and vehicles fueled by alternative fuels, without tax credits.

Boes, Richard F., and G. Michael Ransom. "Clean-Fuel Vehicles and Refueling Property in the United States Tax Code." Logistics and Transportation Review. March 1994.v.30. pp. 73-79.

Chirinko, Robert S., Steven M. Fazzarri, and Andrew P. Meyer. "How Responsive is Business Capital Formation to its User Cost? An Exploration with Micro Data." Journal of Public Economics vol. 74 (1999), pp. 53-80.

Cohen, Darryl, and Jason Cummins. A Retrospective Evaluation of the Effects of Temporary Partial Expensing. Federal Reserve Board Staff Working Paper 2006-19, April 2006.

Cordes, Joseph J. "Expensing," in the Encyclopedia of Taxation and Tax Policy, Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds (Washington: Urban Institute Press, 2005).

Cummins, Jason G., Kevin A. Hassett, and R. Glenn Hubbard, "A Reconsideration of Investment Behavior Using Tax Reforms as Natural Experiments." Brookings Papers on Economic Activity, 1994, no. 1, pp. 1-72.

Hungerford, Thomas L., and Jane G. Gravelle. Business Investment and Employment Tax Incentives to Stimulate the Economy. Library of Congress, Congressional Research Service Report R41034. Washington, DC: July 21, 2010.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

U.S. Department of Energy. TAFV Alternative Fuels and Vehicle Choice Model Documentation. Prepared for Oak Ridge National Laboratory (ORNL/TM-2001/134), by David L. Greene. July, 2001.

U.S. Department of Energy. Alternative Fueling Station Total Counts by State and Fuel Type. Energy Efficiency and Renewable Energy: Alternative Fuels and Advanced Vehicles Data Center. September 30, 2010.

"Tax Briefing: A Look at the Energy Tax Incentives Act of 2005 and the SAFE Transportation Equity Act of 2005." Taxes. September 2005. v. 83. pp. 19-27.

Yacobucci, Brent. Advanced Vehicle Technologies: Energy, Environment, and Developmental Issues. U.S. Library of Congress: Congressional Research Service. CRS Report RL30484, December 6, 2007.

The production tax credit (PTC) is generally available for 10 years, beginning on the date the facility is placed in service. Certain facilities placed in service prior to August 8, 2005 are only eligible to receive the PTC for 5 years. To qualify for the credit, wind facilities must be placed in service by December 31, 2012. The placed-in-service deadline for other technologies is December 31, 2013.

The PTC is phased out as the price of electricity exceeds a threshold level. Specifically, when the annual average contract price per kWh of electricity sold (the reference price) in the prior year exceeds 8¢ per kWh (adjusted annually for inflation), the credit phases out over a 3¢ phaseout range. Given 2010 electricity prices, the phaseout does not apply for electricity sold in 2010.

Generally, the taxpayer must own the qualified facility and sell the electricity produced to an unrelated party to qualify for the tax credit. A lessee or operator may claim the credit in lieu of the owner for qualified open-loop biomass facilities. A lessee or operator may also claim the credit for qualified closed-loop biomass facilities modified to co-fire with coal, other biomass, or with a combination of the two.

The amount that may be claimed as a PTC is reduced for projects receiving other federal tax credits, grants, tax-exempt bonds, or subsidized energy financing. In all cases, the reduction cannot exceed 50% of the otherwise allowable credit. Open-loop biomass facilities and co-fire closed-loop biomass facilities are eligible for the full credit, regardless of other credits, grants, or subsidized financing received.

Cooperatives that are eligible for the PTC may elect to pass through any portion of the credit to their patrons. To be eligible for this election, the cooperative has to be more than 50% owned by agricultural producers or entities owned by agricultural producers. The election is made on an annual basis, and is irrevocable once made.

The PTC is a component of the general business credit and is subject to the rules and limitations associated with the credit under Internal Revenue Code (IRC) § 38. General business credit limitations do not apply to the PTC during a facility's first four years of production. Under the general business credit, excess credits may be carried back for one year or carried forward for up to 20 years.

Section 1603 Grants in Lieu of Tax Credits. The American Recovery and Reinvestment Act of 2009 (P.L. 111-5), Section 1603, allows taxpayers eligible for the PTC to instead claim the renewable energy investment tax credit (ITC, discussed elsewhere in this compendium). Taxpayers unable to fully claim the ITC may apply to the Treasury to receive a cash payment in lieu of tax credits. Facilities eligible for the PTC may qualify for a grant equal to 30% of a qualifying project's eligible basis.

Grants are eligible for property that is placed in service during 2009, 2010, or 2011. Projects where construction began during 2009, 2010, or 2011 may also be eligible to receive the grant so long as the property is placed in service prior to the PTC's placed-in-service deadline (December 31, 2012 for wind property; December 31, 2013 for other eligible properties).

In 2009, renewable energy's share in total U.S. energy consumption was approximately 8%. Of that 8%, 50% was from biomass, 35% from hydroelectric, 9% from wind, 5% from geothermal, and 1% from solar.

Wind electricity generation capacity, while still a small share (approximately 1%) of total energy production, has increased in recent years. At the end of 2000, installed wind capacity was approximately 2.5 kWh. By the end of 2005, installed wind capacity had more than tripled, to 9.1 kWh. Between the end of 2005 and the end of 2009, installed wind capacity quadrupled to nearly 35 kWh. Biomass, as a share of U.S. energy production has also increased in recent years. In 2005, biomass was the source of energy for approximately 4% of U.S. energy production. By 2009, biomass's share had increased to more than 5%.

As of August, 2010 the Treasury had awarded $5.2 billion in grants under the grants in lieu of tax credit program. More than 85% of the funds awarded to date have been for wind projects that would otherwise have qualified for the PTC. The Treasury department has estimates that outlays under this program will top $15 billion, as grants will continue to be made as projects come online.

The Energy Policy Act of 2005 (P.L. 109-58) extended the placed-in-service deadline for all facilities except for solar energy facilities described in § 45(d)(4) to December 31, 2007. In addition, P.L. 109-58 extended the credit period to 10 years for all qualifying facilities placed in service after the date of enactment (August 8, 2005), eliminating the five-year credit period to which some facilities had been subject. Also, the definition of qualified energy resources that can receive the credit was expanded to include qualified hydropower production, although a qualified hydroelectric facility would be entitled to only 50% of the usual credit. The Tax Relief and Health Care Act of 2006 (P.L. 109-432) extended the placed-in-service date for facilities other than solar, qualified coal and Indian coal to the end of 2008. The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) extended the placed-in-service date through December 31, 2009 in the case of wind, and through December 31, 2010 in the case of other sources. The 2008 law also expanded the types of facilities qualifying for the credit to new biomass facilities and to those that generate electricity from marine renewables (e.g., waves and tides). The law also updated the definition of an open-loop biomass facility, the definition of a trash combustion facility, and the definition of a non-hydroelectric dam.

The American Recovery and Reinvestment Act of 2009 (P.L. 111-5) extended the placed-in-service deadline by three years for most technologies (the placed-in-service deadline for marine and hydrokinetic facilities was extended for two years). P.L. 111-5 also introduced the Section 1603 Treasury grant program, allowing facilities eligible for the PTC to instead elect to receive the ITC or apply to the Treasury for a cash grant. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312) extended the Section 1603 grant program for one year, through 2011.

In an empirical study evaluating the effect of the PTC on installed with capacity, Metcalf (2009) concludes that the PTC strongly influences installed wind capacity. Specifically, the PTC reduces the user cost of capital for wind investment. Estimates suggest that the ratio of the percentage change in investment relative to the percentage change in the user cost of capital exceeds one (in absolute value), and that much of the current investment in wind capacity can be explained by the PTC.

In addition to the PTC, additional policies may also be responsible for increased installation of renewable energy capacity. For example, renewable portfolio standards at the state level also encourage renewable generation installations. To the extent that future policies at the state and federal level mandate renewable energy use, or increase the relative price of non-renewable energy alternatives, the share of renewables in U.S. energy production is expected to increase.

Production subsidies for renewable electricity may be economically justified as producing electricity using renewable resources minimizes negative environmental impacts. There are likely market failures in electricity production using coal and natural gas, as such resources are associated with carbon emissions believed to be the cause of global climate change. As electricity producers fail to fully account for negative environmental costs when making production decisions, the market outcome results in an economically inefficient amount of energy production from polluting energy resources. While subsidizing renewable energy resources is one policy option for increasing the share of renewables in the energy portfolio, taxing polluting energy resources directly would be a more economically efficient policy option.

A further concern with subsidizing renewables as opposed to taxing polluting energy resources is the potential effect on total emissions. While subsidizing renewables increases renewables share in the overall energy portfolio, such subsidies also reduce energy prices. As energy prices fall, overall energy consumption increases, potentially mitigating gains in carbon emissions reductions.

Bolinger, Mark, Ryan Wiser, Karlynn Cory, and Ted James. PTC, ITC, or Cash Grant: An Analysis of the Choice Facing Renewable Power Projects in the United States, National Renewable Energy Laboratory NREL/TP-6A2-45359. March 2009.

Bracmort, Kelsi, Jonathan L. Ramseur, James E. McCarthy, Peter Folger, and Donald J. Marples. Methane Capture: Options for Greenhouse Gas Emission Reduction. Library of Congress, Congressional Research Service Report R40813. May 10, 2010.

Carlson, Curtis and Gilbert E. Metcalf. "Energy Tax Incentives and the Alternative Minimum Tax." National Tax Journal. September 2008, v. 61, pp. 477-492.

DeCarolis, Joseph F. and David W. Keith. "The Economics of Large-Scale Wind Power in a Carbon-Constrained World." Energy Policy, v. 34, March 2006, pp. 395-410.

Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17. August 1989, pp. 397-406.

Hutchinson, Emma, Peter W. Kennedy, and Cristina Martinez. "Subsidies for the Production of Cleaner Energy: When Do They Cause Emissions to Rise?" The B.E. Journal of Economic Analysis & Policy. vol. 10, no. 1. (2010)

Inyan, S., L. Sunganthi, and Anand A. Samuel. "Energy Models for Commercial Energy Production and Substitution of Renewable Energy Resources." Energy Policy, v.34. November 2006, pp. 26-40.

Kobos, Peter H., Jon D. Erickson, and Thomas E. Drennen. "Technological Learning and Renewable Energy Costs: Implications for US Renewable Energy Policy." Energy Policy, v. 34, September 2006, pp.16-45.

Grobman, Jeffrey H. and Janis M. Carey. "The Effect of Policy Uncertainty on Wind-Power Investment." The Journal of Energy And Development, v. 28, Autumn 2002. pp. 1-14.

Metcalf, Gilbert M. "Investment in Energy Infrastructure and the Tax Code." In Tax Policy and the Economy, Vol 24, ed. Jeffery R. Brown. pp. 1-33. The University of Chicago Press. 2010.

Owen, Anthony D. "Environmental Externalities: Market Distortions and the Economics of Renewable Energy Technologies." The Energy Journal, v. 25. Fall, 2004, pp. 127-156.

Petersilk, Thomas W. Modeling the Costs of U.S. Wind Supply. U.S. Department of Energy. Energy Information Administration. EIA/DOE-0607(99).

Price, Jeff. The Production Tax Credit: Getting More Credit Than It's Due? Public Utilities Fortnightly, May 15, 2002. p. 38-41.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

U.S. Congress. The Joint Committee on Taxation. Present Law Energy-Related Tax Provisions And Proposed Modifications Contained In The President's Fiscal Year 2011 Budget. JCX-23-10. April 12, 2010.

U.S. Department of Energy. Energy Information Administration. Renewable Energy Consumption and Electricity Preliminary Statistics 2009. August 2010.

U.S. Department of Energy. Energy Efficiency & Renewable Energy. U.S. Installed Wind Capacity and Project Locations: Installed Wind Capacity by State. February 4, 2010.

Wiser, Ryan. "Wind Power and the Production Tax Credit: An Overview of Research Results." Testimony Prepared for a Hearing On Clean Energy by the U.S. Senate Finance Committee, March 29, 2007.

Prior allocations were awarded under the Energy Policy Act of 2005 (P.L. 109-58). These first-round allocations provided $800 million for IGCC projects and $500 million for other advanced coal-based electricity generation technologies. The credit rate for IGCC projects was 20%, while the credit rate for other advanced coal-based electricity generation projects was 15%. The Energy Policy Act of 2005 also allocated $350 million for qualified gasification projects. The credit rate for qualified investments in gasification projects was 20%.

Credits are only available for projects certified by the Secretary of Treasury in consultation with the Secretary of Energy. Certifications are issued in a competitive bidding process. The Secretary is directed to give the highest priority to applicants who have a research partnership with an eligible educational institution. For funds allocated under the Energy Improvement and Extension Act of 2008, the Secretary is required to disclose the identity of taxpayers receiving credits and the amount of the award.

Under the Energy Improvement and Extension Act of 2008, the Secretary is directed to award tax credits to projects with the greatest separation and sequestration percentage of total carbon dioxide emissions. At a minimum, qualifying IGCC and other advanced coal projects must include equipment that separates and sequesters at least 65% of the project's total carbon emissions to qualify for the credit under section 48A. Qualifying gasification projects must separate and sequester at least 75% of total carbon dioxide emissions under section 48B.

While clean coal technologies may be technologically feasible, uncertainty surrounding the economic feasibility and commercial viability remains. CO₂-separation exists on a commercial scale but has not been combined with coal-fired power generation beyond the demonstration phase.

American Electric Power has added CO₂ capture to its Mountaineer Plant (New Haven, WV) as part of a validation project to demonstrate CO₂ capture and sequestration. The plant uses Alstom Power's chilled ammonia process to separate and capture CO₂ from the plant's flue gas (post-combustion). The process liquefies the CO₂ and pumps it deep below the plant site.

Three U.S. non-power facilities capture CO₂; the Coffeyville (KS) nitrogen fertilizer plant separates high purity CO₂ that has potential application in the enhanced oil recovery (EOR) market; the Eastman Chemical (Kingsport, TN) coal-gasification plant produces syngas for chemicals; and the Great Plains Coal Gasification Plant (Bismark, ND) produces synthetic natural gas and a stream of CO₂ piped to Canada for EOR.

The Energy Department has committed $1 billion in ARRA funding to build the FutureGen 2.0 project in a cooperative agreement with the FutureGen Industrial Alliance. The project is to retrofit an existing power plant (Meredosia, IL) with oxy-combustion technology and build a pipeline to Mattoon, IL, to sequester the captured CO₂.

Investment tax credits, coupled with accelerated depreciation allowances, work to reduce the after-tax capital costs to potentially attract investment. Additionally, non-tax federal incentives, such as loan guarantees and research and development (R&D) grants, promote investment in clean coal technologies. While clean coal technologies are technologically feasible, uncertainty surrounding commercial viability remains a factor inhibiting investment.

Investment tax credits promoting early adoption of certain clean coal technologies may ultimately lead to technological improvements that reduce the cost associated with investment in clean coal technologies in the future. As the cost of investment in clean coal technologies decreases, relative to other energy investments, clean coal technologies will attract additional investment. Ultimately, one goal could be for clean coal technologies to become commercially viable and for development to occur without investment tax incentives.

Coal-powered generation has been providing base load electricity at the lowest avoided cost. Inherently low-carbon natural gas, increasingly available from U.S. unconventional resources, could displace coal particularly if gas prices remain low. Legislation that would cap carbon emissions or impose a tax, which currently is uncertain, could shift new power generation more toward natural gas. The Environmental Protection Agency, however has published its final rule that sets thresholds for greenhouse gas (GHG) emissions that define when permits under the New Source Review Prevention of Significant Deterioration (PSD) and title V Operating Permit programs are required for new and existing industrial facilities. As of January 2, 2011, the best available control technology (BACT) requirement will apply to projects that increase net GHG emissions by at least 75,000 tons per year of carbon dioxide equivalent (CO₂e), but only if the project also significantly increases emissions of at least one non-GHG pollutant.

During the 2009-10 allocation round, three advanced coal projects were awarded totaling more than $1 billion in tax credits under section 48A. The entire $250 million allocated for qualified gasification projects was awarded to two projects during the 2009-10 allocation round. The remaining $241 million under section 48A is available for projects seeking allocations during the 2010-11 allocation round.

Despite some successful demonstrations, clean coal technologies are still generally economically unproven technologies in the sense that none have become commercial without significant subsidies. As a result, utilities may not have the confidence in them as compared to conventional systems. Even with reduced capital costs, the unpredictability of the clean coal systems increases risks and possibly operating and maintenance costs to the utility, which may inhibit investment. Thus, even as clean coal technologies become competitively priced, it is expected that market penetration will take some time.

Finally, while investment incentives may be an effective mechanism for promoting clean coal technologies, such subsidies are not economically efficient. Economic efficiency could be enhanced by directly taxing energy sources associated with greenhouse gas emissions, rather than subsidizing the alternative.

Folger, Peter. Carbon Capture and Sequestration (CCS). Library of Congress: Congressional Research Service Report RL33801. Washington, DC: April 13, 2010.

Fri, Robert W. "From Energy Wish Lists to Technological Realities." Issues in Science and Technology, v. 23, Fall 2006, pp. 63-69.

Metcalf, Gilbert E., "Federal Tax Policy Towards Energy," in Tax Policy and the Economy, Vol. 21, ed. James M. Poterba (Cambridge, MA: The National Bureau of Economic Research and the MIT Press, 2007), pp. 145-184.

Lackner Klaus F. "The Conundrum of Sustainable Energy: Clean Coal as One Possible Answer." Asian Economic Papers v. 4. Fall 2005.

McCarthy, James E. and Larry Parker. EPA Regulation of Greenhouse Gases: Congressional Responses and Options. Library of Congress, Congressional Research Service Report R41212. Washington, DC: June 8, 2010.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

U.S. Congress, Joint Committee on Taxation. Description and Technical Explanation of the Conference Agreement of H.R. 6, Title XIII, "The Energy Tax Incentives Act of 2005." July 27, 2005.

U.S. Congress, Joint Committee on Taxation. Present Law Energy-Related Tax Provisions and Proposed Modifications Contained in the President's Fiscal Year 2011 Budget. JCX-23-10. April 12, 2010.

U.S. Department of Energy. Energy Information Administration. Electric Power Annual With Data for 2008: Summary of Statistics for the United States. January 21, 2010.

U.S. Treasury Department. Internal Revenue Service. "Establishing Qualifying Advanced Coal Project Program." IRS Notice 2006-24. Internal Revenue Bulletin. March 13, 2006.

U.S. Treasury Department. Internal Revenue Service. "Updating Procedure for Allocating Credits Under Advanced Coal Project Program of IRC Section 48A." IRS Notice 2007-52. Internal Revenue Bulletin. June 7, 2007.

U.S. Treasury Department. Internal Revenue Service. "Credit Allocations Under Qualifying Advanced Coal Progra Section 48A." IRS Notice 2008-96. Internal Revenue Bulletin. October 8, 2008.

U.S. Treasury Department. Internal Revenue Service. "Deadline for Applications for 2007 Clean Coal Tax Credit Allocation." IRS News Release IR-2007-98. May 9, 2007.

U.S. Treasury Department. Internal Revenue Service. "Special Allocation Round for Coal-Based Integrated Gasification Combined Cycle Projects Under Section 48A." IRS Notice 2008-26. Internal Revenue Bulletin. February 13, 2008.

To qualify for the deduction, original use of the property must commence with the taxpayer. Eligible refineries are those in which a binding construction contract was entered into before January 1, 2010. In the case of self-constructed property, construction must have begun before January 1, 2010, or the refinery placed in service before January 1, 2010. Finally, the refinery must be placed in service before January 1, 2014.

Expansions made to existing refineries may be eligible for the deduction if the expansion increases the refinery's capacity by 5%, or if the expansion increases the percentage of total throughput attributable to qualified fuels such that it is greater than or equal to 25%. Additionally, all refineries claiming the deduction must meet all applicable environmental laws in effect when the property is placed in service.

As of October 3, 2008, qualified refineries include those used in the refining of liquid fuels directly from shale or tar sands. Cooperatives may elect to allocate all or part of the expensing deduction to one or more direct owners that are also cooperatives.

Since the provision is temporary, there is an incentive to speed up the investment in refinery capacity so as to qualify for the tax incentive. Nevertheless, the incentive to speed up investment is limited, because the effective price discount is small. Investing in excess capacity that would not otherwise be desirable would either leave the plant idle or provide too much output and lower prices and profits for a period of time. The latter cost should be at least as big as the cost of remaining idle. With a 5% price discount, the interest cost of carrying excess capacity or losing profits could offset the tax credit's value.

Economic theory suggests, however, that capital investments should be treated in a neutral fashion to maximize economic well being. There is no obvious reason that the price of refined liquids should be subsidized, even for a temporary time. Indeed, there are pollution, congestion, and other external negative effects of the consumption of petroleum products, that might suggest a tax rather than a subsidy.

The transitory subsidy may not have a substantial effect if the temporary subsidy causes investors to change the timing of refinery construction, as opposed to increasing refinery construction. Investors may choose to shift refinery construction projects forward in time to take advantage of the tax incentive. This could temporarily reduce the price of refined petroleum products if capacity temporarily exceeds what it would have been without the additional construction. If, however, the tax incentive only changes the timing of investments, as opposed to generating new investment, the long run prices of petroleum products will not be affected.

The effect on refinery construction is difficult to estimate. The precise effect depends on the price elasticity of investment with respect to changes in costs. To illustrate, if such an elasticity were 1, then a 5.4 percent reduction in costs could be expected to increase refinery capital by 5.4 percent, which would translate into a roughly 900 thousand barrels per day. Such an increase, if it were to materialize, would increase domestic petroleum output and reduce prices. However, recent evidence regarding a similar provision for equipment in general including refineries (bonus depreciation), which applied from 2002 through 2004, indicated that the response was not as large as hoped for and that, indeed, many firms did not appear to take advantage of the provision. In addition, most estimates of the elasticity of investment response to a permanent change in the cost of capital goods suggest a fairly low response, on the order of 0.25, although one study has found a higher response of about 0.66.

Chirinko, Robert S., Steven M. Fazzarri, and Andrew P. Meyer. "How Responsive is Business Capital Formation to its User Cost? An Exploration with Micro Data?" Journal of Public Economics vol. 74 (1999), pp. 53-80.

Cohen Darryl and Jason Cummins. A Retrospective Evaluation of the Effects of Temporary Partial Expensing. Federal Reserve Board Staff Working Paper 2006-19, April 2006.

Cordes, Joseph J. "Expensing," in the Encyclopedia of Taxation and Tax Policy, Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds (Washington: Urban Institute Press, 2005).

Energy Information Administration. Refinery Outages: Description and Potential Impact on Petroleum Product Prices. SR/OOG/2007-01.

Jason G. Cummins, Kevin A. Hassett, and R. Glen Hubbard, "A Reconsideration of Behavior Using Tax Reforms as Natural Experiments." Brookings Papers on Economic Activity, 1994, no. 1, pp. 1-72.

Guenther, Gary. Small Business Expensing Allowance: Current Status, Legislative Proposals, and Economic Effects. CRS Report RL31852, September 8, 2008.

Hungerford, Thomas L., and Jane G. Gravelle. Business Investment and Employment Tax Incentives to Stimulate the Economy. Library of Congress, Congressional Research Service Report R41034. Washington, DC: July 21, 2010.

Gravelle, Jane. Economic Effects of Taxing Capital Income. MIT Press, 1994.

Pirog, Robert. Petroleum Refining: Economic Performance and Challenges for the Future. Congressional Research Service Report RL32248. Washington: June 3, 2008.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

Sterner, Thomas. Policy Instruments for Environmental and Natural Resource Management. Resources for the Future, Washington, D.C. 2003.

U.S. Congress, Joint Committee on Taxation. Description and Technical Explanation of the Conference Agreement of H.R. 6, Title XIII, "The Energy Tax Incentives Act of 2005." July 27, 2005.

U.S. Department of the Treasury. Internal Revenue Service. Accelerated cost recovery: Recovery Classes: Class lives: Recovery Periods. Revenue Procedure 87-56, 1987-2 CB 674, (Oct. 19, 1987).

U.S. Department of the Treasury. Internal Revenue Service. Qualified refinery property: Expense Election. Proposed Regulations (REG-146895-05) (July 7, 2008).

U.S. Department of the Treasury. Internal Revenue Service Refineries: Qualified Refinery Property: Expense Election. T.D. 9412 (July 3, 2008).

There are two types of CREBs. The original CREBs offered a credit rate equal to the percentage that will permit the bonds to be issued without discount and without interest cost to the issuer. The national limit on the original CREBs was $1.2 billion, of which a maximum of $750 million could be granted to governmental bodies (the remainder would go to utilities). The bonds must have been issued before January 1, 2010. The credit rate is equal to the rate that will permit the bonds to be issued without discount and without interest cost to the issuer.

The "new" CREBs were created by the Emergency Economic Stabilization Act of 2008 (EESA P.L. 110-343) for the same purpose . The American Recovery and Reinvestment Act of 2009 (ARRA, P.L. 111-5) contained several bond provisions including an additional $1.6 billion of new CREB capacity. In contrast to the original CREBs, the credit rate on new CREBs is 70% of the credit rate offered on the old CREBs. Now, up to $2.4 billion of new CREBs can be issued before January 1, 2011. Not more than one-third of new CREBs may be allocated to any of the following: (1) public power providers, (2) governmental bodies, or (3) projects of cooperative electric companies.

EESA also created Qualified Energy Conservation Bonds (QECBs) and established a national limit of $800 million for QECBs. ARRA added $2.4 billion of additional capacity. Similar to new CREBs, these tax credit bonds offer a credit rate that is 70% of the credit rate offered on old CREBs. As with new CREBs, issuers of QECBs can choose to receive the credit by direct payment. These bonds are to be used for capital expenditures for the purposes of: (1) reducing energy consumption in publicly-owned buildings by at least 20 percent; (2) implementing green community programs; (3) rural development involving the production of the electricity from renewable energy resources; or (4) programs listed above for CREBs. Also included are expenditures on research facilities and research grants, to support research in: (1) development of cellulosic ethanol or other nonfossil fuels; (2) technologies for the capture and sequestration of carbon dioxide produced through the use of fossil fuels; (3) increasing the efficiency of existing technologies for producing nonfossil fuels; (4) automobile battery technologies and other technologies to reduce fossil fuel consumption in transportation; and (5) technologies to reduce energy use in buildings. Energy saving mass commuting facilities and demonstration projects are also included in the list of qualified purposes.

The maximum maturity of both new CREBs, old CREBs, and QECBs is that which will set the present value of the obligation to repay the principal equal to 50 percent of the face amount of the bond issue. The discount rate for the calculation is the average annual interest rate on tax-exempt bonds issued in the preceding month, having a term of at least 10 years. CREBs and QECBs are subject to arbitrage rules that require the issuer to spend 95 percent of the proceeds within five years of issuance.

In the 111th Congress, P.L. 111-147 created the direct payment option for issuers of new CREBs and QECBs and extended their issuance through 2010.

The two energy bond programs seem popular with lawmakers. CREBs were introduced in 2005 (P.L. 109-58); P.L. 109-432, enacted in December of 2006, increased the capacity amount by $400 million and extended issuance authority through 2008. P.L. 110-343 extended CREBs issuing authority through 2009 and added $800 for a "new" CREB and $800 million for QECBs; both with a smaller federal subsidy (the credit is 70 percent of the credit amount on the original CREBs). P.L. 111-5 extended CREBs through 2010, added $1.6 billion to CREB capacity, and $2.4 billion to QECB capacity.

The direct payment option that is now available for new CREBs and QECBs will likely make the bonds more attractive to a broader investor pool. With the direct payment option, the issuer pays the investor the full taxable interest rate rather than the investor receiving a federal tax credit. This change will make the bonds more attractive to non-taxed investors such as international investors and pension funds. As a result, the interest cost to the issuers may then be lower as the increased demand for the bonds would put downward pressure on interest rates.

In contrast, with tax-exempt bonds, part of the federal revenue loss is a windfall gain for some wealthy investors. The federal revenue loss, and thus benefit, is not fully captured by the issuing government.

Congressional Budget Office and the Joint Committee on Taxation, Subsidizing Infrastructure Investment with Tax-Preferred Bonds, October 2009.

Davie, Bruce, "Tax Credit Bonds for Education: New Financial Instruments and New Prospects," Proceedings of the 91st Annual Conference on Taxation, National Tax Association.

Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997, Joint Committee Print JCS-23-97, December 17, 1997, 40-41.

Joint Committee on Taxation, Present Law and Background Related to State and Local Government Bonds, Joint Committee Print JCX-14-06, March 16, 2006.

Maguire, Steven. Tax Credit Bonds: A Brief Explanation. Library of Congress, Congressional Research Service Report R40523.

__. Tax-Exempt Bonds: A Description of State and Local Government Debt. Library of Congress, Congressional Research Service Report RL30638.

Matheson, Thornton. "Qualified Zone Academy Bond Issuance and Investment: Evidence from 2004 Form 8860 Data," Statistics of Income Bulletin, Internal Revenue Service, Spring 2007, pp. 155-162.

Qualifying pollution control equipment means any technology that is installed in or on a qualifying facility to reduce air emissions of any pollutant regulated by the Environmental Protection Agency (EPA) under the Clean Air Act. This includes scrubber systems, particulate collectors and removal equipment (such as electrostatic precipitators), thermal oxidizers, vapor recovery systems, low nitric oxide burners, flare systems, bag houses, cyclones, and continuous emission monitoring systems. The pollution control equipment needs to have been placed in service after April 11, 2005.

This provision targets electric utilities, a major source of air pollution. And while older coal plants still emit a disproportionate amount of pollution among all coal-fired plants, the provision complements prior law by also targeting emissions from newer plants. The incentive will facilitate utilities in meeting a new suite of EPA mandates to reduce emissions of sulfur dioxide (SO₂), nitrous oxide (NO₂), and mercury (Hg).

The federal tax code has also provided an unintended incentive to retain -- a disincentive to scrap -- equipment and other business assets. One of these tax provisions is the 5-year amortization of pollution control equipment connected with older (pre-1976) power plants. This, and other provisions under prior law (such as accelerated depreciation and investment tax credits), and current tax penalties for premature dispositions of capital equipment under the recapture provisions and the alternative minimum tax may have provided a disincentive to invest in new equipment and other new assets.

Hsu, Shi-Ling. "What's Old Is New: The Problem with New Source Review." Regulation. Spring 2006. v. 29. Washington: pp. 36-43.

Joskow, Paul L. "Competitive Electricity Markets and Investment in New Generating Capacity," MIT Research Paper. April, 28, 2006.

Joskow, Paul L. Transmission Policy in the United States. AEI-Brookings Joint Center for Regulatory Studies. October 2004.

Joskow, Paul L. "Restructuring, Competition, and Regulatory Reform in the U.S. Electricity Sector," Journal of Economic Perspectives. Summer 1997. pp. 119-138.

Lee, Amanda I., and James Alm. "The Clean Air Act Amendments and Firm Investment in Pollution Abatement Equipment." Land Economics. August 2004. v. 80. pp. 433.

McCarthy, James E., and Larry Parker. Costs and Benefits of Clear Skies: EPA's Analysis of Multi-Pollutant Clean Air Bills. U.S. Library of Congress. Congressional Research Service Report RL33165. November 23, 2005.

Parker, Larry, and John Blodgett. Air Quality and Electricity: Enforcing New Source Review. U.S. Library of Congress. Congressional Research Service Report RL30432. January 31, 2000.

Popp, David. "Pollution Control Innovations and the Clean Air Act of 1990." Journal of Policy Analysis and Management. Fall 2003. v. 22. pp. 641.

Sherlock, Molly, Energy Tax Policy: Historical Perspective and Current Status of Energy Tax Expenditures. Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sterner, Thomas. Policy Instruments for Environmental and Natural Resource Management. Resources for the Future, Washington. 2003.

U.S. Congress, Joint Committee on Taxation. Federal Tax Issues Relating to Restructuring of the Electric Power Industry. Hearing before the Subcommittee on Long-Term Growth and Debt Reduction of the Senate Finance Committee, October 15, 1999. JCX 72-99.

The credit for qualified refined coal in 2010 is $6.27 per ton ($4.375 per ton in 1992 dollars, adjusted annually for inflation). Qualifying fuels are those that when burned, emit 20% less nitrogen oxides and either sulfur dioxide or mercury than the burning of feedstock coal or comparable coal. Further, the fuel must sell at a price that is 50% greater than that of the feedstock coal. Qualifying coal must be sold to an unrelated party. The credit phases out over an $8.75 phase-out range as the reference price of the fuel used as a feedstock exceeds 1.7 times the reference price for the fuel in 2002 (adjusted for inflation) (there is no phase out in 2010). The credit is available for facilities placed in service after October 22, 2004 and before January 1, 2012. Refined coal producers may claim the credit for 10 years after a facility is placed in service.

Refined coal facilities placed in service after 2008 do not need to sell qualified refined coal at a reference price that is at least 50% greater than the price of the feedstock coal. Instead, qualified refined coal from facilities placed in service after 2008 need to reduce emissions of either sulfur dioxide or mercury by 40% (rather than 20%) as compared to emissions released by the feedstock or comparable coal.

Producers of refined coal that is a steel industry fuel may qualify for a tax credit in 2010 of $2.87 ($2.00 adjusted annually for inflation) per barrel-of-oil equivalent (defined as 5.8 million British thermal units (btu)). Qualified facilities are those that are placed in service (or modified to use steel industry fuel) prior to January 1, 2010. The credit is available for one year after a facility is placed in service.

Between January 1, 2006 and December 31, 2012 taxpayers may claim credits for the sale of Indian coal produced in the United States by the taxpayer at a qualified Indian coal facility. The credit for 2010 is $2.20 per ton (the credit is adjusted annually for inflation).

The credits for refined coal, steel industry fuel, and Indian coal are part of the general business credit. Unused credits may be carried back one year and carried forward for up to 20 years.

As part of the PTC, refined coal facilities could qualify for the grant in lieu of tax credits authorized under Section 1603 of the American Recovery and Reinvestment Act of 2009 (P.L. 111-5). As of October 2010, no grants have been awarded to refined coal facilities.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

U.S. Congress, Joint Committee on Taxation. Present Law Energy-Related Tax Provisions and Proposed Modifications Contained in the President's Fiscal Year 2011 Budget. JCX-23-10. April 12, 2010.

U.S. Department of Energy. Analysis of Five Selected Tax Provisions of the Conference Energy Bill of 2003. Energy Information Administration. Report SR-OIAF/2004-01. February 2004.

Certified energy-efficient new homes qualifying for the tax credit have an annual heating and cooling energy consumption that is at least 50% below that of a comparable dwelling unit. The home must also be constructed in accordance with the standards of Chapter 4 of the 2003 International Energy Conservation Code, including supplements. Heating and cooling equipment efficiencies must correspond to the minimum allowed under the regulations established by the Department of Energy (DOE) pursuant to the National Appliance Energy Conservation Act of 1987 (P.L. 100-12) in effect at the time construction is completed. Finally, qualified homes must be constructed such that building envelope components contribute at least 1/5 of the 50% in required energy consumption reduction. Manufactured homes meet the requirements above, but must have an annual energy consumption that is at least 30% below that of a comparable dwelling unit. For manufactured homes, at least 1/3 of the reduction must come from building envelope components. Alternatively, Energy Star labeled homes may qualify for the tax credit.

The energy-efficient new homes tax credit is part of the general business credit. It may be carried back for one year and carried forward for 20 years.

The tax credit is not available for energy-efficient new homes acquired after December 31, 2011.

The tax credit for energy efficient new homes was introduced under the Energy Policy Act of 2005 (P.L. 109-58). Initially, the credit was set to expire at the end of 2007. The Tax Relief and Health Care Act of 2006 (P.L. 109-432) extended the credit through December 31, 2008. The Emergency Economic Stabilization Act of 2009 (P.L. 110-343) extended the deadline for claiming the credit through December 31, 2009.

There is a potential market failure in the market for energy-efficient new homes. Specifically, the potential market failure stems from the so-called principal-agent problem. In the case of a new home, builders make decisions regarding energy efficient property. Since the builders are not the ultimate users of such property, and don't realize the energy savings associated with the property, the builder may not decide to incur the higher up front costs typically associated with energy efficient property. The problem is most likely to occur if the builder is not able to recoup the costs associated with energy efficient installations when selling the home. It is not clear if market prices accurately reflect, or capitalize, the value of energy efficiency improvements. If energy efficiency is not accurately reflected in housing prices, builders may underinvest in efficiency.

Internal Revenue Service (IRS), Statistics of Income (SOI), 2009 and IRS SOI Bulletin, Winter 2010.

__ Murtishaw, Scott and Jayant Sathaye. Quantifying the Effect of the Principal-Agent Problem on U.S. Residential Energy Use. Energy Analysis Department, Lawrence Berkeley National Laboratory. LBNL-59773. August 12, 2006.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

Qualified low-speed vehicles are those that have four wheels, have a gross weight of less than 3,000 pounds, can reach a minimum speed of 20 miles per hour (mph), have a maximum speed of 25 mph, and are manufactured primarily for use on public streets, roads, or highways. The vehicle must be propelled by a battery with a capacity of at least 4 kilowatt hours (kWh). In the case of 2-wheeled and 3-wheeled vehicles, the minimum battery capacity is 2.5 kWh.

There are a number of reasons why there might be market failures in the market for conventional gasoline -- and diesel -- powered vehicles. First, gasoline consumption is believed to have negative environmental externalities, imposing social costs that consumers do not consider when making purchasing decisions. Thus, the equilibrium quantity of gasoline consumption might exceed the economically efficient, socially optimal level. Second, conventional gasoline-powered motor vehicles might impose negative externalities through congestion and highway traffic accidents.

Subsidizing plug-in electric vehicles is one way of addressing the potential market failures associated with conventional gasoline powered vehicles. The government could also address the negative externalities associated with gasoline consumption by taxing gasoline directly. Directly taxing activities believed to be associated with negative externalities, such as gasoline consumption, is more economically efficient that subsidizing non-externality-generating alternative activities. Evidence in the market for hybrid vehicles suggests that rising gasoline prices have been more effective in promoting hybrid vehicle adoption than tax incentives.

If tax incentives fail to cause taxpayers to change their behavior, in this case stimulating the purchase of plug-in electric vehicles, such incentives would be economically inefficient. Tax provisions that reward consumers for purchases they would have made without the tax incentive provide a windfall to taxpayers, without increasing the activity the incentive was designed to promote (plug-in electric vehicles). While it is not clear whether tax incentives will be effective at increasing the market share of vehicles qualifying for a credit under section 30, evidence from the hybrid vehicle market does suggest that tax credits for alternative technology vehicles are not a primary driver of vehicle purchases.

Diamond, David, "The Impact of Government Incentives for Hybrid-Electric Vehicles: Evidence from US States," Energy Policy, vol. 37 (2009), pp. 972-983.

Chupp, Andrew B., Katie Myles, and E. Frank Stephenson, "The Tax Incidence of Hybrid Automobile Tax Preferences," Public Finance Review, vol. 38, no. 1 (January 2010), pp. 120 - 133.

Heutel, Garth and Erich Muehlegger. Consumer Learning and Hybrid Vehicle Adoption. Harvard University John F. Kennedy School of Government, Working Paper no. 10-013, April 2010.

Internal Revenue Service. Notice 2009-58: Qualified Plug-In Electric Vehicle Credit Under Section 30. Internal Revenue Bulletin 2009-30. (July 27, 2009).

Sallee, James M., "The Surprising Incidence of Tax Credits for the Toyota Prius," American Economic Journal: Economic Policy (forthcoming).

Sallee, James M., "The Taxation of Fuel Economy," paper presented at the National Bureau of Economic Research Tax Policy and the Economy Conference, Washington, DC, September 23, 2010.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

Yacobucci, Brent. Alternative Fuels and Advanced Technology Vehicles: Issues in Congress. Library of Congress, Congressional Research Service Report R40168. Washington, DC: September 22, 2010.

Advanced energy projects that may qualify for the tax credit include those that re-equip, expand, or establish eligible manufacturing facilities. Facilities that produce the following types of property may qualify: (1) property designed to produce energy using a renewable resource (i.e. solar, wind, geothermal), (2) fuel cells, microturbines, or energy storage systems for use with electric or hybrid-electric vehicles, (3) advanced transmission technologies that support renewable generation (including storage), (4) carbon capture and sequestration property, (5) property designed to refine or blend renewable fuels, (6) energy conservation technologies (i.e. energy-saving lighting or smart grid technologies), (7) plug-in electric vehicles and components, (8) other advanced energy property designed to reduce greenhouse gas emissions.

Applications for the advanced energy manufacturing tax credit were accepted beginning August 14, 2009. It was required that final applications for the first allocation round be submitted by October 16, 2009. All available credits ($2.3 billion) were allocated in this first allocation round.

Applications were evaluated jointly by the Department of Energy and the Department of Treasury. Projects were selected based on their commercial viability, potential for domestic job creation, net reduction in air pollution or greenhouse gas emissions, potential for technological innovation and commercial deployment, levelized cost for energy generation, storage, or conservation, and the project's expected time span.

Generally, the tax credit is awarded when a project is placed in service. For multi-year projects, taxpayers may claim credits based on the project's progress expenditures. All projects must be completed within four years of tax credit acceptance. Taxpayers receiving a credit under section 48C cannot claim the energy investment tax credit (ITC) (discussed elsewhere in this compendium).

The tax credits were designed to address the U.S. position in the global advanced energy manufacturing marketplace. As of 2008, the U.S. had 16% of global wind manufacturing capacity, 6% of global solar manufacturing capacity, and less than 1% of global battery manufacturing capacity. As a result, the domestically produced content of installed renewable generation facilities is relatively low. In the mid-2000s, domestic content for the U.S. wind industry was 25%. That had increased to 50% by 2010, and is expected to reach 70% once the current round of manufacturing expansion is complete.

Investment tax credits for advanced energy manufacturing projects reduce the cost of investment for qualifying projects, relative to other types of investment. Generally, investment subsidies that aim to reallocate capital are inefficient, as such policies direct capital away from what would otherwise be its most productive use.

Tax credits for renewable energy manufacturing may be justified to the extent such incentives address environmental and energy security concerns. Specifically, since traditional energy technologies are often polluting and may be associated with global climate change, subsidizing clean energy alternatives could help reduce reliance on fossil energy resources. Subsidizing clean energy alternatives, however, is less economically efficient than directly taxing activities and energy sources that have negative environmental consequences.

Finally, the fact that the advanced energy manufacturing tax credit was enacted on a temporary basis could also be problematic. While temporary investment tax incentives may cause firms to act quickly to make investments within the credit window, it can also lead to investment uncertainty. Firms that did not receive a tax credit allocation in the first round may put off projects, while other firms may wait before undertaking advanced energy manufacturing projects to see if additional tax credits will be come available.

Hungerford, Thomas L., and Jane G. Gravelle. Business Investment and Employment Tax Incentives to Stimulate the Economy. Library of Congress, Congressional Research Service Report R41034. Washington, DC: July 21, 2010.

Metcalf, Gilbert M. "Investment in Energy Infrastructure and the Tax Code." In Tax Policy and the Economy, Vol 24, ed. Jeffery R. Brown. pp. 1-33. The University of Chicago Press. 2010.

Sherlock, Molly F. Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures. Library of Congress, Congressional Research Service Report R41227. Washington, DC: May 7, 2010.

Sherlock, Molly F., and Donald J. Marples. Energy Tax Policy: Issues in the 111th Congress. Library of Congress, Congressional Research Service Report R40999. Washington, DC: June 16, 2010.

The White House. Office of the Press Secretary, "President Obama Awards $2.3 Billion for New Clean-Tech Manufacturing Jobs," press release, January 8, 2010.

U.S. Congress. Senate Finance Committee. Statement of Henry Kelly Principal Deputy Assistant Secretary, Office of Energy Efficiency and Renewable Energy U.S. Department of Energy. Hearing on Clean Technology Manufacturing Competitiveness: The Role of Tax Incentives. May 20, 2010.

U.S. Department of Energy: Energy Efficiency & Renewable Energy. 2009 Wind Technologies Report. August 2010.

Qualifying contributions in aid of construction received by regulated water and sewage disposal utilities which provide services to the general public in their service areas are not included in the utilities' gross income if the contributions are spent for the construction of the facilities within 2 years after receipt of the contributions. Service charges for starting or stopping services do not qualify as nontaxable capital contributions. Assets purchased with (or received as) qualifying contributions have no basis (hence, cannot be depreciated by the utility) and may not be included in the utility's rate base for rate-making purposes.

Repeal of the special treatment resulted in increases in the amounts utilities charge their customers as contributions in aid of construction. Before TRA86, a utility would charge its customers an amount equal to the cost of installing a facility. After TRA86, utilities had to charge an amount equal to the cost of the facility plus an amount to cover the tax on the contribution in aid of construction. This parallels the pricing of most other business services, for which companies must charge customers the actual cost of providing the service plus an amount to cover the tax on the income.

The higher cost associated with contributions in aid of construction as a result of the change in the TRA86 led to complaints from utility customers and proposals to reverse the change. The special treatment of contributions in aid of construction was reinstated -- but only for water and sewage utilities -- in the Small Business Job Protection Act of 1996. As a result of this reinstatement, water and sewage utility charges for contributions in aid of construction are lower than they would be if the contributions were still taxable. The charge now covers only the cost of the financed facility; there is no markup to cover taxes on the charge.

To the extent that the lower charges to builders and developers for contributions in aid of construction are passed on to ultimate consumers through lower prices, the benefit from this special tax treatment accrues to consumers. If some of the subsidy is retained by the builders and developers because competitive forces do not require it to be passed forward in lower prices, then the special tax treatment also benefits the owners of these firms.

In repealing the special tax treatment of contributions in aid of construction in TRA86, Congress determined that there was no public policy justification for continuing the subsidy. In reinstating the special tax treatment for water and sewage utilities in the Small Business Job Protection Act of 1996, Congress determined that there was an adequate public policy justification for providing the subsidy to these particular utilities.

Conference Report, Small Business Job Protection Act of 1996, Report 104-737, U.S. House of Representatives, 104th Congress, 2d Session, August 1, 1996, pp. 158-160.

Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, Joint Committee Print, JCS-10-87, May 4, 1987, pp. 544-547.

Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997, Joint Committee Print JCS-23-97, December 17, 1997, 40-41.

Maguire, Steven. Tax Credit Bonds: A Brief Explanation. Library of Congress, Congressional Research Service Report R40523.

__. Tax-Exempt Bonds: A Description of State and Local Government Debt. Library of Congress, Congressional Research Service Report RL30638.

Matheson, Thornton. "Qualified Zone Academy Bond Issuance and Investment: Evidence from 2004 Form 8860 Data," Statistics of Income Bulletin, Internal Revenue Service, Spring 2007, pp. 155-162.

An additional issue is whether the favorable tax treatment accorded to the funds simply compensates for other, unfavorable, tax treatment of decommissioning costs. Under current law there is a tax penalty associated with decommissioning because outlays for nuclear decommissioning are not permitted to be deducted until they are actually made. To the extent a taxpayer incurs a liability for those costs in advance of the outlays, this treatment constitutes a tax penalty similar to a reverse tax deferral; accurate treatment would require the costs to be deducted to reflect the loss in value of the plant as the required outlay becomes closer in time.

The likely economic effect of the reduced rates is to encourage outlays on nuclear decommissioning because the tax-saving funds are contingent on making such outlays. At the same time, however, to the extent that decommissioning costs are required by government regulations to be incurred with or without the special tax treatment, the reduced rates pose an incentive to invest in nuclear power plants. The benefit of the favorable tax treatment likely accrues to owners of electric utilities that use nuclear power and to consumers of the electricity they produce.

The reduced tax rate was enacted by the Energy Policy Act of 1992 (Public Law 102-486). The rate was reduced to provide "a greater source of funds" for decommissioning expenses. Congress in 2000 approved a measure that would eliminate the "cost of service" limitation on contributions to funds (leaving intact, however, the limit posed by the IRS determination). The Energy Tax Incentives Act of 2005 (Public Law 109-58) modified the rules on the contribution limits to allow larger deductible contributions to a decommissioning fund.

Palmer, Stephen L. "A Suggestion for Federal Tax Treatment of Accrued Nuclear Power Plant Decommissioning Expenses." Tax Lawyer 35 (Spring 1982), pp. 779-797.

U.S. Congress, Joint Committee on Taxation. Federal Tax Issues Relating to Restructuring of the Electric Power Industry. Joint Committee Print, 106th Congress, 1st session. Washington, DC: Government Printing Office, October 15, 1999, pp. 39-43.

__. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, Joint Committee Print, 98th Congress, 2d session. Washington, DC: Government Printing Office.

__. General Explanation of Tax Legislation Enacted in the 109^th Congress. Joint Committee Print,109th Congress, 2d Session. Washington, DC: Government Printing Office, 2007, pp. 32-35.

U.S. Department of the Treasury. General Explanations of the Administration's Fiscal Year 2001 Revenue Proposals. Washington, DC: 2000, pp. 117-118.

U.S. General Accounting Office, Nuclear Regulation: NRC Needs More Effective Analysis to Ensure Accumulation of Funds to Decommission Nuclear Power Plants. Report GAO-04-32, October 2003.

Zimmerman, Raymond A. and Jeri Farrow. "Decommissioning Funds: Snagged on Tax Law?" Public Utilities Fortnightly 139 (April 1, 2001), pp. 34.

Although producing a relatively neutral reduction in the tax rate, reductions in tax burden reduce the cost of operating proportionally more for long lived assets because the rate of return is more important in cost for more durable facilities. One way to express this difference is in the rental price (or payment that would be required to rent an asset). It is closely related to an equivalent reduction in acquisition cost. For example, for five year assets, the present value of depreciating the asset at a 5% real rate of return and a 2% inflation rate is 87 cents for each dollar of cost. Allowing half of the cost to be deducted immediately (with a value of $1) at a 35% tax rate would be the equivalent of a 2.3% reduction in acquisition cost. For seven year property, the most common depreciation class for equipment, the present value is 83 cents for each dollar of investment and the expensing is equivalent to a 3% reduction in cost. Thus the reduction in overall cost of recycling (which also requires labor and material as well as the use of capital) is relatively small due to this provision.

Another justification for subsidies to recycling is that many of the industries that produce virgin materials are eligible for tax subsidies as well (paper and mining), although an alternative policy would be to reduce those existing subsidies rather than grant new ones for recycling. Certain industries (e.g., aluminum) also benefit from inexpensive hydroelectric power.

If a subsidy is justified for reuse and recycling property, it is not clear that a tax subsidy is the best alternative. Recycling issues are largely in the domain of local governments, and the cost effectiveness depends on many other factors (such as density). Local governments have alternative methods, such as requiring recycling and, in some cases, imposing taxes on trash by quantity (although the evidence does not suggest the latter approach is very successful). At the same time, some of the pollution effects of using energy are national (or even global). Providing a federal subsidy to lower costs might induce more localities to be involved in recycling. The subsidies should result in a greater demand and higher price for scrap. However, for communities already involved in recycling, these benefits would appear in lower costs for trash collection overall, with no specific incentive for recycling.

Fullerton, Don and Thomas C. Kinaman. "Household Responses to Pricing Garbage by the Bag," American Economic Review, Vol. 86, September 1996, pp. 971-984.

Hutchinson, Alex, "Is Recycling Worth It?" Popular Mechanics, December 1, 2008.

National Recycling Coalition, Inc. U.S. Recycling Economic Information Study, July 2001. [http://www.epa.gov/osw/conserve/rrr/rmd/rei-rw/pdf/n_report.pdf] "The Truth About Recycling," The Economist, June 9, 2007.

The Tax Reform Act of 1986 (P.L. 99-514) included uniform capitalization rules which required production expenses to be capitalized in most cases. Timber was among the few categories of property excepted from these rules. No specific reason was given for exempting timber, but the general reason given for exceptions to the uniform capitalization rules was that they were cases where its application "might be unduly burdensome." Although the 1986 act repealed the 10-percent investment tax credit for most property placed in service after 1985, it retained the credit for expenditures that qualify for 84-month amortization, which includes reforestation expenditures.

Expensing of the first $10,000 of reforestation expenditures was introduced by the Recreational Boating Safety and Facilities Improvement Act of 1980 (P.L. 96-451). The expensing provision replaced an existing reforestation credit (Code Sec. 48). The change was made to simplify the treatment of reforestation costs. The basic purpose of the incentive was to encourage reforestation. The American Jobs Creation Act of 2004 (P.L. 108-357) provided for an election to claim the reforestation deduction. The 2004 act also granted taxpayers the ability to revoke an election made prior to the Act to treat the cutting of timber as a sale or exchange. The Gulf Opportunity Zone Act of 2005 (P.L. 109-135) temporarily raised the cap on the reforestation deduction for small timber producers, for expenditures undertaken in the GO Zone through January 1, 2008; taxpayers holding 500 or more acres of qualified timber property at any time during the taxable year were not eligible.

The cap on the deduction for reforestation expenditures has remained at $10,000 -- the level set when the provision was first enacted in 1980. Inflation over thirty years has consequently reduced the real value of the deduction to a comparatively inconsequential level.

U.S. Congress, House of Representatives. Conference report 108-755 to accompany H.R. 4520, American Jobs Creation Act of 2004, 108th Congress, 2d Session, October 7, 2004.

__, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. May 4, 1987, pp. 508-509.

__, Joint Economic Committee. "The Federal Tax Subsidy of the Timber Industry," by Emil Sunley, in The Economics of Federal Subsidy Programs. 92nd Congress, 2nd session, July 15, 1972.

U.S. Department of Agriculture, Forest Service. Forest Landowner's Guide to the Federal Income Tax, Agriculture Handbook No. 718. Washington, DC, U.S. Government Printing Office, March 2001.

U.S. Department of the Treasury. Special Expensing and Amortization Rules in Tax Reform for Fairness, Simplicity, and Economic Growth, v. 2, Nov. 1984, pp. 299-313.

U.S. General Accounting Office. Selected Tax Provisions Affecting the Hard Minerals Mining and Timber Industries, Fact Sheet for the Honorable John Melcher, United States Senate. June 1987.

__. Forest Service: Timber Harvesting, Planting, Assistance Programs and Tax Provisions, Briefing Report to the Honorable Sander M. Levin, House of Representatives. April 1990.

An environmental settlement fund will be exempt from taxation if the following conditions are satisfied: 1) it is established pursuant to a consent decree entered by a judge of a United States District Court; 2) it is created for the receipt of settlement payments as directed by a government entity for the sole purpose of resolving or satisfying one or more claims asserting liability under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980; 3) the authority and control over the expenditure of funds therein (including the expenditure of contributions thereto and any net earnings thereon) is with such government entity; and 4) upon termination, any remaining funds will be disbursed to such government entity (in this case the EPA) for use in accordance with applicable law.

Yet it is unclear from what little information about the provision is available to what extent it has aided or expedited the cleanup of Superfund hazardous waste sites. Responsible parties end up paying for the cleanup of most of these sites. The EPA has reported that so-called potentially responsible parties have conducted the cleanup of 70 percent of the worst sites, those listed in the EPA's National Priorities List (NPL). For the remaining 30 percent of NPL sites, the EPA cannot locate the responsible parties, or those it has found lack the funds to share the cost of the cleanup. In those cases, the EPA draws on funds in the Superfund trust fund to pay for the cleanup. The provision may remove a barrier to increasing the proportion of contaminated sites cleaned up by responsible parties. If this proportion were to rise, less federal money would be needed to do the cleanup.

Reisch, Mark and Jonathan L. Ramseur. Superfund: Implementation and Selected Issues. Congressional Research Service Report RL33426. Washington, DC: November 26, 2007.

U.S. Congress. Joint Committee on Taxation. General Explanation of Tax Legislation Enacted in the 109th Congress. Joint committee print JCS-1-07. Washington, DC: 2007, pp. 269-270.

__, U.S. Government Accountability Office. Superfund: Funding and Reported Costs of Enforcement and Administration. GAO-08-841R. Washington, DC: July 18, 2008.

Wood, Robert W. "Rulings Makes Qualified Settlement funds More Attractive." Tax Notes, May 8, 2006, pp. 673-677.

Wood, Robert W. "468B Qualified Settlement Funds Pending Appeal?" Tax Notes, July 12, 2010, pp. 207-210.

Gorte, Ross W. and Pervaze A. Sheikh, Deforestation and Climate Change, Congressional Research Service Report R41144, 2010.

Sunley, Emil M. "The Federal Tax Subsidy of the Timber Industry," in U.S. Congress, Joint Economic Committee, The Economics of Federal Subsidy Programs, Part 3 -- Tax Subsidies, July 1972, pp. 317-342.

There are two methods of calculating this deduction: cost depletion, and percentage depletion. Cost depletion allows for the recovery of the actual capital investment -- the costs of discovering, purchasing, and developing a mineral reserve -- over the period during which the reserve produces income. Each year, the taxpayer deducts a portion of the adjusted basis (original capital investment less previous deductions) equal to the fraction of the estimated remaining recoverable reserves that have been extracted and sold. Under this method, the total deductions cannot exceed the original capital investment.

Under percentage depletion, the deduction for recovery of capital investment is a fixed percentage of the "gross income" -- i.e., sales revenue -- from the sale of the mineral. Under this method, total deductions typically exceed the capital invested.

Section 613 states that mineral producers must claim the higher of cost or percentage depletion. The percentage depletion allowance is available for many types of minerals, at rates ranging from 5 percent (for clay, sand, gravel, stone, etc.) to 22 percent (for sulphur, uranium, asbestos, lead, etc.).

Metal mines generally qualify for a 14 percent depletion, except for gold, silver, copper, and iron ore, which qualify for a 15 percent depletion. The percentage depletion rate for foreign mines is generally 14 percent.

Percentage depletion is limited to 50 percent of the taxable income from the property. For corporate taxpayers, section 291 reduces the percentage depletion allowance for iron ore by 20 percent. Allowances in excess of cost basis are treated as a preference item and taxed under the alternative minimum tax.

Issues of principal concern are the extent to which percentage depletion:

A court case resulted in the enactment, as part of the Tariff Act of 1913, of a "reasonable allowance for depletion" not to exceed five percent of the value of output. This statute did not limit total deductions; Treasury regulation No. 33 limited total deductions to the original capital investment.

This system was in effect from 1913 to 1918, although in the Revenue Act of 1916, depletion was restricted to no more than the total value of output, and, in the aggregate, to no more than capital originally invested or fair market value on March 1, 1913 (the latter so that appreciation occurring before enactment of income taxes would not be taxed).

On the grounds that the newer mineral discoveries that contributed to the war effort were treated less favorably, discovery value depletion was enacted in 1918. Discovery depletion, which was in effect through 1926, allowed deductions in excess of capital investment because it was based on the market value of the deposit after discovery. In 1921, because of concern with the size of the allowances, discovery depletion was limited to net income; it was further limited to 50 percent of net income in 1924.

For oil and gas, discovery value depletion was replaced in 1926 by the percentage depletion allowance, at the rate of 27.5 percent. This was due to the administrative complexity and arbitrariness, and due to its tendency to establish high discovery values, which tended to overstate depletion deductions.

For other minerals, discovery value depletion continued until 1932, at which time it was replaced by percentage depletion at the following rates: 23 percent for sulphur, 15 percent for metal mines, and 5 percent for coal.

From 1932 to 1950, percentage depletion was extended to most other minerals. In 1950, President Truman recommended a reduction in the top depletion rates to 15 percent, but Congress disagreed. The Revenue Act of 1951 raised the allowance for coal to 10 percent and granted it to more minerals.

In 1954, still more minerals were granted the allowance, and foreign mines were granted a lower rate. In 1969, the top depletion rates were reduced and the allowance was made subject to the minimum tax. The Tax Equity and Fiscal Responsibility Act of 1982 reduced the allowance for corporations that mined coal and iron ore by 15 percent. The Tax Reform Act of 1986 raised the cutback in corporate allowances for coal and iron ore from 15 percent to 20 percent.

As a production subsidy, however, percentage depletion is economically inefficient, encouraging excessive development of existing properties rather than exploration of new ones. Although accelerated depreciation for non-mineral assets may lower effective tax rates by speeding up tax benefits, these assets cannot claim depreciation deductions in excess of investment.

However, arguments have been made to justify percentage depletion on grounds of unusual risks, the distortions in the corporate income tax, and national security, and to protect domestic producers. Mineral price volatility alone does not necessarily justify percentage depletion.

Percentage depletion may not be the most efficient way to increase mineral output. Percentage depletion may also have adverse environmental consequences, encouraging the use of raw materials rather than recycled substitutes.

Anderson, Robert D., Alan S. Miller, and Richard D. Spiegelman. "U.S. Federal Tax Policy: The Evolution of Percentage Depletion for Minerals," Resources Policy, v. 3. September 1977, pp. 165-176.

Conrad, Robert F. "Mining Taxation: A Numerical Introduction," National Tax Journal, v. 33. December, 1980, pp. 443-449.

Crowson, Philip. Inside Mining: The Economics of the Supply and Demand of Minerals and Metals. London: Mining Journal Books, 1998.

Davidson, Paul. "The Depletion Allowance Revisited," Natural Resources Journal, v. 10. January 1970, pp. 1-9.

Dorsey, Christine. "Clinton Administration Revives Plan to Revoke Mining Tax Break." Las Vegas Review -- Journal. February 10, 2000. p. 4D.

Fenton, Edmund D. "Tax Reform Act of 1986: Changes in Hard Mineral Taxation," Oil and Gas Tax Quarterly, v. 36. September, 1987, pp. 85-98.

Frazier, Jessica and Edmund D. Fenton. "The Interesting Beginnings of the Percentage Depletion Allowance," Oil and Gas Tax Quarterly, v. 38. June 1990, pp. 697-712.

Lagos, Gustavo. "Mining Investment and Compensation -- Mineral Taxation and Investment." Natural Resources Forum. August 1993.v.17.

Lazzari, Salvatore. The Effects of the Administration's Tax Reform Proposal on the Mining Industry. Library of Congress, Congressional Research Service Report 85-WP. Washington, DC: July 29, 1985.

__. The Federal Royalty and Tax Treatment of the Hard Rock Minerals Industry: An Economic Analysis. Library of Congress, Congressional Research Service. CRS Report RL34268. Washington, DC: June 13, 2008.

Muzondo, Timothy R. "Mineral Taxation, Market failure, and the Environment." International Monetary Fund. Staff Papers -- International Monetary Fund. March 1993.v.40. Washington, pp. 152-178.

Randall, Gory. "Hard Mineral Taxation-Practical Problems," Idaho Law Review, v. 19. Summer 1983, pp. 487-503.

Tripp, John D., Hugh D. Grove, and Michael McGrath. "Maximizing Percentage Depletion in Solid Minerals," Oil and Gas Tax Quarterly, v. 30. June 1982, pp. 631-646.

Updegraft, Kenneth E., and Joel D. Zychnick. "Transportation of Crude Mineral Production by Mine Owners and its Effect on Hard Minerals Depletion Allowance," Tax Lawyer, v. 35. Winter 1982, pp. 367-387.

U.S. General Accounting Office. Selected Tax Provisions Affecting the Hard Minerals Mining and Timber Industry. GAO/GGD-87-77 FS. June 1987. Washington, DC: U.S. Government Printing Office, June 1987.

Ward, Frank A., and Joe Kerkvliet. "Quantifying Exhaustible Resource Theory: An Application to Mineral Taxation Policy." Resource and Energy Economics. June 1993.v.15. pp. 203-242.

In general, mining exploration costs are those (non-equipment) costs incurred to ascertain the existence, location, extent, or quality of any potentially commercial deposit of ore or other depletable mineral prior to the development stage of the mine or deposit.

Development costs generally are those incurred for the development of a mine or other natural deposits after the existence of ores in commercially marketable quantities has been determined. Development expenditures generally include those for construction of shafts and tunnels, and in some cases drilling and testing to obtain additional information for planning operations. There are no limits on the current deductibility of such costs. Expensing of mine E&D costs may be taken in addition to percentage depletion, but it subsequently reduces percentage depletion deductions (i.e., is recaptured). The costs of tangible equipment must be depreciated.

Expensing of E&D costs applies only to domestic properties; E&D costs on foreign properties must be depreciated. The excess of expensing over the capitalized value (amortized over 10 years) is a tax preference item that is subject to the alternative minimum tax.

Nevertheless they are a capital expense which otherwise would be depleted over the income-producing life of the mineral reserve. Combined with other tax subsidies, such as percentage depletion, expensing reduces effective tax rates in the mineral industry below tax rates on other industries, thereby providing incentives to increase investment, exploration, and output. This cost reduction increases the supply of the mineral and reduces its price.

This tax expenditure is largely claimed by corporate producers. The at-risk, recapture, and minimum tax restrictions that have since been placed on the use of the provision have primarily limited the ability of high-income taxpayers to shelter their income from taxation through investment in mineral exploration.

Prior to the Tax Reform Act of 1969, a taxpayer could elect either to deduct without dollar limitation exploration expenditures in the United States (which subsequently reduced percentage depletion benefits), or to deduct up to $100,000 a year with a total not to exceed $400,000 of foreign and domestic exploration expenditures without recapture.

The 1969 act subjected all post-1969 exploration expenditures to recapture. The Tax Equity and Fiscal Responsibility Act of 1982 added mineral exploration and development costs as tax preference items subject to the alternative minimum tax, and limited expensing for corporations to 85 percent. The Tax Reform Act of 1986 required that all exploration and development expenditures on foreign properties be capitalized.

Lease bonuses and other exploratory costs (survey costs, geological and geophysical costs) are properly treated as capital costs, although they may be recovered through percentage rather than cost depletion. Immediate expensing of E&D costs provides a tax subsidy for capital invested in the mineral industry with a relatively large subsidy for corporate producers.

By expensing rather than capitalizing these costs, the tax code effectively sets taxes on the return to such expenditures at zero. As a capital subsidy, however, expensing is inefficient because it makes investment decisions based on tax considerations rather than inherent economic considerations.

Arguments have been made over the years to justify expensing on the basis of unusual investment risks, the distortions in the corporate income tax, strategic materials and national security, and protection of domestic producers (especially small independents).

Expensing is a costly and inefficient way to increase mineral output and enhance energy security. Expensing may also have adverse environmental consequences by encouraging the development of raw materials as opposed to recycled substitutes.

Congressional Budget Office. Budget Options. Section 28: Repeal the Expensing of Exploration and Development Costs for Extractive Industries. February 2005.

Conrad, Robert F. "Mining Taxation: A Numerical Introduction." National Tax Journal, v. 33, December, 1980, pp. 443-449.

Crowson, Philip. Inside Mining: The Economics of the Supply and Demand of Minerals and Metals. London: Mining Journal Books, 1998.

Dorsey, Christine. "Clinton Administration Revives Plan to Revoke Mining Tax Break." Las Vegas Review -- Journal. February 10, 2000. p. 4D.

Lagos, Gustavo. "Mining Investment and Compensation -- Mineral Taxation and Investment." Natural Resources Forum. August 1993. v.17.

Lazzari, Salvatore. The Federal Royalty and Tax Treatment of the Hard Rock Minerals Industry: An Economic Analysis. Library of Congress, Congressional Research Service. CRS Report RL34268. Washington, DC: June 13, 2008.

Muzondo, Timothy R. "Mineral Taxation, Market Failure, and the Environment." International Monetary Fund. Staff Papers. International Monetary Fund. March 1993.v.40. Washington, pp. 152-178.

U.S. General Accounting Office. Selected Tax Provisions Affecting the Hard Minerals Mining and Timber Industry. GAO/GGD-87-77 FS, Washington, D.C., Government Printing Office, June 1987.

U.S. General Accounting Office. Selected Tax Provisions Affecting the Hard Minerals Mining and Timber Industry. GAO/GGD-87-77 FS. June 1987. Washington, DC: U.S. Government Printing Office, June 1987.

Ward, Frank A., and Joe Kerkvliet. "Quantifying Exhaustible Resource Theory: An Application to Mineral Taxation Policy." Resource and Energy Economics. June 1993.v.15. pp. 203-242.

Wilburn, D.R. "Exploration." Mining Engineering. May 2003. v.55. pp. 30-43.