Alcohol Fuels Tax Incentives

Salvatore Lazzari

Specialist in Public Finance
Resources, Science, and Industry Division

Updated June 23, 1999

98-435E

There are four federal tax subsidies that are available for the production and use of alcohol transportation fuels. However, except for the partial exemption from the motor fuels excise taxes - the tax on gasoline, diesel, and other transportation motor fuels - these subsidies are little used. Thus, this section discusses the tax exemption first, which has been most responsible for the development and growth of the alcohol fuels market. For interested readers, the second section discusses the remaining three tax subsidies, which, although little used, are nevertheless part of the current federal tax laws, and might be used in the future.

Excise Tax Exemption. Virtually all transportation fuels are taxed under a complicated structure of tax rates and exemptions that vary by mode and type of fuel. Gasoline used in highway transportation - the fuel used more than any other - is taxed at a rate of 18.4€ per gallon, composed of: an 18.3€ Highway Trust Fund rate, which finances the federal highway trust fund (HTF); and a 0.1€ rate that is earmarked for the Leaking Underground Storage Tank Trust Fund (LUST).1 Diesel fuel for highway use - the fuel used mostly by trucks - is taxed at 24.4€ per gallon, also consisting of two components: a 24.3€ rate that is allocated into the HTF, and 0.1€ that goes into the LUST flind. In addition, special motor fuels gasoline substitutes), jet fuel, railway diesel fuel, motorboat fuel, and virtually every other transportation motor fuel that is not specifically exempt are also subject to tax.2 Compressed natural gas (CNG) has, since 1993, been subject to an excise tax of 48.54€ per MCF (thousand cubic feet) - marking the onset of the taxation of gaseous transportation fuels.3

The most important tax incentive for alcohol fuels - the one most responsible for the development of the alcohol fuels market - is the partial exemption, at 5.4€ per gallon, from these otherwise standard excise tax rates on gasoline, diesel, and other transportation fuels. Mixtures of 90% gasoline and 10% alcohol (typically called gasohol) are taxed at 13.0€ per gallon - they are exempt from 5.4€ of the tax. Since January 1, 1993, mixtures that are 7.7% or 5.7% alcohol (either ethanol or methanol) have received a prorated exemption. Thus, 7.7% ethanol blends qualify for a 4.158€ exemption (they are taxed at 14.242€ per gallon); and 5.7% ethanol blends qualify for a 3.078€ per gallon exemption (they are taxed at 15.322€ per gallon). The 5.7% and 7.7% blends correspond, respectively, to the 2.0% and 2.7% oxygen content standard for gasoline sold in ozone nonattainment areas and carbon monoxide nonattainment areas under the Clean Air Act.4 Most gasohol sales are exempt at the rate of 5.4€ per gallon because they are 90/10 blends. In all these cases, the exemption equates to 54€ per gallon of ethanol.5 Finally, straight (or neat) alcohol fuels - mixtures that contain a minimum of 85% alcohol -also qualify for the excise tax exemption at varying rates. For example, straight biomass-ethanol is taxed at a rate of 13.0€ (a 5.4€-exemption); straight biomass-methanol is taxed at a rate of 12.4€ per gallon (a 6.0€-exemption). The market for these straight, or neat fuels, is very small.

To qualify for any of the above exemptions, the alcohol must be at least 190 proof (95% pure alcohol, determined without regard to any added denaturants or impurities). Technically, both ethanol and methanol qualify for the exemption as long as they are not derived from petroleum, natural gas, coal, or peat. In practice, however, virtually all fuel alcohol is ethanol produced from corn; very little, if any, methanol is produced from wood, and other biomass (or renewable) sources because it is generally uneconomic.6

The federal tax exemptions for alcohol fuels also apply to certain fuel additives called oxygenates, provided they are produced from renewables such as corn and not from fossil fuels such as natural gas. In 1995, the IRS ruled that blends of ETBE (ethyl tertiary butyl ether) and gasoline would also qualifiy for the reduced partial excise tax exemption. ETBE is a compound derived from a chemical reaction between ethanol and isobutylene (a byproduct of both the petroleum refining process and natural gas liquids).7 In this reaction, the ethanol is chemically transformed and is not present as a separate chemical in the final product. In effect these rulings ensured that the oxygenate required under the CAA would also qualify for the tax subsidies. Allowing ETBE to qualify for this tax exemption was intended to further stimulate the production of ethanol. Allowing ETBE to qualify for the federal tax subsidies reduces the growth of MTBE (methyl tertiary butyl ether), its main competitor. ETBE costs more to produce and therefore, without the tax subsidies, could not compete with the less costly MTBE.

The excise tax exemptions for alcohol fuels are currently scheduled to expire on October 1, 2008; the equivalent blender's tax credits are scheduled to expire on January 1, 2008. The Transportation Equity Act for the 21st Century (P.L. 105-178) extended the exemption by nearly seven years. Prior to these amendments, the exemption was scheduled to expire on December 31, 2000. The 'Transportation Equity Act' also provides for a phased-in reduction in the exemption (and the equivalent blenders tax credit) to: 5.3€ (53€ credit) for the years 2001&2002, 5.2€ (52€ credit) for the years 2003 & 2004, and 5.1€ (51€ credit) for the years 2005-2007. The expiration date of the HTF part of the gasoline tax (the 14.0€) was also extended by the 'Transportation Equity Act' by six years from October 1, 1999 to October 1, 2005 .8 The remaining component - the 4.3€ rate - has no expiration date; and the 0.1€ LUST component expires on April 1, 2005.9 The surface transportation funding bills recently approved by the House (H.R.2400) and Senate (S.1173) would extend the expiration date for the gasoline tax by six years. The House version of this bill contains a termination of the exemptions for alcohol fuels, while the Senate bill contains a six year extension of the exemptions.

Revenue Implications. From 1978 (when the excise tax exemption for alcohol fuels was first enacted), to FY1997, it is estimated that the exemption resulted in over $8 billion in foregone federal revenues. Currently, the annual revenue loss from the exemption is estimated at over $600 million per year.10 Revenue losses from the blender's tax credit and the small ethanol producer credit are estimated at under $50 million per year; there is no indication that the remaining two tax benefits to alcohol fuels generate revenue losses as they are little used.

Under current budgetary scoring rules used by the Congressional Budget Office (CBO), excise taxes earmarked to trust funds - such as the 14.0€ part of the gasoline tax - are part of the baseline. Thus, gasoline tax revenues are included in the baseline revenue projections, as they always have been, even if those taxes are scheduled to expire. This is the only exception to the general rule that scheduled changes and expirations are assumed to occur at that time. Continuation of this structure, i.e., extending the various tax rates and exemptions, is assumed to be revenue neutral: even though the exemptions lose revenue, that revenue loss estimate is incorporated into the baseline. (In other words, the alcohol fuels tax exemptions are, like the gasoline tax and other fuels excise taxes, assumed to be always extended.) Thus, a proposal not to extend the alcohol fuels tax exemptions, which currently are set to expire on October 1, is assumed to raise revenue. Revenue-related provisions of the transportation bill reported by the Ways and Means Committee a revenue gain of $900 million for the period 2001 and 2002. If the exemptions had not been extended, any future proposal to introduce them at a later date would have had to be paid for by either spending cuts, other tax increases, or both.

The Blenders Tax Credit. In place of the excise tax exemption, gasohol blenders may claim an income tax credit for alcohol used to produce a qualified mixture (a mixture of alcohol and gasoline, or a mixture of alcohol and any other special motor fuel) under €40 of the Intemal Revenue Code. The mixture must either be sold for use as a fuel (not merely as an octane enhancer) or used as a fuel in the producer's trade or business. An income tax credit is also available for straight alcohol used as fuel. This credit is available only to the user directly (who must use it in a trade or business), or to the seller who must sell it at retail to the ultimate user (as long as it is placed in the fuel tank of the buyer's vehicle). Thus, whether the alcohol is a blend or straight fuel determines who qualifies for the tax credit. In all these cases, the alcohol may be either ethanol or methanol but must not be produced from fossil fuels, effectively limiting the tax credit to ethanol from corn.

The amount of the income tax credit depends on whether the alcohol is ethanol or methanol, and the strength of the alcohol. If the alcohol is ethanol, the credit is 54€ per gallon of ethanol if the alcohol is at least 190 proof and 40€ if the alcohol is between 150 and 190 proof. This credit is equivalent to 5.4€ per gallon of ethanol mixture. This mixture credit is available only to the blender, who must not only produce the mixture but must either use the mixture as a motor fuel in a trade or business or sell it for use as a fuel. The blender may be the producer, the terminal operator, or the wholesaler. The credit is 60€ per gallon of alcohol if the alcohol is methanol and if the alcohol is at least 190 proof and 45€ if the methanol is between 150 and 190 proof This credit is equivalent to a 6.0€ per gallon of methanol mixture. No credit is available for either ethanol or methanol that is less than 150 proof The two blender's tax credits have been available continuously since 1980, and they are scheduled to expire on the earlier of January 1, 2001, or in the event that the HTh excise taxes are not in effect.

There are several reasons why the tax credit is little used. First, there is the timing differences between the availability of the two tax subsidies. The exemption is available up front - as the fuel is actually being blended- whereas the benefits of the tax credit must await either the filing of the income tax return or the payment of estimated taxes (quarterly). Second, there are a number of restrictions to the blender's tax credit that significantly limit its value: Under IRC €87, the alcohol fuels tax credit is itself taxable as gross income for the tax year in which the credit is earned. Thus, a taxpayer that claims the credit has to add it back as income subject to tax thereby reducing the value of the credit; the alcohol fuels tax credit is a component of the general business tax credit under IRC €38 (which includes the targeted jobs tax credit, research and development tax credit, low-income housing tax credit, and other credits) and is subject to the carryforward and carryback rules of €39; the credits are not refundable; they may be used only against a positive tax liability; they are of no value if the producer has no tax liability.

Small Ethanol Producer Tax Credit. Current law provides for an income tax credit of 10€ per gallon ($4.20 per barrel) for up to 15 million gallons of annual ethanol production by a small ethanol producer, defined as one with ethanol production capacity of less than 30 million gallons per year (about 2,000 barrels per day). This credit, which was enacted as part of the Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508), is strictly a production tax credit available only to the manufacturer who sells the alcohol to another person for blending into a qualified mixture in the buyer's trade or business, for use as a fuel in the buyer's trade or business, or for sale at retail where such fuel is placed in the fuel tank of the retail customer. Casual off-farm production of ethanol does not qualify for this credit. The small ethanol producer credit is limited in the same way as the blender's tax credit. The amount of the credit is reduced to take into account any excise tax exemption claimed on ethanol output and sales.

With the first incentive, taxpayers can deduct from adjusted gross income a portion of the costs associated with the purchase of dedicated altemative fuel vehicles (AFVs), or the costs of converdng vehicles so that they can operate on clean-burning altemative fuels (dual fuel AFVs) in addition to gasoline. Dedicated AFVs are new vehicles designed to run on an alternative fuel only. For dedicated AFVs, costs up to $2,000 for qualified property can be deducted for a vehicle up to 10,000 lbs., up to $5,000 for a truck or van of 10,000 to 26,000 lbs., and up to $50,000 for a truck or van over 26,000 lbs. Qualified property for a dedicated AFV includes the full cost of the engine, the fuel delivery system, and the exhaust system. For a dual-fuel vehicle, the qualified cost is limited to the incremental cost of the same components compared with the systems for conventional fuels. With the second incentive, installation of refueling equipment for alternative fuels is provided with an annual tax deduction of up to $100,000 for the costs of installing alternative fuel storage and dispensing equipment. Qualifying property includes equipment usually purchased by retail service stations and associated with the storage and dispensing of the alternative fuel into the AFVs.

For both of these tax incentives, alternative fuels are defined as compressed natural gas, liquefied petroleum gas, liquefied natural gas, hydrogen, electricity, and any other fuel that includes 85% alcohol fuels, ether, or any combination of these. In addition, all of the property that qualifies for the deduction - the new vehicle, the conversions equipment, or the refueling equipment - must be new. Qualiying vehicles must meet any applicable federal and state environmental standards. For business taxpayers, the basis of the property for purposes of the depreciation deduction is reduced by the amount of clean-fuel-vehicle deduction. However, the normal limitations on the business depreciation deduction for any passenger vehicle are less stringent in the case of clean-fuel vehicles. In general, each of these deductions terminates at the end of 2004. But there is a phase-out provision in the case of new clean-fuel buming vehicles or retrofit equipment. The deduction is phased-out evenly over a 3-year period beginning in January 2002.

The Section 29 Production Tax Credit. An income tax credit is available for the production of a broad variety of fuels derived from various alternative energy resources (such as oil from tar sands or shale, gas from coalbeds, brine or tight formations, synthetic fuels, etc.). This is the alternative fuels production tax credit, also known as the €29 tax credit (because it is part of Internal Revenue Code section 29), which currently is over $6.00 per barrel of fuel. Certain types of alcohol fuels - either ethanol or methanol produced synthetically from coal or lignite - could qualify for this non-refundable tax credit. Plants must have been placed in service before July 1, 1998 - those placed in service after December 31, 1998 do not qualify for this tax credit. Moreover, alcohol fuels produced from coal or lignite may be used as feedstocks, unlike other fuels, without invalidating the tax credit. Alcohol fuels produced from biomass do not qualify for this credit, although gas produced from biomass does qualify for the credit. There is little if any production of synthetic fuels from coal in the United States so that, based on current information, this credit is not claimed on alcohol fuels used in transportation.11

Footnotes:

1 [back] The LUST fund finances the cost of cleaning up spills from underground fuel storage tanks.

2 [back] A variety of off-highway fuel uses (e.g., farming), business uses (e.g., construction equipment), and government uses (e.g., police departments and school districts) are tax exempt.

3 [back] Before 1993, only liquid fuels were subject to the various transportation fuels taxes - fuels that were liquid at the time they entered into the tank of the vehicle. The Omnibus Budget Reconciliation Act of 1993 (P.L. 103-66) introduced a tax on CNG.

4 [back] Clean Air Act (CAA), as amended in 1990 requires that all gasoline sold in the winter months in the 40 carbon monoxide (CO) non-attainment areas contain at least 2.7% oxygenate. Oxygenates add oxygen to gasoline and make the fuel burn more completely and more cleanly. This part of the program began on November 1, 1992. The CAA also requires that all gasoline sold in 9 ozone non-attainment areas be reformulated gasoline, containing at least 2% oxygenates. Reformulated gasoline involves a more complex and extensive change to the chemical properties of fuel to 1) reduce emissions of volatile organic compounds (which form ozone), 2) reduce emissions of toxic compounds (such as formaldehyde), and 3) keep emissions of nitrogen oxide from increasing.

5 [back] Alcohol blended with diesel fuel or any one of the other special motor fuels is also partially exempt from tax. The exemption for "gasohol" blends also applies to blends of diesel and biomass-derived alcohol and blends of a special motor fuel and biomass-derived alcohol, whether ethanol or methanol.

6 [back] Although blends of gasoline with biomass-derived methanol would also qualify under the tax code, such blends are disqualified under the Clean Air Act because of the associated increase of emissions of ozone-forming pollutants.

7 [back] Natural gas liquids are those components of wellhead gas - ethane, propane, butanes, pentanes, natural gasoline, and condensate, etc. - that are liquefied at the sufface in lease separators, field facilities, or gas processing plants.

8 [back] Note that the alcohol fuels exemption expires three years after the gasoline taxes expire. This is odd since the exemption is defined with respect to the gasoline tax - without a gasoline tax, there could be no exemption, (although there could still be a blender's tax credit). On the other hand, the gasoline tax has never been allowed to expire.

9 [back] Prior to October 1, 1997, the gasoline tax bad three components: 14.0€ for the HTF, 4.3€ for the general fund, and 0.1€ for the LUST trust fund. Each of these had different expiration dates. Taxpayer Relief Act of 1997 (P.L. 105-34) reallocated the 4.3€ to the HTF but retained the different expiration dates. The 'Transportation Equity Act' extended the expiration date for all motor fuels excise taxes, but the 4.3€ component is permanent - it does not have an expiration date.

10 [back] U. S. Congressional Budget Office. Reducing the Deficit: Spending and Revenue Options. March 1997. Washington, p.388.

11 [back] For a more detailed description and an analysis see: CRS Report 97-679, Economic Analysis of the €29 Tax Credit for Unconventional Fuels, by Salvatore Lazzari.