Energy Tax Credit Alert

There are two reasons for creating a tax credit. First, it stimulates investment and achieves a nationally significant goal, such as increased energy independence, where businesses or people operating as usual would not. That was the thinking back in the mid '70s when the first residential energy tax credit was established. Homeowners could reduce their taxes by 15% of the cost of several insulation and weather-stripping measures, up to $300. This tax credit quietly lapsed in the '80s after garnering generally negative reviews. The consensus was that the credit wasn't large enough to stimulate consumer interest and was partly claimed by people who had planned to insulate or weather-strip anyway.

The second major reason for creating a tax credit is to create an industry or enlarge an existing one to the point where prices for that industry's goods or services would be lowered for all consumers. The goal of the solar tax credit was to lower the price of solar heating systems by allowing homeowners to claim tax credits for 35% of the system cost. This credit generated a lot of interest and spawned a solar heating industry. Unfortunately, much of the credit was captured by contractors in the form of inflated prices, and solar heating never truly entered the mainstream construction market. The solar industry nearly collapsed after the credit was removed. (It is now slowly reviving, but that is another story.)

Why is a tax credit being proposed now? The U.S. is desperately behind in its commitments to reduce CO2 emissions, so a credit that stimulates energy conservation and a reduction in CO2 emissions is one way to catch up. The proposed credit would build consumer demand for materials and services that reduce a house's energy consumption to levels below that required by the model energy code. This demand should alter contractors' typical responses to consumer requests for relatively simple, but unfamiliar, efficiency measures, which is to inflate their cost. Instead, the increasing demand for efficiency measures should lead to an increased supply of contractors willing to perform efficiency services, and the price for these services should drop.

But there are also good reasons to question a tax credit. First, tax credits use federal money that might be more efficiently spent elsewhere, either by returning it to the taxpayers or by putting it into other federal programs, such as education or vaccinations. Second, tax credits are effective when applied to entities that either exist or do not--like children--but they are notoriously difficult to implement when dealing with items related to quality or extent. As dozens of Home Energy articles have demonstrated, there's a big difference between simply dumping insulation into an attic and competently installing it. The same goes for house tightening measures. Third, tax credits can reward people who would have made those investments anyway. This is called the free rider effect. It's a challenge to design a tax credit so that it will stimulate new activity rather than simply lower the cost for the free riders.

Finally, the cost of administering a tax credit that effectively saves energy may be burdensome. A simple check-list is attractive, but is likely to be abused. On the other hand, consumers will be discouraged from making major conservation investments if eligibility for the credit requires an expensive inspection. Thus, the tax credit must be large enough to justify the certification procedure.

We think that tax credits can be an effective tool to stimulate energy conservation, reduce emissions, and create a lower-cost industry that will benefit non-participants. However, tax credits must be designed with care or they will be squandered. Readers of Home Energy will want to pay close attention to the discussions.

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