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September 25, 2007

Transportation and GHG regulation

On October 15, the Detroit Branch of the Federal Reserve Bank of Chicago will convene a conference examining various policy approaches to reducing carbon dioxide and other greenhouse gases (GHGs). Following electric power generation, the transportation sector is the second largest source of carbon dioxide emissions in the Midwest, as well as in the overall U.S. (Carbon dioxide emissions generally arise from the burning of fossil-based transportation fuel—gasoline more so than diesel fuel.)

Following the energy price spikes of the early 1970s, federal regulations were issued to improve fuel-efficiency of cars and light trucks. Corporate Average Fuel Economy (CAFE) regulations place fleet-wide fuel-efficiency limits on manufacturers for their passenger cars and separate standards for their light trucks (including so-called minivans and sport utility vehicles, or SUVs).

The CAFE standards are sometimes credited with maintaining fuel-efficiency during the late 1980s and throughout the 1990s, when gasoline prices plummeted and one might have otherwise expected vehicle size and fuel consumption to have grown once again. Nonetheless, CAFE standards are often criticized. For one reason, the added cost of introducing new fuel-efficiency technologies into the latest models may be counterproductive. That is because, in confronting higher vehicle costs, automotive buyers may delay scrapping their old vehicles, thereby keeping an older (and less fuel-efficient) fleet of vehicles on the road.

Fuel-efficiency standards have also been criticized for imposing unnecessary and distorting restraints on consumers’ choices of vehicles. Logically speaking, penalties to modify behaviors to align with socially desirable outcomes should be fashioned to most closely target those behaviors that give rise to social costs. Accordingly, rather than forcing fuel-efficiency standards on specific types of vehicles, a preferable approach would be to penalize the actual behaviors that give rise to carbon emissions regardless of vehicle type. That is, a tax on fuel at the pump would be preferred to vehicle fuel-efficiency standards. And a tax per unit of carbon associated with a particular fuel—such as gasoline over diesel—would be preferred to a general fuel tax. Nonetheless, to date, fuel-efficiency regulations have been more palatable to the American public than alternatives such as direct gasoline taxes.

Midwest-domiciled automakers, especially the Detroit Three (Chrysler LLC, Ford Motor Co., and General Motors Corp.), have so far found it more difficult than other manufacturers to achieve CAFE fleet standards on cars and light trucks. Going back to the 1970s and earlier, Detroit Three automakers have tended to offer larger vehicle models for sale, and this specialization has continued into recent years.

The figure below displays the reported average fuel economy in 2006 for major companies selling vehicles in the U.S. market. For both passenger cars and light trucks, the measures of fleet average fuel-efficiency for both Toyota and Honda easily exceed those of the Detroit Three. Indeed, for passenger cars, the fleet fuel economies of Honda and Toyota already approach the hypothetical standard that is being considered for the year 2020.

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CAFE standards may soon become even more onerous for automakers. In June 2007, the U.S. Senate passed legislation mandating stricter standards on both passenger cars and light trucks. By the year 2020, fuel-efficiency standards would rise for such vehicles so that they must achieve 35 miles per gallon. (Such revised CAFE standards will likely be considered by the U.S. House of Representatives during the fall of 2007).

The vehicle fuel-efficiency of major automakers has been changing in recent years. Per the figure displaying the fuel economies of passenger cars below, Toyota’s and Honda’s have gained markedly over those of the Detroit Three during the decade. In contrast, these Japanese automakers have not widened their fuel-efficiency advantages in the light truck category. Within the category, Honda and Toyota have been selling more models that are heavier and less fuel-efficient than they had before; these models would include the Honda Pilot and Toyota Land Cruiser SUV.

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From a Midwest perspective, the region’s light vehicle production facilities tend to be those of companies that will likely find it most difficult to meet more stringent standards. The map below displays the assembly plant locations of the Detroit Three automotive companies, as well as those of the foreign-domiciled automakers. A large majority of the Detroit Three’s light vehicle production facilities are located in Midwest states. In the northern part of the U.S. automotive corridor, which includes the states of Ohio, Michigan, Indiana, Illinois, Wisconsin and Missouri, 24 of its 31 light vehicle plants are owned by the former Big 3 domestics. Accordingly, the region’s residents will be interested to see that any prospective carbon reduction policies are as cost-effective as possible.

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Not everyone believes that GHGs from human activity are significantly contributing to global climate change or, if so, that mitigation policies are advised. Still, it would appear that mitigation policies, including more stringent CAFE standards, will be forthcoming. An informed and judicious choice of alternative policies can contribute to achieving cost-effectiveness while reducing GHG emissions.

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Posted by Testa at 12:10 PM | Comments (1)

September 14, 2007

The Midwest and the regulation of greenhouse gas

After years of inactivity in regulating so-called greenhouse gases (GHGs), U.S. policy may be on the verge of doing so. In April 2007, the U.S. Supreme Court ruled that the federal government was authorized to regulate GHG emissions from human activity, which some believe accelerate warming of the earth’s atmosphere, causing disruptive and costly climate changes. Carbon dioxide is the major source of such GHG emissions, making up 75–80 percent of the total volume. This fall, the U.S. Congress is expected to consider bills to control GHGs. Regionally, state and local governments are already acting to reduce GHGs or curb their growth. Most notably, California proposes to reduce emissions by one-third from 2004 levels by 2020. According to this plan, such reductions will be achieved by requiring more fuel-efficient cars and buildings and by requiring that the state’s electricity is generated from renewable energy sources and less carbon-intensive fuels.

Costs are an important consideration in choosing among the various ways to reduce GHG emissions. For this reason, some U.S. and global regions are choosing to set up or participate in “cap-and-trade” systems for GHG emissions, which will function like markets. Some private companies have also chosen to participate in cap-and-trade systems, such as the Chicago Climate Exchange. In these systems, the total allowable amount of GHG emissions is capped. Each participant is awarded or sold permits, or “allowances,” to release specified amounts of GHG into the atmosphere such that the total permitted GHG by all participants does not exceed an overall cap. In limiting emissions in this way, cost savings accrue from the ability of permit holders to buy and sell their allowances with other participants. Those who can manage to reduce their needs for permits can sell them to others; those who cannot manage must purchase permits. In cap-and-trade systems, there are strong incentives for participants to manage and conserve emissions, since doing so generates cost savings. More importantly, cap-and-trade participants are motivated to come up with emission-conserving technological innovations. Seven governors of the Northeast are moving their states toward a “Regional Greenhouse Gas Initiative,” which will cap carbon emissions from the region’s electric power producers.

Market-based systems such as these can be important to regions in keeping down the costs and impact of mandated reductions of GHG emissions. How will the Midwest adapt to the regulation of GHGs? The Midwest economy will likely be affected by carbon regulation in two major ways, both of which will be addressed at a Chicago Fed conference to be held at the Detroit Branch on October 15. The first avenue of regional impact concerns the degree of direct carbon reduction that may be required of Midwest households and businesses, especially in the generation and use of electric power. A second avenue of impact is less direct. The U.S. Congress is considering greater stringency in the fuel-efficiency of cars, trucks, and other transportation vehicles. Major automotive companies are domiciled in the region, many of which are now financially beleaguered and many of which are thought to face added challenges in complying with heightened fuel-efficiency standards.

Emissions of carbon dioxide have been climbing over time in the Midwest and in the U.S. as a whole. Generally, carbon dioxide is released along with the burning of fossil fuels—coal, petroleum, and natural gas materials. Over time, our growing energy-hungry economy has burned more fuel. Since 1950, U.S. energy consumption is up over three fold, almost entirely from greater consumption of fossil fuels.

U.S. carbon emissions continue to lead the world (China is second), and U.S. carbon emissions have grown more rapidly than the nation’s overall energy consumption. Electric power generation is the source of the more rapid rise in carbon emissions. Among major energy-consuming sectors of the U.S. economy, electric power generation has outpaced the others. The burning of coal remains the primary means to generate electric power, and it is the most carbon-intensive fuel.

Despite rising emissions, the overall carbon intensity of the Midwest economy and the U.S. economy has been falling rapidly along with heightened overall energy efficiency. Over time, the U.S. economy can produce a dollar of real output with less energy input. As shown below, carbon dioxide emissions per dollar of real output are approximately one-half of what they were in the early 1960s. By this measure, the Midwest carbon intensity exceeded the nation by 17.8 percent in year 2001 versus an excess of 4.1 percent in 1963.

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Surprisingly, it is not the Midwest economy’s greater concentration in heavy industry that explains its greater carbon intensity—at least not directly. The figure below reports that the region’s industrial sector accounts for a lesser share of its overall carbon emissions versus the nation’s in its overall emissions. Rather, the region’s electric power sector makes up a larger share of carbon emissions versus that of the U.S., a 42.8 percent share in the Midwest versus 38.4 percent for the nation.

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Nor is it the case that the region’s residents consume considerably more electric power than the national average. Rather, the means of power generation in the Midwest tends toward the burning of coal along with attendant carbon emissions. As shown below, power generation facilities in every Midwest state (save Illinois) burn coal to a greater degree than those of the nation, a 41 percent greater share in May 2007. Illinois’ lower carbon intensity derives from its use of nuclear facilities to generate electric power. Indiana and Ohio are especially dependent on coal to generate power at the present time.

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From these cursory observations, it would appear that, to avoid costs and penalties, the Midwest’s electric power generators would be called on to reduce carbon emissions in the event that state or national policies begin to control GHG emissions. Possible avenues to do so are to rely on more (carbon-free) nuclear generating plants or on renewable means, such as the conversion of wind power to electricity. Various technologies to scrub coal of its carbon are also available or on the drawing board.

In choosing among these vehicles to reduce carbon, cap-and-trade systems are in some respects highly suitable for electric power producers. Electric power plants tend to be large and fixed in number. Accordingly, the issuance, monitoring, and trading of emissions permits can be carried out with little monitoring and administrative cost. Of course, the ultimate costs of achieving carbon reductions remain uncertain. In the 1990s, the nation had favorable experiences with a cap-and-trade market among power producers in reducing sulfur dioxide emissions as required under the Clean Air Act. Emissions were reduced below expectations at costs that were far below expectations. It is hoped that a similarly successful marriage of technological progress and market-based incentives will once again come about.

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Posted by Testa at 7:26 AM | Comments (1)

September 5, 2007

How should states tax business?

As much of the Midwest economy struggles to boost its economic performance and as Midwest governments try to maintain funding for public services, the subject of state and local business taxes arises. This summer, the state of Michigan replaced its innovative but contentious “single business tax” with two lesser taxes, one on business income and the other on business gross receipts. Meanwhile, Illinois’ Governor Blagojevich proposed a hefty tax on business gross receipts that was to begin in 2008. That tax proposal was defeated even as the Governor railed against the interests of high-powered lobbyists “who eat fancy steaks” and “shuffle around in Gucci loafers.” These and other new developments in state–local business taxation will be discussed and analyzed by some of the nation’s leading tax experts at a Bank conference this coming September 17.

What are business taxes, and how should they be viewed? By definition, and in accounting for them, business taxes are any taxes collected from businesses and legally imposed on business revenue, property, assets, sales, right to do business and inputs to production. Measured in this way, business taxes are estimated in a recent study by Ernst & Young to have been $554 billion in 2006, accounting for 45 percent of state–local government tax collections. By this reckoning, their share of these tax collections has fallen by only a couple of percentage points since 1990.

The table below, drawn from the same study, displays business tax collections by type for Seventh District states and the U.S. The following graph allocates property taxes by type into shares of the total collection. Property taxes, which are largely administered and collected by local governments, comprise almost 50 percent of business taxes. Seventh District states have historically drawn on these sources since local governments tend to be prominent here and because the Midwest economy has historically concentrated in property-rich sectors, namely agriculture and manufacturing.

It may surprise many to find that “retail” sales taxes on business transactions rank second in business tax share. Though it is often thought of as a tax primarily levied on consumers at the point of final sale, many intermediate purchases of goods and services between businesses (B to B) are not exempted from it. By one estimate, as much as 40 percent of retail sales tax collections in the U.S. may be collected from B to B sales.

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In fashioning business-type taxes, policymakers seem to be motivated in two primary ways. First, business taxes are often seen as a popular and expedient way of raising revenue for public services and do so at the expense of the business owners. There is a common notion that such taxes are “progressive” and are drawn from the wealth of well-to-do individuals. However, business-type taxes are imposed on certain transactions and not people per se. For example, a particular tax may be called a “retail” tax if it is imposed on telephone or electricity consumption, implying that the consumer is bearing the burden. But, the same tax may be called a “gross receipts” tax when levied directly on the public utility, implying that unidentified “business owners” are bearing the burden of the tax. Yet, in every action in collecting either tax, they are identical. “Who puts the nickel in tax collection box” makes no difference in real impact.

Similarly, while a business tax may be legally written to fall on the purchase of a business input or on the income of a corporation, behavioral adjustments take place in response to the tax that ultimately shift the final burden of the tax. Most commonly, excessive taxes are shifted forward into the prices of goods purchased by consumers—rich and poor alike; or taxes may be shifted backwards onto people who own the factors of production—laborers as well as nonworking households of various income strata.

If it is true that business taxes are shifted, why do we see that business organizations and business owners vigorously fight business tax hikes in state legislatures and in local city councils? Part of the answer is that taxes are only shifted in the long run. In the meantime, because business operators and owners cannot quickly adjust their behavior in response to tax hikes, the tax burdens may indeed fall heavily on them personally. Only after varying periods of time may businesses fully take offsetting actions, such as reducing investment and labor, retrenching production, or moving to other locales. And looking forward, many opportunities for business expansion may be nullified because of disincentives that are attendant to the expanded taxation.

In this light, the other major consideration of policymakers comes to the fore. State and local policymakers worry about their competitiveness in setting business tax policy. In the United States, “tax competition” is highly active among state and local governments. As localities compete for both jobs and tax revenues, taxes do not generally stray too far out of line. Outwardly, states keep their general business tax structures in line with their neighbors so as not to discourage business investment. So too, states and localities often offer generous and other selective tax abatements.

Tax competition serves not only to keep business taxes from being punitive, but in the competition for local investment, localities are often forthcoming in allowing commercial use of land and providing public services to business. In fact, because businesses do directly use public services such as roads, refuse disposal and public safety services, it is clear that business taxes should seldom or never be reduced to zero but should rather cover related costs. Other similar “business generating” costs that have been advanced in this regard include pollution-type taxes, which are more common in Europe, and the business benefits of allowing “limited liability” organization, which may impose costs on governments if businesses fail catastrophically or in unanticipated ways.

Some observers and analysts believe that local governments do not manage well the negotiations with savvy business firms for selective tax subsidies. For this and other reasons related to tax competition, insufficient revenues will be raised to fund basic services to households, such as public education. Accordingly, efforts to limit competition by statute have been advocated, along with proposals to assist governments in bargaining more effectively with arbiters of mobile capital investment.

Is the limiting of tax competition necessary to save governments from themselves? The answers are not yet clear. However, it can be said that local governments are competing on more than the basis of tax competition alone. Several studies have indicated that the quality of life and other household amenities are increasingly the determinants of metropolitan area growth. Local leaders, and especially big city mayors, have responded to this trend by building infrastructure and offering amenities to attract workers—especially educated and skilled work force—to their cities. Such efforts range from festivals and parks to school reform and public safety. Younger people are often the focus, since they are more mobile in their migration patterns. In tandem, cities often couple amenity initiatives with employment strategies such as college internship programs with local firms, recruitment fairs and regional marketing.

Governments also compete in providing public services to business, and they also construct the regulatory and legal environment in which businesses operate. In considering where and whether to invest, businesses must often look to an uncertain future. In choosing where to invest, they accordingly prefer to have some certainty with respect to state and local government behavior toward business activity. They may ask themselves: Do the state and local governments seem to be committed to standing as an attentive and steady partner in providing services as businesses’ needs change over time? Or has the past record of state and local government been punitive and myopic in expanding business taxation when revenue shortfalls arise?

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Posted by Testa at 11:01 AM | Comments (1)