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Abstract
A general theory is developed to analyze the efficiency and income distribution effects of a
biofuel consumer tax exemption and the interaction effects with a price contingent farm subsidy.
Using U.S. policy as an example, ethanol prices rise above the gasoline price by the amount of
the tax credit. Corn farmers therefore gain directly while gasoline consumers only gain from any
reduction in world oil prices due to the extra ethanol production. Domestic oil producers lose.
Because increased ethanol production improves the terms of trade in both the export of corn and
the import of oil, we determine the optimal tax credit and the conditions affecting it.
Historically, the intercept of the ethanol supply curve is above the gasoline price. Hence, part of
the tax credit is redundant and represents ‘rectangular’ deadweight costs that dwarf standard
triangular deadweight cost measures of traditional farm subsidies. We show under what
conditions corn subsidies can eliminate, create, have no effect or have an ambiguous effect on
rectangular deadweight costs. There are situations where corn subsidies have been the sole cause
of ethanol production (and therefore of rectangular deadweight costs), even with the tax credit.
Corn producers do not benefit from a tax credit when the subsidy program is in effect.
Proponents of ethanol argue that the tax credit reduces tax costs of farm subsidies. But this
ignores rectangular deadweight costs. To assess this, we calibrate a stylized empirical model of
the U.S. corn market and determine that total rectangular deadweight costs averaged $1,520 mil.
from 2001-2006. Over 25 percent of this is due to the farm subsidy program which also
increased the tax costs of the tax credit by 50 percent. Furthermore, the tax credit itself doubles
the deadweight costs of the corn production subsidies. Ethanol policies can therefore not be
justified on the grounds of mitigating the effects of farm subsidy programs.