The Whys and Hows of Energy Taxes: The 20th-Century Policy Aimed at Developing Domestic Energy Sources No Longer Makes Sense. the 21st Century Demands a Fresh Approach

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Current federal energy tax policy is premised in large part on a desire to achieve energy independence by promoting domestic fossil fuel production. This, we argue, is a mistake. The policy also relies heavily on energy subsidies, most of which are socially wasteful, inefficient, and driven by political rather than energy considerations. Finally, the energy taxes that are in place could be more precisely targeted to specific market failures, and these higher taxes themselves would encourage the production of alternatives more efficiently than do current subsidies.

It is widely held that the United States must reduce its reliance on foreign oil. The concern over U.S. vulnerability to the disruption of supply by the Organization of the Petroleum Exporting Countries (OPEC) is understandable, given the fact that the United States imports over 60% of the oil it consumes each year. Of the oil that the United States imports, 40% comes from OPEC countries and nearly half of that from the Persian Gulf region. Many Americans are also concerned that oil monies help countries such as Iran pursue activities that are contrary to U.S. foreign policy.

As a response to these concerns, current tax policy promotes domestic oil and gas production in a variety of ways. The federal government provides a production tax credit for "nonconventional oil" (essentially a subsidy for coalbed methane), generous depreciation allowances for intangible expenses associated with drilling, and generous percentage depletion allowances for oil and gas. In addition, the Bush administration has consistently lobbied to allow additional drilling on the Alaskan North Slope.

This supply response ignores a fundamental fact: Oil is essentially a generic commodity priced on world markets. Even if the United States were to produce all the oil it consumes, it would still be vulnerable to oil price fluctuations. A supply reduction by any major producer would raise the price of domestic oil just as readily as it raises the price of imported oil. In addition, if the United States reduces its demand for oil from countries such as Iran, it has little effect on Iran, because that country can just sell oil to other countries at the prevailing world price. Indeed, this effect has been made abundantly clear by historical experience. The United States has cut its dependence on Iranian oil to zero, buying no oil directly from that nation since 1991. Despite the U.S. import ban, Iran was the world's fourth-largest net oil exporter in 2005.

A policy of energy independence that depends on boosting domestic oil and gas supplies through subsidies has several defects. First, subsidies reduce production costs and so do nothing to discourage oil consumption. Second, the policy encourages the consumption of …