Emerging Issues Commentary July 2008 Jenner & Block: Federal and State Tax Incentives for Alternative Vehicles and Fuels By Gail H. Morse and Alexandra E. Dowling Background. 1 Trucks and automobiles run on gasoline and diesel produced from oil, and are a primary reason the U.S. consumes large quantities of fossil fuels. 2 Given the high levels of demand for fuel, federal and state governments have historically provided significant tax incentives to encourage fossil fuel production and lower the cost of gaso- line for consumers. As the scarcity of oil is appreciated, however, the demand for a change in energy policy increases. For example, in response to the OPEC oil embargo and oil crisis in the early 1970s, which many people remember most vividly because it resulted in long lines at gas stations, Congress began to consider the need for a shift from petroleum based transpor- tation fuels and fossil fuel burning vehicles and enacted the first tax incentives to encour- age the development and use of alternative fuel vehicles and fuel efficient vehicles. Today, the tax code has made little progress in keeping up with technology or the de- mand for alternatives to fossil fuel and fossil fuel burning vehicles. Since their introduc- tion 30 years ago, federal income tax provisions for alternative fuels have not been meaningfully updated to compete with the tax incentives provided to fossil fuels. 3 As a result, alternative fuels have not yet significantly affected U.S. energy independence or energy security, nor have they resulted in clear, positive environmental effects. 4 Given the recent focus on the increasing cost of oil and carbon dioxide emissions (the transportation industry, including both commercial and personal vehicles, is responsible for approximately one-third of all carbon dioxide emissions), 5 there has been increasing demand for finding a replacement for fossil fuels and fossil fuel burning vehicles. Most commentators agree that without significantly increasing the federal and state tax bene- fits for the types of alternative fuels that are the most promising alternative sources (or reducing existing tax benefits for fossil fuels), thereby encouraging significant research 1. This article is intended to be a companion piece to the authors’ March-April 2008 article, Federal and State Tax Incentives for Renewable Energy , 2008 Emerging Issues 221 , which reviewed tax incentives for the fossil fuel industry as well as other topics that will be discussed in less detail in this paper. 2. Mona Hymel, The United States’ Experience with Energy-Based Tax Incentives: The Evidence Supporting Tax Incentives for Renewable Energy , Arizona Legal Studies Discussion Paper No. 06-21 (Apr. 2006), at 2. 3. Roberta Mann & Mona Hymel, Getting into the Act: Enticing the Consumer to Become “Green” Through Tax Incentives , 36 Envtl. L. Rep. 10419, 10422 (2006). 4. U.S. General Accounting Office, Effects of the Alcohol Fuels Tax Incentives (March 1997), at 19–20. 5. Energy Information Administration, U.S. Department of Energy, U.S. Carbon Dioxide Emissions from Energy Sources (May 2007), available at http://www.eia.doe.gov/oiaf/1605/flash/flash.html (last visited June 24, 2008). Copyright © 2008, Matthew Bender & Company, Inc., a member of the LexisNexis Group. LexisNexis and the Knowledge Burst logo are registered trademarks of Reed Elsevier Properties Inc., used under license. 1 July 2008 Jenner & Block: Federal and State Tax Incentives for Alternative Vehicles and Fuels By Gail H. Morse and Alexandra E. Dowling and investment in alternative fuels, alternative fuels are unlikely to overcome the incen- tives provided to fossil fuel production. This article will describe the federal and state tax incentives for fuel efficient and alterna- tive fuel vehicles and the prospective efficacy of such incentives. Federal Fuel Efficiency and Alternative Motor Vehicles Tax Incentives. Governments have often provided income and excise tax subsidies to achieve social, economic, or po- litical goals. 6 Fossil fuel producers have long received income tax incentives in the form of percentage depletion and intangible drilling cost expensing. 7 Prior to 1978, there were no tax incentives that encouraged energy conservation or fuel efficiency. In that year, along with tax credits designed to encourage investment in alternative energy sources that were passed in the wake of the OPEC oil crisis, Congress passed the “Gas Guzzler” excise tax to encourage the production of fuel efficient vehicles. The Gas Guzzler tax is imposed today, but given the exclusion of vehicles over 6,000 pounds, which includes most SUVs and trucks, and the failure to increase fuel economy ratings, the tax has not encouraged the design and manufacture of increasingly fuel ef- ficient vehicles. Structurally, the tax is passed on to the consumer at the time of the ve- hicle’s first sale (or first lease) by a manufacturer or importer based on the fuel economy rating of the vehicle. 8 A vehicle achieving fuel economy of at least 22.5 miles per gallon is not subject to the tax; vehicles with a fuel economy rating of less than 12.5 miles per gallon are subject to the highest tax rate at $7,700. 9 The fuel economy ratings have not changed since 1990. In addition to the Gas Guzzler tax imposed on fuel inefficient vehicles, tax credits are available for alternative motor vehicles. There are five general types of alternative motor vehicles described in the tax code: (1) electric battery vehicles that have electric batteries and are plugged in to be recharged; (2) fuel cell vehicles that have electric batteries and are powered by hydro- gen-based fuels that combine with oxygen to convert chemical energy into oxygen; 6. Roberta Mann, Ch. 16, “Subsidies, Tax Policy, and Technological Innovation,” 565, 565, in Global Climate Change and U.S. Law (Michael B. Gerrard ed., Am. Bar Ass’n 2007). 7. Mona Hymel, The United States’ Experience with Energy-Based Tax Incentives: The Evidence Supporting Tax Incentives for Renewable Energy , Arizona Legal Studies Discussion Paper No. 06-21 (Apr. 2006), at 19. 8. 26 U.S.C. § 4064 ; 26 U.S.C. § 4217 (e). 9. 26 U.S.C. § 4064 (a). Copyright © 2008, Matthew Bender & Company, Inc., a member of the LexisNexis Group. LexisNexis and the Knowledge Burst logo are registered trademarks of Reed Elsevier Properties Inc., used under license. 2 July 2008 Jenner & Block: Federal and State Tax Incentives for Alternative Vehicles and Fuels By Gail H. Morse and Alexandra E. Dowling (3) hybrid vehicles that have an internal combustion or a heat engine as well as a rechargeable energy system, such as an electric motor; (4) alternative fuel vehicles that have internal combustion engines but are at least partially run on alternative fuels, such as hydrogen, natural gas, or ethanol; and (5) advanced lean burn technology vehicles that have an internal combustion engine that uses more air than is necessary for complete combustion of the fuel and meets certain fuel economy and emissions standards. 10 The first tax incentives for purchasing an alternative motor vehicle were enacted in 1992. In the wake of the Persian Gulf War, an income tax credit was permitted for 10% of the cost of any electric battery or fuel cell vehicle placed in service during the year, up to a maximum credit of $4,000. 11 Although the amount of the credit (and the $4,000 cap) was never increased, the provision was extended twice before being phased out at the end of 2006. 12 In 1992, Congress also enacted a provision which permitted immediate deductions for certain clean fuel vehicles. Clean fuel vehicles are vehicles that use clean burning fuels, such as natural gas, hydrogen, and fuel blends, at least 85% of which consists of methanol, ethanol, any other alcohol, or ether. 13 The amount of the deduction for most cars, such as the Toyota Prius, was limited to $2,000, but increased to $5,000 for vehi- cles weighing between 10,000 and 26,000 pounds and jumped to $50,000 for vehicles weighing over 26,000 pounds and buses with seating capacity for 20 adults. 14 (As a point of comparison, most of the largest SUVs — including the Hummer H2 — weigh less than 10,000 pounds.) After these provisions were phased out in 2005, Congress introduced the alternative motor vehicle credit, which provides a tax credit for a greater range of vehicles, includ- ing fuel cell vehicles, hybrid vehicles, alternative fuel vehicles, and advanced lean burn technology motor vehicles (although electric battery vehicles are not covered). 15 The amount of the credit is the sum of the vehicle’s fuel economy credit and fuel conserva- 10. Roberta Mann, Ch. 16, “Subsidies, Tax Policy, and Technological Innovation,” 565, 575, in Global Climate Change and U.S. Law (Michael B. Gerrard ed., Am. Bar Ass’n 2007); Martin Sullivan, The Car Credit: How a Tax Break for Engineering Got En- gineered , Tax Notes 1245, 1245 (Mar. 11, 2002). 11. 26 U.S.C. § 30 (a), (b). 12. 26 U.S.C. § 30 (b). 13. 26 U.S.C. § 179A (c), (e). 14. 26 U.S.C. § 179A (a), (b)(1). 15. 26 U.S.C. § 30B (a). Copyright © 2008, Matthew Bender & Company, Inc., a member of the LexisNexis Group. LexisNexis and the Knowledge Burst logo are registered trademarks of Reed Elsevier Properties Inc., used under license. 3 July 2008 Jenner & Block: Federal and State Tax Incentives for Alternative Vehicles and Fuels By Gail H. Morse and Alexandra E. Dowling tion credit, 16 increasing to as much as $40,000 for fuel cell vehicles and alternative fuel vehicles weighing over 26,000 pounds (such as a truck and trailer). 17 An otherwise eli- gible motor vehicle must also comply with applicable provisions of the Clean Air Act and certain safety requirements.