All you need is a subsidy ...oops

It's always dangerous to mess with the price system. Even if there are proven positive or negative externalities from particular types of behaviour, and even if you're careful about how you specify the legislation giving form to the tax or subsidy, there often will be unintended consequences.

Case in point: tax credits for use of alternative fuels. US Congress passed legislation back in 2005 providing tax credits for fuels mixing biofuels with normally-taxed fuels. $0.50 per gallon for those fuels. What happens? Christopher Hayes at The Nation explains:

Enter the paper industry. Since the 1930s the overwhelming majority of paper mills have employed what's called the kraft process to produce paper. Here's how it works. Wood chips are cooked in a chemical solution to separate the cellulose fibers, which are used to make paper, from the other organic material in wood. The remaining liquid, a sludge containing lignin (the structural glue that binds plant cells together), is called black liquor. Because it's so rich in carbon, black liquor is a good fuel; the kraft process uses the black liquor to produce the heat and energy necessary to transform pulp into paper. It's a neat, efficient process that's cost-effective without any government subsidy.

So the paper industry was previously using a kind of biofuel for its heating, prior to the tax credit. Great!

By adding diesel fuel to the black liquor, paper companies produce a mixture that qualifies for the mixed-fuel tax credit, allowing them to burn "black liquor into gold," as a JPMorgan report put it. It's unclear who first came up with the idea--Wrobleski told me it was "outside consultants"--but at some point last fall IP and Verso, another paper company, formerly a part of IP, began adding diesel to its black liquor and applied to the IRS for the credit. (Verso nabbed $29.7 million at just one of its mills in the final quarter of 2008 for its use of mixed fuel.)

...

No one in Congress seems to have anticipated this creative maneuver. This past fall the Joint Committee on Taxation computed the cost of extending the tax credit for three months and projected it would cost a manageable $61 million. It now appears that the extension (which was passed as part of the TARP) could cost as much as $2 billion before the credits expire at the end of this calendar year.

In fact, the money to be gained from exploiting the tax credit so dwarfs the money to be made in making paper--IP lost $452 million in the fourth quarter of 2008 alone--that the ultimate result of the credit will likely be to push paper prices down as mills churn at full capacity in order to grab as much money from the IRS as it can.

It's kinda the point of the price system that nobody has to know all of the alternative uses to which resources can be put. When markets set prices, nobody in Congress has to know that the paper industry uses a byproduct biofuel which readily could be adulterated with taxable fuels to harvest a subsidy. When Congressmen instead set prices, there will always be consequences they hasn't thought of, no matter how well-intentioned or careful they've been.

Hayes draws the useful and depressing conclusion:

Whether or not Congress gets around to turning off the spigot, the episode is a useful reminder of the persistently ingenious ways the private sector can exploit even well-intentioned legislation. Considering that the success of the Treasury's recently announced plan to rescue the financial sector depends, in part, on the private sector not gaming the rules, the black liquor story seems particularly germane.