Welfare Effects of Biofuels Trade Policy in the Presence of Environmental Externalities

Abstract

We develop a stylized model of fuel markets in an open economy and derive the optimal mix of trade and environmental policy instruments for biofuels and gasoline that maximizes social surplus and internalizes externalities from miles and greenhouse gas (GHG) emissions. We use this optimal scenario as a benchmark to compare existing and alternative biofuel policies including the import tariff and the tax credit for ethanol. We show that the optimal tax for fuels is directly related to their GHG emissions intensity while the optimal tariff is inversely related to the excess supply elasticity of imported ethanol. The effect of the tax credit on social surplus is clearly negative, while the impact of the tariff depends on the ability of the US to influence ethanol prices in the world market. Our numerical simulation for the US shows that current ethanol policy of an ethanol tax credit and import tariff increases miles externalities and greenhouse gases and decreases social surplus by $3.6 B relative to non-intervention and by $228 B relative to the optimal scenario.

Keywords: biofuel, transport externalities, optimal taxation