Biofuel subsidies versus the gas tax: The carrot or the stick?

This paper provides an analytical framework to examine the relative efficiencies of a revenue-neutral biofuel subsidy and a gas tax in the presence of pre-existing distortions and growing substitutability between fuels. Both policies are set to achieve a targeted reduction in gasoline use at the state level. The model is then calibrated for a small open economy such as Illinois which is one of the largest producers of biofuels such as ethanol in the U.S. The main result of the paper shows that raising the biofuel subsidy use reduces overall welfare by more than a higher gas tax, both aimed to achieve a targeted reduction in pure gasoline. The relative efficiency of the higher gas tax is primarily due to it exacerbating the pre-existing distortion in the biofuel market by less than the subsidy. Moreover, for current parameter estimates welfare improving policy combinations for achieving a targeted amount of energy security are higher gas taxes combined with lower biofuel subsidies and a lower tax on income. However, the preference for a gasoline–labor tax swap shrinks as the elasticity of substitution between the two fuels rises.