The current legislation that enables ethanol blenders to receive a 45 cent per gallon incentive expires at the end of the year. In anticipation of new legislation, a proposal was developed by University of Illinois economists for a variable incentive program that could save U.S. taxpayers more than $13 billion.

"There are proposals that would eliminate the tax credit entirely and others to keep it exactly as is," said U of I agricultural economist Scott Irwin. "We decided to take a look at a different form of tax credit that would be keyed to the incentives of the blenders themselves rather than just giving them a fixed amount of tax credit regardless of the economics of blending."

The current tax credit incentive arrangement is a direct payment with considerable expense associated with it —about $4 to $5 billion per year, Irwin said. The proposal is an attempt to more efficiently target the incentives to the blenders of ethanol when they need it, but how?

One idea is to key the blenders' credit to the price of crude oil. "When the price of crude oil is very high, blenders might not need a credit, and when it is very low, they may need a large credit as an incentive to blend ethanol," Irwin said. The problem is that there is quite a bit of volatility among energy prices, he said.

Simple equation may be answer

Irwin suggests that a simple equation may be the answer.

"Subtract the price of ethanol from the price of gasoline and that gives you a measure for the incentives to blend ethanol. When that number is positive, that means ethanol is cheaper than gasoline and so blenders will want to include it in the gasoline at the retail supply. When that number is negative, that means the price of ethanol is higher than the price of gasoline and you wouldn't want to use ethanol in terms of the basic market economics. So, we key our rule to zero. Whenever that margin is negative, meaning they would otherwise not want to blend ethanol, that's when the blenders' credit kicks in. The credit is a maximum of the current 45 cents per gallon. So our proposal is to cover negative margins up to 45 cents per gallon and nothing above zero."

Irwin's team tested the proposal and showed that since 2007, the current fixed-rate policy would cost the U.S. taxpayer about $15 billion. "Our proposed new variable blender's rate credit would only cost about $2.5 billion. These are just rough estimates because we're just running the numbers backwards historically, not accounting for the fact that when you change the rules of the game like this, people can change their behavior."

Clearly, there are large potential savings to taxpayers in going to a variable rate system, he said.

Probably the biggest question from crop producers in the Midwest is, "Would that level of reduction in government expenditures hurt the overall level of ethanol prices and corn prices?" Irwin said that's something their report did not address. "We were just looking at how the variable rate might work and what are the implications."

Since the late 1970s, there have been tax incentives in place for the blending of ethanol in gasoline supplies. Prior to last year, the incentive was 51 cents per gallon on domestically produced and blended ethanol. Last year it was lowered to 45 cents per gallon, with a corresponding tariff of 54 cents per gallon on imported ethanol which negates the tax credit.

The full report entitled, "Could a Variable Ethanol Blenders' Tax Credit Work?" was produced by Irwin, Darrel Good, and Mindy Mallory and published on the farmdoc website at http://www.farmdoc.illinois.edu/policy/apbr/apbr_10_01/apbr_10_01.html.