Energy Tax Credits

What are energy tax credits designed to do?

The federal government often incentivizes behavior by using carrots or sticks. Tax credits, like a carrot, are a reward for engaging in behavior the government wants to encourage, like installing solar panels on your home. The alternative strategy is to use sticks, taxing people who do things the government wants to discourage, like operating a coal-fired power plant. Such taxes are discussed in our policy brief on carbon taxes.  Another form of sticks are cap-and-trade systems that limit the amount of greenhouse gases emitted by utilities and other businesses. The policy brief on cap-and-trade has details.  

What energy tax credits are available?

There are many energy tax credits at the federal and state levels. Here, we summarize some of the major programs. Federal programs for individuals give credits for weatherizing homes, installing solar and other renewable energy systems, and buying hybrid and electric vehicles. For example, the Energy Efficient Home Improvement Credit incentivizes homeowners (landlords and renters are not eligible) for weatherizing their homes and making energy-efficiency improvements. This credit is capped at $3,200. The Residential Clean Energy Credit refunds citizens up to 30% of the costs of renewable energy technologies such as solar panels, geothermal heat pumps, small wind turbines, and other renewable systems.

Federal clean vehicle credits reimburse up to $7,500 of the cost of a qualifying electric vehicle. Both individuals and businesses are eligible for these credits, which can cover purchases of new and used vehicles. The qualifications include that the vehicle can be charged by an external source, has undergone final assembly in the United States, and is manufactured by a company that has not manufactured more than 200,000 electric vehicles since 2010. (As of mid-2024, the last provision only disqualifies vehicles produced by Tesla.)

Businesses constructing or retrofitting buildings to be energy efficient can claim the Energy-Efficient Commercial Building Credit. Construction companies that build energy-efficient homes can claim credits up to $5,000 per home. Additionally, the Renewable Electricity Production Tax Credit gives power-generation companies two options: a tax credit for money invested in new renewable energy systems or a credit on the electricity produced by these systems. Credits are also available for construction of energy storage facilities. There are other credits for producing clean fuels (those that produce minimal CO2 when used), building and operating nuclear power plants, facilities that reduce CO2 emissions from factories, and building electric vehicles.

What are the costs of energy tax credits?

The Inflation Reduction Act of 2022 extended many existing energy tax credits into the future, many until 2032. A Brookings Institution study estimates that the cost of these tax credits, in lost tax revenue and direct expenditures, will be $392 billion between 2022 and 2032.

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What are the pros and cons of energy tax credits?

Energy tax credits offer both direct and indirect benefits. The direct benefits include reducing total energy consumption and increasing the energy produced by renewable sources. In addition, tax credits can create a second benefit: if they lead to increased purchases of new systems such as solar cells, producers may respond by investing in production efficiencies and research that lowers the cost to future purchasers. As discussed in our brief on renewable systems, the price of solar electricity systems has sharply declined over the last two decades. Demand stimulated by individual and business tax credits is one possible explanation.

The largest disadvantage of using tax credits to shift towards renewable systems is that governments must make difficult decisions about which technologies to encourage, and is associated with financial implications and restrictions on individual, social and industrial preferences. For example, as the table above shows, over the next ten years, the federal government will spend over $50 billion on tax credits for manufacturing and purchasing electric vehicles. The goal is to reduce CO2 emissions from automobiles and trucks. Is a shift towards electric vehicles the best way to achieve this goal? The same funds might achieve larger reductions if used to improve existing vehicle technologies. As we discussed in our brief on electric vehicles, broad adoption of EVs will require significant investments in charging infrastructure. By implementing an EV tax credit, the federal government is making complex decisions that have long-lasting consequences, in many cases, without having a complete picture of all relevant factors that may impact the outcome of such policies.

A second problem with tax credits is that they can reward people for decisions they would make regardless of the tax benefits. For example, a generation ago, solar energy systems were uneconomic, meaning that the cost per kilowatt-hour of energy produced was far greater than buying energy from a local utility. Tax credits were needed to reduce costs and motivate individuals and businesses to install solar systems. Now, after sharp declines in the price of solar systems, people may buy these systems at comparable prices to alternative sources regardless of the tax benefits. If so, then the credits are depleting taxpayer funds while not having a meaningful impact on changing consumer behavior.

Due to lobby efforts and political influence, much of these tax credits and other incentives typically benefit only a select group of people with influence and power within the energy and related sectors. The credits can also influence land use and associated values for both target and adjoining properties (e.g. how would the majority of Americans feel if a neighboring property’s zoning allowed for a large solar or wind farm next to their home?)

Tax credits can also become feel-good public relations measures with little real benefit. For example, the figure above shows very little use of the credits for carbon capture. One of two things might be true: the credits are too small to change anyone’s behavior, or appropriate technology is not yet available. Either way, the tax credit is unlikely to have its intended effect.