Comparison of a Fixed and Variable Corn Ethanol Subsidy

When the government subsidizes a commodity, it normally intends to promote production and/or consumption of that commodity for either political, environmental, or economic reasons. Today one major subsidy is the ethanol program, currently with a $0.51 per gallon subsidy, which will in the near future amount to a bill of over $3 billion annually on 6 billion gallons of production. This paper investigates the effectiveness of the subsidy and asks whether a cheaper alternative could be developed. Like any government expenditure, the value of a subsidy must be judged on how well it achieves its intended objective – in this case, stimulating the production/consumption of ethanol, and thereby increasing corn demand. How well the objective is achieved can be measured by the stimulus to production versus the cost to the government. Stimulus to production should be tied to the effect of the subsidy on expected profitability and the change in risk for investors. A fixed subsidy could change the expected profitability simply by adding to the expected profit without the subsidy. However, if profit without the subsidy were already high, as at present, the subsidy might have a small impact on investment decisions and ethanol production. On the other hand, a subsidy that was larger with lower ethanol prices or higher input costs could reduce risk substantially and stimulate greater production through that risk reduction. Today with ethanol prices near $3 per gallon, the industry is very profitable without a subsidy, and the added profit from the subsidy likely induces little additional investment. However, if wholesale gasoline and ethanol prices were to fall below $1 per gallon again, the subsidy would provide substantial incentive for additional investment. So, while we cannot predict the change in investment for any given subsidy approach, we can estimate the change in profitability and risk and compare that with the government cost for each approach. The current ethanol subsidy is a flat 51 cents per gallon of ethanol paid to the agent that blends ethanol with gasoline. In the past it took the form of a partial or total gasoline excise tax exemption, but today it is a tax credit for the ethanol blender (Renewable Fuels Association, 2006). The subsidy is paid regardless of ethanol price or production cost. It is possible to develop a subsidy that falls as the price of ethanol increases and increases as the price of corn falls. Here, we develop such a subsidy and compare it with the current subsidy, examining the difference in government cost, and ethanol producer risk and profitability with monthly data from the past ten years. As shown below, we find that government cost and ethanol producer risk is always lower with the variable subsidy, and expected profitability can be the same or lower compared to the fixed subsidy, depending on one of the subsidy parameters. The rest of this paper provides more details on the design of the variable subsidy program and the empirical comparison.