Toward an optimal U.S. ethanol fuel subsidy

Enhanced environmental quality, fuel security, and economic development along with reduced prices of ethanol-gasoline blends are often used as justifications for the U.S. federal excise tax exemption on ethanol fuels. However, the possible effect of increased overall consumption of fuel in response to lower total price, mitigating the environmental and fuel security benefits, are generally not considered. Taking this price response into account, the optimal U.S. ethanol subsidy is derived. Estimated values of the optimal subsidy reveal that the subsidy's environmental and security benefits are questionable. However, positive environmental and security benefits from the ethanol tax-exemption subsidy may be obtained if the subsidy is combined with an increase in the excise tax on gasoline.