Welfare Impacts of Alternative Biofuel and Energy Policies

We employ an open economy general equilibrium model to investigate the effects of government energy policy, with an emphasis on corn-based ethanol, on the U.S. economy. The model specification incorporates world and domestic markets, assumes pollution costs from fuel consumption, and allows endogenous determination of equilibrium quantities and prices for oil, corn and ethanol. The model is calibrated to represent a recent benchmark data set for 2009 and is used to simulate the positive and normative effects of alternative policies. We find that a second best policy of a fuel tax and ethanol subsidy approximates fairly closely the welfare gains associated with the first-best policy of an optimal carbon tax and tariffs on traded goods. The largest economic gains to the U.S. economy from these energy policies arise from the impact of the policies on U.S. terms of trade, particularly in the oil market. We also find that, conditional on the current fuel tax, an optimal ethanol mandate is superior to an optimal ethanol subsidy. In the benchmark case, the optimal ethanol mandate is about 18 billion gallons.