END TAX LOOPHOLE SOCIALISM

Promoting Fair Competition in the Electricity Market

 

Executive Summary

Private utilities serve about 75% of the nation's electricity market, with government owned utilities serving about 15% and nonprofit coops serving the rest. But the government share will dramatically increase in the future unless the government utilities are restricted from using their extensive government subsidies to compete in the newly emerging, national competitive marketplace for electric power.

The government utilities are heavily subsidized, to the disadvantage of the private utilities. They are exempt from federal income taxes and are allowed to use taxfree local government bonds to raise capital to build new plants and finance their operations. The federal government also grants these government owned utilities lowcost power generated by federal hydroelectric projects. Government utilities are also exempt from most state and local taxes.

Altogether, these subsidies cost taxpayers close to $7 billion per year. In contrast, the private utilities pay close to $25 billion per year in federal, state and local taxes. Economists estimate that this disparity lowers the price for government utility power by 20% compared to what it would be with equal rules for everyone.

Electric utilities are no longer natural monopolies restricted to separate local service areas. Due to new technology and encouragement from the Federal Energy Policy Act of 1992, companies can sell their electric power across the country in a national, competitive market. If government utilities can compete, however, with the advantage of the massive subsidies described above, they will greatly expand over time and eventually take over most of the market, directly contrary to the goal of privatizing public enterprises where possible.

Fortunately, corrective legislation has been developed by Rep. Philip English (RPa.). That bill would prohibit government utilities that sell electricity in the general marketplace outside of their direct service areas from issuing new tax-exempt government bonds to finance generation or transmission facilities. It would also impose federal income taxes on the sale of electricity by a government utility outside its service area. This bill would solve the problem, as government utilities could no longer use their subsidies to compete against private utilities in the national market. Americans for Tax Reform (ATR), therefore, strongly urges support for this legislation. In contrast, Sen. Slade Gorton (RWash.) and Rep. J.D. Hayworth (RAriz.) have introduced legislation (S. 386 and H.R. 721 respectively) at the behest of government utilities. These bills would actually expand the ability of government utilities to use their subsidies to compete in the national marketplace, exacerbating the problem. Consequently, ATR strongly urges opposition to these bills.

Introduction

Electric power companies are no longer natural monopolies. Technology has developed now so that electric power can be transmitted long distance over power lines. The power for your home can consequently be purchased as a technical matter from any of the broad array of electric power companies across the country in a competitive marketplace.

Encouraged by the Federal Energy Policy Act of 1992, this competitive marketplace is emerging across the country. Already, 19 states with about half the nation's population have adopted reforms to allow consumers to choose among competing electric power companies. Similar reforms are being considered in the other states.

For such a competitive market in electricity to work, however, all the electric power companies must be subject to a level playing field, meaning equivalent tax and regulatory burdens. Yet, governmentowned utilities enjoy special advantages and subsidies under current law. IRS regulations adopted last year grossly expand the ability of government utilities to use these advantages in the national marketplace.

Eventually, the result of these policies will be to greatly expand the proportion of the market controlled by government rather than private utilities, socializing rather than privatizing the market. It will also shortcircuit the possibility of a competitive market for consumers, as the utilities with special advantages take over the market. Corrective federal legislation is needed so that federal tax policy at least will treat competing companies equally.

Background

Private electric companies serve about 75% of the nation's electricity market. Government utilities, owned mostly by cities and counties, serve about 15% of the market. The remaining 10% is served by electricity co-ops.

The government utilities are heavily subsidized, to the disadvantage of the private utilities. They are exempt from federal income taxes, and they are allowed to use taxfree local government bonds to raise capital to build new plants and finance their operations. These tax exemptions cost the federal government about $3.3 billion in lost federal revenue in 1995.

In addition, the federal government grants these governmentowned utilities low cost power generated by federal hydroelectric projects. In 1995, federal charges for this power were $2.2 billion below market rates.

Government utilities are also exempt from most state and local taxes, resulting in a revenue loss of $ 1.4 billion in 1995 to state and local governments.

Consequently, the subsidies to these government utilities total close to $6.9 billion per year. In contrast, the private, nongovernment utilities paid more than $ 10 billion in federal income taxes and $ 13 billion in state and local taxes in 1995. This total tax burden is over $23 billion per year. This is quite disparate, unfair treatment. Indeed, economists estimate that this disparity lowers the price for government utility power by 20% compared to where it would be with equal rules for everyone.

Adding to the Problem

On Jan. 22, 1998, the IRS issued new tax regulations that greatly add to this problem. Previously, when government utilities used tax-exempt bonds to build power generation and transmission facilities, those facilities could only be used to serve the city or county jurisdiction of the government that owned the facility. They could not be used to compete for electricity sales outside the government's city or county jurisdiction.

But the new regulations now allow government utilities to use tax-exempt bonds to finance power generation and transmission for sale outside the government's jurisdiction, in the open marketplace. Government utilities can sell electricity without limit in such areas under contracts for periods up to six months. These utilities can effectively compete in these markets with successive six month contracts. Moreover, government utilities can also enter into contracts for electricity sales for periods up to three years, when those sales supposedly replace sales of power within their jurisdiction lost to competition.

Government utilities are already moving to exploit the loopholes under current law. A city utility in Seattle is now selling taxfree power to Nordstrom's in California. A local government utility in North Carolina is doing the same with corporate giant Honeywell. The enormous New York Power Authority has announced plans to sell taxfree bonds for the sole purpose of competing against private power companies. A local government utility in Florida has begun plans for construction of a new power plant devoted almost entirely to the sale of power outside its local area.

Moreover, the government utilities have publicly stated their goal of total government ownership of the huge transmission grids that will be built to facilitate a national competitive market in electricity. Indeed, these tax-exempt utilities are already using tax-exempt financing to get into businesses such as cable television, telephone service, and home security systems.

Allowing government utilities to compete with private, investorowned utilities with such preferential tax treatment is a misuse of the tax exemption for government bonds. This tax exemption is allowed because the federal government should not be taxing the public functions and services provided by other levels of government, such as police and fire protection, public schools, courts, prisons, etc. But selling electricity in the competitive marketplace outside the local government's own jurisdiction is not a government or public function or service. It is a commercial service.

Allowing governments to enter into commercial activities with such tax exemptions simply distorts the private competitive market. Instead of the lowestcost and mostefficient producer winning the consumers, a highercost and less efficient government producer will often win because of the cost advantage provided by the tax exemption. This means higher real costs, less efficiency and a slower economy overall.

In addition, government commercial operations, like utilities enjoying such tax exemptions, will shortcircuit competition in the marketplace. The costadvantage provided by the tax-exemption can preclude other power entities from the opportunity to compete at all. As a result, instead of competition, the market would be left again with government utility monopolies.

Such heavy tax preferences for government utilities will ultimately lead those utilities to take over more of the electricity market, displacing privatesector utilities. This would be the reverse of privatization for these markets. It would be a government takeover of the electricity markets. We should be doing just the opposite. We should be privatizing government electric power companies, leaving all such commercial activities to the private sector, where they can be best performed.

The Joint Committee on Taxation has recognized many of these problems, noting in an October 1997 report that, if government utilities are,

"permitted to retain their ability to receive tax-exempt financing, they might have a considerable cost advantage over other generators in a deregulated market for electric power. The market share of such generators would expand and the implicit federal subsidy to electric generation and certain investors might increase."

Similarly, President Clinton's Council of Economic Advisors stated in its 1996 Economic Report of the President,

"For competition to work well, it must take place on a level playing field: Competition will be distorted if producers are given selective privileges or subjected to selective obligations imposed to further even legitimate social goals.... Accordingly, reexamining special privileges of various entities may become more important."

Solving the Problem

Fortunately, Rep. Philip English (R-Pa.) has developed corrective legislation in 1999 - H.R. 1253.

Under Congressman English's bill, government owned utilities are given a choice: continue to operate as you have in the past or participate with other energy suppliers in the competitive marketplace. If government owned utilities elect to compete, any sales of electricity outside their service areas would be subject to federal income tax, just like any other commercial operation. If, again, the choice is to compete, no tax-exempt financing could be used to finance new generation and transmission facilities. Existing bonds would not be affected by this legislation.

 

This bill would essentially provide for fair competition in the electric marketplace. Government utilities could not use federal tax-exemptions to compete in the private commercial marketplace outside their government jurisdiction. They could engage in such competition if they chose, but then they would be subject to the same tax rules as everyone else.

Government utilities, however, would still have an arbitrary tax preference advantage over competition within their government jurisdiction. This can best be solved in the long run by privatizing these government utilities.

Government utilities argue against this proposal on the grounds that private utilities receive an unlimited tax preference as well through accelerated depreciation. This provision allows utilities and all other capital investors across the country in all businesses to deduct the cost of their capital investments over fewer years than the useful life of those investments. For example, the cost of building a power plant that will last 40 years can be deducted over substantially less than 40 years through accelerated depreciation.

But this argument could not be more ridiculous. Accelerated depreciation only defers the taxes utilities must pay for a few years, during the time when they can take higher deductions through accelerated depreciation. Moreover, this argument completely misunderstands the issue of depreciation. There is no reason why capital expenses should not be deducted completely in the year they are incurred, like all other business expenses. Forcing businesses to deduct their capital expenses over several years is a discriminatory burden on such capital investment. Accelerated depreciation merely reduces this discriminatory burden by allowing businesses to deduct their capital investments over fewer years. But that discriminatory burden continues as long as the capital expenditure is not completely deducted in the first year in which it is incurred.

Finally, under the proposed legislation, government utilities that sell electricity in the open market outside their government jurisdiction will, in any event, enjoy this accelerated depreciation "subsidy" on the same terms as all private businesses, as they would be subject to the federal income tax system for those sales.

For all of the above reasons, ATR urges strong and vigorous support for Rep. English's legislation.

Electric Socialism

In contrast to the corrective legislation introduced by Rep. English, Sen. Slade Gorton (R-Wash.) and Rep. J.D. Hayworth (R-Ariz.) have introduced legislation (S.386 and H.R.721 respectively) sought by the government utilities that would make the problem even worse.

Under these bills, government utilities could elect to remove all restrictions on the use of their current tax-exempt facilities for the sale of power outside their current service areas. All of their outstanding bonds that they used to finance their current facilities would then be grandfathered as permanently tax-exempt. In return, they would supposedly give up the right to issue tax-exempt bonds for the construction of new power plants in the future.

But the bills would still allow these utilities to use their current tax-exempt financed facilities to sell electricity outside their current market areas taxfree. The bills would not impose any income tax on sales outside current service areas. So government utilities could sell their power in direct competition with private utilities with the artificial, governmentcreated, 20% price advantage.

Moreover, these utilities could still use tax-exempt bonds to build new transmission facilities. This would directly help government utilities to achieve their goal of complete government ownership of the nationwide transmission facilities in the new competitive market. In contrast, the Administration has proposed prohibiting any new tax-exempt bonds for transmission facilities.

In addition, the bill creates broad loopholes for the restrictions that it would supposedly retain. Current law allows sales outside a government utility's service area up to 10% of total sales or $15 million, whichever is less. But S. 386/H.R. 721 also exempts sales to all current customers. So everyone who fell under the 10%/$15 million exception before would be automatically exempt, and government utilities could then sell to new customers to fill the exception. This would effectively double the current exception. New tax-exempt bonds could then be used to build new generation facilities to serve these new out-of-area customers.

Moreover, tax-exempt bonds could be sold under the bills to finance new pollution control facilities and repairs for existing generation facilities, including repowerings and other life extensions for those facilities. Again, the Administration, by contrast, has proposed that no new tax-exempt bonds be allowed for generation facilities.

By effectively expanding the subsidies and favorable tax treatment for government utilities, the Gorton/Hayworth bills would lead to greater control of the market by government utilities, directly contrary to privatization goals. Consequently, this is bad legislation that should be vigorously opposed.

Conclusion

Congress should enact the legislation proposed by Rep. English. That bill would simply provide the same tax treatment to government utilities selling electricity in the general marketplace as private utilities. That would promote fairness, efficiency, competition, general tax relief and overall economic growth.