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Welcome to the RFF Policy Commentary, which is meant to provide an easy way to learn about important policy issues related to environmental, natural resource, energy, urban, and public health problems.

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The U.S. government has been supporting consumer purchases of hybrid vehicles in the form of federal income tax deductions before 2006 and federal income tax credits since then. Because these credits are set to expire in 2010, it is especially timely to consider how effective they have been in promoting hybrid sales and whether they should be renewed.

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What Motivates People to Buy Hybrids?
Shanjun Li
November 13, 2009

In the nine years since hybrid vehicles were introduced into the U.S. market, they have moved from being the rare status toy of “green” Hollywood actors to a good option for average commuters, or so the media would have us believe. Today, hybrids represent roughly three percent of new car sales because of—or perhaps in spite of—federal subsidies, which are due to expire across the board in 2010.

The evidence to support those subsidies is somewhat mixed. For example, in the two years since federal subsidies for the most popular hybrid, the Toyota Prius, have ended, it has continued to gain market share. While most observers agree that federal subsidies were critical to gain market acceptance of what was then a brand-new technology, is that still true today? Or is what matters most the price at the pump?

How Hybrids Work

The level of fuel economy and carbon dioxide (CO2) emissions produced by a conventional gasoline vehicle is largely a reflection of the low efficiency of internal combustion engines. Only about 15 percent of the fuel energy consumed by these engines gets used for propulsion, while the rest is lost to engine and drive-train inefficiencies and idling. Hybrid vehicles combine power from both a gasoline engine and an electric motor that runs off the electricity from a rechargeable battery. The battery harnesses some of the energy that would be wasted in typical automobile operations (such as energy from braking) and provides power whenever the gasoline engine proves to be inefficient and is turned off.

A hybrid model typically costs around $4,000 more on average than its gasoline equivalent because of the battery required for on-board electricity storage and the computer control system that regulates use of the electric motor. Offsetting this is the fuel savings, due to higher fuel economy. For example, a hybrid vehicle achieving a fuel economy of 55 miles per gallon will save $2,340 over the first five years compared with an equivalent regular vehicle with fuel economy of 35 miles per gallon, assuming the vehicle is driven about 15,000 miles a year and the retail gasoline price is $3 per gallon. Hybrids are especially attractive to urban commuters who experience stop-and-go traffic on a regular basis.

Hybrids were first introduced in the United States in 2000 when the Toyota Prius and Honda Insight entered the market. Since that time, the number of hybrid models has increased to 15 in 2007 and there could be as many as 40 hybrid models by 2012. Sales of new hybrid vehicles have increased from less than 12,000 in 2000 to its recent peak of about 350,000 in 2007, with the most popular model, the Prius, accounting for over 50 percent. In 2008, sales of new hybrid vehicles dropped about 10 percent from its 2007 level, likely in large part due to the recent recession. In July 2009, hybrid sales as a percent of total new vehicle sales set a record at 3.55% with the start of the “Cash for Clunkers” program.

What Explains the Increase in Popularity?

One obvious factor is the recent run-up in gasoline prices. For example, the average gasoline price rose from $1.50 to $2.60 per gallon in 20 U.S. metropolitan areas between 2000 and 2006, the data period of the study. Arie Beresteanu and I estimate that this increase in fuel prices accounts for 37 percent of hybrid sales in 2006. If prices had risen to $4 (rather than $2.60) and consumers had expected future prices to stay that high, we estimate that hybrid sales would have been higher still, by about 65 percent, in 2006. And of course, both gas prices and hybrid sales have subsequently risen in 2007 and the early part of 2008.

The Energy Information Administration, for example, projects the hybrid share in new vehicle sales to rise progressively to 17 percent by 2030 as retail gasoline prices rise (in real terms) to $3.80 a gallon, and consumers become more familiar with the new technology.

The second factor is tax incentives and other forms of incentives at federal, state, and local levels.  At the federal level, income tax incentives were modest initially: from 2001 to 2005, purchases of hybrids were eligible for an income tax deduction of $2,000, which amounted to a subsidy of $500 for an individual in the 25 percent federal income tax bracket. In 2005, the tax deduction was replaced by an income tax credit of up to $3,400 a vehicle, with the credit varying based on the savings in gasoline per mile of the vehicle relative to its gasoline counterpart. (If instead tax credits were based on differences in miles per gallon, this would imply much larger subsidies for a given reduction in fuel per mile for small vehicles.)

Not surprisingly, we found that federal income tax deductions had a very minor effect prior to 2006, explaining less than 5 percent of hybrid sales. However, the more generous incentives made a bigger difference, spurring some 20 percent of hybrid sales in 2006.

 










Shanjun Li
Fellow

If tax credits had been twice as large, the average hybrid sale would have received a subsidy of about $4,700 and, according to our estimates, hybrids sales would have been 23 percent greater than their actual sales in 2006.

However due to the small market share of hybrids at present—just three percent of the light-vehicle fleet—the federal incentive program has had very limited effects on overall fuel economy of new passenger vehicles. We estimate that the average fuel economy of new passenger vehicles in 2006 is barely noticeably higher at 23.2 miles per gallon with the program, compared with 23.1 miles per gallon without. Even if tax incentives had been twice as large, the average fuel economy of the new passenger vehicle fleet would have only been a further 0.1 miles per gallon higher. To induce the same level of change, a 10-cent gasoline price increase would suffice, without considering its further impact on driving.

Many state and local governments offer their own programs such as sales tax waivers, state income tax breaks, access to high occupancy vehicle lanes, and exemptions from parking charges. These programs also likely played some role in contributing to hybrid sales. In the context of these state and local incentives, a study by Gallagher and Muehlegger shows that upfront sales tax waivers, which are immediate and automatic at the time of purchase, are much more effective than state income tax breaks, which consumers have to understand and apply for during the filing of state tax returns.

Moving Forward

Federal income tax credit amounts begin to phase out for a given manufacturer once it has sold over 60,000 eligible vehicles. The credit ran out for Toyota and Honda in 2007 and 2008, respectively. In addition to the phase-out rules, the credit policy is scheduled to end after December 31, 2010. Is there still a case for retaining incentives or offering new policies for hybrid vehicle purchases? There exist several arguments for government support of hybrid vehicles, including significant economies of scale in automobile production, advantages of learning by doing on both consumption and production sides, failure to fully take into account the fuel saving of fuel-efficient vehicles by consumers, as well as the political difficulty of raise gasoline taxes in order to correct for the externalities associated with gasoline consumption.

Should the incentives for hybrid vehicle purchases be continued, current research points to several considerations to be taken into account in the future. Our analysis shows that a flat rebate, irrespective of household income-tax liabilities, could be more effective than the current income-tax incentives. Households with higher tax liability can take greater advantage of the income-tax credits for hybrids, although they may not be as sensitive to such incentives as lower-income households with less tax liability. Moreover, a flat rebate program would eliminate the uncertainty in the amount of benefit for consumers at the time of purchase. In light of the finding by Gallagher and Muehlegger that upfront sale tax incentives are more effective than income tax incentives, the rebate would likely be more effective if it is applied at the time of purchase.

Shanjun Li is a fellow at Resources for the Future, with research interests in  environmental and energy economics, empirical industrial organization, and applied microeconomics.

Further Readings:

Beresteanu, Arie and Shanjun Li. 2009. Gasoline Prices, Government Support, and the Demand for Hybrid Vehicles in the U.S. International Economic Review, forthcoming.

Gallagher, Kelly and Erich Muehlegger. 2009. Giving Green to Get Green? Incentives and Consumer Adoption of Hybrid Vehicle Technology. Working paper. Cambridge, MA: John F. Kennedy School of Government, Harvard University.

McConnell, Virginia and Tom Turrentine. 2009. Technical Report: Hybrid Vehicles and Policies to Reduce GHG Emissions.

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