Unintended consequences: $8 billion bonanza for paper mills

This article in The Nation describes a classic case of the unintended consequences that arise from government decisions to use tax credits to try to change the way markets work. I am reminded of how Argentina has repeatedly used devaluations to boost the competitiveness of its export industry, only to repeatedly discover that it doesn't work. Excerpts from the article:

Thanks to an obscure tax provision, the United States government stands to pay out as much as $8 billion this year to the ten largest paper companies. And get this: even though the money comes from a transportation bill whose manifest intent was to reduce dependence on fossil fuel, paper mills are adding diesel fuel to a process that requires none in order to qualify for the tax credit.

The origins of the credit are innocent enough. In 2005 Congress passed, and George W. Bush signed, the $244 billion transportation bill. It included a variety of tax credits for alternative fuels such as ethanol and biomass. But it also included a fifty-cent-a-gallon credit for the use of fuel mixtures that combined "alternative fuel" with a "taxable fuel" such as diesel or gasoline.

Enter the paper industry. Wood chips are cooked in a chemical solution to separate the cellulose fibers, which are used to make paper, from the other organic material in wood. The remaining liquid is called black liquor. Because it's so rich in carbon, black liquor is a good fuel; the kraft process uses the black liquor to produce the heat and energy necessary to transform pulp into paper. It's a neat, efficient process that's cost-effective without any government subsidy.

By adding diesel fuel to the black liquor, paper companies produce a mixture that qualifies for the mixed-fuel tax credit, allowing them to burn "black liquor into gold," as a JPMorgan report put it.

No one in Congress seems to have anticipated this creative maneuver. This past fall the Joint Committee on Taxation computed the cost of extending the tax credit for three months and projected it would cost a manageable $61 million. It now appears that the extension (which was passed as part of the TARP) could cost as much as $2 billion before the credits expire at the end of this calendar year.

In fact, the money to be gained from exploiting the tax credit so dwarfs the money to be made in making paper--IP lost $452 million in the fourth quarter of 2008 alone--that the ultimate result of the credit will likely be to push paper prices down as mills churn at full capacity in order to grab as much money from the IRS as it can.