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INSIGHT: Positive Revenue, Economic Impact of Energy-Efficiency Tax Deduction

Jan. 23, 2020, 2:00 PM

Just like people, public corporations and government entities often end up making short-term decisions with insufficient regard to the future. That such a thing happens with regularity may seem counterintuitive; most governments have ready access to credit markets and can borrow at a low interest rate for a considerable term. Investors like to lend to governments because they rarely default and there is a tax break for municipal bonds to boot.

However, the reality is that capital projects begun by a state or local government can face significant fiscal constraints: Elected officials, operating at the perceived behest of its citizenry, often feel compelled to push its architects and engineers to reduce costs as much as possible. Explaining to voters that accoutrements to an already-expensive project being paid for by their taxes will pay off only after a decade—or longer—can be a difficult conversation to have for most politicians.

Such short-term construction exigencies are exceedingly common with potential energy-efficient investments. School boards and city councils can find it difficult to convince constituents it should spend money to reduce energy costs, especially if there is a limited budget and doing so would require the school to forego other features that parents or voters desire.

As a result, government projects can be plagued with penny wise but pound foolish decision-making. For instance, a central Illinois high school that saved $30,000 by shrinking its gymnasium footprint during its construction 20 years ago now finds itself renting space to accommodate its swelling sports teams and is contemplating spending millions to construct a new gym.

Another Illinois high school installed a state-of-the-art power plant during its construction that relied solely on oil and chose to forego connecting to the grid. High oil prices a decade later made this arrangement financially prohibitive and necessitated significant capital spending to create a connection to the grid—made much more costly because it was not done during construction.

This myopia can be endemic in commercial construction as well, where short-term tenants or lenders can force a developer to approach a building that might be designed to last at least 50 years with a payback period of no more than five or 10 years. These situations also can result in architects jettisoning energy-saving modifications to adhere to a strict bottom-line budget.

One solution to budgetary myopia for energy-saving investments and one that would ultimately save money for taxpayers and reduce total energy usage in the U.S.—is for the federal government to change the short-run calculus and nudge the designers of commercial and public buildings to incorporate cost-effective energy-efficient investments.

The federal government has a carrot that does precisely this: the tax code Section 179D Commercial Buildings Energy Efficient Tax Deduction. By providing a tax incentive upfront for money spent on the design of energy-efficient buildings, it incentivizes the architects of public and commercial buildings to spend the additional money required to design new or remodeled buildings that use less energy. The tax deduction reduces the fixed costs of such investments, effectively allowing governments to recoup these investments in fewer years, which causes more energy-efficient construction to occur.

The History of Section 179D

The Energy Policy Act of 2005 was a bipartisan piece of legislation signed by George W. Bush that became law at a time of rising energy prices that many believed portended future oil shortages. It a created numerous incentives intended to reduce the consumption of oil and gas. One such provision was Section 179D, the energy efficient commercial buildings deduction. Section 179D provides a tax deduction of up to $1.80 per square foot of property with newly installed energy-saving equipment and technology—either in a new building or retrofitted within an existing building.

The Act originally made the Section 179D tax incentive available for just two years, a common maneuver for targeted tax breaks of that epoch. Congressional Pay As You Go budget rules were the main reason for its impermanence, although Republican ambivalence then also played a role.

However, Section 179D has garnered considerable bipartisan support since its inception, and Congress has seen fit to extend it several times. For instance, the Tax Relief and Health Care Act of 2006 extended the deduction by one year, and then the Emergency Economic Stabilization Act of 2008 extended it through 2013. The Tax Increase Prevention Act of 2014 extended the deduction for an additional year, and the Consolidated Appropriations Act of 2015 extended it for two additional years.

More recently, the Bipartisan Budget Act of 2018 extended 179D to cover qualified property placed in service in 2017. The provision expired in 2018 and Congress once again approved on Dec. 19 legislation that reinstated the tax incentive through the end of 2020.

The reason for its bipartisan embrace is simple: It provides a big bang for the buck by reducing energy consumption and the concomitant emissions while saving governments—state, local, and federal combined—more money than the deduction foregoes. It is akin to the virtual $20 bill lying on the sidewalk.

The Design of 179D

Section 179D provides a deduction intended to incentivize the improvement in the energy efficiency of commercial and government buildings. To qualify, taxpayers must install equipment or technology related to a buildings’ lighting system; heating, cooling, ventilation, or hot water systems; or the building’s overall envelope. To receive a deduction, the taxpayer must demonstrate substantial savings in energy consumption—at least 50% in the most recent iteration of the legislation—compared to a similar reference building that meets certain energy efficiency criteria. (Standard 90.1-2007 of the American Society of Heating, Refrigerating, and Air Conditioning Engineers and the Illuminating Engineering Society of North America (ASHRAE/IESNA). In 2015, Congress updated this standard from the previous efficiency benchmark 90.1-2001.)

The maximum value of the deduction is equal $1.80 per square foot of area, although improvements made to single systems or that do not meet the fifty percent reduction standard can still qualify for a lesser deduction.

The savings must be certified by qualified engineers and attributable to the specific system—that is, either the lighting, HVAC, or the building envelope. As a result of this specificity, the process for claiming the deduction is not a walk in the park. Taxpayers hoping to claim the deduction want to engage the services of a company that specializes in such certifications to maximize the savings. These independent certifiers are commonly able to streamline the certification process. IRS guidance states that the company which certifies the energy efficiency cannot be the same one that claims the deduction.

Section 179D provides an accelerated cost recovery for qualified investments that improve energy efficiency. When a business constructs a new building or makes a substantial investment to improve an existing building, the tax code has traditionally required the firm to deduct this investment not in the year it makes the investment but to apportion it over the estimated life of the investment instead, which can be as much as 30 years. Delaying the time over which it can depreciate an investment reduces the present value of the tax deduction, which in turn lessens the amount of investment that takes place as well.

Accelerated cost recovery is a favorite tool of Republican tax writers—the Tax Cuts and Jobs Act of 2017 (TCJA) provided for the full expensing of qualified investment in Section 168(k) through 2023. The Act also expanded Section 179 expensing for small businesses (a separate and distinct provision from 179D), allowing them to immediately deduct up to $1 million in new investment per annum.

However, Section 168(k) largely excludes real estate investment, which means that a productive investment in a building that would potentially generate decades of savings via lower energy costs would not receive a beneficial tax treatment, unlike most other investments. Section 179D fixes that tax code lacuna by providing accelerated cost recovery for property that must otherwise be depreciated over time, allowing investments that reduce energy consumption in construction to be treated similar to other productive investments.

Section 179D alleviates another tax code disparity as well: The tax code allows firms to deduct their energy costs immediately, but long-term capital projects that serve to reduce energy consumption must be amortized over the life of the investment. This makes no economic sense.

For certain installations, the cost of these energy-saving improvements can exceed the thresholds set forth in Section 179. Section 179 expensing allows for an immediate deduction of up to $1 million in qualifying investment, but phases out on a dollar-for-dollar basis for investments above $2.5 million. The phase-out means that a $3.5 million investment would completely exceed the limitation, rendering any otherwise qualifying investment ineligible for an immediate deduction.

As a result, in many instances 179D is the only enhanced cost recovery provision for energy-efficient investments, despite the broad expansions in investment incentives in the TCJA.

While 179D provides an immediate tax benefit, it also requires that the cost basis of the qualifying property be reduced by the amount deducted under the provision. For example, a taxpayer claiming a $100,000 tax deduction under 179D on a $1 million installation would only be able to depreciate $900,000 of the investment going forward. As a result, taxpayers forgo some future tax benefits that would be claimed under depreciation, reducing long-term obligations.

The revenue cost for section 179D is quite low, as far as tax incentives go: The Joint Committee on Taxation estimates that the most recent extension of 179D in 2018 cost $79 million in foregone tax revenue in 2018, but just $69 million over the entire 10-year budget window―because of the smaller amount depreciated over future years.

How 179D Saves Money for Government(s)

One goal of Section 179D was to improve energy efficiency for federal, state, and local government buildings. Of course, governments do not pay taxes, so we cannot give a tax break to a city or county. Instead, the provision grants a tax break to the designer—the architect or engineer—of a new or renovated government building that achieves significant energy efficiency improvements.

Such an incentive works in two ways: for starters, designing a building that is more energy-efficient typically costs more money, which the tax break defrays. What’s more, the tax break is also reflected in the ultimate cost the government pays for its new or renovated building. While the designer of the building may receive the deduction, the local governments effectively share in this benefit as well: When the government puts a project up for bid that would be eligible for 179D, the bidders take into account that the project will generate a tax break for their work, so they are inclined to bid less for the job.

The tax break addresses what appears to be an example of a market failure in the design and construction of commercial buildings, which can result from the inability of a developer to either obtain capital for such incremental investments or an inability to convince potential customers—public and private—of the present value of reduced future energy bills. Such fuel-saving myopia is endemic; for instance, research has found that while most purchasers of new cars hold onto their vehicles for a decade, they tend to discount any savings from increased fuel efficiency that occur after three years.

Left to their druthers, building designers, engineers and architects have found it expedient to offer the lowest bid and not bother selling potential clients of potential long-term cost savings created by energy-efficient design and investment. The deduction reduces the incremental cost of designing a more efficient building for the government. The reduced cost would be reflected in lower bid for a building design that demonstrates achieves substantial energy-saving improvements.

It is notable that the private sector has recognized this inefficiency and attempted to devise various ways to incentivize governments to reduce energy consumption as well, but with limited success. For instance, a government entity that needs a new building can partner with a construction firm and have it design, construct, and operate its building for an extended, fixed term. Such an arrangement gives the operating company every incentive to pursue cost-efficient ways to construct a building that minimizes its long-run operating costs.

There are also companies that will make all cost-effective energy-savings investments in a public building for free in exchange for a share of the cost savings.

The fact that neither model is all that ubiquitous in the public sector manifests the fact that managing public buildings can be quite complicated for politicians and civil servants, who have many masters and a variety of tasks they are expected to fulfill. Deprioritizing an opportunity to save taxpayers money five or 10 years down the road can represent a path of least resistance for bureaucrats, especially when few of them will ever realize the opportunity cost of such a decision.

In other words, the market does not appear to be capable of completely eliminating such lost opportunities.

179D’s Impact on the Energy Efficiency of Government Buildings

Budgetary scorekeepers can find it difficult to account for the extent to which the 179D tax deduction can potentially reduce governments’ energy bills. There is considerable evidence that such savings completely negate the foregone revenue.

The federal government owns or manages more than 360,000 buildings, which makes it the nation’s largest energy consumer. In 2018 federal agencies used 897 trillion British thermal units (Btu) of delivered electric and thermal energy from both fossil fuels and renewable sources, and 40% of that energy went to operate federal buildings and facilities. The federal government spent over $16 billion that year on energy, and state and local governments consume roughly the same amount on energy as the federal government.

Heating, cooling, and operating buildings consumes 41% of all energy used in the U.S.

In short, governments in this country—across all levels—use an enormous amount of energy, which means that any effort to reduce energy usage or its concomitant emissions would be remiss if it did not pursue avenues to reduce energy usage in commercial and public buildings. The 179D tax deduction is the only tax incentive intended to facilitate the construction of more energy-efficient buildings.

Firms can find it costly to comply with the provisions’ standards, which likely reduces the extent to which they pursue the deduction. The fact that Congress has irregularly enacted the deduction since its 2005 inception, sometimes for only one year at a time and with occasional lapses, hinders planning, which further reduces its embrace. Since it can take several years from inception to the date at which a building can be inhabited, developers relying on the deduction may naturally worry that the law under which they planned may not match the law in existence when the building is operationally ready, which is when they can claim the deduction.

There has been legislation in the House and Senate to extend the deduction for additional years and increase the square footage cap. At least one bill increases the cap to $4.50 per square foot for new construction and $9.25 per square foot for retrofitted buildings. The Obama administration proposed expanding the deduction and reforming the benchmark for evaluating the relevant energy savings in its budget for 2017.

The Total Energy Savings from Section 179D

Despite its various limitations, the 179D deduction has proven to be an effective tool for reducing energy consumption both in the private and public sector. According to an analysis done by the statistical consulting group Regional Economic Modeling Inc., or REMI, extending the 179D program would generate significant savings for American taxpayers via reduced public sector energy costs―more than enough to make up for any foregone federal revenue. Table One contains its annual estimates of energy savings both by the public and the private sector. The governments’ energy bill reductions tally nearly $6 billion in the next six years.

Table 1

When Congress considers legislation that potentially impacts either spending or tax revenue it must have a “score” attached that provides an estimate of its net cost to the government. Federal law and Congressional budget rules require that these estimates be done by either the Congressional Joint Committee on Taxation or else the Congressional Budget Office.

Congressional budget rules circumscribe how the two entities score legislative proposals; For instance, they must base their analysis on the current law, and not what anticipate what is likely to transpire legislatively. They also—naturally—estimate the effects on federal tax and spending flows, and ignore any impact proposed legislation may have on the fisc of any state and local governments.

And budget rules prescribe budget impact estimates be kept to a 10-year horizon. This constraint causes revenue estimators to overstate the true cost of an extension of 179D insofar as that investment would produce energy savings for decades beyond any 10-year budget window.

Revenue estimators at CBO and JCT tend to be conservative in accounting for behavioral responses (such as a reduction in energy usage) that might have a secondary impact on revenue, reflecting a broader institutional conservatism. For instance, previous research on wealth taxes suggest that their implementation would result in a significant underreporting of net assets, which is something that revenue estimators might find computationally or practically difficult to incorporate into their models.

Accounting for the long-term cost savings from more energy-efficient government buildings is a complicated second-order effect that a revenue estimator may find easier to dismiss as well.

According to the REMI study, the estimated savings in annual energy costs across governments at all levels from 179D gradually increase over time, with savings reaching over $1.2 billion in 2026, the last year of its analysis, while that year’s estimated federal revenue loss would be $324 million. This constitutes hyper-efficient tax policy—more revenue and reduced energy consumption.

A wealth of congressional testimony from industry supports REMI’s revenue estimates. For instance, Johnson Controls testified that the company performed projects for a local school district that saved its taxpayers over $4 million over 15 years. The firm also recently completed a $9 million project in San Antonio it expects to generate savings of $15.6 million just within the first two years. The company had a similar experience in El Paso, where the firm’s energy-efficiency improvements saved taxpayers $4.7 million.

Other governments have seen similar energy-saving improvements resulting from buildings that qualified for Section 179D. Miami-Dade County realized $1.14 million in savings to improvements in its chilled water system serving over a dozen buildings in the downtown area. The Port Authority of New York and New Jersey recognized $400,000 in savings at their new station at the One World Trade Center and saved $660,000 from investments facilitated by 179D made in the Bus Terminal and Stewart International Airport.

Conclusion

The potential savings to be gained from cost-effective investments that reduce energy consumption is enormous: the McKinsey Group estimates that if all public and private entities in the U.S. were to undertake all net present-value positive investments that improved energy, the country would reduce its energy consumption by nearly 25%.

Section 179D helps the private sector realize benefits from new energy-efficient investments up front—just as the tax code treats most other investments—rather than over its productive life, thereby spurring more firms into making such socially and economically productive investments.

It also helps state and local governments make investments that can benefit taxpayers over the long run and corrects the under-investment in energy-efficient buildings that pervades commercial building construction.

The 179D deduction contributes to a salutary trend in the improvement of the energy-efficiency of private and public buildings. Given the advanced age of government buildings across the country, 179D should remain as an important tool in modernizing this portfolio.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Ike Brannon is a senior fellow with the Jack Kemp Foundation.

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