When Congress passed its latest farm bill in 2008, it included a new $1.01 per-gallon tax credit for ethanol produced from cellulose. The intended beneficiaries of the $1.01-per-gallon credit were companies that use expensive, cutting-edge technologies to distill ethanol from plant materials instead of corn. Today's New York Times business section had an upbeat article about the exciting new developments relating to these fuels produced from biomass. But these new technologies developed by fledging companies will get peanuts compared to the windfall pulp manufacturers will get from the new credit.

Background: A by-product of the pulping process is a combustible aqueous solution known as "black liquor." Earlier this year the Treasury and Senate leaders expressed concern when they discovered that the paper industry was getting an unintended tax benefit for its age-old practice of using black liquor as fuel to generate power at its own manufacturing facilities. The tax benefit in question was the 50-cent-per-gallon alcohol fuel mixture credit, which is due to expire at the end of this year.The Joint Committee on Taxation in September reported that during the first six months of 2009 alone, the industry claimed more than $2.5 billion in tax credits.

Well, believe it or not, the IRS has just given the industry a green light to use an even larger loophole. The source of this fantastic news for pulp producers is a just-released legal memorandum (ILM 200941011) from the IRS chief counsel dated June 3, 2009. The memo says that when the alcohol fuel mixture credit expires at the end of this year, black liquor will still be eligible for an even more generous tax credit -- the $1.01-per-gallon cellulosic biofuel producer credit. It is not scheduled to expire until the end of 2012. By our estimates, this credit will provide the paper industry with $25 billion of additional tax benefits that Congress never intended.

Here is an estimate of the amounts at stake: If a 50-cent alternative fuel mixture credit costs $2.5 billion for six months, arithmetic tells us that a $1.01 cellulosic biofuel producer credit will cost more than $30 billion over its remaining three years. The only major disadvantage of the $1.01 credit relative to the 50-cent credit is that it is not refundable. Taking that into account, we should adjust the raw $30 billion figure downward. Exercising a revenue estimator's prerogative to substitute judgment in the absence of hard data, we arrive at a forecast of $25 billion in tax reductions for pulp producers claiming the cellulosic biofuel tax credit over the next three years.

Congress tilted tax credits to cellulosic from corn ethanol because the explosion of production of ethanol distilled from corn was driving up food prices and because greenhouse gas emissions from cellulosic ethanol were considerably less than those from corn ethanol.

But if Congress allows the recent IRS decision to stand, it will just be another massive windfall for the paper industry. The move would not achieve the congressional objectives of rewarding innovation and substituting domestic fuel for imported oil because in order to get the credit the paper industry will just continue doing what it has always done.

The new loophole will discourage the recycling of paper because the production process for recycled paper wins no tax benefits. It will have a hugely upsetting effect on world paper markets and will likely ignite a trade war with Canada and other paper producers. It will impose significant new pressures on the budget just when Congress and the administration are scouring the code for revenue raisers.