Detroit's Stealth Subsidy

Another year, another change to the tax laws.

Actually, I suspect there will be more than one change to tax laws this year (for details, consult your accountant). But the one I want to talk to you about today is the new incentive being served up to buyers of hybrid automobiles, and how it'll likely affect the fortunes of world automakers.

Ever since 1999, buyers of hybrid vehicles such as the Toyota (NYSE:TM) Prius, the Honda (NYSE:HMC) Civic hybrid, and the Ford (NYSE:F) Escape hybrid have been able to use a $2,000 income tax deduction as partial compensation for the added cost of a hybrid package (on average, $2,500 to $5,000 more than non-hybrid equivalents). In tax year 2006, that $2,000 deduction gets upgraded to a tax credit of $250 to $3,400.

The difference in wording is even more important than the difference in numbers. A tax "deduction" is just that: the amount you deduct from your taxable income before calculating the tax on that income. For example, if you're in the 35% tax bracket, a $2,000 deduction is worth about $700 to you. The lower your tax bracket, the less a deduction is worth. In contrast, a tax credit is like a cash rebate toward whatever taxes you owe. Owe $3,000? Got a $3,000 credit coming to you? Poof! Now you owe no taxes.

Thus, the 2006 tax laws stand to greatly increase buyer interest in hybrid vehicles. If you can buy a fuel-efficient Escape hybrid for -- let's say Ford is feeling exceedingly generous and call it $2,600 over the list price for an ordinary Escape (the same amount as the credit in this case) -- you'd be crazy to buy the non-hybrid version. Same SUV. Same price. Better gas mileage. It's a no-brainer.

What does take a little thinking, though, is deciphering the stealth objective of the credit. You see, Congress isn't just doling out greenbacks for the sake of being green. It's also giving domestic manufacturers a leg up on their Japanese rivals -- a chance to ramp up sales of hybrid Fords and Chevys. The credits are not without limit; the first 60,000 buyers of a manufacturer's hybrids can claim the full credit. After that limit is reached, the credit begins to phase out. It continues for three months, then shrinks by half for the next six months, then by another half for the next six months, then vanishes.

As a result, buyers of the 100,000-plus Toyota hybrids expected to be sold here in 2006 will find their hoped-for credits disappearing around the middle of the year. Honda buyers should be fine throughout 2006 and start getting hit sometime in 2007. Meanwhile, Ford and GM (NYSE:GM), which have minimal hybrid sales, should be free to sell as many credit-worthy hybrids as they like for the next two or three years. Among penny-pinching car buyers, at least, the tax credit will work to help bridge the hybrid market-share chasm that separates Detroit from Tokyo.

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Fool contributor Rich Smith does not own shares of any company named above.