Replacing gasoline: efficiency, alternatives or both?

Over at Energista they're examining a proposed state tax credit for alternative fuel vehicles in Minnesota, and I think Christopher's comments are worth examining. He decries a credit for alternative fuel vehicles because it can end up subsidizing the purchase of fuel inefficient cars.

The implied argument is that when it comes to developing energy independence, reducing overall fuel use is more important than alternative fuel capability. (It's also important to distinguish between a vehicle that's capable of using alternative fuels from one that is actually run on them - an E85 compatible car can also use straight gasoline)

That particular distinction is what makes this tax credit bad policy. Helping people buy an E85 car is counter-productive if they end up filling up with 100% gasoline. Furthermore, as this op-ed piece notes, tax credits tend to skew benefits toward upper incomes. Shouldn't we expect people of all income levels to help reduce gasoline use? And shouldn't we make sure that government incentives for alternative fuel use actually guarantee that use?

Instead, government could subsidize alternative fuel use - as the feds do, to the tune of 51 cents/gallon - making it more price competitive.

But what about the efficiency issue? Cheaper fuel, even alternative fuel, tends to encourage greater fuel use (although fuel demand is relatively inelastic). And alternative fuels will be able to displace more gasoline use if our overall use is lower. From that perspective, perhaps government is better off just increasing the price of gasoline with a gas tax (exempting alternative fuels like ethanol or biodiesel based on their proportion in our fuel - e.g. 10% off for 10% blend).

A gas tax with a renewable exemption can reduce overall fuel use and shift consumption to alternative fuels. To keep tax burdens equitable, the proceeds can be used to reduce taxes on the poor, who will otherwise be disproportionately burdened by increased gas taxes.

So, a tax credit that may be ineffective (and that will put a hole in the budget) or a gas tax that could be revenue-neutral? Tough choice...