Gasoline Tax

Gasoline Tax vs. Fuel Efficiency:
By Rajeet Guha, Clarion University of Pennsylvania
Fall 2006

A continuing concern in the US has centered on the vulnerability of this nation caused by increased gasoline consumption, a large part of which is imported from the Middle East. While tracing back to the oil price rise after the Yom Kippur war, this concern has been aggravated by recent geopolitical developments such as the Iraq war and consequent anti American sentiments, and more recently the stand-off with Iran The fear of a breach of energy security in the wake of any major disruption of imports is further compounded by long term concerns regarding environmental pollution and consequent global warming and climate change brought about by unchecked carbon emissions from gasoline use. Therefore Congress has from time to time debated measures for reducing gasoline consumption.

Central to this debate, is the whole question of when government intervention in the market is warranted and at what costs. Economists generally believe that the allocation of resources is optimum under conditions of competition and the free market. The questions of what to produce, how to produce, how much to produce, and for whom to produce is answered best under laissez-faire capitalism. Scarce resources are best utilized by the markets to satisfy consumer’s unlimited wants. The price mechanism distributes resources in an efficient manner. Therefore government efforts towards an altered allocation of resources create inefficiencies and loss of public welfare. There are only two scenarios in which government intervention in the market could be justified. In the first place, there could be a rationale for govt. intervention in markets when there are externalities. “Externalities are the costs and benefits of market transactions not mirrored in the prices of goods. Externalities take place when a third party other than buyers or sellers is affected by its production or consumption. The benefits or costs of the third party, which is either a household or business are not taken into consideration by buyers or sellers of an item whose production or use results in an externality.” The other situation in which govt. intervention could be justified is when the companies have a monopoly over production and distribution and are making windfall profits. Both are situations of failure of the market and the price mechanism.

There is therefore a prima facie case for govt. intervention in the gasoline market. This is so since the consumption of gasoline creates the externality of pollution and thereby global warming through carbon emission as part of automobile exhaust fumes. Use of gasoline driven vehicles also leads to road congestion, accidents etc. Third parties suffer from the use of gasoline but the marginal social cost of gasoline use is not reflected in the price of gasoline. Moreover, according to some estimates, the supply of gasoline might run out in 30 years time. This raises the scepter of loss of energy security which has engaged Congress for the last three decades. The reductions of supply with the war in Iraq and major demand for energy by China and India have been amongst the causes of global price hikes and dangers of supply disruption. The OPEC cartel has once again become very powerful. Venezuela and Iran are both hostile to the U.S., and are members of this cartel. Hence, there has also been increasing discussion about measures that could ensure that less gasoline is consumed and thereby less exhaust generated and less dependence on imported crude oil from unfriendly countries.

A second reason being put forward for govt. intervention has been triggered by the recent rise in gasoline prices over the past two years and hurricane Katrina. Gasoline prices in the US had tripled in just one year i.e. between September 2004 and September 2005 from $1.22 per gallon to $3.26 per gallon. Many average Americans are of the view that domestic American oil companies are making profits, which are above normal profits through monopoly over the distribution and sale of gasoline. The Great American Dream is fuelled by gasoline. A hike in price of gasoline would make a severe dent in the purchasing power of the average Americans. There has thus been an argument for putting a price cap on gasoline.

Therefore essentially two kinds of desired outcomes are debated in terms of the result of government intervention in gasoline markets both in economic and political circles: a cap on prices that would ensure the availability of gasoline at reasonable prices and/or measures to reduce consumption of gasoline either through a gasoline tax or measures to enforce a certain fuel efficiency standard by which less gasoline will be consumed per mile. Our major emphasis in the essay will be in trying to evaluate the efficacy of measures to achieve the latter outcome i.e. reduction or controlling the consumption of gasoline through Government intervention.

The issues in this debate are centered around oil conservation, pollution, traffic congestion, traffic accidents, global warming and finally energy security. There are two alternative mechanisms to deal with the externality of pollution and consequently global warming, as well as other problems. The first option is that of using a gasoline tax. The second option is the increase in corporate average fuel economy standards (CAFÉ) for automobiles. CAFE standards have remained in force for quite some time. The current standards in the US are: 27.5 miles per gallon (mpg) for cars and 20.7 mpg for light trucks. The average fuel economy of each manufacturer's fleets of cars and light trucks must meet those standards, or the firm will be subject to a fine.

A gasoline tax would be levied on consumers. It would increase the price of gasoline per gallon. Therefore, the quantity of gasoline demanded will be less than it was before the tax. If less gasoline is used than before then there will be less pollution, less global warming, more oil conservation and ultimately this will reduce America’s dependence on imported oil. On the other hand corporate average fuel economy (CAFÉ) standards would impose costs on automobile companies. These companies would then pass on these costs to consumers. These standards would increase mileage and contribute to less pollution by less gasoline consumption. Less pollution would mean less global warming. This will also conserve oil and once again reduce America’s dependence on imported oil.

The strongest support for the gasoline tax option is from an economic point of view that an externality is tackled most effectively by imposing an appropriate tax and letting the market work. “One reason for embracing a tax over, say, tightening the Corporate Automobile Fuel Economy (CAFE) standards is that a tax unleashes the power of the market rather than relying on bureaucratic rulemaking. The price of gas goes up. Consumers then decide how to spend their money rather than Congressional barons and high-paid petro-and auto-lobbyists negotiating over minimum mileage standards, truck weights, or any of the other controversial issues that dog CAFE.”

According to Ian W.H.Parry, the major passenger vehicle externalities are two fold: those that vary with the extent of fuel use (carbon monoxide emission and dangers of breach of oil security) and those that vary with the miles driven (traffic congestion, accidents, road damage, noise etc.). Parry derives a simple formula for the optimal gasoline tax to address motor vehicle externalities:
Externality tax, cents/gallon=
(Cost of externalities proportional to fuel use, cents per gallon)
+
(Cost of externalities proportional to mileage, cents/mile)
X
(Miles per gallon)
X
(Fraction of the reduction in gasoline use due to reduced mileage)

Parry stresses that it is important to bear in mind that over the long run, besides reducing oil use because of tax-induced higher prices, consumers will also shift to smaller vehicles or cars in which manufacturers incorporate fuel saving technologies.

According to the TDM online Encyclopedia there are several justifications for increasing taxes on motor vehicle fuel by way of tackling the range of externalities resulting from motor vehicle use and gasoline consumption: to compensate for road use (user fee) and fund maintenance and new roadway projects; sometimes as a revenue-neutral tax shift: which means increasing taxes on resources such as fuel to offset reductions in taxes which are more economically harmful in terms of the economic disincentives they give rise to, such as those on income and investments; but most importantly to encourage energy conservation to reduce dependence on imported energy, as a climate change emission reduction strategy, and as a way to preserve fossil fuel resources for future generations. North American taxes are by and large lower than those in other developed countries(the United States now has a gas tax that is "only" 37% of the retail price, whereas in Western Europe the gas tax averages over 70%) . Nevertheless fuel tax increases often face consumer, voter and industry opposition. There is the argument that it penalizes rural people who are required to commute greater distances than in urban areas. A response is that the proceeds of the tax will be used to "invest" in America's highways, thereby aiding the drivers. But if it goes into highways, how will it help reduce the deficit? The second argument is that the gas tax in being uniformly applicable to al who drive cars injures the poor and broad middle classes more and is therefore a regressive tax. Fuel/gasoline tax also meets with the general opposition that views all taxes as bad economics and dampening production.
The popular opposition to fuel price increases, including via gasoline tax, particularly after the oil price increases in 2004-2005 and following Katrina, have led to proposals which represent different variants aimed at obviating the sting of increased taxes. One such variant is the proposal of US Congressman Robert Frank. He suggested that there be a gasoline tax levied on consumers and then the entire revenues generated from this are rebated to consumers through some payroll or other tax saving scheme. Thus, this would increase the price of gasoline thereby reducing gasoline consumption, pollution and global warming. At the same time the rebate would save consumers from being hit too hard. This can be illustrated through the application of indifference curves and budget lines. On the vertical axis we plot expenditure on other goods while on the horizontal axis we plot amount of gasoline consumed. Before the imposition of a gasoline tax the consumer is on indifference curve U2. Indifference curve U2 is tangent to the budget line at A. The quantity of gasoline consumed is QA. After the imposition of a gasoline tax the budget line shifts to the left and the consumer is on indifference curve U1. Indifference curve U1 is tangent to the new budget line at B. The quantity of gasoline consumed is QB. Now, the consumer is on indifference curve U1 and thus gets less satisfaction than before. However, after the consumer gets the rebate he moves to indifference curve U3(U3 is not shown on the graph because it would make the graph look messy) which is higher than U1 but less or lower than U2. His budget line is now the right of the post taxation budget line but still to the left of the pre-taxation budget line. The final budget line is tangent to U3(not shown) at C. The quantity of gasoline consumed is QC. Here, his satisfaction is higher than at B but still less than at A. This is because of the low-income elasticity of demand of gasoline so that the substitution effect is stronger than the income effect. Here's a graph of what happens before and after the tax, and after both the tax and the rebate.

http://economistsview.typepad.com/economistsview/2006/06/a_gas_tax_with_.html

Politicians and economists supporting the increasing of corporate average fuel economy (CAFE) standards for passenger vehicles argue that this is a simple proven way to decrease the United States' dependence on oil and emissions of carbon dioxide (the predominant greenhouse gas). As we have seen above, opponents argue that CAFE standards are a costly and cumbersome way to reduce gasoline consumption: that they interfere with the market and unduly burden U.S. business, and because given lower per mile costs, this may actually encourage more driving and alter vehicle design and this way this may even compromise the safety of motorists.
Moreover, the corporate average fuel economy standards can be applied to new cars only.

The Congressional Budget Office (CBO) has estimated the relative costs and benefits of reducing gasoline consumption through a higher gasoline tax vis-à-vis those of achieving the same result through an increase in CAFÉ standards. Its results show that a 10 percent reduction in gasoline consumption could be achieved at a lower cost by an increase in the gasoline tax than by an increase in CAFE standards. It is also argued that while an increase in the gasoline tax would reduce driving, leading to less traffic congestion and fewer accidents, higher CAFE standards would by lowering the per-mile cost of driving, provide new-vehicle owners with an incentive to drive more and this could actually reduce social welfare by worsening traffic congestion and increasing the number of traffic accidents. There “CBO does find that, given current estimates of the value of decreasing dependence on oil and reducing carbon emissions, increasing CAFE standards would not pass a benefit-cost test”. (Ibid)
Parry breaks up the welfare from improved fuel efficiency norms on new cars into three components:(a) The welfare change in the gasoline market resulting from less fuel consumption:(The aggregate reduction in gasoline demand, in gallons)X(The cost per gallon of externalities proportional to fuel use- the gasoline tax)If the external cost of gasoline use (cents per gallon) is more than the gasoline tax, the gasoline demand curve shifts inward improving economic efficiency because drivers are in that scenario undercharged for fuel use. If externality costs of gasoline use are less than the gasoline tax currently levied, the reduction in gasoline demand is welfare reducing, because drivers are already over charged for fuel use. (b) The second welfare component is a welfare loss resulting from people driving more because of improved fuel efficiency:
| (The increase in mileage as people drive vehicles more when fuel costs per mile fall)X(External costs per mile from mileage related externalities)

(c) The third component of welfare comes from the increase in the fuel economy:(Discounted fuel savings over the life time of the vehicle)_(Cost of incorporating fuel efficiency technology in new vehicles)



CAFÉ, however, is invariably a more popular measure than gasoline tax. The New York Times conducted a poll last month asking consumers their preference between requiring manufacturers to produce energy efficient cars or imposing higher Federal gasoline taxes in order to reduce energy use and global warming. Overwhelmingly the consumers chose against the gasoline tax in favor of requiring manufacturers to make fuel-efficient vehicles. Question: "In order to cut down on energy consumption and reduce global-warming, which would you prefer – requiring car manufacturers to produce cars that are more energy efficient OR imposing an increased federal tax on gasoline?"

Supporting Information
Question: "In order to cut down on energy consumption and reduce global-warming, which would you prefer – requiring car manufacturers to produce cars that are more energy efficient OR imposing an increased federal tax on gasoline?"
Share of Respondents
Mandate more energy efficient cars 87%
Federal tax on gasoline 8%
No opinion/Don't know 5%
Source: New York Times/CBS News Poll, February 22-26, 2006, N=1018 (PDF 119 KB) Download Adobe Reader.

Furthermore some empirical research discounts the commonly held view that with CAFÉ standards the gains of fuel efficiency per mile are neutralized by increased driving. In the long run policies towards making the fleet of vehicles more efficient are more effective than seeking to reduce fuel use through gasoline tax. The answer perhaps is a combination of both gasoline tax and CAFÉ. For instance as Sofronis Clerides and Theodoros Zachariadis (Ibid ) show the extent to which gasoline taxes need to be raised in order to achieve reductions equivalent to CAFÉ standards, would be to the tune of 780%, clearly an order of increase not politically feasible. Experience also shows, for instance, that if there were no fuel efficiency standards in force, fuel consumption of new cars would not have improved at the rates that have been seen in Europe. Moreover if we are to avoid raising fuel efficiency standards by further 10% (calculated by CBO) we would have to raise fuel prices by 20% in order to obtain the same savings. In any case as mentioned earlier the current gasoline tax rates in the US are on an average much lower than that in most developed countries. Conversely in Europe they are already high and further increases are infeasible: therefore the policy option can be more towards increased CAFÉ while in the US the reverse is the case. Moreover increased gasoline taxes will further technological innovation in terms of more energy saving technology, and different forms of bio diesel and hybrids. As the market for such innovations grow, the cost of technological innovation will also fall, although in the short run the pain of increasing taxes will be higher and result in welfare loss even if tax rebate measures are introduced as shown in the graph on page 8. Furthermore as the Business online article by Farrell argues (Ibid) through market mechanisms any cut in disposable incomes will not last long: oil and gas prices will fall as demand declines and conservation grows. Even foreign producers, despite their cartels will keep prices in check in their own interests. Once combined with CAFÉ standards (which as we have seen exist and could do with some modest increases) and their long run effect on the vehicle fleet, the economic logic of gasoline tax increase in the immediate run far outweighs popular objections. The challenge of course is, and particularly so in an election year, who will have the political integrity, courage and leadership to push for the unpopular and therefore the unthinkable.