Tax

During the last two years of our stay in Delhi (2000-2002), before we moved to New York City, I witnessed a remarkable, if not dramatic change in the environment of Delhi. Delhi in 2000 was known as one of the most environmentally polluted cities of the world. The smog simply wouldn’t go away, ones eyes burnt if one walked on the streets for too long, especially in winter and from the aircraft, as it landed, the city seemed perennially covered by a dark haze. In 2002, this was all gone. The reason was clear. In 2000, the Supreme Court of India had ordered the Delhi government to ensure the change over of all buses on the street from using diesel to CNG and the enforcement of strict (so called Euro 2) emission norms for all new cars. There was a huge hue and cry: public transporters went on strike, automobile companies filed counter cases in the Supreme Court and civil rights groups predicted untold economic hardship for the poor whose transportation costs would go up and the zero sum effect of the change as the average middle class would continue to use their old fuel-inefficient cars or two wheelers. Four years and perhaps the collapse of a few old bus owners later, Delhi continues to be a bustling, crowded city but with CNN weather reporting good air quality many more days of the year. This to me encapsulates some of the critical issues this essay is expected to examine.

A continuing concern in the US Congress, particularly since the oil price rise after the Yom Kippur war, and aggravated by recent geopolitical developments such as the Iraq war and consequent anti American sentiments, and the stand-off with Iran has centered around the vulnerability of this nation caused by increased gasoline consumption, a large part of which is imported from the Middle East. This fear of a breach of energy security in the wake of any major disruption of imports is 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, are an array of arguments for as well as against the notion of government intervention if any in the market. Economists generally believe that the allocation of resources is optimum under conditions of capitalism 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 could intervene in the market. 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 part 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 is not taken into consideration by buyers or sellers of an item whose production or use results in an externality.”(Hyman, David. Public Finance: A contemporary application of theory to policy. 4th ed. Dryden Press) Another sound reason for govt. intervention is when the companies have a monopoly over production and distribution.

There are some who believe that in the market for gasoline, govt. intervention may be needed. This is so since the consumption of gasoline creates the externality of pollution and thereby global warming through exhaust fumes. Third parties suffer from the use of gasoline but the marginal social cost of gasoline is not reflected in the price of gasoline. Moreover, according to some estimates, the consumption of gasoline might run out in 30 years time. This raises the scepter of loss of energy security which as mentioned has engaged Congress for the last three decades. As also mentioned earlier, there is the major negative externality of pollution resulting from consumption of gasoline and subsequently global warming. Hence, there has also been a discussion about raising fuel economy standards (Corporate average fuel economy standards: CAFE) such that less gasoline is consumed per mile and thereby less exhaust generated.

A second reason put forward for govt. intervention is that domestic American oil companies are making profits, which are above normal profits. In fact above normal profits is an understatement as these companies are making windfall profits. A few companies have established a monopoly over the distribution and sale of gasoline. Of late the price of gasoline has also become an emotive issue for the American public. The recent rise in gasoline prices over the past two years has alarmed the average American. Gasoline prices have tripled in just one year i.e. between September 2004 and September 2005 from $1.22 per gallon to $3.26 per gallon The Great American Dream is fuelled by gasoline. The average American has always been used to cheap gasoline historically except for a few years in the 1970s. A hike in price of gasoline would make a severe dent in the purchasing power of the average Americans. Gasoline is at the very foundation of America’s industrial, technological and military complex. The entire American economy would come to a standstill if gasoline became scarce and expensive. The reductions of supply with the war in Iraq and major demand for energy by China and India have been amongst the causes of the price hike. OPEC cartel has once again become very powerful. Venezuela and Iran are both hostile to the U.S., and are members of this cartel. There has therefore raged a debate as to whether a gasoline tax should be imposed or not in order to reduce the use of gasoline. There has also 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 both in economic and political circles: a cap on prices that would ensure the availability of gasoline at reasonable prices 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. While this essay will examine the different strands of these arguments by reviewing the available literature on this subject, 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.

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. A gasoline tax would be levied on consumers. It would increase the price of gasoline. 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 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. However, the corporate average fuel economy standards can be applied to new cars. 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 reduce America’s dependence on imported oil.

A Senator suggested an innovative proposal. He suggested that there be a gasoline tax levied on consumers. This tax would generate a lot of revenue. Out of the revenues generated from this, a part of the revenue would be rebated to consumers. 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 U1. Indifference curve U1 is tangent to the budget line B1 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 U2. Indifference curve U2 is tangent to budget line B2 at B. The quantity of gasoline consumed is QB. Now, the consumer is on indifference curve U2 and thus gets less satisfaction than before. However, after the consumer gets the rebate he moves to indifference curve U3 which is higher than U2 but less or lower than U1. His budget line is now B3, which is to the right of B2 but to the left of B1. B3 is tangent to U3 at C. The quantity of gasoline consumed is QC. Here, his satisfaction is higher than at B but less than at A. This is because of the low-income elasticity of demand 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 tax rebate.