As a part of my economics course this semester, we were asked to use the concepts we learned in class and apply them to a current policy issue. I chose to write about gasoline prices. Enjoy!
Reducing
U.S. Gasoline Consumption By Raising Taxes
Introduction
Gas prices have returned to a hot topic
in the news, as prices are expected to soar again over the summer to all time
highs of $5 per gallon. These high prices have clearly upset Americans –
however, despite these prices, high volumes of gasoline continue to be consumed
throughout the United States. In other words, the American short run demand for
gasoline is inelastic. Even though companies are not making that much more on
gasoline due to higher acquisition costs, the lack of substitutes allows gasoline
companies to maintain a transportation monopoly in many parts of the country.
It
is no secret that consuming the amount of gas that Americans do has a lot of
negative consequences. Because there are countless political issues with
drilling American oil in Alaska, California, or on ocean shelves in the gulf,
most of the money being pumped into gasoline every year is escaping the
American economy, and going into foreign markets. Additionally, the emissions
created by gasoline have many negative impacts on health the environment.
Because
of this, lawmakers have been looking into ways to reduce reliance on gasoline
in the United States, and have been grappling with the idea of increasing taxes
on gasoline in order to achieve this goal. This policy is attractive because assuming
that the demand for gasoline is more elastic in the long run, the tax will change
consumption patterns while simultaneously collecting additional revenue. Historically,
in the United States gasoline has only had excise taxes, whose purpose is to
create revenue, not curb behavior.
Is this idea economically sound? Would raising
taxes on gasoline be a good policy move for the United States, or is there an
alternative that would be more successful? To speak to these issues, this paper
will give a background on gasoline taxes in the United States, and discuss how
raising these taxes will induce income and substitution effects. It will then
outline the issues associated with raising these taxes, and give some
alternative solutions to achieve the goal of curbing consumer demand of
gasoline. The paper will conclude
by discussing the political feasibility of this proposal.
Background: Excise Taxes
on Gasoline
An
excise tax, which is a tax on a specific good, was first applied to gasoline in
the state of Oregon in 1919. Within the following ten years every state had
adopted some form of a gasoline excise tax[1].
To this day, every state has a varying amount of excise tax on gasoline; this
is the main reason why gas prices vary from state to state.
Even though it initially failed in
Congress in 1914, a federal excise tax of one cent per gallon of gasoline was
added amongst a wide range of other excise taxes as a part of the Revenue Act
of 1932 to balance the federal budget[2].
The gasoline tax proved to be extremely lucrative, generating $125 million in
the first year, which amounted to over 15% of the internal revenue collected in
1933. Originally, this tax was meant to be temporary, and was supposed to be
removed as soon as highways and roads were built and/or maintained.
However, because of its success, it was
not repealed, and is still in effect today as a part of the Highway Revenue Act
of 1956, with the creation of the Highway Trust Fund. This changed the purpose
of the tax from collecting revenue to become a type of user tax for the state
highways and roads. Instead of the money simply going to the general treasury,
the earnings from the gasoline excise tax went into a special account to be
specifically used for roads. Starting in 1982, under the Surface Transportation
Assistance Act, a small percentage of these funds were also allocated to mass
transit purposes.
In the 1990s, the excise tax for gasoline
continued to rise. The Omnibus Budget Revenue Reconciliation Act of 1990
changed the function of this tax again by allocating some of its funds away
from the Highway Trust Fund to deficit reduction and the Leaky Underground
Storage Tank Trust Fund. Over the decade the distribution of the tax between
these different funds shifted several times.
Currently, the federal tax on gasoline is
18.4 cents per gallon, or 24.4 cents per gallon for diesel fuel. State taxes
range from 4 to 32 cents per gallon, with some states having provisions to
fluctuate their rates in response to any change in the federal rate. This would
offset changes to the federal tax level for consumers, and keep the combined
State-Federal tax nominally constant[3].
Recently, has been discussion about
expanding the gasoline taxes to cover some of the negative externalities
associated with high gasoline consumption. In his discussion paper, Ian W.H. Parry
conducted a cost-benefit analysis, correcting some of these negative
externalities through Pigouvian taxes on gasoline. The externalities he chose
to include in his analysis were local pollution, global warming/CO2 pollution,
oil dependence, congestion, and accidents[4].
He concluded that to cover all this and the current revenue needs, gasoline
taxes should be at least $1.23 per gallon, which is almost seven times the
amount of the current tax. Legislation has not been made in this direction yet
because it lacks political support and would change the nature of the tax
completely.
How Raising Taxes on
Gasoline Causes Income and Substitution Effects
Changing the price of a good incites two
different types of changes to consumption – income effects, and substitution
effects. As Browning and Zupan explain, these effects cannot be observed
separately; rather, when consumers change their behavior, the combined effect
of both factors can be observed[5].
The
income effect is the change in the consumer’s real purchasing power brought
about by a change in the price of a good[6].
If gasoline prices were to go up, the consumer’s real purchasing power for all
other goods decreases, thus shifting back their budget line in a parallel
fashion. This price increase would decrease real income, which causes the
consumer to fall to a lower consumer curve.
The
substitution effect is an incentive to increase consumption of a good whose
price falls at the expense of other, now relatively more expensive goods[7].
As prices change around each other, the consumer will choose to consume different
consumption bundles based on their preferences at a given price. When gas
prices rise, it is expected that the consumer will substitute away from driving
and consuming gasoline in favor of other less expensive ways to transport
themselves, such as using a carpool, public transportation, obtaining a more
fuel efficient car, etc.
It is easy to see how these effects go
hand in hand. As expected, as prices rise there is a negative income effect and
a negative substitution effect. In order to maintain gas consumption at the
higher prices, consumers would have to change their consumption bundles and
substitute other goods for gasoline, or find alternatives and spend less on
gasoline. Because employers will not raise salaries just because gas prices go
up, it can be assumed that consumers will generally have the same income, and
thus it is guaranteed that their purchasing power will decrease.
Issues with Increasing
Taxes
If taxes on gasoline are raised, it is
expected that the elasticity, or consumer responsiveness of the quantity of
gasoline demanded to a change in price, will change. When considering this
policy, it is important to take two different types of elasticity into
consideration – short run, which looks at more immediate changes in consumption,
and long run, which looks at changes over a longer period of time. Demand elasticities
can either be positive or negative to indicate which direction the quantity
changes in, but we are more concerned with the magnitude of the elasticity than
the direction. For this reason, it is common to consider elasticity as an
absolute value during analysis. If the elasticity of demand is zero, it is
perfectly inelastic and quantity consumed is immune to price changes. The
elasticity of demand is considered inelastic if its absolute value is between
zero and one, and elastic is its absolute value is greater than one.
Luckily,
because of fluctuations in state taxes and in the pretax price of gasoline, we
are able to predict elasticities on gasoline despite the fact that the federal
tax has not changed in recent years. Currently, studies show that the elasticity
of demand for gasoline is between -0.034 and -0.077 in the short run[8].
These results are highly inelastic. The long run elasticity is more difficult
to calculate due to many outside factors over time (including recessions,
embargoes, etc.), but studies estimate that it is also highly inelastic, at an
approximate value of -0.31[9].
This makes sense because there are not many substitutions for gasoline in some
areas, so consumers have no choice but to consume gasoline. Elasticity may be
higher if alternative transportation options were more prevalent in the United
States, but these are not necessarily a reality outside of metropolitan areas.
From
an economical perspective, the inelasticity of gasoline is fantastic news for
the federal government because even if the price is raised due to taxes on a
good with inelastic demand, people will continue to consume it. Based on the
elasticities stated above, if gas prices were to rise 10% due to additional
taxes, demand would only decrease by 0.55% on average in the short run, and by
3.1% in the long run. This means that a significant amount of tax revenue can
be collected as a result.
On the other hand, from a social
perspective the inelasticity of gasoline is not good. While increasing taxes on
gasoline would be beneficial for previously stated reasons, it will also hurt
the consumers by decreasing their purchasing power. Excise taxes are extremely
regressive, and affect lower income families more than others. Policymakers
need to take this into account while making their analysis. To address this,
many have suggested that a “tax-plus-rebate” program should be used to help
offset the income effect, where qualified consumers would get a tax rebate in
the form of unrestricted cash transfers[10].
However, this is not ideal because there is no clear way to define who would be
qualified for the rebate (i.e., based on location, income level, or both) and
it would go against the goal of the policy by not promoting consumption
reduction.
Alternative Solutions
In
order to achieve the goal of reducing gas consumption, the federal government
has several other options to consider, other than increasing and expanding the
current excise taxes:
Regulation
Regulating
gas prices, and/or consumption, is an alternative solution that has been
relatively popular. If the government
chose to regulate prices, they would create a price ceiling, or maximum price
that could not be surpassed by any firm, and the market would determine the
quantity supplied. Because much of our gasoline is from the foreign market at
prices we cannot control, this is a dangerous policy to put into effect. As
seen in the Arab Oil Embargo in 1973, these prices could quadruple overnight,
which would make the regulation worthless. If companies cannot make or sell
their product at the set price, they will make less of it and shortages will be
created. Studies in various industries have proven that the market and natural
supply and demand works better than regulation, so this should be avoided if
possible.
Another
form of regulation that has been discussed is limiting the amount of gas an
individual can consume, a form of rationing. This would be similar to the “cap
and trade” programs being created in response to greenhouse gas emissions, in
that the government would create an aggregate amount to be consumed, and make
available only enough permits to match this amount[11].
In this way they are specifying the quantity, and letting the market choose the
prices. Those who need more gasoline could buy extra amounts from those who do
not need nor want it. Again, this would be disadvantageous to many Americans
who do not have transportation alternatives to substitute into, so it would be
difficult to get Congress to pass such a bill. For citizens living in more
rural areas of the country with less access to public transportation and other
fuel alternatives, it is not reasonable to limit them to the same amount of
fuel as Americans living in larger cities with many other options. Additionally
there may be high transactions costs in running this type of program, making in
not technically feasible. Despite these issues, historically cap and trade
style programs have been more politically feasible than other regulations because
they can specify limits with more ease and still allow flexibility in the
market. On top of this they do not specifically tax people, which is good in
our tax-adverse society.
Creating More Low-Cost Green Alternatives
While
some automobile companies have begun to create cars that are more fuel
efficient, these options are not always economically available to all
Americans. The Car Allowance Rebate System (CARS), also known as “Cash for
Clunkers” program tried to help offset this in the summer of 2009 by giving
vouchers between $3500 and $4500 to Americans for new vehicles whose current mileage
ratings were 18 mpg or less[12].
The hope was that this would help the environment and cut gasoline costs for Americans
while stimulating the economy because new cars get better mileage and create
lower emissions. When the program concluded in August 2009, a total of 690,114 “clunkers”
were traded in, with $2.877 billion in vouchers distributed[13].
A study by the University of Michigan reported that this program improved the
fuel economy in the United States by 0.6 mpg in July 2009 alone[14]. However, most economists agreed that
this program spent billions of dollars to accelerate purchases of new cars only
by a few months; studies show that as gas prices rise the sales of high-mpg
vehicles rises without intervention[15].
A large amount of government money was spent on a program that made a limited
impact, so CARS was not very effective.
Other
incentives can be created to promote green options. One program run by the U.S.
Department of Energy is the alternative fuel tax program, which refunds
consumers 50 cents per gallon for using gasoline alternatives, such as
compressed natural gas, liquefied natural gas, liquefied petroleum gas,
P-Series fuel, liquid fuel derived from coal through the Fischer-Tropsch
process, and compressed or liquefied gas derived from biomass[16].
If these programs were better known, consumers may be more likely to use these
alternative resources and reduce gasoline consumption. The problem with
alternative fuels is that they cost more to produce than you can sell them for.
Crops need fertilizer and gas to harvest and transport. Electricity needs to be
generated at a time when the grid is overwhelmed and the supply constrained.
Electric cars have limited range and take a long time to charge. Hydrogen is
very explosive and there are few stations to provide it. Natural gas is bulky
and needs high-pressure tanks. Unfortunately gasoline is a perfect medium, as
is diesel, and getting a new car with better mileage and lower emissions will
be more cost effective than dealing with this green alternative.
More Emphasis on Public Transportation
If
policymakers truly wanted to reduce reliance on gasoline, it would be essential
to provide more, and better alternative forms of transportation for consumers
to substitute into. In Europe, for example, the short run elasticity of demand
on gasoline is closer to the world demand of -0.40, which is significantly more
elastic than the U.S. elasticity of demand[17].
Because public transportation is more commonly used, they are able to tax
significantly more on gasoline – currently, taxes on gasoline in many European countries
exceed $2 per gallon[18]. This tax
provides much more revenue, and is widely accepted because public
transportation is a solid substitute.
Because public transportation in the
United States is not as widespread or developed to the same degree as Europe,
and major cities and businesses are more geographically spread out, it is
difficult to use that as a substitute for consumers if prices of gasoline were
to go up. However, if excise taxes continue to help pay towards these transportation
development projects, this could eventually be a possibility. This is probably
the most politically feasible option, but it still has its issues.
Conclusion and Political
Feasibility
There is no clear answer on what policy
is best to reduce gasoline consumption in the United States. Most policymakers
agree that gasoline taxes are low, not only in comparison to other countries
internationally, but simply because they have not been adjusted in years. While
it has remained constant in nominal value, it has decreased in real value because
it has not even been adjusted for inflation. It is reasonable to expect this
tax to rise in the coming years, if not only to adjust for inflation.
Raising taxes on gasoline is not
impossible since the government has done this already with other excise items,
such as cigarettes. Behavioral economic analyses and econometric studies
produced consistent estimates, showing that the price elasticity of demand in
cigarettes rose as price rose. Long run elasticities were between -0.27 and -0.48,
approximately double of the estimated short run elasticities[19].
This means that people were more likely to change their consumption habits over
time; they bought tobacco from alternative sources, quit smoking, or reduced
their consumption as prices went up. This was a market-based solution to the
problem, and proved that the government is capable of gaining extra revenue
while still causing behavioral changes.
There is skepticism of whether the same
effect would happen with gasoline because at best it would take a 10% increase
in gasoline prices in order to achieve a 1% decrease in gasoline consumption in
the short run[20]. However, a
study in 2011 tested correlation between gasoline taxes and tax-exclusive
gasoline prices and several factors that effect consumption, and found that in
four of their six specifications gasoline consumption is more negatively
correlated with the tax rate than with the tax-exclusive price[21].
Their results suggested that higher taxes on gasoline might affect consumer
demand more than previously estimated – elasticity of demand will be different
based on the consumer’s perception of whether the change in gasoline price is
permanent or not[22]. Because taxes
seem more permanent, they predict that the elasticity of demand would actually
be higher than predicted, and that a higher tax would change consumer demand.
As previously mentioned, because some of
the excise taxes are being used on other transit projects, it is not
far-fetched to use gasoline taxes to achieve other goals than as a user fee for
highways and public roads; it’s just a matter of how much we are willing to
charge. As discussed in Ian Parry’s article, we have to ask ourselves how
serious we are about correcting these externalities created by gasoline and
reducing consumption. Luckily, there are many feasible options for the United
States to explore and use in combination with each other. For example, Richard
Posner claims that a Pigouvian tax would still bring in revenue because
complete substitution is rarely achieved. If policymakers wished to induce this
type of tax instead of our current excise tax, the original purpose of the
excise tax would not be completely lost.
The biggest roadblock to this regulation
is the politics themselves. Because terms in Congress are so short it is better
to pass legislation that would produce quick results; this would not be the
case if taxes on gasoline were raised. As previously discussed the demand for
gasoline is extremely inelastic in the short run so you will not see an
immediate impact – you will only see minor results in the long run, which is
most likely past the political life of the politicians currently in office. This
issue is extremely politically sensitive, especially in a down economy. In a
political climate where an annual budget cannot be passed as 85% of the GOP has
pledged to never raise taxes, it is hard to expect Congress to agree to change
and raise this tax. However, if this legislation were changed in a way that
would protect the middle class and poor families from negative income effects,
such as the aforementioned tax-plus-rebate program, there would be many
positive effects in the United Stated economy and the goal of reducing gasoline
consumption would be achieved.
References
American
Petroleum Institute. “Motor Fuel Taxes: State Gasoline Tax Reports”. Last
modified April 2012. http://www.api.org/Oil-and-Natural-Gas-Overview/Industry-Economics/Fuel-Taxes.aspx.
Browning, Edgar K. and Mark A. Zupan. Microeconomic Theory & Applications, 10th Edition. (Hoboken, NJ: John Wiley & Sons, Inc.), 2009.
Browning, Edgar K. and Mark A. Zupan. Microeconomic Theory & Applications, 10th Edition. (Hoboken, NJ: John Wiley & Sons, Inc.), 2009.
Chaloupka, Frank
J. “How Effective are Taxes in Reducing Tobacco Consumption?” August 1998. http://tigger.uic.edu/~fjc/Presentations/Papers/taxes_consump_
rev.pdf.
rev.pdf.
Department
of Transportation. “Cash for Clunkers Wraps up with Nearly 700,000 car sales
and increased fuel efficiency, U.S. Transportation Secretary LaHood declares
program ‘wildly successful’”. DOT Press Release, August 26, 2009. http://www.dot.gov/affairs/2009/dot13309.htm.
Executive
Office of the President Council of Academic Advisors. “Economic Analysis of the
Car Rebate System (Cash for Clunkers).” September 10, 2009. http://www.whitehouse.gov/assets/documents/CEA_Cash_for_Clunkers_Report_FINAL.pdf.
Francis, Brian. “IRS
Report: Gasoline Excise Taxes, 1933-2000”. Winter 2001.
http://www.irs.gov/pub/irs-soi/00gastax.pdf.
http://www.irs.gov/pub/irs-soi/00gastax.pdf.
Havranek, Tomas,
Zuzana Irsova, and Karel Janda. “Demand for Gasoline Is More Price- Inelastic
than Commonly Thought”. Working paper from September 2, 2011. http://ageconsearch.umn.edu/bitstream/120416/2/CUDARE%201118%20Janda.pdf.
Hughes, Jonathon
E., Christopher R. Knittel, and Daniel Sperling. “Evidence of a Shift in the
Short-Run Price Elasticity of Gasoline Demand”. February 14, 2007.
http://www.econ.ucdavis.edu/faculty/knittel/papers/gas_demand_083006.pdf.
Li, Shanjun,
Joshua Linn, and Erich Muehlegger. “Gasoline Taxes and Consumer Behavior”.
March 2011. http://economics.stanford.edu/files/muehlegger3_15.pdf.
Metcalf,
Gilbert. “Market-based Policy Options to Control U.S. Greenhouse Gas
Emissions,” JEP Spring 2009.
Parry, Ian W.H.
“How Much Should Highway Fuels Be Taxed?” Resources for the Future Discussion
Paper 09-52, December, 2009.
Pindyck, Robert
and Daniel Rubinfeld. Microeconomics, 7th edition (Upper
Saddle River, NJ: Pearson Education, Inc.), 2009.
Posner,
Richard. “Should Gasoline Taxes Be Raised or Lowered? Posner’s Comment”. July
2008. http://www.becker-posner-blog.com/2008/07/should-gasoline-taxes-be-raised-or-lowered-posners-comment.html.
Sivak, Michael
and Brandon Schoettle. “The Effect of the ‘Cash for Clunkers’ Program on the
Overall Fuel Economy of Purchased New Vehicles.” September 2009. http://deepblue.lib.umich.edu/bitstream/2027.42/64025/1/102323.pdf.
Small, Kenneth
A. and Kurt Van Dender. “Fuel Efficiency and Motor Vehicle Travel: The
Declining Rebound Effect”. Working Draft, June 3, 2005. http://www.economics
.uci.edu/files/economics/docs/workingpapers/2005-06/Small-03.pdf.
.uci.edu/files/economics/docs/workingpapers/2005-06/Small-03.pdf.
U.S. Department
of Energy. “Alternative Fuel Excise Credit”. June 2011. http://www.afdc.energy.gov/afdc/laws/law/US/319.
Zingales,
Luigi. “It’s Not About Revenue”. The
Economist, June 2010. http://www.economist.com/economics/by-invitation/guest-contributions/
its_not_about_revenues
its_not_about_revenues
[1]
Brian Francis. “IRS Report: Gasoline Excise Taxes, 1933-2000” (2001) http://www.irs.gov/pub/irs-soi/00gastax.pdf.
[3]
Francis. “IRS Report: Gasoline Excise Taxes, 1933-2000”
[4]
Ian W.H. Parry. “How Much Should Highway Fuels Be Taxed?” Resources for the
Future Discussion Paper 09-52, (2009).
[5]
Edgar K. Browning and Mark A. Zupan,
Microeconomic Theory & Applications, 10th Edition
(Hoboken: John Wiley&Sons 2009) 90
[8]
Jonathon E. Hughes, Christopher R. Knittel, and Daniel Sperling. “Evidence of a
Shift in the Short-Run Price Elasticity of Gasoline Demand”. February 14, 2007.
http://www.econ.ucdavis.edu/faculty/knittel/papers/gas_demand_083006.pdf.
[9]
Tomas Havranek, Zuzana Irsova, and Karel Janda. “Demand for Gasoline Is More
Price- Inelastic than Commonly Thought”. Working paper from September 2, 2011.
http://ageconsearch.umn.edu/bitstream/120416/2/CUDARE%201118%20Janda.pdf.
[11]
Gilbert Metcalf, “Market-based Policy Options to Control U.S. Greenhouse Gas
Emissions,” JEP Spring 2009.
[12]
Executive
Office of the President Council of Academic Advisors. “Economic Analysis of the
Car Rebate System (Cash for Clunkers).” September 10, 2009. http://www.whitehouse.gov/assets/documents/CEA_Cash_for_Clunkers_Report_FINAL.pdf.
[13]
“Cash
for Clunkers Wraps up with Nearly 700,000 car sales and increased fuel
efficiency, U.S. Transportation Secretary LaHood declares program ‘wildly successful’”.
DOT Press Release, August 26, 2009.
http://www.dot.gov/affairs/2009/dot13309.htm.
[14]
Michael
Sivak and Brandon Schoettle. “The Effect of the ‘Cash for Clunkers’ Program on
the Overall Fuel Economy of Purchased New Vehicles.” September 2009. http://deepblue.lib.umich.edu/bitstream/2027.42/64025/1/102323.pdf.
[15]
Shanjun Li, Joshua Linn, and Erich Muehlegger. “Gasoline Taxes and Consumer
Behavior”. March 2011. http://economics.stanford.edu/files/muehlegger3_15.pdf.
[16]
U.S.
Department of Energy. “Alternative Fuel Excise Credit”. June 2011.
http://www.afdc.energy.gov/afdc/laws/law/US/319.
[17]
Robert
Pindyck and Daniel Rubinfeld. Microeconomics, 7th edition
(Upper Saddle River, NJ: Pearson Education, Inc.), 2009, 56.
[18]
Parry. “How Much Should Highway Fuels Be Taxed?”, 9.
[19]
Frank J. Chaloupka. “How Effective are Taxes in Reducing Tobacco Consumption?” August
1998. http://tigger.uic.edu/~fjc/Presentations/Papers/taxes_consump_rev.pdf.
[20]
Kenneth A. Small and Kurt Van Dender. “Fuel Efficiency and Motor Vehicle
Travel: The Declining Rebound Effect”. Working Draft, June 3, 2005. http://www.economics.uci.edu/files/economics/docs/workingpapers/2005-06/Small-03.pdf.
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