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Taxes and Prices: In Defense of the Simple Story

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Alex Tabarrok chides the man-in-the-street for believing that cutting gas taxes will cut gas prices:

Does the lifting of the tax change the demand for gasoline? No. Does it change the physical supply? No. At least not by much in the short run and especially not by much when the tax relief is known to be temporary. Since neither supply nor demand change neither does the price. What does change is that with the tax the government collects the revenues, with the "tax relief" the suppliers of gasoline collect the (former) revenues. Either way, no gain to the consumer.

I agree with Alex if he's talking about the world tax rate. But there is no world tax rate. If one part of the world cuts taxes and the rest doesn't, then gas flows into the lower-tax area, and consumers in that area benefit. This is clearly true for state-level gas taxes. If Virginia dropped it's gas tax, more gas would flow into Virginia. And since the U.S. is just one corner of the world economy, cutting gas taxes in the U.S. would cut U.S. gas prices - even if global production is unchanged.

I'm not saying, of course, that the man-in-the-street understands any of this. But his knee-jerk conclusion is correct. The worst you can say about it is that it's incomplete: At least in the short-run, cutting gas taxes reduces your gas prices by raising them everywhere else.

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The author at blogs for industry in a related article titled I only took one Econ class... writes:
    ...and as I recall I didn't do that well in it. So perhaps I'm missing something in Alex Tabarrok's and James Hamilton's arguments about taxes and prices...but then EconLog's Bryan Caplan doesn't seem to be buying it either. Tabarrok: Ask the man ... [Tracked on September 6, 2005 1:40 AM]
The author at The Dead Parrot Society in a related article titled Do Gas Taxes Holidays Cause Lower Prices? writes:
    Georgia recently suspended their gas tax for a month. Tax Policy Blog linked to a story that New York is considering tax relief that would last through New Year's. There is disgruntlement in Connecticut, as well. Will reducing gas taxes reduce prices? ... [Tracked on September 8, 2005 7:25 PM]
The author at Econbrowser in a related article titled Gasoline taxes revisited writes:
    Kudos to Bryan Caplan of Econlog, Victor of Dead Parrot Society, and the Governor of Georgia for proving wrong my conjecture that lowering gasoline taxes in the present environment would not result in cost savings for consumers. [Tracked on September 9, 2005 2:30 PM]
COMMENTS (17 to date)
Eric writes:

Don't local clean air requirements mean that gas isn't really a commodity that ships easily inter (or even intra) state? In medium term it might mean that refiners produce more of the blend in use in the cheaper district, but it won't be immediate. The EPA's waiving of clean air requirements on gas in wake of Katrina won't be permanent....

Alex Tabarrok writes:

Apparently not only is the man in the street mistaken but so is the man in the office next door!

The tax cut is on gas not oil - there is a big difference. We import oil from Saudi Arabia not gas, gas has to be refined from oil. As Eric mentions there are lots of regulations which are local. More importantly, the major cause of the recent increase in gas prices is damage to refineries and pipelines from Hurricane Katrina. The supply bottleneck cannot in the short run be easily alleviated.

This is why I said supply is more or less fixed, i.e. quite inelastic. A temporary tax cut at the present time will not increase supply and thus will not cut price.

Bryan's mistake was to think that this was an Econ 101 problem. On the contrary, it's an exercise in applied economics which cannot be solved by armchair reasoning alone.

Tyler Cowen writes:

Both Bryan and Alex are wrong. The industry is more or less competitive. Lower gas taxes means a lower marginal cost. Even short-run supply has some elasticity through changes in inventories. If you think the costs of adjusting inventories are very high, perhaps price will stay about the same. But that is a special case. We should expect short-run price to fall with marginal cost.

Alex Tabarrok writes:

Well at least lunch will be lively today.

Quick response. Of course supply is not perfectly inelastic! Straw man anyone? Supply doesn't have to be perfectly inelastic to get to the main point which is that a temporary price tax cut in today's situation of relatively inelastic supply will flow mostly to producers not consumers.

Silviu writes:

Supply is relatively inelastic, sure, but so is demand in the short run. It seems hard to say who will benefit "most" from the cut.

SteveSC writes:

Perhaps Tyler is right that there is some supply elasticity, but this may be offset by demand elasticity due to consumers well-known love of getting stuff tax-free. Here in SC we have a sales-tax free weekend for school related stuff, and people will line up to save 5%. Many of the items 'on sale' for 5% off are regular price that weekend, but are later truly on sale for 25% to 50% off once the tax holiday ends.

This implies that consumers value a dollar going to taxes more than a dollar going to purchases. Or, alternatively, they believe they get a better return on purchases than taxes. Has anyone studied this?

NCA writes:

In lieu of something useful to contribute: Bryan, I think you mean "man-on-the-street," not in -- though I wouldn't put the possibility of a man-in-the-street past VDOT...

And while we're at it, the possessive form of "it" has no apostrophe

Bob Knaus writes:

Jeez, you guys sure can make a Rube Goldberg contraption out of something simple.

Gasoline taxes are best thought of as a retail sales tax. They are collected by the wholesaler, but the amount per gallon is determined by the retail use. Auto gasoline has one rate, that sold at a marina has another, and if it is sold for off-road use you get a special low rate.

Retail gasoline is a notoriously cut-throat business. There are no "back-to-school" sales because profit margins won't allow it. For decades, retailers have been trying to pump up their margins with various premium gasolines, but to little avail.

On regular gasoline, the amount of retail tax is 5X to 10X the dealer's gross profit margin. It's certainly possible that retailers would try to bump up their profit margins a bit in the event of a temporary tax cut. But most of the cut will flow to the consumer, because of pricing pressure from the dealer acoss the street.

spencer writes:

Removal of a state tax on gas could have several outcomes.

1. assuming that is the only price change it would increase demand.

2. Assuming it allows gas prices to rise more then they otherwise would have it should induce some increase in supply. For example, if the price is $3.25 and removing a $0.05 tax and the price settes at $3.225 it will increase both demand and supply. How it settle out depends on the price elasticity of both demand and supply. At the current time the demand elasticity is high and the supply elasticity is essentially zero, so the price probably would settle in much closer to the original $3.25 then to $3.20.

Why is this so difficult?

spencer writes:

The price will settle at the point where supply and demand are back in balance. So the impact on physical demand and supply has to be euall and of the opposite sign.

Victor writes:

Aren't BOTH Bryan and Tyler correct? I.e., even if taxes were reduced -- today -- around the country, producers optimize profits over time and would shift sales into today until marginal revenue today reduces to equate to the newly lowered marginal cost. (Tyler's argument)

However, optimization also suggests that marginal revenue equals marginal cost in each jurisdiction. If the costs in one jurisdiction drop, then more quantity will flow to it so that marginal revenue and marginal costs remain in balance. (Bryan's argument)

Interestingly, James Hamilton makes this second argument in his "Lockyer" post ... $3/gal gas in California and $4/gal gas in Georgia encourages shipments from Calif. to Georgia ...

Dunno. Maybe cross-state taxes aren't sufficient to induce transport (although I doubt this, especially along state borders), but I do suspect that Cowen's mechanism -- inventories -- is alive and well despite record-low inventories at the moment.

Victor writes:

spencer -- At the current time the demand elasticity is high ... if this is true, why are there hour-long waiting lines?

Christian writes:
if this is true, why are there hour-long waiting lines?

There are no waiting lines in Northern Virginia that I have seen. I've actually noticed less cars at the pumps I visit


fling93 writes:

Uh, from a simplistic Econ 101 view, doesn't the tax essentially increase costs for the producers, shifting the supply curve to the left (and thus causing demand to shift along the demand curve, increasing the price)? Thus, wouldn't removing the tax have the opposite effect?

K writes:

Most of the discussions apply classical economics. And I think that misses the point.

The problem is said to be short-term difficulties in production and refining. So I doubt that world tax rates, market clearing, etc. apply.

If gasoline is selling out at $3.00 with $.50 tax in Baton Rouge today I don't think removing the tax will make gasoline appear tomorrow at $2.50. Why pump at $2.50 when you will sell out at $3.00?

Only if a greater supply became immediately available would the price fall.

The proper role of government is to discourage, not encourage, gasoline purchases during a shortage so that some supply will remain available for the most urgent needs.

Anonymous909 writes:

I dug up my old economics textbook with the classic supply/demand graphs. It shows pretty clearly that if you add a tax and both supply and demand curves have at least some slope (they aren't completely inelastic):

- the supply curve is shifted up (or left)
- the price goes up but by a smaller amount than the added tax
- quantity demanded decreases.
- both supply surplus and consumer surplus decrease
- there is a deadweight loss (the consumer surplus and supplier surplus drop more than the tax collected)

This all would imply that if you raise gas tax, price goes up, if you lower gas tax, price drops.

This applies even if there is a world tax rate. Please clarify what I am missing.

Bryan Caplan writes:

Your textbook is fine. I was essentially replying to a post by Alex that said precisely that the supply curve is almost perfectly inelastic now.

BTW, in discussions with Alex and others, I've learned that the U.S. imports a much smaller percentage of gas (10%) than oil (50%+). Furthermore, some states (e.g. CA) basically produce their own gas because of state-level regulations. So Alex is closer to right for this particular market than I originally thought.

On the other hand, Alex has admitted to me that under normal conditions, a gas tax cut would work even in the short-run because refineries are usually below capacity. It is only under the current emergency conditions that his story might hold.

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