Bryan Caplan  

California Dreaming

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California's latest crazy initiative helps James Hamilton get in touch with his inner Bastiat:

The only reason I can imagine for a specific tax on California oil producers is the apparent belief by the proponents of the tax that these costs will be borne not by California drivers but instead by big oil companies. One of the most curious features of the Act is Section 42004(c):
The assessment imposed by this part shall not be passed on to consumers through higher prices for oil, gasoline, or diesel fuel. At the request of the authority, the board shall investigate whether a producer, first purchaser, or subsequent purchaser has attempted to gouge consumers by using the assessment as a pretext to materially raise the price of oil, gasoline, or diesel fuel.

The standard explanation economists give for why a tax like this would of course raise the price to consumers is that it will cause the least profitable California oil reserves not to be extracted. With less supply, the price has to rise. This is not a conscious decision of anybody to "pass on" a cost or "gouge" a buyer, but simply is the way that markets work. The designers of this legislation evidently recognized this as a potential concern, and decided simply to rule out the natural and necessary market outcome with the stroke of a pen, leaving yet another job for judges to try to divine whatever California voters must have intended by terms like "pass on" or "gouge".

Growing up in L.A., I often heard jokes about what a bunch of nuts we Californians were. At the time, I didn't get the joke - the only status quo I ever knew seemed normal to me.

Unfortunately, now that I see more clearly, the joke's not funny anymore. Economic illiteracy is no laughing matter.


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COMMENTS (8 to date)
Ragerz writes:

This tax is not likely to raise gas prices by a significant amount because gas prices are set on world markets and gasoline is such a fungible commodity. If you want to look to a force that is likely to have a large affect on gas prices, it isn't this tax, it is OPEC, which already artificially restricts oil supply.

Of course, one beneficiary of artificially restrained output is California oil producers; their product is worth more given the existence of OPEC. To the extent that this tax makes "marginally profitable" California wells unprofitable, this relieves pressure on OPEC to restrict supply. There is no reason to think that decreases in supply will be significant. (To the extent that such decreases in supply are significant, we can expect those effects to be massively overwhelmed by even more significant decisions by OPEC.) Overall, the incidence of the tax will come out of the pockets of oil companies. The price of oil is primarily set in world markets, not in California.

In my view, Hamilton is the wacky one. He writes the following:

"If you look just at the tax incidence of the proposal, it is inconceivable that the tax change could have any effect other than to reduce the amount of oil California produces and increase the amount we import from other states or countries. And yet, proponents of Proposition 87 advance as one of their arguments the claim that the Act would reduce our dependence on imported oil!"

This is a nice static argument. *Yawn.* I could make it my sleep, just give me a supply and demand curve. But it ignores dynamic advances in technology as a result of this proposition. The funds raised by this tax will be spent to provide incentives for research and development, as well infrastructure and subsidies for alternative fuels. To the extent that alternative fuels experience economies of scale and these subsidies help industry reach such economies and to the extent that research and development results in new technology, this proposition will result in less dependence on ALL oil, which of course would include foreign oil. Hamilton needs to lay off the exclamation points. His static analysis is very lacking and does not even address the dynamic changes that this proposition will bring about.

Hamilton asserts the following: "A far more logical way to raise revenue is with a tax on the gasoline consumed in California rather than a tax on the oil that is produced in California."

That is not logical. That would be politically stupid. A use tax would increase the price of gas at the pump. The tax as structured will have de minimis effects on prices at the pump, if any. Further, the tax will fall primarily on oil companies. Maybe they will have less money to pay their CEOs. Oh well. Maybe the next CEO of Exxon will get a little less than the $400 million received by former CEO Lee Raymond. Oh so very sad.

Here is an idea for the oil companies. If they want to recoup some of the tax, they can apply for some of the funds available for private research and development into alternative fuel.

Overall, I am disappointed in Caplan's analysis. He labels supporters of this tax as "economically illiterate" but then fails to consider the dynamic effects. Does he not even realize that they exist? Further, he did not even acknowledge that it will be very difficult for oil producers to pass on much of this cost to consumers. Oil refiners faced with higher priced California oil will likely find it cost effective to import it from abroad.

Caplan's failure (and Hamilton's failure) to even address these issues, if only to debunk them, makes me question the degree to which they should be questioning the economic literacy of others. Which is not to say that they are economic illiterate themselves, only that they are perhaps to quick to assume that those who back proposition 187 are economically illiterate.

I know how I am voting on November 7th. Luckily, Caplan won't cancel out my vote, because he lives in Virginia. =)

Ragerz - the ex-libertarian

Ragerz writes:

I refered to the proposition once as 87 and once as 187. The correct number is 87.

Mike writes:

Ragerz ...

maybe you should reread this ...
http://www.tcsdaily.com/article.aspx?id=101706A

David writes:

Just be thankful if you're not in the California media market that you don't have to watch the Prop. 87 ads every day on TV. One of them even features Al Gore, who says that 87 will help us solve the "climate crisis". One of the failures of the media campaign in favor of 87 will be that nearly all people watching realize that taxing domestic production will not decrease our dependence on foreign oil, despite the menacing images of Saudi oil sheikhs and angry Middle Eastern Muslims burning Old Glory. And I know that according to Arnold Kling we are not supposed to base our objections to policies on motivations, but I have read that one of the money men behing the initiative manages an investment fund for alternative energy. If true, this tax looks good for his holdings.

dearieme writes:

If they really want to Save The World, why don't they just repeal the Second Law of Thermodynamics?

Ragerz writes:

Mike,

Very interesting article. I should point out that the idea of paying for output (results) instead of input (grants for R&D) in this TCS article has costs as well as benefits.

By definition, with a reward system for output, you only pay for successful research. This has the disadvantage of making it more challenging for new researchers to enter the field. The ex ante probability of any particular line of research leading to a success is very difficult for anyone, including private sector actors, to determine.

A more significant disadvantage of a reward system is that it will have a tendency to reward only those who do later-stage research to bring a project to completion, even if their work built on that of others. Because those who perform earlier-stage research will not benefit unless they themselves are the ones to do the later-stage research to bring the project to completion, there will be a large incentive to conceal research results and other information, resulting in duplicative research. Grants from the government can be conditioned on information sharing and can thus help minimize duplicative research efforts.

Then there is the question of optimal allocation of risk. Say that idea X has a 1% chance of being successful, idea Y has a 1% chance, idea Z has a 1% chance and so on. Ex ante. Of course, ex post, we know that some of these ideas are more promising than others. Should researchers bear the full brunt of them eliminating an initially promising idea from consideration, merely because it later turns out that the ex post probability of success is lower than the ex ante probability? Furthermore, a researcher who does try idea X and finds out that it doesn't work has every incentive to conceal that from competitors. Overall, it would be more beneficial to spread both risks and rewards and require participants to engage in information sharing.

Overall, I am not against a system with a reward component, but I do think that it would be a mistake to have a pure reward system. It would be better to give grants to organizations, conditioned on them sharing the results of their research to some degree, but then provide a lucrative reward for results. In addition, maybe we should fund a Nobel Prize in energy.

mobile writes:

Ragerz,

All the oil produced in California is refined in California. This means that there is some economic surplus to be had by the fact that the producers are so close to the refiners. If this were not the case, the producers would make more money sending some of the oil out of state to be refined. Unless you believe that the entire surplus is captured by the producers, then it follows that refining oil from California is a better value than refining imported oil for California refineries.

If something causes production costs to rise, either the producers will try to pass the costs on to the refiners ("illegal" under prop 87), or they will move down on their supply curve and produce less oil. The refiners will have to import this oil from other states or countries. Either way, refiners' costs (and ultimately, consumer costs) increase.

Ragerz writes:

mobile,

I agree with your analysis. I just don't think that this will be an effect with a very large magnitude. It is also possible that a decrease in California oil production might have some effect on world prices. Overall, both of these effects, while they exist, are de minimis. Thus, they should not be a concern for voters considering the merits of Prop. 87.

If you think oil prices are too high, I suggest a better route is to get the President to pressure OPEC to not restrict supply so much or have Congress pass a law allowing legal action to be taken against OPEC countries.

One last point. Whether this measure will decrease oil production depends on whether the marginal cost of oil production ever approaches the marginal price. It could be that California production is limited by physical factors rather than economic factors. In other words, that the artificially high price of oil (due to OPEC) means that California oil producers are over-incentivized. They may produce all the oil (or nearly all the oil) that it is physically possible to produce.

Whatever the case, with artifically high prices for oil anyway, it seems likely that the disincentive of this tax will be especially minor. Thus, you are most likely talking about a very small production effect, if any.

As long as oil producers have an incentive to continue production at current levels (assuming that the reason they don't pump more oil are physical constraints rather than economic constraints) given the laws prohibition on passing the cost of the gas onto refiners, they will pay the full cost of the tax.

Finally, it should be noted that, assuming gas is $60 a barrell, the tax is only 2.65%. So, we have a very small tax anyway. So, what we are talking about here is a small risk of a very small part of a very small tax being passed onto consumers.

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