David R. Henderson  

The Problem with a Variable Tax on Gasoline

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Unintended Consequences of Gov... We Are So Different...

"Let's make our demand for gasoline even more inelastic."

Other economists suggest a gasoline tax that would increase as gasoline prices fall toward a predetermined floor and decrease as pump prices rise above it. This way, OPEC countries would be unable to manipulate prices lower so as to destroy the returns of persons risking capital in alternative-energy investments, which the cartel has adeptly done in the past.

This is from Jim McTague, "Obama is Humbled by the Market," Barron's, March 24, 2012. Greg Mankiw linked to it this morning. I'm guessing that what caught Greg's attention was the article's advocacy of a tax on gasoline. I won't bother revisiting that well-worn debate.

Instead, I want to focus on a paragraph that I bet Greg didn't focus on, the one I reproduced above. I wrote about a similar proposal, a variable import fee on oil, in two articles (here and here) in the Energy Journal in 1989. A variable gasoline tax is not quite the same, but it would have a similar unintended, but completely predictable, consequence.

The argument I'm about to give rests on the assumption that the world oil market has an entity in it, OPEC, that has some market power. If you don't believe that, then you won't find the rest of the argument convincing. But notice that McTague does believe it. Check the quote from his article above.

What constrains OPEC from raising price above whatever level it's at? Three things: (1) production by non-OPEC suppliers, (2) strains within OPEC as members find it increasingly attractive to "cheat" on the cartel agreement by cutting price a little, and (3) the size of the world's elasticity of demand.

It's on (3) that I want to focus. The United States consumes about 25% of world oil and (I don't have it handy) more than 25% of world gasoline. There's some elasticity of demand without the proposed variable tax.

But now assume that the government says that the target price of gasoline, in 2012 dollars, is $4.00 a gallon. For simplicity of exposition, assume a combined federal and state gasoline tax of 50 cents per gallon at that price. So the price minus tax is $3.50 a gallon. What happens if OPEC cuts the price of oil, which would cut the price of gasoline? Normally what would happen is that OPEC would sell more oil used to make U.S. gasoline. But if OPEC cuts the price of oil, the price of gasoline as seen by the U.S. consumer would not be allowed to fall. If the price minus tax would have been, say, $3.25, then the tax would rise to 75 cents. The consumer would see the same price of gasoline he would have seen and, therefore, will not change his quantity demanded. So that one source of elasticity of demand that previously confronted OPEC--the U.S. gasoline consumers' elasticity of demand--no longer exists. The government has created a perfectly inelastic demand curve for gasoline. That, on the margin, reduces OPEC's incentive to cut price.

Similarly, if OPEC is contemplating a price increase that would normally drive the price of U.S. gasoline above $4.00 a gallon, one thing constraining it is the fact that U.S. consumers would cut back the amount of gasoline they demand. So, for example, if OPEC raised the price of oil so that the price of U.S. gasoline, including the normal 50 cent tax, would be $4.25, then OPEC would know that U.S. consumers would cut back somewhat. But now OPEC would know that the price the U.S. consumer would see is only $4.00 a gallon because at the higher price of crude that would normally yield a market price of $4.25, the U.S. government would cut the gasoline tax to 25 cents a gallon to keep the price of gasoline at $4.00 a gallon. So why not raise the price of oil?

Of course, there are a few "why nots:" factors (1) and (2) mentioned earlier, and the elasticity of demand of the rest of the world and of U.S. consumers of non-gasoline refined products. But the variable gas tax eliminates the U.S. demand for gasoline as one of these factors.

So, ironically, but completely predictably, a policy allegedly aimed at undercutting OPEC's monopoly behavior would actually strengthen it.


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COMMENTS (8 to date)
Daniel writes:

You are assuming, of course, that the $4.00 floor doesn't wind up meaning that an alternative fuel gets developed due to the fact that the investors know that the price of gasoline can't drop. If the substitute is developed, and especially if its production cost falls as the technology to to make it matures, the OPEC's monopoly power would surely be damaged.

This, at least, is the grounds upon which I supported the idea of a floor price for gasoline ever since I took my first economics of energy course and saw the research showing that various alternatives to gasoline would be economical to make if gas prices were just a bit higher.

Of course, that was in 1989, and I dare say that gas real gas prices has risen since then (and if the technology for producing these substitutes hasn't improved in 20 years, I'd like to know why not). Since then, I've become much more skeptical of claims like "if gas was just five dollars a gallon, biodiesel from algae would work!!!"

David R. Henderson writes:

@Daniel,
Good point. It’s not so much that I’m assuming it as I’m saying that here’s a downside that the advocates don’t consider.

Mike Hammock writes:

I am a bit confused about how such a tax would be implemented in practice. For, suppose the price of gasoline a station charges is $3.50, and therefore the federal government assesses at $0.50 tax, bringing the price paid by consumers up to $4.00 (assuming perfectly inelastic demand). If that's the case, why wouldn't the gas station owner just push his pre-tax price up to $4.00 anyway and pocket the extra money? Or would the tax be based on a national average gas price, rather than a per-station basis? I must be missing something. If the price is always at least $4.00, wouldn't this reduce someone's incentive to shop around or keep an eye on costs?

Daniel writes:

Mike,

I think that the only thing you are "missing" is the fact that the logic you cite applies equally well to the original supplier of the oil. Why should they produce more oil than is necessary to produce a price of $4 a gallon naturally when, if they do, the price will fall to $4 - $X, which will induce a tax of $X, which will drive the price back to $4 (that, at least, is the end result, multiple move by the producer and counter-moves by the government might be needed to get there)?

Saturos writes:

It seems to me that the idea is to prevent some sort of "predatory pricing" - to actually prevent OPEC from lowering prices to consumers, as much as possible. If this leads to a contraction of the overall supply, so much the better; the "alternative energy" constituency should be quite pleased.

It's not quite so clear then why the government wants to reduce taxes proportionately to higher base prices - surely a steady rate would discourage consumption even more? However, if you view the government itself as a monopolistic revenue-raiser, then perhaps their strategy makes more sense.

Joe Cushing writes:

The price would just rise to $4. and there would be no taxes collected.

Kevin H writes:

I have to agree with Mike and Joe, the price of gasoline would rise almost immediately to eat up all the taxes. At first I think the difference would go to the gas station owner if his contract and law permits. Next the difference would work it's way down the supply chain. Due to limited refinery capacity and the fact not all oil is refined into gasoline not all of the difference would work its way back to the well but enough of it will. Oil producers would start pumping the more expensive oil and holding the cheaper to extract oil for the future.

So basically gas becomes more expensive to the consumer and almost no new tax revenue would be produced.

Mark Zdeblick writes:

Clearly, a "variable" tax that was described won't work for logical reasons you ably present. But... this isn't the only form of a variable tax.

For simplicity, let's say that at $3, the tax is 10%, and at $5, the tax is 20%, with a linear variation between the two. So... a $0.30 tax on $3/gal gas, but a whopping $1/gal tax on top of $5/gal gas.

As producers try to raise prices, demand is further reduced by the accelerating tax rate. Similarly, as price falls, demand more dramatically increases by the decelerating tax rate.

Such an approach should amplify any elasticity exists in the supply / demand curve, and thus tend to keep the price in a more predictable range.

Governor Sarah Palin signed in to law a tax on mined oil whose rate increases w/ price. While those holding investments in such oil-producing properties received returns that didn't rise as much as originally expected when prices skyrocketed, they also benefited from higher returns due to ... skyrocketing prices.


Other variables would come in to play: reduction in incentives to explore "expensive" oil fields and imbalances w/ manufacturers in nations w/o such taxes, etc.

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