http://neutralsource.org/content/blog/detail/1007/ Gas Tax Holidays... ...and how they conflict with the candidates' energy policy proposals 2 May 2008 in Regulatory Economics Recently, Sens. John McCain (R-AZ) and Hillary Clinton (D-NY) have proposed a "gas tax holiday" in which the federal government would suspend its collection of motor fuel taxes during the summer vacation travel season. Sen. Barack Obama (D-IL) has opposed it because it would provide minimal relief. The proposed gas tax holiday is an odd idea to dominate an energy policy debate. All three candidates have promised to take action if elected that would dramatically and permanently increase gasoline prices. News reports suggest that economists of all stripes side with Obama on the gas tax holiday. For example, former chairman of the Bush administration's Council of Economic Advisers Gregory Mankiw says I don't know any prominent economist who favors this McCain-Clinton proposal. More common is the reaction of a friend of mine (a veteran of the Clinton administration) who calls the idea "ludicrous." And indeed, we've had trouble finding an economist who favors a gas tax holiday. One reason may be that there that at least three economic principles operating simultaneously. The first has to do with the magnitude of the income effect consumers could experience. The second concerns the matter of tax incidence: What proportion of the value of the tax suspension would be captured in lower prices? The third issue is a but more subtle: Even if it is assumed that the retail price of gasoline fell by an amount exactly equal to the tax, consumers would respond by increasing consumption, and that would cause retail prices to rise by some fraction of the value of the gas tax. Another reason economists may side with Obama is that a gas tax holiday conflicts with the policy proposals all three candidates have made to address global climate change. (In his remarks opposing the gas tax holiday, Obama does not discuss the effect his global climate change proposal would have on gasoline prices.) WHAT IS THE MAXIMUM SAVINGS FROM A GAS TAX "HOLIDAY"? The federal excise taxes on gasoline and diesel are 18.4 cents and 24.4 cents per gallon, respectively. The current nationwide average prices for gasoline and diesel are $3.603 and $4.177 per gallon, respectively. Thus, federal excise taxes comprise 5% and 6% of the retail price, respectively. State excise and other taxes vary from a low of 8 cents per gallon in Alaska to a high of 45.5 cents per gallon in California, with a US average of 28.8 cents per gallon. If asked, few consumers are likely to know how much they pay in gas taxes. Many would mistakenly think that the McCain and Clinton proposals encompass both federal and state taxes. It is helpful to put these figures in perspective. Washington Post staff writer Steven Mufson attributes to Exxon Mobil vice president Kenneth Cohen the estimate that gasoline refining and marketing earns less than 5 cents per gallon in profit. That's 27% and 17%, respectively, of the federal government's and average state government's take in taxes, and 1.4% of the retail price. Still, it's worth understanding that, on average, a state gas tax holiday has greater potential consumer cost savings than the proposed federal suspension, and a combined federal and state gas tax holiday could provide a noticeably large reduction in retail prices. In California, the potential retail gasoline price reduction is 63.9 cents per gallon. Sen. Obama says a federal gas tax holiday is a gimmick that would save consumers about $28 over the summer. He also says this is "an idea that some economists think might actually raise gas prices," though neither the details of his savings calculation or the identity of the economists he is relying upon are disclosed. In any case, if prices fell the entire amount of the tax, a consumer would have to spend about $1,850 to buy 544 gallons of gasoline at at an average price of $3.40 just to save $100. A 5% price decline is still only 5%. TAX INCIDENCE Mankiw and Len Burman from the Urban Institute/Brookings Institution say that gasoline refiners would capture essentially the full value of the gas tax suspension. This conclusion is premised on the assumption that US refineries operate at full throttle during the summer months, meaning that supply is fixed and price is controlled solely by market demand, which in the short run at least is highly inelastic. The authority provided is a six-year old popular article written by Robert Eisenbeis, senior vice president and research director of the Atlanta Federal Reserve Bank. It's an odd source, however, because Eisenbeis' article has nothing to do with the peculiarities of summer gasoline production; it's about general constraints on refining capacity during a period in which the average price of gasoline was about $1.50 per gallon. If there is one thing that can be expected to reduce the need for refining capacity, it's a sustained period of high retail prices. (Mankiw says as much. In a more recent blog post, he highlights anecdotal empirical evidence that people are responding to high gasoline prices by purchasing more fuel-efficient vehicles.) Underlying the prediction that producers would capture the full value of a gas tax suspension is another assumption that may not be valid -- that retail gasoline markets operate in much the same way as the wholesale market. The retail gasoline business is especially competitive, and consumers are known to bear seemingly irrational costs to save a penny or two per gallon. Dealers who attempted to retain suspended gas tax revenue would be severely punished. ADAPTIVE RESPONSE Suspending the gas tax over the summer also creates an income effect, albeit a small one. (It would be larger in any state that simultaneously suspended its own, typically larger, gas tax.) But a small income effect is still an income effect, and economic theory predicts that even if some pocketed the full value of the suspended tax, consumers in the aggregate would respond by purchasing more gasoline. That adaptive response would dampen the retail price decline. So, if Obama's (unsourced) estimate of $28 savings over the summer is right, the income effect from reduced gasoline prices would reduce those small savings even further. OTHER PROPOSALS TO REDUCE GASOLINE PRICES The most notable irony about the debate over a gas tax holiday is that all three contenders for the presidency have advocated changes to energy policy that would either increase gasoline prices dramatically. Among the proposals with at best negligible effects are so-called windfall profits taxes on oil companies. Windfall profits taxes transfer wealth from some people (primarily stockholders) and give it to others (primarily beneficiaries of new government programs). It would have no effect on retail gasoline prices in the short run. To the extent that it deterred investment in refinery capacity or crude oil discovery, it would result in higher retail gasoline prices in the long run. It also would reduce returns on investment, including returns to current and future retirees who now own oil company stocks but neglect to sell them before the market capitalized the tax into stock prices. That could create a rather large and negative income effect on retirees. Sens. Clinton and Obama have both advocated windfall profits taxes, and both have claimed that this would reduce energy costs, though the mechanism by which this would occur is not very clear. Sen. McCain appears to be dodging having to take a position, and thus might be inferred to oppose a windfall profits tax despite its obvious popular appeal. Obama's proposal is the most specific; he would treat as a taxable windfall the profit US companies make when crude oil sells for more than $80 per barrel. This would eliminate any incentive US-based multinationals have to discover and bring new supplies to the US market. Indeed, it would invite them to sell assets to non-US based companies or reduce output. The predictable effect of capping gross profit at $80 per barrel is a spectacular decrease in the quantity of oil delivered to the US market and increase in the US retail price of gasoline. Windfall profits taxes have popular appeal but tend not to get enacted. A more important energy policy proposal that all three candidates have advocated is the radical reduction in US emissions of greenhouse gases. Clinton and Obama both propose reducing carbon emissions 80% by 2050; McCain is the co-sponsor of legislation that would reduce carbon emissions 60% by that date. Both goals are ambitious. They can be accomplished three ways: Rationing, where government decides who gets to use carbon-based fuels, how much they get to use, and for what purposes. Establishing a tax on carbon emissions, where the price of carbon-based energy is increased directly by an amount large enough to reduce the consumption of carbon-based fuels 60--80% Establishing a cap-and-trade allowance regime, where the price of carbon-based energy is increased indirectly by the same amount as would occur under a carbon tax. No one has proposed rationing. A carbon tax would make transparent to consumers (and voters) that government is directly responsible for their financial pain. This would have significant electoral effects. Because consumers would not pay directly, a cap-and-trade allowance regime would make it appear as if business was responsible. This might avoid significant electoral effects. All three candidates support a cap-and-trade approach. Nonetheless, dramatically higher gasoline prices are an essential programmatic feature of any aggressive global climate change mitigation program. They are not a side-effect that can be avoided perhaps with clever program design. If gasoline does not become very expensive, the program will fail. Thus, the political debate about high gasoline prices, and what ought to be done to reduce them, is fundamentally at odds with this crucial energy policy, which each of the candidates has promised to implement if elected. All three are in favor of very high gasoline prices -- prices much higher than $4 per gallon -- achieved in a manner that disguises the government's role. The fact that a gas tax holiday is being discussed at all suggests that none of the candidates wants to make transparent the cost to consumers of implementing the climate change mitigation program each of them supports.