Monday, March 24, 2008

A Better Gas Tax?

This isn’t an argument about whether or not taxes—particularly energy taxes—are “good” or “bad.” Rather, this essay has a narrow focus: IF we’re going to attempt to reduce gasoline demand through taxation, what is the best way to do it?

Here’s my somewhat counter-intuitive theory: to most effectively reduce long-term gasoline demand, gasoline taxes should increase, not decrease, long-term price volatility.

First, let’s look at European gasoline taxes. In the UK, gasoline tax is .50 GBP per liter plus 17% VAT ($3.75/gallon before VAT, $4.42/gallon with VAT). In Germany it’s .65 Euro per liter plus 19% VAT ($3.80 per gallon before VAT, $4.53/gallon with VAT). Compare that with US taxes, which range from a low of $0.26/gallon (Alaska) to a high of $0.63/gallon (California). The much higher European taxes operate to reduce price volatility because they remain static in the face of changes in the underlying price of gasoline. For example, if taxes effectively double the price of gasoline, then a 10% increase in the pre-tax gasoline price results in only a 5% increase in the after-tax price of gasoline paid by the consumer.

Why does price volatility matter? Let’s pretend that individual consumers consciously perform risk-management analysis on their future gas requirements (in decisions such as where to live or what car to drive). In that calculus, the theoretically rational consumer would look at the gas requirement of a purchase at today’s gas price (say, the gas cost of a daily commute). This consumer would also consider the possibility that gas prices would increase or decrease, and calculate the present value of these changes. The key question here is not whether gas will get cheaper, because that only results in making a presently affordable choice still affordable. Rather, the key question is whether it is possible that gas will get so expensive as to force the consumer to forfeit the presently affordable choice. Therefore, the potential for volatility making gas cheaper won’t spur an increase in present demand choices to the same extent that the potential for volatility making gas more expensive will reduce the present demand choices.

Here’s an example. You’re looking in to buying a moving, and the new location is 10 miles (each way) farther to your job. You drive a car that gets 20 mpg (only for the sake of simpler math). If present gas prices are $3/gallon, and you commute to work 200 days per year, then this new location will cost you $600/year more than your old location. If you assume that volatility is low—say, that prices can only move by a factor of 2 either way—then the most you could save is $300/year (at $1.50 gas), and the most additional expense would be $600/year (at $6 gas). However, if volatility is extreme—say a factor of 10 either way—then the most you could save is $540 (at $.30 gas), and the most additional expense would be $6000/year (at $30 gas). The second scenario—more assumed potential for price volatility—will have a greater demand-reducing effect on today’s choices than does the low-volatility assumption because the risk of rising prices is much more potentially damaging than the potential benefit of falling prices.

It’s difficult to compare European and American gas demand (especially the elasticity of that demand) because the culture and built-environment are so different. However, assuming everything else is equal, what happens when the underlying cost of wholesale (pre-tax) gasoline goes from $2/gallon to $4/gallon? In Europe, assuming a gas tax of $5/gallon, the price rises from $7/gallon to $9/gallon—a change of 28.6%. In America, assuming a gas tax of $.50/gallon, the price rises from $2.50/gallon to $4.50/gallon—a change of 80%. When contemplating a consumer choice such as what car to buy (and how much to weigh fuel efficiency) or how long a commute is affordable, the higher volatility regime necessitates that gasoline demand will play a higher role in that decision, all things being equal.

What does this mean? It tells us that, IF the goal of a gasoline tax is to cause consumers to make choices that reduce gasoline demand, then that tax should operate to increase volatility. One way to do this is to make the tax per gallon a function of the price of that gallon of gasoline—for example, make taxes 100% of the wholesale price of exchange traded gasoline on a week-to-week basis. This would, nearly, double the volatility already present in wholesale price swings, whereas setting gasoline tax at a fixed level equal to the price of today’s wholesale price of gasoline (and not adjusting it continually as that price changes) would effectively halve volatility.

So far, this analysis has made one essential assumption—that consumers will rationally consider the risk inherent in future gasoline price swings, and will adjust their risk calculations based on the impact of a changing tax regime. Surely that won’t be universally true, but, in addition to at least some of the general public, more sophisticated businesses will should be able to understand this (especially when the policy is explicitly labeled as intending to increase volatility), and it can be communicated to the public in general as the rationale behind a shift in tax regimes. Getting Americans to consider a gas tax increase as a good idea, of course, is an entirely separate matter!

Do examples from the real world validate this notion that increased price volatility reduces the demand for a commodity? I think it does, at least within the world of energy. As I recently observed, gasoline consumption choices in Germany seem to actually be moving away from efficiency (though I can’t show that this is more than correlation based on anecdotal evidence). Within the US, a recent report by Deloitte concluded that US utilities are focusing on “demand management” and energy efficiency rather than investing in new generating capability precisely because there is increasing uncertainty over the future of regulations on greenhouse gas emissions. The Deloitte report suggests that increasing volatility leads directly to increasing efforts at demand reduction.

While I’m the first to admit that gas taxes are only a preliminary step to dealing with Peak Oil, if we’re going to use them for the purpose of demand reduction, we should do so in an efficient—rather than counter-productive—manner. A common adage is that gas tax must sting in order to work—and a tax that is designed to increase volatility is a tax that is more effective at stinging. Gas taxes should be variable and a percentage of the current underlying price of wholesale gasoline in order to enhance, rather than reduce, the consumer’s exposure to volatility. The pessimist in me realizes that this is very unlikely in America (I think it’s more likely that gas taxes are rolled back to pander to the near-term concerns of voters). Maybe the Europeans will listen—they explicitly use gas tax to reduce demand, and seem to understand that such a tax must sting to work, but currently tax in a counter-productive fashion.


Tom Konrad said...

"Let’s pretend that individual consumers consciously perform risk-management analysis on their future gas requirements "

Oh, c'mon. If consumers performed risk management analysis on their future gas requirements, we wouldn't need a gas tax at all... we'd already be driving 50mpg+ vehicles.

The problem is that purchasers of automobiles apply a *very* high discount rate to costs, weighing the cost of the vehicle far more than they do the cost of ownership.

If we're going to apply a tax, the point to apply it is at the point of purchase... penalizing inefficient vehicle purchases...

On the other hand, I do agree with your conclusion... but only because I expect prices to go up and charging as a percentage of the gas price rather than a fixed number of cents per gallon would likely have a grater effect.

Jeff Vail said...

Sure, assuming rational consumer behavior is pretty silly, but any other basis of assumptionis even more silly. Imagine the policy decisions we would make if we started with the assumption of irrational consumer action. The best, unfortunately, that we can hope for, is that some portion of the consumer base acts rationally, some portion acts unconsciously in a rational manner, and that we can work to effectively communicate why people more people should join the first camp.

I think that the problem is less one of hoping that people will figure out on their own that increased volatility should lead to their lowering demand, and more a problem of effectively communicating to them that this is the rational step for them to make (and why)...

Theo_musher said...

Who would make this happen?

It would have to be the democrat version of Dick Cheney, who would raise gas taxes even though the majority of the American people don't want it, and respond by saying "so?"

But unlike the war this is an issue that most people actually would get up in arms about. I don't see it ever happening.

The only possible way I see it working would be if the corporate world got behind it simultaneously and rolled out a really chaep affordable prius type car. There are new hybrids out, its just that you have to be pretty well off to buy one.

Tom Konrad said...

Human behavior is irrational, but it's systematically irrational. People are systematically willing to sacrifice tomorrow for today. The best policies recognize that.

An example of a good policy is getting people to save more for retirement in terms of a "pay more later" principle. While they may not be willing to save more for retirement today, most are willing to commit to have a large portion of future pay raises automatically go into their retirement plan.

Similarly, a plan to get people to drive less might be more effective if it worked with people's willingness to commit today to better behavior tomorrow. For instance, auto registration could be changed so that if people commit to buying an annual bus pass in 6 months, they get a small discount on their registration (only a fraction of the cost of the bus pass.) Six months later, they get the pass in the mail, and their credit card is charged. Now they have an incentive to use the bus because the marginal cost is zero (unlike driving.)

I'm sure there are some kinks, but the point is to allow people to commit today to good behavior in the future, and have an enforcement mechanism when the time comes.

Jeff Vail said...

My concern with the "commit now to pay more later" approach is that, when that "pay later" starts to really bite, there will be ample reactionary, political will to undo one's commitment. No matter how "legally binding" some future commitment is now, it can always be undone later. I think that, in order to get us out of the collective mess that we're in, the degree of future commitment would end up being undone because people would buy into the sales pitch (explicit or implicit) that "it won't hurt that bad," and feel betrayed when it does "hurt that bad." One reason that I'm not particularly optimistic about our ability to address the problems facing us is that I think the only way to make the necessary changes is to come to the realization, in the present, that we need to make sacrifices now. I think that "commit now to pay later" schemes work because they implicitly deny that sacrifices will ever be needed, or they simply play off humanity's tendency to use a high discount rate for future dopamine release :) I think they work just fine in a world with sufficient and perpetual economic growth, but won't work at all in a world that has problems today, and won't have sufficient (or even positive?) economic growth to allow us to continue to defray paying the piper. I realize that this argument includes the assumption that significant economic growth is unlikely--that's an assumption that I am willing to accept, but that many people are not. Who knows who is right--my concern is the moral problem of defraying cost (even if only upon our future selves, not upon future generations) when we don't know that we'll be able to meet those payments. A bit of a rant here, I apologize, but I think the only way we can have that envisioned future growth is if we attack the crux of the problem, the long pole in the tent, first: get people to accept that sacrifice must be made now, and can no longer be defrayed on hope that we'll be able to pay later. I realize that the odds of the public accepting this en mass are near zero, but I think that if select institutions, if enlightened sub-groups, etc., begin to adopt this outlook, that would be better than nothing.

Interestingly, while there are many significant differences between the US and Europeans, they seem to be much more willing to pay now--if not to address their mounting entitlement problems, at least to address issues like climate change. Why do European climate change proposals that require payment up front succeed, while similar thinking in America (and in Europe re: their pension issues) fail? We all have the same genetic foundation to work with, so figuring out why some of these proposals fail when others succeed might give us the tools that we need to make them work more often?

Toes said...

So, let's say a forward thinking politician decides he can get elected in California by reducing gas taxes. He proposed and somehow manages to pass through the California legislature a measure that changes the gas tax from $0.63 per gallon (approximately 20% tax) to a 15% tax. The voters love him because the tax has been reduced by about $0.15 - 0.20 per gallon.
Since this is the extreme in the US ($0.63 per gallon), it would have the biggest effect on pricing. At $5.00 per gallon, the 15% tax would bring in only $0.75 per gallon - not likely to have the effect you mention.
My point is that if in the extreme condition of California, I think it would still take a net tax increase (to a 25+% tax) to have the effect you seek. I see the chances of even the 15% tax passing the state legislature as almost zero (reduce tax revenue?). The chances of getting reelected after having raised gas taxes are even less likely.
So where does the political will come from to effect such a change?
A typical consumer owns his or her car (or has committed to a payment plan). He or she is committed to pay for insurance and registration, etc. These things can't be turned off. I can decide to ride the bus or not tomorrow and it will mean only that I have spent or not spent the fare. I can drive or not drive my car tomorrow and the only change in my variable cost is the fuel and maintenance. I still am out the insurance, registration and car payment. In fact, the more I drive, the lower my cost per mile.
Do we move to a "no-fault" auto insurance plan to lower the insurance cost? Does an entrepreneur buy fleets of highly efficient vehicles that are available for simple daily rentals (like renting movies -
Great post. Makes one think more than most. Thanks.

Jeff Vail said...

This post is also up at The Oil Drum:

Jeff Vail said...

I'd like to see this begin at a federal tax that is 100% RBOB wholesale gasoline price, updated monthly. Right now that's about $2.63/gallon, and would apply in addition to taxes raised by states.

On the flex-car note. A friend in San Francisco doesn't own a car, but frequently rents one by the hour to go to Trader Joe's (grocery chain... PLEASE come to Colorado). She's signed up in advance, much like netflix, and just goes to their parking space two blocs from her apartment, enters her key code in whichever of their several Toyota Priuses that she wants (no reservation), and drives off. She gets billed $15/hour (that number is a few years old) and that includes insurance, gas, etc. Not a bad plan...

small business idea said...

assuming rational consumer behavior is pretty silly
I think that people will figure out on their own that increased volatility should lead to their lowering demand

Jeff Vail said...

Isn't "people will figure out on their own that increased volatility should lead to their lowering demand" the same thing as assuming rational consumer behavior?

Anyway, there's a discussion above in comments about the issue of the rational consumer: if you don't want to assume a rational consumer (and try to educate as necessary to this end), what assumption do you use in its place? Assuming an irrational consumer makes any policy program designed to impact consumer behavior pretty silly.

Tom Konrad said...

I absolutely agree that we need to act ASAP. However, your arguments that any currently-agreed imporvements will late be undone applies even more so to any changes we want to make now. Getting a gas tax of any form passed today is impossible, for the same reason a "pay later" reform might be undone... but it lacks the advantage of buy-in.

Look at my example of a voluntary commitment to buy a bus pass in return for a small discount to vehicle registration...

I admit it's not nearly enough, but it would do two things: raise money for public transit, and slightly decrease driving, both of which would decrease fuel use over time. Not enough, but it is the type of thing that is politically possible now, as opposed to any sort of gas tax.

Assuming an irrational consumer is realistic and possible. Most salesmen have been doing it forever. That's why luxury stores exist. That's why mutual funds can get away with charging ridiculous fees.

Anyway, you gave me an idea for an interesting post of my own on the subject.

Alan J Simpson said...

I would add that there is an underlying flaw in comparing the US consumer to the European Consumer when increases in gasoline costs are considered, that of alternative transportation.

Europe has an outstanding network of quality public transport, and when required the private vehicle can be left at home. In the USA the special interests of Big Auto and Big Oil have destroyed effective public transport networks.

So a consumer in Northern England for example can elect to jump on a fast train to go to London, or elsewhere. In fact he can jump on a train and end up in Cairo or ride across Siberia. Locally the Bus service can take them to the local Supermarkets.

Here in the USA few communities have access to similar networks. For me to get a gallon of milk I need a private vehicle.

I could suggest laying railway track like crazy in preparation for the spiraling Oil prices thanks to Bush's Folly in the Middle East. That would be a waste of time as China has bought up all the steel for rail track.

Alan Simpson

Rice Farmer said...

We're about to get another case study on this very subject: a special gasoline tax in Japan is about to expire.

It will be instructive to see what changes this brings about. For example, the tax was used for road construction and maintenance, so what will happen to roads? Sales of larger passenger cars have languished, and those of the compact "K cars" have skyrocketed to new heights. Will this reverse the trend? How will it affect sales of hybrids? Will gasoline consumption rise significantly?

Of course, if politicians reach a new agreement on the gas tax by summer, the lower prices could be too short-lived to make any difference.

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