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May 2, 2008

Gas tax holiday: Who gets the benefit?

Let us begin with this short little post from Brad DeLong which sums it up nicely.

In my inbox right now, from a highly-respected public finance economist:
In the long and sad annals of truly bad ideas, it is unusual for one to receive bipartisan support at such high levels right in the middle of a campaign as this one has...

He is referring, of course, to what has come to be known as the McCain-Clinton gas tax holiday. Reuters has the summary.

"Score one for Obama," wrote Greg Mankiw, a former chairman of President George W. Bush's Council of Economic Advisers. "In light of the side effects associated with driving ... gasoline taxes should be higher than they are, not lower."
Republican McCain and Democrat Clinton, who is battling Obama for their party's nomination, both want to suspend the 18.4-cents-per-gallon federal gas tax during the peak summer driving months to ease the pain of soaring gas prices. The tax is used to fund the Highway Trust Fund that builds and maintains roads and bridges.
Economists said that since refineries cannot increase their supply of gasoline in the space of a few summer months, lower prices will just boost demand and the benefits will flow to oil companies, not consumers.
"You are just going to push up the price of gas by almost the size of the tax cut," said Eric Toder, a senior fellow at the Urban-Brookings Tax Policy Center in Washington.

Paul Krugman adds,

Why doesn’t cutting the gas tax this summer make sense? It’s Econ 101 tax incidence theory: if the supply of a good is more or less unresponsive to the price, the price to consumers will always rise until the quantity demanded falls to match the quantity supplied. Cut taxes, and all that happens is that the pretax price rises by the same amount. The McCain gas tax plan is a giveaway to oil companies, disguised as a gift to consumers.
Is the supply of gasoline really fixed? For this coming summer, it is. Refineries normally run flat out in the summer, the season of peak driving. Any elasticity in the supply comes earlier in the year, when refiners decide how much to put in inventories. The McCain/Clinton gas tax proposal comes too late for that. So it’s Econ 101: the tax cut really goes to the oil companies.
The Clinton twist is that she proposes paying for the revenue loss with an excess profits tax on oil companies. In one pocket, out the other. So it’s pointless, not evil. But it is pointless, and disappointing.

Is it?

Maybe not totally pointless, but definitely in the neighborhood. This is Econ 101--tax incidence theory. This is bread and butter for economists. But our pronouncements are only as good as what we really know about the relevant supply and demand elasticities. To make things even more interesting, the question of incidence (i.e. whose price will rise or fall) is not just a matter of absolute elasticities, but of the relative elasticities of demand and supply. Supply may be relatively fixed in the summer, but if short run demand is also inelastic, it is not a foregone conclusion that the suppliers will get all the benefit.

We take as one of our stylized facts that gasoline demand is fairly inelastic in the very short run. A 10% change in gas prices this month will probably not cause me to change my driving habits much. A permanent 10% increase will cause me to change my habits more over time. The federal excise tax of 18.4 cents is roughly 5% of the going price. In fact, I think we can expect that the fluctuations in price over the summer due to refinery maintenance, hurricanes, pipeline problems, etc. could be as large or larger in magnitude. I wouldn't expect it to change driving habits much at all. In other words, the demand is inelastic. Not perfectly inelastic, but quite inelastic.

Krugman suggests that the supply is practically fixed. If he's right in the extreme case (i.e. perfectly inelastic supply) then the game's over. The oil companies get all the benefit. But that's probably not the case either. A commenter at Angry Bear posts a link to the ever useful Energy Information Administration, or EIA. They point out in a recent newsletter that gasoline inventories are currently at the high end of the normal range. Given that production of the summer formulations has probably not fully ramped up yet, they probably have a little more wiggle room than Krugman is assuming. I'm not saying that they have a lot. But if demand is also quite inelastic, they wouldn't need an awful lot of wiggle room for the tax incidence to be split more equally.

The most recent piece of academic research on this that I could find is in Economics Letters (2004) by Hayley Chouinarda and Jeffrey M. Perloff (non-gated version here). They find that the incidence of the federal tax is split roughly equally between suppliers and consumers. The state taxes fall more on the consumers, and the burden on consumers is smaller in large states.

That last fact might have been useful for Obama to have known back in 2000 when he supported a statewide gas tax holiday in Illinois. As a resident of Illinois then as now, I can tell you that I didn't notice much of a difference. All I remember is seeing the signs on the pumps that told us that the legislature had suspended the sales tax on gas and that this should be reflected in the price.

I remember how I chuckled about it each time I filled up.

You did notice a few cents difference in the immediate run (i.e. shorter than the short run... first few days), but as time went on, elasticities and tax incidence theory did their thing. It was hard to see the difference with the naked eye. So was there any academic research on it?

Funny you should ask... in fact there was. (Hat tip to Daily Kos). Joseph J. Doyle, Jr. and Krislert Samphantharak of MIT and UCSD, respectively, found that the elimination of the 5% tax was associated with about a 3% drop in the retail price, or 6 cents on the (now) quaint sounding average price of $2 per gallon. But again, with the normal market fluctuations going on in the background, this was hard to see without your econometric glasses on.

But that's actually a reasonable conclusion. Given that Chouinarda and Perloff find that the consumer incidence of state taxes was quite high (close to 100%) but definitely smaller in the larger states (like Illinois), I would not be surprised to see that the breakdown was maybe somewhere between 50 and 75% for a state like ours. Doyle Jr. and Samphantharak put it at 60%. So like I said, it's reasonable.

But if Chouinarda and Perloff are correct in that the burden of the federal tax is more evenly split, then you'd notice it even less than we did in Illinois in 2000. If Krugman is even somewhat correct that it is too late in the game for quantity adjustments to be made, then the consumer's benefit shrinks further. Just guessing at a number, say maybe the consumer gets 5 or 6 cents out of the 18.4. With gas at $3.50 and perhaps more than 5 cents of variation across local markets and over time... you're going to need to have super-powered econometrics glasses to see the effect.

My conclusion: Maybe you would benefit 5 or 6 cents per gallon, give or take a couple pennies. Maybe a couple dollars a week. Better than nothing, I suppose, but only a tiny fraction of the "fiscal stimulus" check that I received this week. But then there's the issue of how to replace the lost revenue (revenue that is used to maintain the crumbling roads and to create jobs in a seasonal industry that is going to need to take up some of the slack from the slowdown in construction and manufacturing). Clinton proposes a tax on oil company profits. That's the part that Krugman calls not evil, but pointless. In one pocket and out the other. Maybe not totally pointless, but definitely in the neighborhood.

UPDATE: The Wall Street Journal's Real Time Economics blog says that my comments (specifically the last sentence above) are "probably the strongest show of support available". That may be. Though I meant it to be a bit of "damning through faint praise." My criteria for good public policy is that it be well out of the neighborhood of "pointless." Still, I'll bet others would agree that the consumer might benefit a few cents, but I think it is safe to say that we stand firm in agreement that this is a bad, bad idea.

Posted by William Polley at May 2, 2008 10:35 PM

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Thanks for this excellent post and the reference to the AB comment box where our readers have argued that some of the benefit accrues to the consumer. I'll just have to take the liberty of posting this over at Angrybear. If I didn't, our readers would have a rightful complaint.

Posted by: pgl at May 3, 2008 9:09 AM


Posted by: rdan at May 3, 2008 10:00 AM


Posted by: William Polley at May 4, 2008 1:35 AM

Good post. After Krugman's article, I called him out on his blog on the assumption of perfectly inelastic gasoline supply. What empirical evidence did he have? He gave slight mention to the fact that summer blends are already being produced and stockpiled, but blithely dismissed it with a wave of his magical hands. He was bound and determined to conclude the tax holiday was a "giveaway" to oil companies; this drove his assumptions. There was no uncertainty whatsoever in his cursory analysis.

The gas tax holiday may very well be an election year gimmick and the pennies it saves might require a magnifying glass to recognize, but I can't escape the observation that Krugman is an ideologue which distorts his otherwise brilliant economic mind.

I recommended that he give Barack Obama the Econ 101 lesson that the Iraq War (and George Bush) is not the main cause of high gasoline prices. Paul demurred.

Krugman's article seemed to be more of an argument for increased refining capacity rather than opposition of a gas tax reprieve.

Posted by: R. Miller at May 5, 2008 2:56 PM

Thanks.... and if you liked this post and want more information on capacity utilization, then you'll want to read my latest post.


Posted by: William Polley at May 5, 2008 3:10 PM

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