Is there a macroeconomic rationale for higher gas taxes?

Several of my favorite bloggers like to argue that the macroeconomic effects of oil shocks justify higher taxes on oil, to bring down overall consumption and the harm from future shocks. While I agree that oil should be taxed at a higher level, I’m not sure that this provides a convincing rationale.

First of all, we need to be clear about why oil shocks have an effect on the economy. To my knowledge, there are three main possibilities:

  1. As consumers spend more on oil, they spend less on other forms of consumption, thus lowering output.
  2. Higher oil prices make the production of certain goods uneconomical, and there is an optimizing shift away from these goods, possibly lowering overall output.
  3. An increase in oil prices raises inflation fears and pressures the Fed into adopting a tighter policy.

Though #2 is certainly a possibility, it doesn’t offer any clear reason why we should raise the gas tax. After all, the entire point of the price mechanism is to encourage consumption when costs are low and discourage it when costs are high. Someone investing in a factory that requires oil inputs does so in full awareness that future oil increases might render her investment unprofitable. To justify adding an additional disincentive to using oil, we need to identify some kind of externality from this decision, or interaction with a market imperfection. And while there are certainly externalities from pollution and congestion, a purely macroeconomic externality seems hard to identify.

Possibility #3 is more plausible. But as Charles Evans, president of the Chicago Fed (and a monetary economist of some repute), points out in a a recent article, it is quite difficult in the post-Volcker era to identify either a substantial response in monetary policy or an response in inflation to an oil shock. The increase in prices shows up as a one-time uptick in the headline CPI, of course, but does very little to influence future inflation. As Evans observes:

The modest dependence of policy on energy and other commodity prices implied by our analysis is not surprising. The shares of firm costs accounted for by energy and commodities are not large and, in fact, have fallen over time. Moreover, at least in the case of oil, price increases tend to slow the economy even without any policy rate increases. Of course, if commodity and energy prices were to lead to a general expectation of a broader increase in inflation, more substantial policy rate increases would be justified. But assuming there is a generally high degree of central bank credibility, there is no reason for such expectations to develop—in fact, in the post-Volcker period, there have been no signs that they typically do.

Ultimately, the need for the Fed to offset the rise in inflation following a surge in oil prices is very small—because there isn’t much of a rise at all.

Of course, this doesn’t prevent crazy people from using commodity prices as a justification for tight policy, and to the extent that Fed decisions are influenced by such individuals it’s possible that oil shocks are macroeconomically corrosive in practice (even if they shouldn’t be in theory). But then the macroeconomic justification for gas taxes rests mainly on the idea that monetary policymaking is poorly implemented—and if we’re talking about an idea as politically difficult as increasing the gas tax, we probably want to consider the more direct step of making monetary policy more effective. Regardless, given the relatively small influence of commodity prices on monetary policy in the last few decades, the case here for a significantly higher gas tax appears limited.

Finally there is possibility #1, which is the most common intuition for how higher oil prices impact the economy: when consumers are spending more money on gasoline, they have less money to spend on everything else, and output declines.

It’s important to realize that this story is not as straightforward as it seems. When consumers spend more on imported oil, there are two possibilities: either (1) exports increase and the current account deficit stays the same, or (2) the current account deficit increases. In case (1), the rise in exports means that there isn’t a direct hit to output. With (2), meanwhile, we have to remember that the inevitable correlate of a current account deficit is a capital account surplus. To exactly the extent that a oil shock causes imports to rise above exports, there is a rise in the flow of capital into the United States. Since the financial system isn’t perfectly frictionless, this capital inflow won’t necessarily be directed to the consumers forced to cut back by higher oil prices—but it will ultimately end up with someone, and there is only a macroeconomic effect to the extent that the “someone” is less likely to spend than the consumers and businesses paying more for oil. While this is completely plausible (after all, credit constraints are everywhere), it’s not clear that the magnitude is large enough to justify much of a tax.

It’s even harder to see the externality here. A consumer who buys an SUV is probably aware of the fact that higher gas prices will cause him trouble in the future—you don’t need to be hyperrational Economic Man to say “hey, the last time gas was at $4 a gallon, I had to cut back on some other spending, and it wasn’t much fun”. To the extent that government adds a tax on top of this, it’s making the incentive to avoid spending on oil even larger than it should be.

Perhaps in a liquidity trap there’s some macroeconomic spillover. But that brings us to a key point: commodity prices are highly procyclical. Though they fluctuate for many reasons, they tend to decline tremendously during a severe recession, which arguably makes them a stabilizing force during times of economic distress. It’s easy to imagine this effect overwhelming all the other macroeconomic consequences of oil—after all, a recession is precisely the time when credit constraints (which are the mechanism through which short-term commodity price changes have an influence on other types of consumption) are most binding.

In the end, therefore, it’s not clear that oil price movements are destabilizing at all, much less destabilizing in a way that justifies a preventative tax. There are many reasons to tax gasoline, but macroeconomics isn’t one of them.

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7 Comments

Filed under macro

7 responses to “Is there a macroeconomic rationale for higher gas taxes?

  1. I think you mean “commodity prices are highly procyclical”… 😉

  2. However, commodity *expenditure* is indeed highly countercyclical, which of course was your point. 🙂

    • Oh, I see that that wasn’t your point either…you just meant that falling oil prices in a recession have an expansionary effect, and hence the contribution to aggregate demand from oil prices is countercyclical…

  3. What about in a globalized economy where some countries recoveries increase the price of oil all in all countries including those with negative, no, or sluggish growth. What about in a world where commodities are traded as financial assets and speculation drives up prices independent of (or contra to) a business cycle?

    Wouldn’t weaning the consumer off of oil reduce the output externalities of those two events?

  4. it eats

    “Since the financial system isn’t perfectly frictionless, this capital inflow won’t necessarily be directed to the consumers forced to cut back by higher oil prices—but it will ultimately end up with someone, and there is only a macroeconomic effect to the extent that the ‘someone’ is less likely to spend than the consumers and businesses paying more for oil.”

    i wonder if a person could argue that there is a macroeconomic effect of having the outflowing money concentrate in hands who use it to finance anticompetitive practices.

  5. anon

    From a microeconomic POV, the difference between expenditure on oil, gasoline etc. and expenditure on consumer goods is that the latter are priced above marginal cost due to imperfect competition. Thus, in the short run, increasing expenditure on such goods causes a real, non-pecuniary externality on firms’ profits. Does this imply that such expenditure should always be subsidized, even when the long-run response is taken into account? It’s not clear that it does, but if so, this would be a real argument for increasing taxation on oil and decreasing it elsewhere.

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