Tag Archives: policy

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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Why do voters care most about the prices politicians can’t change?

Every day, there’s a new story about the political importance of gas prices. Apparently, voters jump to blame their leaders (especially the President) whenever they’re facing high prices at the pump.

Of course, this is complete nonsense. There is virtually nothing that American politicians can do to change the price of oil. Mitt Romney talks about the need to keep “supply” in line with demand, but he neglects to mention that the relevant quantities are world supply and world demand, and that the US has nowhere near enough oil to make a dent in world supply. Although producing more oil would be financially beneficial for the US, this is only for the very simple reason that selling oil earns money, not the tiny impact that higher US production would have on prices faced by consumers. (Norway has probably managed to figure this one out by now.)

At the same time, however, there is an even more important price that politicians around the country can change: the price of housing. Especially in major cities like New York, San Francisco, Washington and (gah!) Boston, a tangle of zoning and building restrictions makes housing far more expensive than the direct costs of supplying it would suggest. Changes in population from state to state are dominated by a general trend of moving to where housing is cheaper. The costs of shelter account for more than 20% of consumer expenditures. Clearly this a very, very important issue for consumers’ well-being—yet we don’t see a popular response that comes close to matching the ferocity of the reaction to gas prices.

To be fair, there is some response, and it usually takes the form of misguided measures like rent control or top-down efforts to provide “affordable housing”. But I think it’s fair to say that housing is, most of the time, much less salient as a political issue than energy.

Why is this? The obvious explanation is that richer and older people—the ones who vote—are disproportionately more likely to be homeowners. According to the Consumer Expenditure Survey, 89% of the top quintile are homeowners, compared to 40% of the bottom quintile. If we look at the data by age, roughly 80% of households led by people 55 and older own their own home, versus 14% for households led by someone under 25. Homeowners, of course, generally benefit from an increase in housing costs: they own an asset whose price reflects both housing costs today (which they have to pay whether or not they own a home) and housing costs in the future. Since most homeowners are going to die long before their houses or land become uninhabitable, an increase in those future housing costs leads to a direct increase in their real wealth. (Unless, of course, they care about their great-grandchildren’s wealth just as much as their own.)

Perversely, their incentive is to choke off the housing supply as much as possible, not look into ways to create affordable housing. And now, in a world where higher house prices are (mistakenly or not) viewed as essential to economic recovery, this manipulation even acquires an air of legitimacy.

With energy prices, on the other hand, there’s an element of politicians creating their own reality. Since energy encounters price spikes so frequently, it’s an obvious target for popular anger, and thus an easy target for political pandering. Even if there’s absolutely nothing they can do on the issue, politicians are forced to say something about it. And since politicians talk about energy prices so much—and those prices become perceived as a legitimate topic of political debate—voters assume that government must be able to have some impact.

Meanwhile, hardly anyone in the US—save for Alaskans and investors piling into Exxon Mobil stock—benefits from high energy prices. It’s hard to imagine anything less politically risky than complaining about the price of gas. And so we’re left with a bizarre distribution of political attention: massive coverage of a less important price that we can’t change, but relatively minor interest in a more important price that we can.

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Is it better to tax goods with inelastic demand? (Atkinson-Stiglitz redux)

Not necessarily.

Bloggers across the political spectrum, from Noah Millman to Ryan Avent, have recently argued that because the demand for oil is inelastic with respect to price, a gas tax is a relatively efficient way to raise revenue. Though I support a higher gas tax, I don’t think this argument is quite right.

It’s true that the deadweight loss from a tax (a standard measure of inefficiency) is intimately connected to the supply and demand of the good being taxed. If either supply or demand is inelastic with respect to price, the deadweight loss will be low. But when designing a tax system, the deadweight loss isn’t the only relevant consideration.

To see why, let’s consider a silly example. Imagine a tax with the lowest deadweight loss imaginable: a tax on breathing, levied at a rate of $10 every day that you take a breath. The demand elasticity here is exactly zero—no one (I hope) is going to stop breathing for an entire day just to avoid paying the tax. This is a wonderfully efficient tax: it has zero deadweight loss.

In fact, this is effectively a lump-sum tax, a tax demanded equally of every individual. Since lump-sum taxes are a perfectly efficient way to collect money, anyone thinking about how to minimize deadweight loss will always raise revenue exclusively through lump-sum taxes. But this is a cheat: obviously we don’t observe lump-sum taxes in practice, even though at the margin it would be possible to implement them. (If the government demanded that everyone coughed up an additional $50, almost everyone could manage to do it.)

The reason why the government doesn’t do this, of course, is distributional: we care about the poor, and it wouldn’t be fair to ask them to pay exactly the same dollar amount as the rich. This is important for even the most conservative fiscal policy proposals—many of them suggest flat taxes, but never a regressive lump sum. And one we realize that this is a key issue, it’s critical for our understanding of optimal taxation, far beyond the observation that lump sum taxes are a bad idea.

A famous result in public finance, the Atkinson-Stiglitz theorem on the optimality of direct taxation, captures this intuition in a striking way. Atkinson and Stiglitz show that if the utility function is weakly separable between consumption of various goods and labor (intuitively, the amount you work has nothing to do with your consumption choices, except insofar as working more gives you more money to spend), then no consumption taxes are needed to attain the optimum. You don’t levy higher taxes on gas than soy milk because soy milk has a higher elasticity; you just determine the optimal tax schedule on income and then stay away.

Why is this? Well, the reason we don’t levy lump-sum taxes is that we’re concerned about distribution. But it’s also a story about information: if we knew exactly what each person was capable of making, we could assign everyone personalized lump-sum taxes, and achieve our distributional goals without distorting any incentives. (“Matt, the government has calculated that you are easily capable of making $1 million a year over the next 10 years; therefore you must pay $300,000 in tax every year, regardless of your actual income.”) Of course, we don’t have this information, and we’re forced to use income as a proxy for ability to pay instead. But then we reach the Atkinson-Stiglitz result: if your exact consumption decisions don’t add any information about this ability, they shouldn’t be part of the tax. Unless gasoline consumption indicates that you have high hidden earnings potential, it shouldn’t be subject to any special charges.

Mapping this result onto the real world is tough, since “income taxes” in practice include taxes on saving (i.e. capital income), rather than the original income itself. Unless propensity to save or access to savings vehicles offer additional information about underlying earning ability, the Atkinson-Stiglitz results suggest that taxes on capital income should be zero, and that our current regime is inefficient. In this context, it might be efficient to raise gas taxes if they’re replacing taxes on capital gains. But it would be even more efficient to replace capital gains taxes with taxes on regular income*, or implement a progressive consumption tax. It’s tough to imagine a world where hiking gas taxes is the fiscally optimal thing to do, or even the second best.

Of course, this isn’t to say that gas taxes aren’t a good idea. If they’re correcting an externality, gas taxes are absolutely appropriate. They’re just hard to justify on fiscal grounds alone.


*Since people with lots of capital tend to be rich, and they acquired that capital under the assumption that it would be taxed, in practice a sudden implementation of this change would represent a windfall gain for the rich. But this could be counteracted either through an explicit one-time expropriation of capital or an implicit expropriation through an increase in consumption taxes.

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