Werner's Blog — Opinion, Analysis, Commentary
Fuel tax cuts are popular but badly misguided

Economists broadly agree that cutting fuel taxes is a bad idea in the current situation. Yet, they are very popular with motorists as gas prices push record highs. Motorist in Vancouver, BC, have seen gas prices rise to nearly $2.30/L amidst global supply shortages due to Russian oil being subject to sanctions, and also due to local factors that have seen a huge spike in the refinery margin. No wonder that politicians are rushing to provide relief to motorists, as gas prices have always been a touchy issue in politics. Unfortunately, some governments have turned towards the wrong approach: cutting fuel taxes, and some politicians are calling for similar action in British Columbia. So why is cutting fuel taxes a bad idea? Here are five good reasons.

Reason #1: some and possibly much of the fuel tax cut ends up with oil producers, not motorists

When governments raise taxes or lower taxes, not all of the increase or decrease is passed on to consumers. Economists call this phenomenon "imperfect pass-through". I had written about it in my blog Tax Pass-Through for Beginners, and it is a common topic in many public economics textbooks and articles. For example, my economist colleagues Juston Marion and Erich Muehlegger wrote about this topic in Fuel tax incidence and supply conditions in the Journal of Public Economics (2011). Most researchers consider the case of tax increases and find that under certain conditions, including available storage, taxes get passed on to consumers nearly fully. In general, the rate of pass-through goes up when supply is more elastic and demand is more inelastic. If supply is perfectly elastic or demand perfectly inelastic, then we get full pass-through. When markets are imperfectly competitive, we may get both over-shifting and under-shifting, as Weyl and Fabinger (Journal of Public Economics 2014) find. When fuel taxes are lowered, however, pass-through may be lower when markets are imperfectly competitive. It is possible that the lower prices are not passed on to consumers fully, but stick with the producers. There is an asymmetry in response. This is what Benzarti, Carloni, Harju and Kosonen (Journal of Political Economy 2020) find: what goes up may not come down, at least not quickly. With any temporary tax cut, there is even greater risk that pass-through is incomplete. And what is the point of cutting taxes when a large chunk stays with the producers rather than consumers? How would consumers tell the difference as fuel prices are highly volatile? After all, the refinery margin (the difference between wholesale price and the crude oil input price) has ballooned from its usual 45 cents/L level to over 70 cents/L. There is plenty of scope for market frictions to swallow up any tax cuts. And fuel producers are the least that need help at this time; their profits are way up. Even if only 10% or 20% of the tax cut go to producers, that's still 10% or 20% that is going where it is not needed.

Reason #2: there is no free lunch

When it comes to government revenues and expenditures, there is no free lunch. When governments reduce revenue by cutting fuel taxes, the money is missing and ultimately this means governments will need to reduce other programs and expenditures. So cut fuel taxes and cut health care? Or add the revenue shortfall to the provincial debt and pass it to the next generation of taxpayers? BC's neighbour Alberta is in a different position. As an oil-producing province, Alberta's government is benefiting from a windfall in taxes and royalties. They can afford to lower some taxes because they gain other taxes. BC, on the other hand, is not in that fortunate position. Cutting revenue in one place means cutting expenditures in another place.

This argument applies in principle to any form of relief. If we provide relief for fuel costs, then what about food costs or the cost of housing? There has been considerable inflation for these as well. Affordability remains a broad concern across the spectrum, so we should be careful where relief is provided and why. If governments decide to provide relief for fuel costs, they should have a strong argument why this relief has a higher priority than other worthy targets for support. Economists generally prefer income support than support through interfering in market outcomes.

Reason #3: it's a beggar-thy-neighbour policy

There is a global shortage of oil—at least for some time until various producers can increase production to offset the missing oil from Russia. Demand needs to adjust to match the supply shortfall, and the only mechanism through which this happens is higher prices. So now take two jurisdictions, one that can afford to lower its fuel taxes to keep demand high, and another jurisdiction that cannot afford to do that. So in this case most of the burden of adjustment shifts to the jurisdiction that cannot afford to lower taxes. In other words, rich jurisdictions can shift the adjustment problem to poor jurisdictions, and rich countries to poor countries. Cutting fuel taxes amounts to propping up demand. What is intended as relief for domestic motorists ends up putting a higher burden on foreign motorists. It's a beggar-thy-neighbour policy. Whatever the good intentions of the tax cut policy, it puts a negative externality on other jurisdictions.

Reason #4: not everyone needs relief

There are lots of cars on the roads in British Columbia that show that their owners are wealthy: Lamborghinis and Ferraris, Porsches and high-end Teslas. Owners of these vehicles do not need any relief; they don't blink an eye when they fill up their tank with premium gasoline. They can easily afford to pay higher gasoline prices. It is difficult to feel sympathy that some motorists are hard done by when they drive vehicles with oversized engines and when their driving style signals that they have little concern about fuel efficiency. So not everyone needs relief. If you bought a fuel-inefficienct vehicle, you have to bear the consequences of that choice. Don't ask others to subsidize your prodigious fuel consumption.

Who suffers the most due to high fuel costs are low-income households because fuel costs are regressive. Lower-income households spend a larger share of their income on energy than high-income households. And the motorists who are affected most are long-distance commuters who do not have transportation alternatives (e.g., public transit) or those who must use their vehicles for work. So how can one target relief to these? The answer is: definitely not through giving everybody a fuel tax cut. Those who use their vehicle for work should be able to pass on the higher cost to their employers or through the products and services they provide. Providing targeted relief is rather difficult. But we know that low-income households suffer the most, and thus relief should target them most. What we know for sure as well is that cutting fuel taxes benefits the rich more than the poor.

Reason #5: there's a better way

‘We should support needy households, not fuel consumption.’

Economists know that interfering in the supply and demand of the market makes little sense unless it is meant to offset an externality, such as pollution. So when there is a supply shortage, the market needs to adjust through higher prices. What we care about are the distributional outcomes: who is particularly worse off. For energy costs, that tends to be low-income households. It is possible to design policies that do not change the incentive to drive less. Providing targeted support to particularly hard-hit groups, or financial support broadly to low-income households, is a much better way. This is what British Columbia has been pursuing with a one-time fuel relief, distributed through ICBC, worth $395 million. Every motorists gets $110, and owners of commercial vehicles $195. Help is provided without reducing the incentive to drive less. Still, the targeting is not perfect (and yes, it includes owners of electric vehicles), but it is still much better than interfering in the fuel market. Of course, the criticism that $395 million is now missing somewhere else in the provincial budget still applies. If prices remain high, this relief will be little to dampen motorists' frustration. But even lowering fuel taxes won't do much either when prices have risen from $1.55/L in December 2021 to $2.25 in May 2022. Even fuel taxes don't come to 70 cents/L. The bottom line: if we need to support households, support their income, not their fuel expenses.

So how can we deal with sky-high fuel prices?

In the short term, we need to encourage more people to return using public transit. Ridership was down during the pandemic but has not yet fully recovered to pre-pandemic levels. Many people reverted to using motor vehicles during the pandemic out of concerns about covid transmission, but now is the time to consider returning to using public transit. All the extra demand on gasoline is contributing to high fuel prices in BC, and the extra driving is also contributing to increasing road congestion.

If you can use a bicycle to get around town, why not consider biking and doing something for your health as well? Dedicated bike lanes in many cities make bicycling safer and more enjoyable. Obviously, this is not a choice everywhere in BC, but there are also other creative solutions to economize on driving a car.

In the long term, we need to accelerate the transition to using electric vehicles. If we use BC-made electricity, we won't be paying oil producers for their overpriced products. The sooner BC can become energy independent, the better for motorists in this province. The future of driving is electric. In July 2020 I wrote about How much money could be saved by driving electric in Canada?. At the time, driving electric had one-quarter of the per-kilometer cost of driving with gasoline. That gap has widened substantially.

In the long term, we also need to improve public transit, with the Broadway Subway Extension under construction, and the Millennium Line UBC SkyTrain Extension in planning. Translink has recently its priorities for the next decade: we need more Bus Rapid Transit lines. With a growing population in the region and increasing road congestion, developing more public transit is an absolute necessity.

Posted on Wednesday, May 11, 2022 at 12:15 — #Energy | #Economics | #Politics
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© 2022  Prof. Werner Antweiler, University of British Columbia.
[Sauder School of Business] [The University of British Columbia]