Werner's Blog — Opinion, Analysis, Commentary
What is the optimal fuel tax level?

Who doesn't want a break from taxes? Whether you are a business or an individual, nobody enjoys paying taxes. Yet we all know that taxes are necessary to pay for the numerous services that governments provide, from national defense to hospitals. Some taxes are less popular than other taxes, but economists have studied closely which taxes are needed where, and what level is economically optimal. Especially when it comes to environmental and other types of externalities there is a simple rule: the tax rate should be equivalent to the marginal damage caused by the activity.

When politicians start calling for tax holidays, you can bet that an election is getting closer. Conservative Party leader Pierre Poilievre called for a summer break on the 10-cent-per-litre federal fuel tax, federal carbon tax, and GST between Victoria Day and Labour Day, about 105 days. In Ontario that would come to just over 29¢/L. If the average motorists consumes about 1,200 liters per year, that would be equivalent to a $100 rebate. So why not cut a cheque to each citizen for that amount rather than mess around with fuel taxes? The political objective appears to be more directed at villifying fuel and carbon taxes rather than getting people a welcome financial break.

There is never a compelling economic reason for an ad-hoc tax holiday, and even more reasons why lowering fuel taxes even temporarily is an absolutely terrible idea.

First, if the economically optimal fuel tax rate was lower, then it should be lowered permanently and not temporarily. Futhermore, there is absolutely no reason to think that summer and winter driving cause different levels of externalities that would justify a differential summer/winter treatment of fuel taxes.

Second, the economically optimal fuel tax rate are likely higher, not lower, than today's rate. I will illuminate this question below in light of past and recent economic research.

Third, politicians who call for tax reductions—regardless of political stripe—must unambigously state how they want to cover the revenue shortfall. Which expesnses and servies will be cut how much, or how much will this add to the national debt?

Fourth, if the objective is merely to provide tax relief, why single out fuel and carbon taxes? Is this the economically most efficient way to help people most in need? Or is it merely an exercise in populism? While fuel taxes are somewhat income-regressive, more-affluent households consume more fuel than less-affluent household. The bulk of the benefit of lowering fuel taxes would go to households that are not desperate for financial relief.

Fifth, cutting fuel taxes while we are suffering through climate change is as disingenuous as politics get. Lower fuel taxes increase fuel consumption. Carbon taxes are meant to reduce fuel consumption and carbon dioxide emissions, and incentivize the transition to cleaner modes of transportation. Getting rid of carbon pricing in Canada (which is what the Conservative leader is also calling for) is equivalent to stating that the optimal carbon price is zero, even when the social cost of carbon is estimated at over $260/tonne.

Economists readily agree that the optimal level of fuel taxation is positive. But what is the right level? The literature on optimal fuel taxation is long and well established. A classic article by Parry and Small (2005) decomposed the optimal fuel tax into separate components for carbon pollution, local air pollution, congestion, and accidents. Even in 2005 (some twenty years ago), the authors found the optimal fuel tax to be 248 US-cents/gallon, roughly five times the prevailing rate of 40 cents/gallon at the time. In today's Canadian prices that would be (248*1.54*1.34/3.785=) 135 ¢/L. Congestion costs were the largest single component.

‘Economic research shows that current fuel taxes are too low, and by a wide margin.’

But even that estimate misses a key issue. New research by van den Bijgaart et al. (2024) takes newer data into account along with the fact that too much driving isn't very healthy for us. Motor vehicle use induces inactivity and related health costs. It turns out that the optimal fuel tax rate in the United States is a whopping 1292 cents/gallon, or 899 US-cents/gallon without the health benefits. That number translates into an astounding 318 ¢/L in Canadian terms. You read that right: in the US, the optimal rate of fuel taxation would be about eighteen times higher than the actual rate. If you think that number is crazy, please read the research carefully and tell me where the researchers have erred. If this estimated optimal rate is indeed reflecting the social cost of driving, any fuel tax less than that amounts to an implicit subsidy towards driving. Motorists in Canada and the United States should be grateful for their low fuel taxes. An OECD comparison of fuel taxes by country shows that Canada (and even more the United States) are at the bottom end of fuel taxation.

To be clear: I am not arguing that Canada should start raising fuel taxes dramatically, but staying the course for increased carbon pricing is imperative. Historically, low fuel prices have been a contributing factor to locking in a pattern of urban development with low population densities. I have written about the population density deficit of Canadian cities before. Urban sprawl comes along with (excessive) commuting. Gradually rising fuel prices could help correct this trend, and even transitioning to electric vehicles should account for this through the development of a VKT tax down the road.

Let me add one final line of thought. The federal fuel tax rate has been set at 10 ¢/L of gasoline in 1995, and 4 ¢/L of diesel in 1987. Using the Bank of Canada's Inflation Calculator, if the fuel tax had been indexed to inflation, it should now be 18.33 ¢/L for gasoline and 9.47 ¢/L for diesel.

Further readings and sources:

Posted on Friday, May 17, 2024 at 11:30 — #Transportation | #Economics
© 2024  Prof. Werner Antweiler, University of British Columbia.
[Sauder School of Business] [The University of British Columbia]