Jun 7, 2008

I want $10/gallon gas.

It is too bad that economics is often unintuitive. If it was more intuitive, government pandering wouldn't work well and we'd have far saner governments. I'm late to the news, but a few weeks back Senator McCain started pushing the idea of a National Gas Tax Holiday. The basic idea, if you didn't already hear it, was to stop taxing gasoline for a few months in the summer to give American consumers a break from high gas prices. Hillary Clinton jumped on the bandwagon and supported the idea. Barack Obama opted out and did not support it.

The economic question that has an unintuitive answer is the following: Would a National Gas Tax Holiday save the consumer at the pump any money? Lets make the question simpler: What if I were to propose removing the tax on gasoline permanently, Would implementing that idea save American consumers money?

First, let me make up some numbers. Gasoline costs $3.50/gallon in terms of the total cost of drilling it, transporting it, selling it, etc. There is a $0.50/gallon tax on top of that meaning that I pay $4/gallon at the pump. These are simplifying numbers, but any real numbers would work.

Let me also simplify by saying that the entire United States' population contains 3 people:

  1. Rich Richie - Richie is filthy rich, won't bother to bend over to pick up a $100 bill.

  2. Poor Paul - Paul has a manual labor job paying minimum wage and can barely make ends meet.

  3. Industrious Ike - Ike owns a fleet of trucks, which represents the commercial part of our economy moving goods around. Both Richie and Paul buy things from Ike.

So, what happens to each person when I remove a tax on gasoline?

Any change in the price of gasoline is unlikely to affect Richie Rich since it will literally be a drop in his large bucket of cash. Industrious Ike will be pinched, but he can pass along the price hikes as increases in the price of the goods he sells to Poor Paul and Richie Rich. Poor Paul seems like he will be the big winner or loser from changes to gas prices.

Making up some more numbers, Richie jets around the world every month, so he uses 1,000 gallons of gas. He is going to save himself $500/month with this tax break. He doesn't notice. Ike burns 200 gallons of gas per month driving products around the country, so he saves $100. Since he has competition, he lowers his prices on goods $80 - this saves Richie (who buys alot of crap) another $60 and saves Paul $20. Paul has to get to work every day and goes out on weekends, so he normally buys 100 gallons of gas a month. He now saves $50 plus the $20 Ike's prices have gone down, for $80/month in his pocket. He earns only $1,000/month, so this $80 is very welcome.

That picture seems pretty rosy - Paul, who is the person we really want to help, seems to have 8% more money to spend! The other two are minimally affected, but they save money too! BUT, this picture isn't accurate. Paul saved $80, Richie saved $560, but the government made $80 + $560 = $640 less. That little bit is ignored. What happens when the government has $640 less money to spend? Paul actually benefits the most from the government, since he drives on roads, is protected from theft by the police, depends on social security and medicare when he retires, etc. Richie doesn't care much about deterioration of the government. If the roads are congested, Richie gets to watch the cars out the window of his jet. He has too much value in his house to rely on the police so he already hires private security and buys lots of insurance. Social Security doesn't pay out to him. Ike is ambivalent - if he has to pay more because the government can't support him, he will indiscriminately pass the costs onto Paul and Richie. Richie is saving $500 on taxes, but most of those $500 would have disproportionally gone to help out Paul.

Alternatively, the government might not choose to stop spending money on roads, police, and social security. The government might just borrow more. Government borrowing raises inflation. Inflation is a tax on every dollar earned, regardless of your income. It is a non-progressive "flat" tax which disproportionally hurts Paul again.

It gets worse. Gas has dropped from $4 to $3.50. Since Ike's prices are lower, demand increases for his products. Since he is selling more, he has to use more gas to transport it, raising demand for Gas. As the demand for gas rises, so does it's base economic price. It goes from $3.50 it would have been with a $0.50 tax, to $3.80 without a tax. Still cheaper than before, but not by as much. Now Paul is not saving $80/month, he is saving $32/month, but the government is still out the $640 in taxes which mostly would have gone to support Paul. Where is the $0.30/gallon going? It is going to the person who sells the gasoline - not an American citizen but someone in Saudi Arabia, Russia, or Iran, an Exxon Mobile owner at best, a terrorist supporting regime at worst. Lowering the gas tax is a way for Americans to indirectly pay money to the Middle East through taxes.

Let's try the reverse for fun. New magic numbers, same 3 Americans. Gas's basic economic cost (without taxes) is $4/gallon and there is currently no tax on gas. I propose we add an additional $4/gallon tax on gasoline (or carbon, or oil imports, or whatever) doubling the price at the pump to $8/gallon. What happens?

Richie continues to burn through 1,000 gallons/month of gasoline generating a hefty $4,000/month tax revenue and never notices.

Paul, feeling that gasoline is getting hard to deal with, once a week tries to get to work without his car - carpooling, public transit, bicycling, etc. Maybe he takes a job a little closer to home, maybe he eventually trades for a little bit smaller car. His usage drops from 100 gallons/month to 80 gallons/month. He used to pay $400/month for gas, and now pays 80*$8 = $640/month for gas, $240 more than before.

Ike starts raising his prices which causes demand to drop a little and hence he drives a little less - using 10% less gasoline out of the gate. He also notes that since the prices for his and his competitors' good have gone up more, there are more options for cutting costs. All of the sudden, the time it would take to get a pay-back from buying a more fuel-efficient truck drops from 10 years to 3 years. He upgrades his fleet and starts using another 25% less gas, in total bringing his gas usage down 35% in short order. Now, I's is using 130 gallons of gas instead of the 200 he was before the tax hike. It costs him $1040 for that gas instead of the $800 he was paying before ($240 more), so he charges Paul $60 of that and Richie $180 of it since Richie buys more stuff to make up the difference in prices.

Poor Paul is now spending $300 more on gasoline a month in total ($240 through his own use and $60 through cost of goods).

The government is collecting $4,000 more in taxes from Richie, $320 more from Paul, and $520 more from Ike for a total windfall of $4,840/month in taxes. Most of that nearly 5 grand is going to Paul, either in terms of less taxes or better public services.

Gasoline demand has dropped as well - In total our 3 citizens used to use 1,300 gallons and even though Richie hasn't cut back, they are now using 1,210 gallons instead. So the base price in turn drops. Instead of sending 1,300 * $4 = $5,200/month overseas, the price drops to $3.50 and we send 1,210 * 3.50 = $4,235/month overseas - collectively our 3 Americans save almost $1,000 combined that we would otherwise be sending out of the country. Some of that might go into Richie and Ike's pockets, some might go into better public services like schools and roads.

Over the course of 10 years, things get even more exciting. Now that the cost of energy is so high ($7.50 / equivalent of gallon gasoline), other options which didn't make sense before start sounding useful. A company that can make fuel from prairie grass at $6/gallon equivalent starts making bunches of money when before nobody wanted their products. Paul, Ike and Richie start buying this fuel instead of gasoline. Paul's gasoline related costs drop from $640 to $480 (just $80/month above what he was paying before the $4 tax hike).

Demand for real gasoline drops even more - it has to keep a price of $2/gallon (+$4tax) to be competitive with prairie grass fuel or nobody will buy it. Demand and price having dropped, we collectively buy 500 gallons of gasoline at $2/gallon - or only sending $1,000 of what would have been over $5,200/month overseas. Eventually, the prairie fuel company ratchets down their cost to $5/gasoline gallon equivalent. Gasoline demand drops further to 250 gallons until the untaxed price hits $1/gallon, sending a measly $250/month overseas. Eventually prairie gas costs $4/gallon or less or electric cars become economical. Gasoline demand literally dries up for most all applications. A few antique "collector" cars belonging to Richie still run on it occasionally for fun, but the usage is negligible.

In the process, we've created tons of tax revenue for the government, convinced Paul to get some exercise once a week biking to work, saved all Americans a ton of money, stopped funding terrorism, built several new American technology industries (prairie gas and electric cars) which we start selling around the world, and of course - averted the climate crisis.

You might think I have wishful thinking, but these changes are already coming about with only $4/gallon gas:

- Walmart is upgrading it's entire truck fleet to double the fuel efficiency gradually between now and 2015 (http://www.rmi.org/store/p15details10.php)
- Public Transit usage has grown 25% in one year (http://www.apta.com/media/releases/080602_ridership_report.cfm
- Ford's Monster Truck the F-150 has been the highest selling vehicle nearly every month for the last 30 years, but last month was 5th behind several fuel-efficient vehicles (http://online.wsj.com/article/SB121250107132341361.html
- GM's Hummer sales have dropped almost 60%, GM is discountinuing plus-sized Tahoe, Suburban and Yukon lines as early as 2009 and is closing or coverting several plants that produce these large inefficient vehicles (http://www.bizjournals.com/milwaukee/stories/2008/06/02/daily9.html
- One of my co-workers commented that in just the last couple weeks he has seen a marked increase in the number of people biking on his morning commute. Some of this is likely the great weather lately, but some may not be.

I want the second scenario, not the first. I want $10/gallon gas, and I want it yesterday. $20/gallon if I could get it. Bring it On.


jcr said...

I'll sell you all the gas you want for $10/gallon. Where would you like it delivered, and how will you be paying for it?

-jcr (this offer is good for the next 30 days.)

doctorb said...

Your scenario leaves out a very important, perhaps most important, element. Too sharp of a rise in gas price too quickly will trigger a significant increase in social unrest. Riots, increased crime, and vandalism are serious adverse consequences which need to be carefully considered.

Greg said...

Very cute, jcr. My point would be at $10, gasoline would be more prohibitive and I'd end up buying less of it which would lower demand and hence price for everyone.

doctorb, I tried to address your concern a little more clearly in a newer post. If I hiked a person's gas price by $6/gallon but simultaneously started wroting them a $300 check every month, I doubt that you would honestly see alot of social unrest.

stevebaka said...

why don't we tax the shit out of richie rich so we can use that money to build 100 new refineries and drill for oil in the usa? Richie Rich has plenty of money and should share what he throws away. Some black guys should rob his dumb rich ass.

Ryan Street said...

It all sounds good in theory, of course, but that is exactly what it is. But you've stepped on your own foot in one aspect.

Paul doesn't have the money to pay for gas. He then loses his job because he can no longer afford to drive to work and misses too many days. He ends up on welfare. He is now taking more money out of government instead of contributing any at all. He has officially become a negative that cancels out the others.

And the car plants that have shut down their facilities just laid off numerous other people, forcing them into government assistance without putting any back into the system. Suddenly, we have a great amount of people that suddenly are taking without giving any back into the system. This causes deficit, which makes the government borrow money from other countries, (with interest of course) which is giving money to other countries, which what was one of the points we were trying to do away with in the first place. Bummer.

I know this is a bit lofty, but so was your theory. I like your ideas, and you are in a good direction, but we need a way to keep america employed and lower prices at the same time. That is the real problem.

keep up the good work!!!

Amit Wadhwa said...

Yup there are many negative scenarios you haven't looked at here...

1. Rise in Gas prices will also increase Public transportation prices.

2. Companies will be forced to increase salaries as goods prices will also increase and they will notice moving work offshore is more profitable now leading to more job cuts and suddenly those people will "realise" how much costlier stuff has become.

And yeah Praire company fuel has no tax... so the extra tax money for govt would be a temporary source of income.

As a side note, such a high gas price would be disruptive for the economy and bring unrest to people/economy/country in general even for the greater good.

Greg said...

Ryan Street, I recommend you read my later blog post on how this really won't put everyone on the street.

Car companies don't necessarily mind higher gas prices. They aren't selling the gas. In fact, it gives them a way to encourage many people to buy newer, more efficient cars to replace their aging gas-guzzlers. GM for example is "betting the farm" on their chevy volt and creating alot of jobs in the process.

Amit, I'll reply in kind to your bullets:

1) Public transportation isn't always the most efficient way of transit anyway(there are numerous studies that show that many transit systems use more oil per person per mile than cars), but when it is efficient it will still get costlier, but at a slower pace than cars, making it increasingly a more valuable alternative. Still, there are many other alternatives without this drawback like carpooling, walking, biking, more efficient cars, telecommuting, living closer to your work, etc.

2) As for business moving overseas, it is a valid point called a "carbon tax leak", but that would only be true if other countries didn't also pass similar laws. The US can enforce that on it's trading partners through import tariffs if it so desires. Things like Kyoto and the new UN talks are designed to address this issue as well.

As for general economic unrest, I would also recommend reading my later post as to how this wouldn't put anyone on the street. It doesn't have to happen overnight either, usually laws like this are passed to slowly take affect gradually over the course of several years so that the changes are predictable and incremental.