The Optimal Gasoline Tax

I guess we can give thanks as we headed out on our commutes to friends and relatives that gasoline prices were not as high as they were two months ago. Keeping in the spirit of the holidays – James Hamilton declares the windfall profits tax proposal a real turkey as he links to Arnold Kling who summarizes a paper from Ian W. H. Parry and Kenneth A. Small. Their Does Britain or the United States Have the Right Gasoline Tax, which was published in the September 2005 American Economic Review, suggests that the UK should cut its gasoline tax in half, while the U.S. should double its gasoline tax. The UK tax rate is around $2.80 per gallon, while the U.S. tax rate is around $0.40 per gallon.

Parry and Small note a variety of driving externalities including pollution and congestion costs. They also note a Ramsey rational for using higher gasoline taxes instead of higher taxes on employment to fund government spending, which is interesting because the Bush Administration seems to think we can avoid tax increases on either gasoline or labor (or capital income) even as it has no other serious proposals to reduce the massive Federal deficit.

Given my suggestion that a gasoline tax would be mainly paid out of economic rents from oil suppliers, I was curious as to the relative elasticities of demand and supply in the Parry and Small model. While they provided various demand-type elasticities, their model assumed fixed supply prices. In such a model, a higher tax would be fully reflected in the price at the pump with no effect on economic rents. I guess some liberal politicians might suggest that they have overestimated the impact on prices by assuming a perfectly elastic supply response. But let’s be clear – increases in gasoline taxes would raise the price to consumers, which is why it would tend to reduce pollution and congestion. I also find it interesting that the British pay more in taxes for their gasoline than we do in total.

Happy Thanksgiving!

Update: MovieGuy must have some devastating critique in store as he is inviting me to provide an update. All I have for now are a couple of things. One is this interesting discussion of fuel taxes in the UK, U.S., Canada, and China. The other comes from one my favorite sources for the components of the retail price of gasoline, which reports that the average price was $2.90 per gallon in September and $2.72 per gallon in October – of which $0.44 was attributable to gasoline taxes. But here is what I found really interesting. The contribution from refinery margins dropped from $0.79 per gallon in September to only $0.41 per gallon in October. In other words, rents for the refinery function dissipated rather quickly.