Question

Suppose that the government wants to reduce emissions from vehicles. Two viable policies have been suggested. One is a per-gallon tax on gasoline and the other is an ad valorem tax on gasoline- powered vehicles. How will each policy affect consumer choice respectively? Which one will reduce the demand for gasoline-powered vehicles by more? Which one will generate more revenue for the government?

Please write as many as you can

Answer 1

• An ad valorem tax is more likely to keep up with inflation.

The per-gallon tax on gasoline suffers from a serious problem – we need elected officials to increase it periodically in order to maintain its purchasing power. This was true even when Vehicle-Miles-Travelled (VMT) was increasing nationally. The primary advantage of an ad valorem tax on gasoline is that as the price of gasoline rises, as it is predicted to do over time, so does the amount of revenue from taxation. In theory, this will provide sufficient growth to maintain and improve the nation’s transportation infrastructure.

• An ad valorem tax has greater potential fallout from coming changes.

The litany of changes that are the cause of declining revenues to the Highway Trust Fund (HTF) can be, and often are, recited by virtually any transportation expert, lobbyist, or legislator. VMT nationally has stopped growing, cars are becoming more fuel efficient, and there is no political will to increase the gas tax. The ad valorem tax not only addresses none of these fundamental flaws, it may actually make them worse.

Gasoline taxes affect both the national economy and the decisions of individual consumers. If set at a sufficiently high level, they can reduce gasoline consumption to levels that some say reflect the adverse effects of gasoline use, including environmental damage and national security costs. However, these taxes can also slow the level of macroeconomic activity, although they might contribute to lowering the trade deficit by reducing the need for imported oil. If, as in the United States, federal gasoline tax revenues are directly tied to financing highway construction and maintenance, they can also create jobs and improve the national infrastructure. If the gasoline tax is designed in such a way that it contributes to stabilizing the price of gasoline, more informed decisions concerning the purchase of fuel-efficient vehicles and the funding of mass transit might also be made.

It is widely believed that the federal gasoline tax is unpopular with consumers and that increasing the tax will likely generate opposition. The perceived unpopularity of the tax could make renewing it when the legislation expires at the end of fiscal 2011 controversial. However, the federal tax on gasoline is relatively low, only about 5% of the average price per gallon in August 2011, and less than 5% of the average price earlier in 2011, the most recent peak in gasoline prices. The tax raises revenue for highway construction and maintenance, which is directly related to automobile and gasoline use, suggesting that the tax can be viewed as a user charge. Many attempts to increase the tax since the early 1970s, especially those tied to energy policy initiatives, have been defeated; however, over that period the tax increased in several steps from 4 cents per gallon to the current rate of 18.4 cents per gallon.

Economic Effects

The purpose of a tax is to fund government through a transfer of resources from the taxpayer to the government. As a result, every tax leaves the taxpayers with less purchasing power than they had before the tax was levied. However, the government may use the resources acquired through levying the tax to finance the provision of public goods and services for the benefit of the taxpayers.⁷ Because it is unlikely that every taxpayer can, or will, agree concerning the proper mix and level of every public good and service, as well as every choice and level of tax instrument, taxes are unlikely to be voluntary, and the government must use the force of law to levy and collect taxes.

In addition, taxes can have a wide variety of economic effects, from altering consumer decisions concerning mix of goods to purchase, to national macroeconomic issues of economic growth, employment, and inflation.

Changing Demand-Supply Relationships

The legal, or statutory, incidence of an excise tax on gasoline is on the refiner; however, the tax is typically passed on to the consumer, and is paid at the pump along with state and local taxes, leaving the economic incidence of the tax with the consumer. This result is in accord with economic theory that suggests that if the demand for the product is totally or nearly totally inelastic, the firm will pass the tax on to consumers who will pay the tax, independent of the nature of supply. Although the demand for gasoline is not totally inelastic in the short run, its elasticity is very low, approximating total inelasticity. Analytic studies suggest that the elasticity of gasoline demand over a wide range of price variation is low, and perhaps near zero in the short run.⁸ In the case of gasoline taxes, the supply side of the market is likely to support the demand side result because of the wide range of essentially constant cost output levels of gasoline from modern refineries.

Reducing Gasoline Price Volatility

Two key factors in explaining gasoline demand in the United States are price and consumer income. Economists have empirically estimated that in the short run, the sensitivity of the quantity demand of oil, and therefore, gasoline quantities, to price variations is low.¹⁰ Low price elasticity of demand, a percentage quantity variation less than the percentage price variation, suggests that the good is viewed by consumers as a necessity, one that must be purchased with little quantity variation, even in the face of higher prices. Additionally, commodities with low price elasticity of demand tend to be subject to substantial price volatility when quantities available on the market vary.

Revenue Effects

With U.S. gasoline consumption generally in the range of 9 million barrels per day (378 million gallons per day), the gasoline tax would have a large base. If, for example, the tax were initially set at $2 per gallon, to achieve a tax inclusive target price of over $5 per gallon, revenues could approach $1 billion per day, minus the effect of conservation

Revenues generated by the gasoline tax could also assure funding for the Highway Trust Fund, improve the mass transit infrastructure, and fund research and development of alternative energy sources, as well as contribute to deficit reduction.

Refining Industry

The U.S. petroleum refining industry experienced what some have called a "golden age" during the years 2004-2007. A combination of rapidly increasing demand for petroleum products, especially gasoline, coupled with favorable price spreads between high and low quality crude oils, led to high rates of capacity utilization, yielding record profit levels for both the major oil companies and independent refiners. During this period, concern was expressed that U.S. refining capacity was not increasing rapidly enough to keep up with demand growth in the petroleum product markets.

This imperfection in the gas tax for addressing congestion problems will worsen in the future. For one thing, the share of the vehicle stock comprised of hybrids, electric vehicles, and other alternative fuel vehicles is steadily rising. The Energy Information Administration forecasts that 12 percent of all cars and light-duty trucks on the road in 2025 will be alternative fuel vehicles, up from only 5 percent in 2010. This increase is partially spurred by new fuel economy standards, which require new cars to achieve a minimum of approximately 40 miles per gallon by 2017, ratcheting up to 55 miles per gallon by 2025. Light-duty trucks face similar increases. These new standards will make the per-gallon gasoline tax an even less-effective tool to combat urban congestion.

Moreover, the standards will diminish much-needed revenues from a gas tax for our nation’s roads. Virginia’s governor, Bob McDonnell, recognized this in his recent proposal to drastically alter the way the state raises funds for transportation. Governor McDonnell proposed eliminating the state’s 17.5 cents-per-gallon gasoline tax and replacing it with a combination of a general sales tax increase; an increase in motor vehicle registration fees, including a surcharge on alternative fuel vehicles; and a plan to capture more revenue from Internet sales.

In late February, the Virginia legislature adopted most of the governor’s key recommendations—removing the per-gallon gas tax and increasing the sales tax and motor vehicle registration fees. The legislature also added a 3.5 percent wholesale tax on motor fuels. This percentage-based, or ad valorem, tax allows revenues to increase as gas prices rise (and decrease as they fall), unlike the traditional per-gallon tax.