Bastiat’s Bastions

In case you haven’t heard, Sen. Clinton and Sen. McCain have each advocated cutting the federal highway-use tax on gasoline from Memorial Day to Labor Day to save drivers (rather, voters) a whole 18.4 cents per gallon, which amounts to about 5% of what they spend on gasoline. Senator McCain suggests making up the difference in the federal highway infrastructure fund with money from the federal government’s general fund, adding about $10 billion to our already blossoming federal deficit. Sen. Clinton, along with Sen. Obama have advocated placing a windfall profits tax on the oil companies . Obama, it should be noted, has opposed the Clinton-McCain gas tax holiday.

Some opponents of the tax holiday (New York Times Blog and Wall Street Journal) have countered that the short-term tax break would not affect prices that consumers pay, and these opponents are correct. Think about the underlying downward-sloping demand and somewhat upward-sloping supply of gasoline. The short-term upward-sloping supply of gasoline, during the summer months, becomes vertical, as the refineries in the U.S. are all operating at their maximum output levels. With a completely inelastic supply of gasoline, all of any tax falls on the suppliers, but all of any tax-cut is enjoyed by the suppliers. If the price to buyers were to decrease at all from their present levels, the quantity demanded would increase as buyers respond to lower prices by buying more, which we know from the law of demand. But with no more units able to be supplied by refiners, there would be a shortage which would push the price up, back up to its original level. This would save nothing for tax payers over the summer and would cut highway infrastructure moneys, money that could build new bridges, like the ones we see we could use after the Minneapolis bridge disaster last year.

A similar disaster for the millions of drivers would occur with Clinton and Obama’s windfall profits tax on oil. The Carter windfall-profits tax amounted to little more than an excise tax on gasoline from domestic oil, raising gas prices for consumers, cutting the profits on domestic oil, cutting domestic production, and raising reliance on foreign oil. Even if a tax were devised that taxed just profits, which is not what happened with the 1980 windfall profits tax under Jimmy Carter, the long-run results of such a tax would be to make refineries less profitable, reducing long-run supply from what it would have been otherwise, and raising the price of gasoline at the pumps from what it would have been. The Obama plan would put a tax on every barrel of oil that sold at a price higher than $80, which would mostly just get passed along to consumers, who have a very inelastic demand for oil, while oil companies could easily sell their oil outside of the US without the tax (elastic supply of oil to the US), reducing the amount of oil supplied in the US and increasing the prices at the pumps for consumers.

But this increase in prices because of the tax is something that consumers never see, never seem to notice, and blame the higher prices on the oil companies, and not on the federal government, just as the high prices from the lack of investment in new refineries is blamed on the oil companies instead of the myriad of federal and state regulations, such as the needed, but ill-designed air pollution regulations.

What Clinton and McCain want is a reduction in gas prices now, but their tax-holiday idea, while popular, would completely fail to do what taxpayer/voters want it to do, cut prices at the pump. What it will do is make them relatively more popular than Obama, from what they would have been otherwise (economists say, “ceteris paribus”), because voters hear the speech and believe what their candidate tells them. All Clinton and Obama’s windfall profits tax would do is to raise prices on gasoline, as a tax would tend to fall on consumers who have a relatively inelastic demand for gasoline, instead of on owners of oil companies, the stockholders of oil companies. Stockholders have many options in the long run and will divert their funds away from oil companies if these companies are forced to pay a profits tax. Cutting supply raises price. Cutting supply to a good that has an inelastic price raises price a lot.

Clinton says she is “reluctant to throw her lot in with economists.” I’m even reluctant to throw my lot in with politicians. While corporations that lie in their ads and promotions can be convicted for fraud, it seems that fraud does not apply to politicians vying for our votes.

Two lessons. One, people trying to get elected are to be believed about as much as those emails from the dying wife of the Nigerian Oil Minister who wants to make you rich. The other lesson is that what we have been talking about in class with burdens of taxes and elasticities was to help understand real proposals, and to help us detect BS before we down in it face first.

And here is a little update–other economists weigh in here.

-MC

This entry was posted on Sunday, May 4th, 2008 at 3:17 pm and is filed under General, Political Economy, Taxes. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.