"It's Unanimous!"

Dr. Kevin Christ

By: Dr. Kevin Christ - Associate Professor of Economics, Rose-Hulman Institute of Technology

Category: Economy

Unanimity is rare among economists, but that’s exactly what happened when Democratic presidential candidate Hillary Clinton announced her support for a gas tax holiday during the final days of the recent Indiana primary election. When asked to name an economist who thought the gas tax holiday was a good idea, she avoided the question.

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There was good reason, because there weren’t any. Why such unanimity in a profession that is better known for contentious debate? Well let’s just say “it’s simple economics.”

Currently the federal excise tax on gasoline is 18.4 cents per gallon. The key question in evaluating the potential impact of a gas tax holiday is how much might gas prices fall if the government were to suddenly stop collecting the tax? The answer is probably not too much, but not for the reasons most people think. Some people contend that gasoline retailers would simply leave prices unchanged and pocket the 18.4 cents per gallon reduction in cost as pure profit. This assumes a very low level of competition among retailers. In fact, gasoline retailing is very competitive. It is more likely the case that some retailers will seize the opportunity afforded them by an 18.4 cent per gallon reduction in their costs to shave their price a bit. But by how much?

To answer that question, we have to consider the “incidence” of taxation – the determination of who really bears the burden of a tax. It turns out that the true incidence of an excise tax gets divided between buyers and sellers based, in large part, upon the responsiveness of buyers and sellers to changes in price – something known in economics as the elasticity of demand and supply. If buyers of a good are relatively impervious to price changes for that good, they end up paying most or even all of a tax on it because sellers find it easy to pass the costs of the tax along in the form of higher prices. Gasoline is such a good.

Economists have ways of estimating price elasticity of demand. If it’s less than 1, we say that consumer demand for a good is inelastic. For example, if price elasticity of demand for a product is 0.5, this means that if prices rise by 10 percent, customer purchases of that product will decline by 5 percent. Most estimates of price elasticity of demand for gasoline in the U.S. range from 0.1 to 0.4, meaning that demand for gas is very inelastic, as we would expect. This also means that when the government imposes a tax on gas, consumers end up paying most, but not all, of the tax.

But it is important to understand that this analysis works both ways – when the government imposes a new tax, the price goes up, but not by the full amount of the tax. Conversely, when the government eliminates a tax the price goes down, but not by the full amount of the tax.

Based upon current prices and our best estimates of price elasticity of demand for gasoline, buyers of gasoline probably end up paying between half and two-thirds of the 18.4 cent per gallon federal excise tax. So elimination of the tax might result in prices at the pump falling by between 9 cents and 12 cents per gallon.

Let’s look at a hypothetical example of a person who drives 1,500 miles per month in a vehicle that gets 25 miles per gallon. At a price of $3.50 per gallon, this person would be spending $210 a month for 60 gallons of gas. If elimination of the federal gas tax leads to a 10 cent drop in the price of gasoline at the pump, the savings to this consumer add up to a whopping $6 per month.

And remember, by not collecting the tax, the government will forego revenue that could be used on highway construction and maintenance, and will have to either delay such expenditures or finance them through other means. Is that really worth it?

So it’s not difficult to see why economists were unanimous in feeling that the proposed gas tax holiday wasn’t a good idea. Some may even have agreed with Barack Obama when he called the proposal an election-time gimmick. While Clinton may have hoped that her support for this gas tax holiday would generate great benefits for her at the polls, simple economics shows that the real benefit to the rest of us would have been fairly insignificant.

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