Tax incidence – HubbardOBrienEconomics.com Blog

Solved Problem: Elasticity and the Incidence of the Gasoline Tax

Supports: Microeconomics and Economics, Chapter 6.

Photo from the New York Times.

Blogger Matthew Yglesias made the following observation in a recent post: “If you look at gasoline prices, it’s obvious that if fuel gets way more expensive next week, most people are just going to have to pay up. But if you compare the US versus Europe, it’s also obvious that the structurally higher price of gasoline over there makes a massive difference: They have lower rates of car ownership, drive smaller cars, and have a higher rate of EV adoption.” (The blog post can be found here, but may require a subscription.)

What does Yglesias mean by Europe having a “structurally higher price” of gasoline?
Assuming Yglesias’s observations are correct, what can we conclude about the price elasticity of the demand for gasoline in the short run and in the long run?
Currently, the federal government imposes a tax of 18.4 cents per gallon of gasoline. Suppose that Congress increases the gasoline tax to 28.4 cents per gallon. Again assuming that Yglesias’s observations are correct, would you expect that the incidence of the tax would be different in the long run than in the short run? Briefly explain.
Would you expect the federal government to collect more revenue as a result of the 10 cent increase in the gasoline tax in the short run or in the long run? Briefly explain.

Solving the Problem

Step 1: Review the chapter material. This problem is about the determinants of the price elasticity of demand and the effect of the value of the price elasticity of demand on the incidence of a tax, so you may want to review Chapter 6, Section 6.2 and Solved Problem 6.5. (Note that a fuller discussion of the effect of the price elasticity of demand on tax incidence appears in Chapter 17, Section 17.3.)

Step 2: Answer part a. by explaining what Yglesias means when he writes that Europe has a “structurally higher” price of gasoline. Judging from the context, Yglesias is saying that European gasoline prices are not just temporarily higher than U.S. gasoline prices but have been higher over the long run.

Step 3: Answer part b. by expalining what we can conclude from Yglesias’s observations about the price elasticity of demand for gasoline in the short run and in the long run. When Yeglesias is referring to gasoline prices rising “next week,” he is referring to the short run. In that situation he says “most people are going to have to pay up.” In other words, the increase in price will lead to only a small decrease in the quantity demanded, which means that in the short run, the demand for gasoline is price inelastic—the percentage change in the quantity demanded will be smaller than the percentage change in the price.

Because he refers to high gasoline prices in Europe being structural, or high for a long period, he is referring to the long run. He notes that in Europe people have responded to high gasoline prices by owning fewer cars, owning smaller cars, and owning more EVs (electric vehicles) than is true in the United States. Each of these choices by European consumers results in their buying much less gasoline as a result of the increase in gasoline prices. As a result, in the long run the demand for gasoline is price elastic—the percentage change in the quantity demanded will be greater than the percentage change in the price.

Note that these results are consistent with the discussion in Chapter 6 that the more time that passes, the more price elastic the demand for a product becomes.

Step 4: Answer part c. by explaining how the incidence of the gasoline tax will be different in the long run than in the short run. Recall that tax incidence refers to the actual division of the burden of a tax between buyers and sellers in a market. As the figure in Solved Problem 6.5 illustrates, a tax will result in a larger increase in the price that consumers pay for a product in the situation when demand is price inelastic than when demand is price elastic. The larger the increase in the price that consumers pay, the larger the share of the burden of the tax that consumers bear. So, we can conclude that the tax incidence of the gasoline tax will be different in the short run than in the long run: In the short run, more of the burden of the tax is borne by consumers (and less of the burden is borne by suppliers); in the long run, less of the burden of the tax is borne by consumers (and more of the burden is borne by suppliers).

Step 5: Answer part d. by explaining whether you would expect the federal government to collect more revenue as a result of the 10 cent increase in the gasoline tax in the short run or in the long run. The revenue the federal government collects is equal to the 10 cent tax multiplied by the quantity of gallons sold. As the figure in Solved Problem 6.5 illustrates, a tax will result in a smaller decrease in the quantity demanded when demand is price inelastic than when demand is price elastic. Therefore, we would expect that the federal government will collect more revenue from the tax in the short run than in the long run.

California Deals with the Paradox of Tobacco Taxes

(Photo from Zuma Press via the Wall Street Journal.)

When state and local governments impose taxes on sales of liquor, on cigarettes and other tobacco products, or on soda and other sweetened beverages, they typically have two objectives: (1) Discourage consumption of the taxed goods, and (2) raise revenue to pay for government services. As we discuss in Chapter 6 of Microeconomics (also Economics, Chapter 6), these objectives can be at odds with each other. The tax revenue a government receives depends on both the size of the tax and the number of units sold. Therefore, the more successful a tax is in significantly reducing, say, sales of cigarettes, the less tax revenue the government receives from the tax.

As we discuss in Chapter 6, a tax on a good shifts the supply curve for the good up by the amount of the tax. (We think it’s intuitively easier to think of a tax as shifting up a supply curve, but analytically the effect on equilibrium is the same if we illustrate the effect of the tax by shifting down the demand curve for the taxed good by the amount of the tax.) A tax will raise the equilibrium price consumers pay and reduce the equilibrium quantity of the taxed good that they buy. For a supply curve of a given price elasticity in the relevant range of prices, how much a tax increases equilibrium price relative to how much it decreases equilibrium quantity is determined by the price elasticity of demand.

The following figure illustrates these points. If a city implements a tax of $0.75 per 2-liter bottle of soda, the supply curve shifts up from S₁ to S₂. If demand is price elastic, the equilibrium price increases from $1.75 to $2.00, while the equilibrium quantity falls from 90,000 bottles per day to 70,000. If demand is price inelastic, the equilibrium price rises by more, but the equilibrium quantity falls by less. Therefore, a more price elastic demand curve is good news for objective (1) above—soda consumption falls by more—but bad news for the amount of tax revenue the government collects. When the demand for soda is price inelastic, the government collects tax revenue of $0.75 per bottle multiplied by 80,000 bottles, or $60,000 per day. When the demand for soda is price elastic, the government collects tax revenue of $0.75 per bottle multiplied by 70,000 bottles, or only $52,500 per day.

One further point: We would expect the amount of revenue the government earns from the tax to decline over time, holding constant other variables that might affect the market for the taxed good, . This conclusion follows from the fact that demand typically becomes more price elastic over time. In other words, when a tax is first imposed (or an existing tax is increased), consumers are likely to reduce purchases of the taxed good less in the short run than in the long run. This result can a problem for governments that make a commitment to use the tax revenues for a particular purpose.

A recent article in the Los Angeles Times highlighted this last point. In 1999, California voters passed Proposition 10, which increased the tax on cigarettes by $0.50 per pack, with similar tax increases on other tobacco products. The tax revenues were dedicated to funding “First 5” state government agencies, which are focused on providing services to children 5 years old and younger. The article notes, as the above analysis would lead us to expect, that the additional revenue the state received from the tax increase was largest in the first year and has gradually declined since as the quantity of cigarettes and other tobacco products sold has fallen. (Note that over such a long period of time, other factors in addition to the effects of the tax have contributed to the decline in smoking in California.) As a result, the state and county governments have had to scramble to find additional sources of funds for the First 5 agencies. The article quotes Deborah Daro, a researcher at the University of Chicago, as noting: “It seemed like a brilliant solution—tax the sinners who are smoking to help newborns and their parents …. But then people stopped smoking, which from a public health perspective is great, but from a funding perspective for First 5—they don’t have another funding stream.”

Would Cutting the Federal Excise Tax on Gasoline Lower the Price that Consumers Pay?

The federal government levies an excise tax of 18.4 cents per gallon of gasoline. (An excise tax is a tax that a government imposes on a particular product. In addition to the tax on gasoline, the federal government imposes excise taxes on tobacco, alcohol, airline tickets, and a few other products.) In February 2022, inflation was running at the highest level in several decades. The average retail price of gasoline across the country had risen to $3.50 per gallon from $2.60 per gallon a year earlier. The following figure shows fluctuations in the retail price of gasoline since January 2000.

Policymakers were looking for ways to lessen the effects of inflation on consumers. An article in the Wall Street Journalreported that several Democratic members of the U.S. Senate, including Mark Kelly of Arizona, Maggie Hassan of New Hampshire, and Raphael Warnock of Georgia proposed that the federal excise tax on gasoline be suspended for the remainder of 2022. The sponsors of the proposal believed that cutting the tax would reduce the price of gasoline that consumers pay at the pump. Other members of the Senate weren’t so sure, with one quoted as saying that cutting the tax was “not going to change anything” and another arguing that oil companies would receive most of the benefit of the tax cut.

Some members of Congress were opposed to suspending the gasoline tax because the revenue raised from the tax is placed in the highway trust fund, which helps to pay for federal contributions to highway building and repair and for mass transit. In that sense, the gasoline tax follows the benefits-received principle, under which people who receive benefits from a government program—in this case, highway maintenance—should help pay for the program. (We discuss the principles for evaluating taxes in Microeconomics, Chapter 17, Section 17.2 and in Economics, Chapter 17, Section 17.2) Other members of Congress were opposed to suspending the tax because they believe that the tax helps to reduce the quantity of gasoline consumed, thereby helping to slow climate change.

Focusing just on the question of the effect of suspending the tax on the retail price of gasoline, what can we conclude? The question is one of tax incidence, which looks at the actual division of the burden of a tax between buyers and sellers in a market. In other words, tax incidence looks beyond the fact that gasoline stations collect the tax and send the revenue to federal government to the issue of who actually pays the tax. As we note in Chapter 17, Section 17.3:

When the demand for a product is less elastic than supply, consumers pay the majority of the tax on the product. When the demand for a product is more elastic than supply, firms pay the majority of the tax on the product.

Consumers would receive all of the tax cut—that is, the retail price of gasoline would fall by 18.4 cents—only in the polar case where the demand for gasoline were perfectly price inelastic. Similarly, consumers would receive none of the tax cut and the price of gasoline would remain unchanged—so oil companies would receive all of the tax cut—only in the polar case where the demand for gasoline is perfectly price inelastic. (It’s a worthwhile exercise to show these two cases using demand and supply graphs.)

In the real world, we would expect to be somewhere in between these two cases, with consumers receiving some of the benefit of suspending the tax and producers receiving the remainder of the benefit. The short-run price elasticity of demand for gasoline is quite small; according to one estimate it is only −.06. The short-run price elasticity of supply of gasoline is likely to be somewhat larger than that in absolute value, which means that we would expect that consumers would receive the majority of the tax cut. (Note that we would expect the long-run price elasticities of demand and supply to both be larger for reasons we discuss in Chapter 6, Section 6.2 and 6.6.) In other words, the retail price of gasoline would fall, holding all other factors constant, but not by the full tax cut of 18.4 cents.

Joseph Doyle of MIT and Krislert Samphantharak of the University of California, San Diego studied the effect of suspension in the state excise tax on gasoline in Indiana and Illinois in 2000. In that year, Indiana suspended collecting its gasoline excise tax for 120 days and Illinois suspended its tax for 184 days. The authors estimate that consumers received about 70 percent of the tax cut in the form of lower gasoline prices. If we apply that estimate to the federal gasoline tax, then suspending the tax would lower the price of gasoline by about 12.9 cents per gallon, holding all other factors that affect the price of gasoline constant. As the above figure shows, the retail price of gasoline frequently fluctuates up and down by more than 12.9 cents, even over fairly brief periods of time. In that sense, the effect on the gasoline market of suspending the federal excise tax on gasoline would be relatively small.

Sources: Andrew Duehren and Richard Rubin, “Some Lawmakers Want to Halt Gas Tax Amid High Inflation. Others See a Gimmick,” Wall Street Journal, February 16, 2022; Tony Romm and Jeff Stein, “White House, Congressional Democrats Eye Pause of Federal Gas Tax as Prices Remain High, Election Looms,” Washington Post, February 15, 2022; Joseph J. Doyle, Jr., Krislert Samphantharak, “$2.00 Gas! Studying the Effects of a Gas Tax Moratorium,” Journal of Public Economics, Vol. 92, No.s 3-4, April 2008, pp. 869-884; and Federal Reserve Bank of St. Louis.