Thursday, April 27, 2006

How Not to Respond to High Gas Prices

Reuters reports:

Senate Republicans unveiled a proposal on Thursday to soften the blow of rapidly rising gasoline prices by giving taxpayers a $100 check and suspending a retail fuel tax....The proposal was similar to a Democratic measure first proposed by Senate Minority Leader Harry Reid of Nevada.

One might be tempted to applaud this sudden rush of bipartisanship. But let's first consider the economics of the proposal. I can see four drawbacks.

1. The economy is at or near full employment, and the Fed is raising interest rates to prevent the economy from overheating. Any stimulus to consumer spending would likely cause the Fed to increase interest rates to higher levels than it otherwise would have. The end result would be more consumption and less investment.

2. A lump-sum tax rebate has no supply-side incentive effects. Indeed, the history of such proposals is that the payments often phase-out as income rises. If so, this would be an increase in the effective marginal tax rate, which has adverse supply-side effects.

3. The federal budget is already on an unsustainable path. From the standpoint of the government budget constraint, this is a step in the wrong direction.

4. If gasoline taxes are suspended whenever prices go up, then consumers are partly insulated from price increases, making the effective demand curve for oil products less elastic. To the extent that prices are set by a supplier with market power (OPEC), a less elastic demand curve means higher prices.

Fortunately, the Senate proposal is a bit better than it might at first appear because
To pay for the lost revenues, [Senator] Thune said, the legislation "would suspend a number of tax credits and royalty waivers received by oil corporations."
I don't know enough of the details to say whether these "tax credit and royalty waivers" should be suspended. But it seems that these policies should be judged on their own merits. The evaluation of these provisions need not be coupled with a lump-sum tax rebate and lower gasoline taxes, which are hard to defend on economic grounds.

Related link: Economist Jim Hamilton discusses President Bush's proposals to deal with higher gasoline prices.