Killing a 5th, and Big, Bird

Co-blogger Scott Sumner has written an excellent post on how a temporary cut in the federal gasoline tax (from its current 18.4 cents to gallon to zero) will cause the 4 effects he mentions.

I think Scott leaves out a 5th effect that swamps his 4: it will increase Americans’ demand for price controls on gasoline.

The one thing I want to take issue with in Scott’s post is his statement that “Most of the tax cut goes to suppliers in the short run, helping refiners.” Scott may well be right, but it’s important to uncover an implicit assumption that he doesn’t mention: his assumption that the demand for gasoline is substantially more elastic than the supply of gasoline.

I agree with Scott that the supply of gasoline is highly inelastic. But we energy economists are also used to thinking of the demand for gasoline as being highly inelastic. It’s true that we don’t know much about the elasticity of demand for gas at current prices because we haven’t had much experience with prices at this level, even inflation-adjusted. Helping Scott’s case is the basic idea that the higher the price you start at, the more elastic is demand. Hurting Scott’s case is that there is some degree of discretion on the part of refiners in the extent to which they produce gasoline or produce other refined products. So even with a completely fixed refining capacity, an increase in the price of gasoline as seen by refiners can increase the amount of gasoline produced.

Let’s set a base case. If the demand for gasoline is just as elastic as the supply, then an 18.4 cent tax cut will be shared equally between producers and consumers. Producers will get a price net of tax that is 9.2 cents higher; consumers will get a price gross of tax that is 9.2 cents lower.

But if, as Scott expects, the demand is substantially more elastic than the supply, producers will get a much larger share of the 18.4 cents and consumers will get a much smaller share.

Say consumers get 5 cents of the tax cut per gallon.

What happens next?

A lot of them are going to be angry. “Those so-and-so oil companies were greedy and they kept the lion’s share of the tax cut. Let’s have the feds impose price controls so that we can get a bigger share.”

We all know what happens with price controls. When the price control keeps the price below the free-market price in a relatively competitive industry, there’s a shortage. People line up for gasoline. And the deadweight loss from their time in line can be a bigger factor than any of the 4 factors that Scott mentions.

A case in point is Proposition 13 in California, which, when passed in June 1978, immediately cut property taxes by a massive amount. I had some economist friends who were finishing their PhDs at UCLA and were in rental apartments. Their landlords, and many other landlords in California, sent fliers to their tenants before the vote telling the tenants that if Proposition 13 passed, their rents would fall. We economists knew that was unlikely because governments in coastal California were heavily restricting supply, making it highly inelastic, whereas demand was somewhat elastic.

Proposition 13 passed, rents didn’t noticeably fall, and tenants were pissed. What did they do? Call for rent controls, which were imposed in many cities in California. In some cities, such as Santa Monica, over 40 years later, rent control is still in force, with all the distortions it causes.