Summer Tax Holiday

In a speech on taxes yesterday the presumptive Republican presidential nominee, John McCain, suggested suspending the collection of federal gasoline and diesel taxes during the summer driving season, from Memorial Day to Labor Day. Most of the commentary I've seen on this so far focuses on the idea's potentially counterproductive impact on fuel consumption and greenhouse gas emissions, as well as on the federal highway budget, which is funded by the revenue from these taxes. These are important concerns. What I haven't seen yet, however, is an analysis of how such a plan would work, and whether it would even achieve its stated goal of reducing fuel prices. The structure of the fuels marketing business and the mechanism for collecting these taxes would likely dilute the benefits of the Senator's proposal, or perhaps negate them entirely.

Senator McCain seems to be responding to one of the most common complaints in today's economy. This week's average US retail price of $3.389/gal. for unleaded regular gasoline is $0.59 higher than the average for 2007, and diesel is $1.12 higher than last year. Waiving the 18.4 cent per gallon federal gas tax and the 24.4 cpg diesel tax would cost the Treasury $9.5 billion, based on last summer's gasoline and diesel volumes. The tax holiday would provide the average driver with a total benefit of about $25, assuming that 100% of the tax cut would be passed on, an outcome that seems optimistic in light of the way the tax is collected.

Under the IRS code, gasoline and diesel are taxed when they leave the distribution terminal in a tank truck or railroad tank car, not when fuel is pumped into your car. If the retail facility is owned and operated by an integrated oil company or a large refiner or distributor, there's no practical difference. But if you buy from one of the country's tens of thousands of independent retailers, the tax is already included in the charges collected by the supplier from the retailer when a truckload of fuel is dispatched to the station. In that case, waiving the tax reduces the payment to the supplier, but it does not guarantee that the retailer will reduce the pump price accordingly, even though the retailer technically only sets the "pre-tax" price.

In the short run, the strongest pressure on retailers to pass on the full effect of a fuel tax holiday would come from the other local stations with which they compete, rather than from their suppliers. So while company-owned and operated stations would likely cut their prices by the full amount of the tax from day one, because of their higher visibility, I wouldn't be surprised to see some retailers initially retain some of the savings, to improve their margins. They're in a tough business, and the temptation would be understandable. Competition would gradually dampen that urge, but we routinely see wide local variations in the retail price of gasoline, which can be as large as $0.50/gal. for the same grade in some markets. A tax cut might amplify those spreads.

Over time, and without any changes in the price of crude oil, gasoline prices would tend to drift back up. Lower prices would stimulate demand--or at the current level it's probably more sensible to think of them reducing demand by less than they would without the tax holiday. More demand means more truckloads dispatched from terminals to service stations, and that signal shows up on the desktop of company pricing managers. It might take longer than three months for this process to displace the entire amount of the tax cut, but by the end of the summer enough of it would have been eroded that when the tax was reimposed after Labor Day, prices would end up higher than they would have been without the cut. It might take several weeks for market forces to compete away that spike.

While consumers would certainly see some benefit from a summer-long suspension of the federal tax on gasoline and diesel fuel, a portion of the savings would stay in the pockets of independent retailers, who would be under less scrutiny to pass on the full tax cut than the major oil companies. Then in September at least some of the benefit would be given back, while the market adjusted to the restoration of the tax. On balance, and ignoring the policy concerns raised by this proposal, it might be simpler and more beneficial all around to send every American a $20 bill and call it a fuel tax rebate.