Can Fuel Taxes Be Too High?

It's fascinating watching the debates over fuel taxes on both sides of the Atlantic. The US has among the lowest fuel taxes in the industrialized world, but, yielding to public pressure to lower gas prices, many state legislatures are considering suspending portions of their fuel tax collections. Europe, on the other hand, with both the highest gasoline prices and fuel tax rates (no coincidence there) in the world, is attempting to hold firm in the face of growing public protests from truckers and farmers. Who is right? In my estimation, neither.

As recently as last Friday I wrote about the importance of allowing prices here to rise when demand is constrained, in order to restore balance. Lowering fuel taxes here would either increase demand, if the savings are passed through to consumers, or boost the profits of oil refiners and marketers, if they are not. Europe is another story, however.

Gasoline prices there were already high enough to promote efficiency, even before the crude price run-up of the last 18 months. Volume-based fuel taxes in the EU are only part of a broader tax strategy to reduce demand, including high taxes on vehicles and specific taxes on engine size. This links to the EU's policies on managing traffic congestion and protecting the environment, particularly with regard to climate change. These taxes have been effective, resulting in smaller, lighter cars than here, more use of diesels, and higher mass transit utilization, although total kilometers driven has been rising. They also bring in enormous revenues. In fact, as of a couple of years ago, the government of Germany made as much money from fuel taxes as Saudi Arabia did producing crude oil.

Now, none of these circumstances suspend the laws of supply and demand, and price increases are as necessary in Europe as they are here to restrain demand in the wake of an event that reduced the global supply of oil and petroleum products. But that doesn't mean that European governments need to profit at the expense of their consumers, who have fewer options than Americans for further efficiency gains. European parliaments should fix their tax receipts at pre-Katrina levels and allow fuel prices to rise and fall cent-for-cent with the world market, rather than compounding taxes on the increases at rates that include Value Added Taxes as high as 18%.

The end result is a scenario that few would have believed only two years ago: the US with gasoline prices at a level we've always associated with Europe, and Europe with gasoline prices that are running at twice that level ($1.83/liter = $6.92/gal.) Through this combination of market response and taxation, we have embarked together on a wrenching experiment testing what economists call the "price elasticity of demand," i.e. how much will demand fall for each unit of increased price? While painful to millions, you have to believe this is going to create great opportunities for alternative energy all over the globe.