A Gasoline Floor Price for Hybrid Cars

The coverage of this year's Detroit Car Show has focused on hybrids and electric vehicles, with a number of high-profile launches, including the debut of the third generation Toyota Prius. However, as convinced as I am that electric-drive cars represent the future of the car industry and will make important contributions to reducing greenhouse gas emissions and oil imports, the collapse of oil prices has erected a substantial barrier to the rapid market penetration of these technologies. Nor can the answer be simply ratcheting up the nation's Corporate Average Fuel Economy (CAFE) standard, as the New York Times recently suggested. We need a practical way to bridge the gap between consumers' growing interest in electrified vehicles and the economic deterrent posed by the added cost of these complex systems. Rather than taxing fuel itself, as has been widely suggested, we should consider a new hybrid car tax credit based on the price of fuel.

Despite growing interest in hybrids, these vehicles accounted for only 2.4% of the 13.2 million light-duty vehicles sold in the US last year. Although its 2008 sales of around 160,000 units made the Prius the 15th most popular model in the US last year, it did not even make it into the top 20 for December, thanks to slumping gasoline prices and the credit crunch. For that matter, the December monthly figures showed trucks, including SUVs, outselling cars again at 53% vs. 47% of the market, essentially back to their average for 2007. For all of 2008 cars outsold trucks by 51% to 49%, though that included those summer months of $4 gas when you couldn't have given a big SUV away. Perhaps the most encouraging news in this data is that sales of "cross-over" SUVs declined much less than other light trucks to become the largest segment of that market. (Moving someone from a 15 mpg SUV to a 22 mpg crossover saves more gallons of gas than converting a Camry owner to a Prius driver.)

The lackluster hybrid sales at the end of the year shouldn't surprise anyone. Consider the Saturn VUE crossover SUV. The sticker for the hybrid version is $4,880 higher than the base model with the same 4-cylinder engine. Boosting fuel economy from an EPA-estimated combined 22 mpg to 28 mpg saves 117 gallons of gas per year, based on 12,000 miles of annual driving. Yet even if gas were still $4 per gallon, it would take 10.4 years of fuel savings to pay out the hybrid premium. With gas at $1.78/gal., that stretches to 23 years. If the savings at the pump aren't sufficient to justifying spending an extra $5k on the hybrid, a buyer must bet that the combination of higher resale value and lower maintenance costs would close the gap.

How could the government induce more consumers to buy hybrids, even when fuel costs are too low to justify the extra investment? One option is to raise the CAFE standard beyond the 35 mpg target that the industry must meet by 2020. That might force manufacturers to produce more hybrids, bringing their cost down, and sell fewer non-hybrids, which would tighten the market, reducing the effective premium from both ends. The Congress would like to impose that outcome, in any case, as a condition of financial assistance to Detroit. Unfortunately, such a command-and-control approach risks creating another disconnect between car companies and consumers, and the modest fines by which CAFE has been enforced may end up looking more attractive to Detroit than the distortions an unrealistic fuel economy standard could create in their already-strained sales channels.

Another solution would be a big increase in the gasoline tax, or a floor-price tax on gas, to boost pump prices to a level that would ensure high demand for very fuel-efficient cars. As I noted the other day, however, the gas tax looks like a much less effective way to reduce greenhouse gas emissions than a tax on carbon or emissions cap-and-trade that would create a similar disincentive for CO2. Nor does raising the gas tax during a major recession--even if a large portion of the revenue could be returned to taxpayers--look like smart economic policy, when the recent drop in fuel prices is among the few forms of relief actually reaching consumers and smaller businesses.

Perhaps the answer lies in inverting the proposition offered in those car ads we saw when gas prices were rising steadily--the ones that promised your first few years of fill-ups at some low fixed price. To make hybrids more attractive, we could replace the current, expiring hybrid tax credits with a new, fully-refundable tax credit--one that the government pays even if it exceeds your income tax liability for the year--that would create an effective gasoline floor price of $4, but only for the purchasers of hybrid cars. The amount of the credit would be set by the difference between $4 per gallon and the national average pump price for each year, applied to the EPA fuel economy rating of the hybrid purchased. This could easily be made technology-neutral by extending it to any car exceeding the actual new-vehicle CAFE for the previous year, which for the 2008 model year averaged 31.2 mpg for cars and 23.4 for trucks. Even with this modification, the bulk of the subsidy would still flow to the models that save the most fuel.

For example, if we calculated the credit on 10,000 miles of annual usage, a buyer of the new 37 mpg Ford Fusion Hybrid would receive a credit of $600 for 2009, if gasoline remained at last week's average of $1.78/gal for the entire year. Of course, that would be in addition to roughly $260 of actual fuel savings, compared to the 24 mpg non-hybrid Fusion. If gas prices averaged $3 in 2010, this taxpayer's credit would drop to $270, while fuel savings rose to $440. Once gas was back over $4, the tax credit would go to zero.

It sounds complicated, though in practice it would merely be a hedge contract on the price of fuel--in the opposite direction from the ones typically offered to heating oil customers--conferring the equivalent of a set of annual put options on gasoline at $4. It probably would not be any more difficult to implement than a floor-price tax for all gasoline sold, even if the latter were politically feasible or economically desirable. It would also have the benefit of a built-in phaseout, as overall fleet fuel economy increases and future gas prices rise.

Perhaps someone can think of a simpler way to reduce the uncertainty of hybrid car buyers about future fuel prices than by issuing federal gasoline floor price tax credits. What we can't do is merely to hope that gas prices will recover enough to make hybrids and other advanced technology vehicles attractive on their own merits, or to assume that consumers will remain so stunned by last summer's high gas prices that they will buy the most efficient cars possible, even if they don't promise a financial return. This discussion will turn distinctly non-theoretical as soon as the government considers another round of financial assistance for a Detroit that it insists must build as many hybrids as possible.