An Ill-conceived Tax Idea

Yesterday we learned that President Obama's final budget proposal includes a plan to raise money for transportation projects and other uses by imposing a per-barrel tax on US oil companies. Here are a few quick thoughts on this ill-conceived idea:

• As I understand it, the tax would be imposed on oil companies, exempting only those volumes exported from the US. The US oil industry is currently in its deepest slump since at least the 1980s. Having broken OPEC's control of prices and delivered massive savings to US consumers and businesses, it is now enduring OPEC's response: a global price war that has driven the price of oil below replacement cost levels. This is evidenced by the recent full-year losses posted by the "upstream" oil-production units of even the largest oil companies: ExxonMobil, Chevron, Shell, BP and ConocoPhillips, particularly in their US operations. The President has wanted to tax oil companies since his first day in office, but his timing here would only exacerbate these losses, putting what had been one of the healthiest parts of the US labor market under even more pressure.
• This tax would also increase OPEC's market leverage, providing a double hit on the cost of fuel for American consumers: We would pay more immediately, when the tax was imposed and companies passed on as much of it as they could, and then even more later when OPEC raised prices as competing US production became uneconomical.
• Focusing the tax on the raw material, crude oil, rather than on the products that actually go into transportation, as the current gasoline and diesel taxes do, is guaranteed to produce distortions and unintended consequences. For starters, exempting exports--a sop to global competitiveness?--would give producers a perverse incentive to send US oil overseas instead of refining it in the US. It would also shift consumption toward more expensive fuels like corn ethanol, which provides no net emissions benefits but has been shown to affect global food prices.
• Singling out oil, which is not the highest-emitting fossil fuel and for which we still lack scalable alternatives, will put all parts of the US economy that rely on oil as an input at a competitive disadvantage, globally, and undermine what had become a significant US edge in global markets. Petrochemicals, in particular, would be adversely affected. The President's staff is well aware that the distribution of lifecycle emissions from oil, and the structure of the industry and markets, make policies focused on consumption far more effective than those aimed at production. This is why his administration's first act in implementing the expanded interpretation of the Clean Air Act to greenhouse gases was to tighten vehicle fuel economy standards. Taxing the upstream industry does nothing for global emissions but makes US producers less competitive, ensuring a return to rising oil imports and deteriorating energy security.

As widely reported, the Congress will not enact a budget containing this provision. It is hard to gauge whether this proposal represents a serious attempt to inject new thinking into the debate on funding transportation upgrades, or is simply one last shot across the bow of the administration's least favorite industry before leaving office in 349 days. It's not unusual for the wheels to come off as a presidency winds down, and this particularly flaky and futile idea might just be an indicator of that.

Disclosure: My portfolio includes investments in one or more of the companies mentioned above.

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.

Full Disclosure on Fuel Taxes

A pair of opinion pieces in yesterday's New York Times addressed the merits of taxing energy from entirely different perspectives. But while their conclusions weren't quite diametrically opposed, the unconventional views in an op-ed on recycling the revenue from a carbon tax struck me as ultimately much more practical than the entirely predictable viewpoint of a Times editorial lamenting the results of our lack of European-style fuel taxes. Unfortunately, neither one highlighted the role of fuel taxes in reducing consumer uncertainty about future fuel prices, rather than just reducing current consumption. This issue will become a lot less academic, when the Congress takes up the question of a cap & trade system for greenhouse gas emissions, this year or next.

The Times editorial emphasized the shortcomings of the current administration's focus on increasing supplies of conventional energy, instead of curbing consumption, citing the contribution of higher energy taxes in making "other rich countries...more energy-efficient across the board." The projected 2 million barrel per day reduction in projected oil demand expected from the 2007 Energy Bill's fuel economy provisions didn't impress the editors.

Suppose that President Bush's first act in office in 2000--or more plausibly in the immediate aftermath of 9/11--had been to raise motor fuel taxes by $2.00 per gallon. Consumers would have seen average retail gas prices at $3.50/gal. at least seven years sooner than otherwise, and US oil consumption might have leveled off at 2001's 19.7 million barrels per day instead of the recent 20.7 million. However, oil prices wouldn't have stood still. Lower demand growth from the US might have slowed oil's upward trajectory, but some of the slack would have been taken up by the other growth factors cited by the Times. So oil might now be $10 per barrel lower, but instead of $3.25 per gallon, US consumers would be paying $5.00. That seems a better fit with the Times' characterization of "Pain at the Pump."

Now consider the European fuel taxes extolled by the Times. Europeans don't drive smaller cars because fuel prices are higher than here, today. They drive smaller cars because their fuel prices have been high for as long as anyone can remember. Any American who has ever rented a car in Europe, or lived there, as my family did in the 1960s and as I did again in the late '80s, understands that. It's no accident that the "muscle car" in the recent "retro" hit series on the BBC, "Life on Mars," was a 4-cylinder 1974 Ford Cortina--a far cry from a comparable US Ford of similar vintage. European refiners pay essentially the same price for crude oil as ours do, and they receive a similar margin, but for decades European governments have imposed fuel taxes that have typically exceeded the raw materials cost of the fuel. The result has been much greater predictability for consumers. Every car buyer in the EU knows that even if oil were $20/bbl cheaper next year, the price of fuel wouldn't change by enough to make a gas guzzler--or a 100-mile daily commute--a good choice.

Now, the US isn't about to impose a $2.00 per gallon gasoline tax. However, the end result of a cap & trade system or a direct carbon tax might not be as far from that as you might think. With all three presidential candidates talking about carbon caps that would reduce emissions by somewhere between 60% and 80% of their current level by 2050, it's a good bet that the price of the emissions permits in the accompanying trading system would have to be a lot higher than $20 per ton for many years, perhaps over $100 per ton, as some studies have shown. And because oil refineries are unlikely to receive grandfathered emissions allowances under any of these proposals, including the current Lieberman-Warner Bill, $100 per ton of CO2 will translate more or less directly to an extra $1.00 per gallon at the gas pump.

Americans' vehicle preferences and the larger issue of annual vehicle miles traveled won't change overnight, even with the prospect of cap & trade. If we want to get the maximum benefit from policies such as this, which if still not quite inevitable have at least become entirely plausible, then we ought not to wait for consumers to be shocked when they are enacted and cause gas prices to go up. We should be candid with them now about the likelihood of higher fuel prices in the future. At the very least, we should warn them not expect retail gasoline or diesel prices to decline for more than short periods over the useful life of the next car they will buy. By itself, that could hasten the global convergence of car models that some analysts expect, while beginning the harder task of nudging our lifestyles away from choices such as long-distance commuting that will make a lot less sense with eventual $5 per gallon gasoline.

The Oil Price Tax

An article in today's Washington Post compared the recent rise in oil prices to a $150 billion dollar-per-year tax on the US economy, enough to negate the various economic stimulus plans being discussed by the Congress and White House. It's a shocking figure, and it helps feed the forecasts of recession, which tend to be at least partially self-fulfilling. But before we accept that $150 million figure at face value--despite its impressive pedigree--it's worth spending a moment on a few ballpark validations. Above all, we should remind ourselves that if high oil prices are a tax, they tax producers, not consumers, who rarely purchase crude oil to use in our homes or vehicles.

The article cites a 2004 comment from Fed Chairman Bernanke noting that firms don't always have the ability to pass on the full effect of a commodity price shock to their customers. At least for oil refineries, now is such a time. Most of last year's oil price appreciation occurred following the end of peak driving season, after Labor Day. Between August and December, the average monthly futures price for West Texas Intermediate crude oil on the New York Mercantile Exchange went up by $19.38 per barrel. The average for January so far would add another $5 to that, so let's call it $25/bbl. With US refineries running at 15.5 million barrels per day, and using the increase in WTI as a proxy for the change in the oil prices actually paid by refiners, their costs have gone up by about $11.5 billion/month. That's close to Professor Nordhaus's $150 billion annualized pseudo-tax.

As I noted above, however, consumers don't buy oil; they buy gasoline, diesel fuel and heating oil. Although the prices of all those products have gone up considerably since Labor Day, only retail heating oil has gone up by as much as crude oil. So far, the average retail price of diesel fuel has risen by about $20/bbl and gasoline by only about $13/bbl. At current consumption rates, the direct impact on consumers is thus around $6.6 billion/month, or $80 billion per year. That ignores increases in the cost of plane tickets, plastics, food and many other things that consumers buy that include a significant energy component, but then, the prices of those goods and services are influenced by many other factors aside from the price of energy. That indirect impact has been further buffered by the relatively low price of natural gas, which supplies a large fraction of the energy and feedstock for the broader manufacturing, chemicals and power sector, and which has been virtually unaffected by the recent change in oil prices.

When we consider the net impact on the entire US economy, we see an increase in the price we pay for imported oil and petroleum products on the order of $9 billion/month since September, or $108 billion/year. Consumers have experienced about three-quarters of that, with businesses absorbing the rest, for now, along with the residual higher cost of domestically-produced oil. If the price of oil remains at this level, more of the increase will flow through to consumers, particularly with the seasonal return of higher gasoline demand in the spring.

$100 billion is not a trivial sum, particularly when it's added to the ongoing expense of two wars and the ultimate cost of repairing the damage caused by the sub-prime debt meltdown. In particular, taking the annualized equivalent of $80 billion out of consumers' disposable income has to worry any business hoping to sell them some product or service this year. But in an economy with nearly $10 trillion of consumer spending, it's the rough equivalent of a 1% tax. Consumers, businesses and policy-makers might want to keep that in perspective, before they panic.

Advice from the Czar

In a counterpoint to yesterday's posting, it seems that although many 1970s energy notions are well past their sell-by dates, there are still some figures from that period who have useful advice to impart. While I was focused on "energy theater" in D.C., I missed seeing an eminently sensible op-ed in the NY Times on the requirements of effective energy policy. It was written by President Ford's energy advisor, Frank Zarb. Describing our problems with a level of objectivity that evokes nostalgia, he observed, "The basic elements of a responsible energy policy are not complicated, but the politics are horrendous." While the first portion of that sentence is bit of an over-simplification, its punchline is spot on.

I'm just old enough to remember news reports during the first energy crisis that began something like this: "In Washington today, Energy Czar Frank Zarb said..." I was always amused by the coincidence of an official with such an alliterative name and title. After President Ford died last year, Americans were able to reconsider his brief but challenging term of office from the vantage point of three decades. The pragmatism and frankness of his administration looked wise, rather than naive, after so many years of arguing about ideology. Mr. Zarb's comments on energy policy reflect that same kind of pragmatism, criticizing the mistakes of others in the mildest terms, and looking back to look ahead, rather than score points.

A glance at yesterday's weekly report from the Department of Energy reminds us how much the problem has evolved since Mr. Zarb ran one of its predecessor agencies. Not only does the US now import twice as much crude oil as we produce--that ratio was 1:3 back then--but we rely on foreign refiners to satisfy 12% of our gasoline demand (2006 average). If a new poll is right about the level of gasoline prices necessary to induce consumers to change their driving habits--$4.38/gallon--it will be extremely difficult to reverse these trends. Nor can our energy problems be solved in isolation from the local environmental concerns that were mostly evident in the 1970s and a global challenge that certainly wasn't. Ultimately, energy security is a much more appropriate target and mindset now than energy independence, which might have looked achievable in 1975.

Mr. Zarb is entirely correct that any effective US energy policy must employ coordinated efforts to increase supply and reduce demand, and that we cannot ignore some of our best options. That would mean simultaneously tackling the politics of fuel taxation, fuel economy, energy infrastructure, offshore drilling, nuclear power and nuclear waste--on a practical, rather than ideological basis. Are we really ready for that, or are we happier looking for scapegoats? The poll referenced above offers an answer: a third of Americans blame high gas prices on oil company greed, compared to only 15% who attribute them to supply and demand.

Fuel Economy Policies

A column in today's Wall St. Journal takes on proposed increases in the Corporate Average Fuel Economy standards (CAFE) but unfortunately fails to offer a better alternative. The author, Mr. Jenkins, regards CAFE as anti-Detroit, anti-consumer, and ultimately poor policy. He may be right about the latter, but at the heart of his critique is the question of whether doing nothing about automotive efficiency--other than waiting for better technology--remains an option. If you believe that climate change is a serious concern, then you end up with a slate of policy choices, none of which seems likely to appeal to Mr. Jenkins' previously-expressed skepticism on the subject. The right question to be asking here is how CAFE stacks up to the other options for reducing the greenhouse gas emissions from transportation.

Last week's Economist (subscription required) offers some worrying insights. Apparently the high level of European fuel taxation, which yields prices for gasoline and diesel fuel that are roughly double what we pay here, has not created sufficient incentives for Europeans to buy cars that are frugal enough to meet the EU's emissions reduction targets. The EU is looking to congestion charges, higher registration fees for gas guzzlers, and even bigger fuel taxes, under the rubric of shifting the tax burden from labor to pollution. European vehicles already average much better gas mileage than US cars, so the hurdle for further reductions is higher. But it should give all of us pause that the equivalent of a $3 gas tax hasn't delivered the 40+ mpg that California is targeting in its proposed state CAFE.

We also can't forget that a reasonable protection for commercial vehicles in the original 1970s CAFE framework became the well-known "SUV loophole", which has boosted US oil consumption by more than the 6 billion gallons per year that ethanol will supply this year. The true impact of new CAFE standards on consumers and US car manufacturers will depend heavily on how "light trucks", "flexible fuel vehicles" and advanced technologies like plug-in hybrids are treated. Nor is it apparent that Americans would pay as much attention to a ramped-up CAFE standard as they did in the 1970s. As illustrated in this chart from the Agoraphilia blog, the gasoline price increases of the last several years have not been very dramatic in terms of purchasing power for most Americans, other than those with the lowest incomes. For the portion of the population that buys most new cars, effective fuel prices--and thus fuel economy worries--are still much lower than they were in the last energy crisis.

CAFE is only one of many policy options for addressing climate change, and it's one of the weaker ones, because it only affects the mix of cars that is offered for sale, not what consumers actually choose. Even if the political environment were right for tackling one of the tougher options, such as a carbon tax on fuel, the European experience suggests that the results might not be as dramatic as policy makers would expect. Until we have a comprehensive framework for greenhouse gas emissions, in which vehicle fuel economy is only one aspect of a broader approach on transportation emissions, higher CAFE standards are at best a symbolic step. If they are indeed a given, as appears likely, then let us hope that they are at least crafted to minimize unintended consequences along the "SUV loophole" line. Otherwise, they could further distort the market for alternative fuels and create lock-in for a marginal improvement like ethanol.