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.

A Taxing Opportunity

While watching the scenery from Amtrak's Acela on my way back from a meeting in New York yesterday, I made my first sighting of $1.99 per gallon gasoline, posted on the polesign of a station in Delaware. With wholesale gasoline trading on the New York Mercantile Exchange for $1.138 per gallon at yesterday's close--nearly $7 per barrel below the closing price for light sweet crude oil--most of the country could shortly be paying less than $2/gal. for unleaded regular, for the first time in more than three years. An op-ed in yesterday's Washington Post started me thinking about gasoline taxes, again, and I agree that the current gas price collapse provides a uniquely opportune time for a symbolic increase in the federal gasoline tax, which has not been raised since 1993.

Raising taxes in a recession isn't terribly sound economics in general, but gasoline in 2008 presents an unusual case. As I noted in Monday's posting, the decline in prices from their summer peak to last week's $2.22/gal. average puts roughly $260 billion per year back in the pockets of US consumers, at a time when that ought to be quite helpful. However, it's equally clear that low gasoline prices will complicate the task of selling more efficient cars to an American public that is already buying fewer cars than at any time since the recession of the early 1990s. Moreover, with gasoline demand running at least 3% below last year's at this time, and with prices now a dollar per gallon lower than they were a year ago, and below their annual averages for 2005, 2006 and 2007, state and municipal tax revenues from sales taxes on gasoline will also fall well below expectations. That puts further pressure on state and local budgets already stressed by falling home values and rising unemployment, and it could force cuts in infrastructure projects that many economists suggest we need more of, just now, not less.

This needn't conflict with the necessity to put a price on our emissions of greenhouse gases, effectively taxing fuels on their inherent carbon content. My preference has been for cap & trade, but a simple carbon tax would do much the same thing. Every $10 per ton imposed on CO2 emissions would raise gasoline prices by roughly 10 cents per gallon, anyway, so I'd resist calls for the "big honking tax on gasoline" that Mr. Sloan's op-ed suggests. But with gas prices dropping by more than a dime per week since September, a 10 cent gas tax hike would scarcely be noticed, leaving that $260 billion effective stimulus I mentioned earlier untouched. It could also be shared with the states, with half of the roughly $14 billion per year it would raise going to fund federal infrastructure projects, and the other half allocated to backstop state-financed road and bridge work.

Ten cents a gallon might not sound like much, though the 4.3 cent increase in 1993 cost another first-year President a good deal of political capital. By itself, it wouldn't change the way Americans drive or buy cars. Nor would it be sufficient to nudge consumers towards diesel cars, when diesel fuel has carried an average premium of $0.50/gal. over unleaded regular this year, and currently sells for $0.73/gal. more. However, it would indicate the willingness of the government to intervene in gasoline pricing, when appropriate, in a manner that doesn't impede the market's ability to balance supply and demand, as price controls or a floor price mechanism would. And unlike raising income taxes when salaries and consumer spending are falling, a period of falling gasoline prices is precisely the right moment to raise the federal motor fuel tax, even if just by a little.

The Right Nudge

I've covered the idea of a government-set floor price for petroleum several times in the last couple of years, so I didn't immediately feel obliged to address the latest such proposal from Tom Friedman in yesterday's New York Times. Enough readers sent me links to his column to convince me that it merited another look. The idea of setting a $4.00 per gallon floor under the average retail price of gasoline in the US has far fewer drawbacks than the previous crude oil floor price proposals I have reviewed, particularly in combination with a suggestion for minimizing the impact of this regressive tax on lower-income Americans. But while it's worth examining it both conceptually and in terms of the mechanics of implementation, it must also be considered in the context of other proposals concerning our use of energy. In that respect it comes up short.

The main benefit of setting a fixed floor under the price of gasoline is that it would reduce uncertainty about future prices. Uncertainty is the enemy of action, and informed consumers must surely be torn between two huge uncertainties about oil prices that have recently been dueling in the media. On the one hand, they are confronted by opinions--backed by some evidence--that global oil supplies are approaching, or have already reached, a plateau beyond which they cannot be increased to meet rising demand, and from which they will eventually decline. Adherents of the Peak Oil Meme see $130 per barrel oil as a bargain, compared to what it might cost in a year or two. Meanwhile, other observers suggest that oil may be experiencing a speculative asset bubble, as investors flee to non-perishable commodities for safety from weak stock markets, low bond yields, and the sliding dollar. The Congress heard testimony to that effect last week. If you accept the Oil Bubble Meme, crude could be back under $70 within a year. How should the average consumer decide which view to believe, in deciding whether to replace that gas-guzzler with a hybrid? A floor price resolves at least half of that uncertainty.

Implementing a gasoline floor price tax would involve several key decisions, including whether to set it nationally or regionally. Since local and regional price variations reflect disparate supply and demand factors--the most extreme examples being found in the California market--any such tax should be imposed as a flat addition to the existing 18.4 cent per gallon federal gasoline tax, so as to avoid creating local distortions. An even more serious question is whether it should only apply to gasoline. The best answer appears to be yes, for now. The price of diesel fuel has a strong, direct effect on economic activity, including agriculture and freight, and propping it up with a tax would reinforce its contribution to consumer price inflation. If singling out gasoline for a floor price resulted in consumers switching to more efficient diesel cars, or to cars running on LPG, natural gas, or other alternative fuels, that wouldn't be a bad thing, unless it created an offsetting rebound in vehicle miles traveled.

How should we determine the right level for such a floor price? A year ago, Mr. Friedman thought $3.50/gal. appropriate, when the average US retail price of unleaded regular gasoline was $2.19/gal. Today, with the average pump price only pennies below $4.00, he sees that as the right target, based on the demand destruction it has triggered. From my perspective, a floor has a better chance to succeed if it is set below the current price level, at least initially. Even $3.50/gal. would send a strong signal that consumers would never again see last spring's $2.50/gal. And if oil is in a bubble, and it did revert to $65/barrel, a floor price tax set at $3.50 could ultimately generate more than $1.00/gal. of revenue, or upwards of $142 billion per year, basis last year's consumption. That raises the equally thorny question of what to do with the revenue.

Because of the uncertainties affecting the fuels market, there is no reliable way to predict whether a gas price floor tax would generate any revenue, some, or a huge amount. So it would be hard to use it to fund a specific initiative, such as payroll tax relief or alternative energy R&D, unless it were done retrospectively, based on the previous year's tax receipts. However the government chose to use the proceeds, it would create a new constituency for this tax, with an interest in ratcheting up the level of the floor price over time, if oil prices rise, to keep the money flowing. That might eventually turn a floor price tax into a European-style fuel tax, and that's where my discomfort with the whole idea really kicks in.

I have generally opposed higher taxes on fuel, originally on principle but more recently because I believe setting a price for greenhouse gas emissions would kill two birds with one stone, and the right bird first. Getting our emissions under control will automatically address our energy problems, but the reverse isn't necessarily true. Although a floor price on gasoline wouldn't inherently conflict with the kind of federal cap & trade system for greenhouse gas emissions that is about to be debated in the Congress, the political prospects of enacting both seem poor, and setting a value on carbon emissions is a higher priority than enacting a floor price tax that might never be triggered. Only if cap & trade or its cousin, the carbon tax, proved entirely unworkable should the floor price tax rise to the top of the agenda.

A Better Floor

Does Tom Friedman of the New York Times read my blog? After reading his column on Wednesday (Times Select required) I have to wonder. Last month, he proposed instituting a $45/barrel floor price for crude oil, as a way to stimulate alternative energy investment and reduce US reliance on oil imports, especially from the Middle East. I posted a lengthy critique (1/18/07) of this idea, concluding that it would be too difficult to administer and do little to promote conservation. Now, Mr. Friedman has apparently switched from a floor price for crude oil to a $3.50/gallon floor price for gasoline. Although it would probably be even harder to achieve politically, the latter doesn't have nearly as many drawbacks as a crude price floor, and it would probably contribute more--and more quickly--to our energy security than any other single idea currently under consideration.

Why would a floor price on gasoline work differently from one on crude oil? First and foremost, it would spare US businesses an increase in their energy and raw material costs that their international competitors wouldn't face. It would give consumers an incentive to be more efficient, without disrupting the international markets and flows of oil and its products, which trade on a pre-tax basis and are essential for responding to sudden changes in supply, such as after Hurricane Katrina. In addition, although many different formulations of gasoline are sold across the US, because of differences in local environmental regulations and regional "attainment" status under the Clean Air Act, these distinctions are not nearly as great as those between crude oil grades. Once you set a floor price for conventional unleaded regular gasoline, the market will sort out the relative value of costlier grades and formulations.

Like any idea of this type, a gasoline floor price doesn't lack for complications. For example, how should it apply to imported gasoline--of which we buy more each year--as a tariff, or when it leaves the blender's terminal? Even thornier, should the same floor price apply across the entire US, or should it take into account the differences in regional markets and state taxes? If we were to impose such a tax this week, prices on the East Coast would rise by $1.33/gallon, while those in California would go up by $0.97. Finally, a floor price is still a form of gasoline tax, and just as regressive as a flat per-gallon tax. Buffering its impact on low-income Americans would be tricky, because the level of the tax would vary continuously with fluctuations in the wholesale markets, which reflect crude prices, refining margins and many other factors. Unlike a flat-rate tax, however, it would make consumer fuel prices much more predictable and stable (see Tuesday's posting,) reducing the uncertainty involved in the decision to buy a hybrid or some other fuel-efficient car.

The prerequisite for any substantial new tax on gasoline, however, is the recognition that all of our technology options for improving vehicle efficiency and producing oil substitutes will take more than a decade to reverse the current trend of our oil imports. We would also have to conclude that that timeframe is not adequate--or exceeds our patience--to address the energy security or climate change risks that lead us to want to reduce gasoline consumption in the first place. Combining those realizations would lead us to conclude that we must tackle the consumption of today's entire vehicle fleet. Only then would a gas tax rise to the top of the list of options. Now compare that sequence of events to the current state of play concerning Corporate Average Fuel Economy standards. What external events would we have to see, before Congress and the Administration would be ready to take on something as radical as Mr. Friedman's floor price?