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Energy and the role of gasoline taxation: Can increased taxes help reduce consumption of gasoline? An assessment of seven industrial countries’ experience

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1980
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Alan A. Tait and David R. Morgan

Since 1974, the major objective of energy policy in countries belonging to the Organization for Economic Cooperation and Development (OECD) has been to reduce their dependence on imported oil. In October 1977, in an unprecedented move, International Energy Agency (IEA) ministers adopted the so-called Group Objective of limiting oil imports to 25 million barrels a day by 1985. Higher gasoline taxation was one instrument advocated to help achieve this objective. However, the experience of seven major OECD countries for the period 1970-78 indicates that gasoline taxation has, in fact, generally declined in real terms. The IEA’s report for 1978 stated that the Group Objective was unlikely to be met and that a major reason for this was the underutilization of gasoline taxation.

Reluctance to use this important tax seems to derive from skepticism regarding its potential to reduce demand for gasoline. Critics have also expressed concern that higher taxation would conflict with other macroeconomic objectives—that it would, in particular, exacerbate inflation, hinder efforts to achieve equity in the distribution of the costs of higher oil prices, retard economic growth, and upset external equilibrium. This article, which is based on a recent study of taxes on gasoline in seven OECD countries, tries to evaluate these concerns. The tentative conclusion is that their importance is often exaggerated and that, in general, excessive stress has been placed on the macroeconomic implications of an essentially microeconomic issue.

This conclusion should not convey the impression that higher gasoline taxation is costless but rather that at a macroeconomic level the costs—for example, those that will be associated with the adjustment to the July 1979 oil price hikes—appear to be more modest than suggested in most public debate. On the basis of the experience of the past six years, the OECD countries will regard this round of increases as rendering it more difficult to restore or in crease the real value of gasoline taxes. However, the price hikes might also serve to emphasize that the lower gasoline taxes themselves helped to encourage such price increases.

Both oil consuming and oil producing nations should appreciate the need for establishing greater certainty about the direction and the timing of oil and oil product price changes. If oil exporting and oil importing groups of countries could agree on arrangements to make such changes in a more orderly fashion, it would reduce uncertainty; in time, it would make it easier for the oil importing countries to plan national structural changes to cope with increased energy costs.

Role of gasoline taxation

Traditionally, gasoline taxes in the OECD countries have been levied by central or federal governments either to meet road construction and maintenance costs or as a source of general revenue (see Table 1).

Table 1.Gasoline taxation in selected OECD countries
CountryNature of taxLevel of

government
Purpose
BelgiumValue addedCentralNot earmarked
ExciseCentralTo finance road infrastructure
CanadaSalesFederalNot earmarked
ExciseFederalNot earmarked
Retail salesProvincialTo finance highway maintenance and construction
DenmarkValue addedCentralNot earmarked
ExciseCentralTo make users pay for bridge and highway costs
FranceValue addedCentralNot earmarked
Internal consumptionCentralNot earmarked
Levy for support fund for indigenous hydrocarbonsCentralFor research
Germany, Fed.Value addedFederalNot earmarked
Rep. ofMineral oilFederalTo help coal
ItalyGeneral turnoverCentralNot earmarked
ExciseCentralNot earmarked
JapanGasolineFederalAll taxes earmarked for highway and road construction and maintenance
Local roadFederal
Liquefied petroleumFederal
SwedenValue addedCentralNot earmarked
GasolineCentralUsed to defray road building costs
United KingdomValue addedCentralNot earmarked
ExciseCentralNot earmarked
United StatesSpecialFederalBoth taxes earmarked for highway maintenance
SpecialState
Source: Various country documents.
Source: Various country documents.

The oil price increases of early 1973 and late 1974 created a new potential role for gasoline taxation—as an instrument to reduce dependence on imported oil. Such a role ideally meant that the real value of gasoline taxation had to increase from October 1973 levels; at the very least, a real decline had to be avoided. (Gasoline taxation could also have been used to avoid any decline in real gasoline prices arising from temporary declines in crude oil prices or from particular currency appreciations vis-à-vis the U.S. dollar.)

However, gasoline taxes were not used to reduce demand for oil, in fact they declined sharply in real terms between 1970 and 1979. During the 1970s, retail prices for gasoline primarily reflected crude oil prices and gasoline taxation. While prices for crude oil rose, gasoline prices barely increased in real terms up to June 1979, mainly because of the declining rate of taxation. Although the relationship between the price of crude oil and the price of gasoline varies—according to the refining process, the joint product nature of the numerous final products from crude oil, the degree of market monopoly, and the different qualities of crude oil—nevertheless, retail gasoline prices during the 1970s were largely determined by the two factors mentioned: crude oil prices and gasoline taxation.

As Chart 1 illustrates, the largest increases in both nominal and real crude prices occurred in January 1974. Since then, although the nominal price has increased in each year except 1974 and 1975, the real price of crude oil between January 1974 and mid-1979 remained more or less constant in most countries. In fact, it was declining between 1974 and 1979, and the May 1979 price increases only reestablished the real value of the cost of crude oil in January 1974. Thus, while increases in crude oil prices exerted considerable pressure on gasoline prices to rise in real terms immediately after the initial round of oil price increases in 1973-74, that pressure disappeared during the 1975-78 period and only re-emerged with the latest rises in crude oil prices in July 1979. Then by August 1979 the real price of Arabian light crude was just over five times the January 1970 price.

Chart 1.Nominal and real prices of Arabian light crude oil, 1970-79

(In U.S. dollars per barrel, f.o.b.)

Source: U.S. Department of Energy, International Petroleum Annual; International Monetary Fund, International Financial Statistics; and data prepared by IMF staff.

The doubling of real crude oil prices between 1970 and 1978 was not reflected in retail gasoline prices in most of the OECD countries (see Chart 2). The increase in the real price of gasoline over the period was less than 8 per cent in five out of the seven countries, and actually declined in Japan and the United Kingdom. Chart 2 shows that the major changes in real retail prices per gallon occurred immediately after the large increases in the world price of crude oil, with gasoline prices generally either remaining fairly constant or declining in real terms during the latter part of the 1970s until the further price increases in 1979. These increases pushed 1979 gasoline prices up to about 20 per cent more than 1970 levels, except in Italy and the United States. But the annual rate of increase in real gasoline prices, averaged over the seven countries for the period, was still only around 1.1 per cent up to 1978 and 2 per cent by 1979.

Chart 2.Real retail gasoline prices by country, 1970-79

(In U.S. dollars per gallon)

Source: IMF, International Financial Statistics.

Nominal prices deflated by consumer price index (July 1975 = 100)

A major factor in this modest increase in real gasoline prices was that gasoline taxes were not adjusted upward sufficiently to match the general rising price level over the period. Gasoline taxation rates declined sharply between 1970 and 1979 in all seven countries considered here, with almost all of this decline occurring immediately after the increases in world crude oil prices in early 1974. As the net-of-tax price of gasoline increased due to higher costs of imported crude oil, per gallon taxes in nominal terms were not increased sufficiently to maintain the existing tax rates. The real value of gasoline taxation per gallon also declined, although the decline was less dramatic. (The effective rate of tax is calculated as the value of the gasoline tax per gallon divided by the net-of-tax price per gallon (see Chart 3).) Italy was the only country in which the value of real taxes per gallon rose between 1970 and 1979. In the United States such taxes on a per gallon basis remained virtually fixed in nominal terms between 1970 and 1978.

Chart 3.Nominal and real retail gasoline taxes, 1970-79

(In units of domestic currency per U.S. gallon)

Source U.S. Department of Energy. International Petroleum Annual and International Monetary Fund International Financial Statistics; Nominal values deflated by the domestic consumer price index July 31 1975 1001

Why not more taxation?

Several reasons could be given for the fact that gasoline taxation has not been widely adopted as a policy instrument to conserve energy. In many countries there was skepticism regarding the effectiveness of, or the necessity for, higher gasoline taxation as a way of reducing demand for energy. Higher gasoline taxation, too, was viewed by some as inconsistent with other government objectives, including the control of inflation and an equitable distribution of income. It was also thought that higher gasoline taxation could induce further oil price increases by the major oil exporting nations.

How valid are these fears about the effects of gasoline taxation? Regarding the argument that large increases in gasoline taxation would not yield significant energy savings, several empirical studies, particularly within the United States, have attempted to determine the relationship between the consumption and the price of gasoline. The general conclusion appears to be that, while in the short run the price of gasoline does not affect demand much, it does have a significant impact in the long run. Thus, while the initial response to a 10 per cent increase in gasoline prices (whether due to higher crude oil prices or to higher taxes) might only lead to a 2-6 per cent decline in per capita gasoline consumption within the first year, it would ultimately cause a drop of about 7-14 per cent when all adjustments have been made. It appears that these estimates apply both to the United States and to Europe; but, given the large number of American “gas-guzzlers” with heavy consumption, there is greater potential in the United States than in Europe for major savings by using smaller, more fuel-efficient cars.

This leads to perhaps the most interesting implication of these estimates, particularly for North America, that the largest reduction in gasoline consumption for any given increase in price would be made by increasing the efficiency of the stock of vehicles rather than by reducing substantially the number of miles driven. This conclusion tends to contradict the arguments that gasoline prices and taxes may distort existing economic activity (by reducing tourist trade, for instance, or discriminating against suburban and low-income residents). If, in the long run, the primary response to higher gasoline prices is increased vehicle efficiency, then it is unreasonable to expect that conservation policies working through higher gasoline taxes will have detrimental effects in the long run on those sectors of the economy that appear to be hardest hit in the short run.

Effects on inflation

The possibility that higher gasoline taxation will raise prices in general seems to have been a major preoccupation of the authorities. However, experience shows that higher gasoline taxation would have very modest direct effects on the overall price level. Even these direct effects can be offset by using part or all of the proceeds to reduce other indirect taxes. The indirect effects of higher gasoline taxes on prices would depend on the subsequent wage, price, and monetary adjustments, which are by no means automatic and some of which may be under the control of government.

In this context, three points need to be kept clearly in mind: (1) the distinction between individual price changes and the general rate of inflation; (2) the distinction between a price increase resulting from an increase in a domestic tax and one resulting from a deterioration in the country’s terms of trade; and (3) that direct expenditures for gasoline probably account for less than 5 per cent of private consumption expenditures as represented in consumer price index baskets.

Traditionally, economists have tended to belittle the impact of a rise in price of a single commodity on the general rate of inflation, where inflation is defined as a dynamic disequilibrium phenomenon rather than as an increase in a consumer price index. They argue generally that relative price changes can have inflationary consequences only if the authorities pursue an accommodating monetary policy.

However, some recent empirical evidence for the United States might be considered a challenge to this traditional thesis. The findings of the studies seem to imply two propositions. First, that if prices, including wages, do not fall in the short run, an individual price increase will result in an increase in the overall price level. Second, that relative price changes might generate accommodating policy responses—particularly policies increasing the money supply—and these policies will validate or sustain inflation.

It is important to emphasize the difference between an increase in the price of gasoline emanating from an increase in imported crude oil prices and an increase resulting from an increase in gasoline taxation, because the former involves a real income loss for the importing country, whereas the latter does not. It can be expected that economic agents, namely, households and companies, will react more strongly to resist an import price increase, and thus the pressure for an accommodating policy response—generating inflation—might be greater. (Even so, economic agents may also often react to higher gasoline taxation as if it, too, involved a real income loss, ignoring the cuts in other taxes, or the increases in government expenditure that the higher gasoline taxation makes possible.)

This point also raises another obvious distinction between the two situations. Higher gasoline taxation provides the government with the revenue to offset any direct impact on the overall price level and any deflationary impact on aggregate demand, for example, by reducing other indirect taxes. Clearly, increases in imported oil prices will have similar cost and demand effects without at the same time providing government with the resources to counteract this effect.

Thus, while the consumer may regard the source of an increase in gasoline prices as irrelevant, gasoline price increases caused by higher gasoline taxation pose considerably fewer difficulties for macroeconomic management—and are less inflationary—than price hikes caused by imported oil costs.

Resource allocation and growth

The 1973-74 oil price increase represented a massive change in the cost of a major input relative to output prices. In all of the OECD countries, the change in the cost of energy rendered part of the existing capital stock obsolete. Moreover, in the absence of offsetting reductions in real wages, profitability of enterprises (other than those producing energy) was reduced. Changed cost structures and relative prices would have required resource reallocations even if the adjustment of final sales prices was unimpeded. As it was, the authorities implemented price controls and restrictive demand management policies; as a result, the countries did not adjust completely to the initial oil price rise until some time later.

Probably most economists would argue that, to facilitate the real adjustments in patterns of production and consumption needed to offset the rise in oil prices, final sales prices should be allowed to adjust without delay. But it might also be argued that the implementation of new technologies takes time and that adaptations to changed relative prices should be made as far as possible without undue disruption. Specifically in the case of gasoline prices, motor vehicle technology cannot be retooled rapidly to produce a substantially more fuel-efficient fleet (though a European alternative technology exists for use in North America), nor can public transportation systems be rapidly changed or expanded. It takes time, for instance, to introduce an underground rail system to replace, even partially, existing motor transport. Required rundowns in certain industries—such as parts of the tourist service industry heavily dependent on private motoring—may occur more smoothly if achieved over a longer period. It can, therefore, be argued that if the relative magnitude of future oil prices can be predicted, appropriate resource reallocations can be made more smoothly. However, real increases beyond a certain magnitude will, in the short run, have no discernible impact on resource reallocation but will create undue disruption.

The growing use of adjustment assistance schemes in OECD countries aimed at smoothing the transfer of resources gives ample precedent for a similar approach—working through gasoline taxation—to be used in the case of gasoline. However, the actual experience with such schemes—often established in response to lower levels of protection and the presence of more competitive goods on domestic markets—also suggests caution in endorsing them. Recent OECD studies of such schemes concluded that they often tend to delay rather than facilitate adjustment. While this delay is in part attributable to avoidable defects in the design of particular schemes, there are more general shortcomings that are relevant to efforts to smooth the path toward higher gasoline prices. Specifically, if the “smoothing” is too tentative, it can readily degenerate into price changes so modest that they bear no relation to the magnitude of the required adjustment.

The experience of most OECD countries with gasoline prices seems to illustrate this problem. Substantial help for adjustment to higher prices might have been justified in the period immediately following the initial round of price rises when there existed reasonably widespread expectations that the new higher relative price of oil could not be sustained. But once it became clear that prices were not only going to remain at that level but were likely to increase in real terms, prompt structural adjustment to the higher levels was clearly needed.

Distribution of Income

Governments usually want to ensure that, at least, the impact of higher taxes does not fall on the poorer groups of society. To the extent that higher gasoline prices were found to have this effect, governments may have been (and remain) reluctant to compound higher gasoline prices with additional taxation, even though energy conservation and additional public revenue would result.

Studies for the United States indicate that additional increases in gasoline prices and taxes will, in fact, inflict a greater relative expenditure-based burden on lower-income groups than on higher-income groups. However, it may not be possible to generalize these results to other OECD countries, since Canada and the United States may be the only economies in which automobile ownership is virtually universal. In fact, recent evidence suggests that even in these countries the impact of higher gasoline taxes on low-income families has been overstated.

In general, the progressivity-regressivity issue may not be important enough to override other policy objectives, such as the attainment of an efficient allocation of resources or a reduction in foreign oil imports.

But there are issues concerning horizontal equity that may be more difficult for the authorities to balance against the need to achieve such objectives as conserving energy. An increase in gasoline taxation may, for instance, cause a shift in residential property values so that suburban house-owners incur a capital loss and inner-city houseowners reap a capital gain. Other possible gains and losses may occur between industrial sectors as share values and incomes decline in such industries as tourism and automobile manufacturing. Because such gains and losses are likely to transcend income classes, so that intraclass variation is just as likely as interclass variation, the maintenance of horizontal equity may be more difficult than the maintenance of vertical equity during a transitional period of adjustment.

It should be noted, however, that the more certainty there is about the direction of changes in both oil prices and gasoline taxes, the less serious such horizontal inequities are, if prices are permitted to adjust to reflect the likelihood of such changes. For instance, house prices in more remote suburban areas could be expected to fall relative to prices for housing within a short commuting distance; certainty about the direction and speed of oil price changes will enable housing price changes to adjust more quickly and efficiently.

In the discussion of appropriate gasoline pricing and tax policies, it is important to distinguish between distribution and allocation issues. The fact that a policy such as higher taxes on gasoline consumption carries with it possible adverse distributional impacts does not constitute a sufficient reason for discarding it. Adjustments in the general tax-transfer system may be a more appropriate means of maintaining equity than a complete abandonment of gasoline tax policies.

BOP considerations

What is the impact of higher gasoline taxation on industrial competitiveness between various OECD countries? From the experience so far, it is difficult to accept that gasoline taxation could have an important impact on industrial competitiveness. The major reason why competitiveness could be affected is presumably that higher taxation would have a once-and-for-all impact on the price level, leading to wage, price, and monetary expansion. This has been discussed earlier. A second argument may be that higher gasoline taxation might induce an appreciation of the exchange rate, through its impact on oil imports and hence on the trade balance. However, lower oil imports are also likely to be associated with lower autonomous capital inflows; the possible impact on the exchange rate depends on the effects on the overall balance of payments (BOP) not merely on the trade balance.

Another mechanism linking gasoline taxation and external competitiveness derives from the impact of gasoline prices on tourism. However, to state the obvious, this argument is only valid to the extent that the gasoline price affects the total basket of goods and services tourists consume, not merely gasoline.

Thus, the major impacts of higher gasoline taxation on the BOP are probably the longer-term influence on the cohesion of the Organization of Petroleum Exporting Countries (OPEC) and the minimization of risks of further large increases in the relative price of imported oil. These factors would appear to be far more important than the somewhat tenuous arguments outlined above.

Possible OPEC reaction

Another explanation advanced for the apparent underutilization of gasoline taxation is the chance that higher gasoline taxation would induce retaliatory action by the oil exporting nations in the form of higher oil prices. According to this view, higher gasoline taxation would be viewed as an attempt by the consuming nations to gain a larger share of the value generated by a barrel of crude oil, and oil exporting nations would respond by restricting output and increasing prices to restore their pretax profit margins. This view assumes that the major oil exporting nations (1) can be regarded as a monopolist or tight cartel; (2) are not presently maximizing their profits; and (3) have the market power required to at least restore their profit margins when faced with increased gasoline taxation.

This retaliation argument, however, does not necessarily make a valid case against higher taxation. Indeed, one argument is that higher taxation by the oil consuming governments will eventually lead to a situation in which consuming governments would have the power to pre-empt most or all of the profit of the oil exporting countries. In practice, this is most unlikely; but if, on the other hand, gasoline taxes are actually reduced in real terms to partly offset the increase in crude oil prices, consuming nations are forgoing part of the market value of this commodity. They are transferring potential revenue to the producing countries (and relieving the gasoline consumer at the expense of other taxpayers), thus at the same time inducing domestic budgetary difficulties, worsening their BOP, and sacrificing the objective of a reduced dependence on oil imports.

The message for oil consuming countries may be to establish the upward trend of prices, in part, through recourse to taxation as an instrument both of conservation and of fiscal redistribution of the real costs of the higher oil prices among their local population. Cooperation between oil exporting and oil importing countries could result in more certainty about the timing and direction of oil price changes and could help control the adverse inflationary effects as well as the uncertainty experienced thus far in the adjustment of oil importing countries to high energy prices.

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