Why a Gas Tax Holiday Probably Won’t Work

I think many of our political leaders have a comical view of how gasoline prices are set. They envision oil companies adding up all their input costs and then setting a profit margin. Oddly enough, sometimes the oil companies are really generous and sell gas for less than $2.00 a gallon. Other times the belief must be that they are super gluttonous and sell it for $6.00 a gallon.

Taxes are in addition to all input costs and profit margins. The state and federal governments get a share of every gallon of gasoline sold. Since 1993, the federal portion of the gasoline tax has been 18 cents per gallon. Add costs, profit margin and taxes, and you end up with the price of gasoline. Or so the belief goes.

Some politicians have floated the idea of ​​a gas tax exemption to help lower prices at the pump. President Biden is said to be evaluating this idea now.

One of the problems with such a system is that these taxes help fund the country’s transportation infrastructure, such as highways and bridges. If that money stops coming in, it will either mean a cut in those programs, more deficit spending, or the revenue will have to be clawed back elsewhere.

But there is a more fundamental problem. Gasoline is not really priced according to the notion mentioned above. In fact, gasoline is a commodity whose price is fixed in the market. Instead of adding up inputs, including a profit margin, and then adding gasoline taxes, the profit margin fluctuates up and down with the price, which is based on supply and demand. It’s a fundamentally different model, which also explains why oil company profit margins are so volatile.

What would happen in such a model if gasoline taxes were reduced? If you assume that the price of gasoline is based on supply and demand, reducing gasoline taxes does nothing to adjust supply and potentially increases demand. So you could easily see gas prices rebound quickly to their current level following a gas tax cut. It’s just that the 18 cents that are currently captured by the federal government would simply move elsewhere in the supply chain. This would improve the profits of the retailer, refiner and oil producer to varying degrees.

Do not mistake yourself. I like lower taxes. It’s just that in this case, a commodity like gasoline that operates on supply and demand is not going to respond as expected to a reduction in the gasoline tax.

Consider that on June 1, New York State suspended its fuel tax of 8 cents per gallon, as well as its 4% sales tax to $2 per gallon. According to AAA data, on June 1, the average retail price of gasoline in New York City was $4.93 per gallon. Two weeks after the tax exemption of about 16 cents per gallon took effect, the average price in New York was $5.04 per gallon. (Of course, the underlying price of oil has a big impact on gasoline prices, but the fact is that consumers haven’t seen a drop in gasoline prices despite the large reduction in tax).

If cutting gasoline taxes doesn’t work, then what might? Another idea floated was discount cards. That might work, as long as the rebate cards aren’t gasoline specific. If they are, it’s the same dynamic as with the gas tax reduction. It does not attack supply, but can increase demand.

If, instead of a gas rebate card, consumers simply received a rebate card that they could spend anywhere, it could have the desired effect. In this case, there is still an incentive to consume less (and produce more), as gasoline prices remain high. But then the money would be available to consumers to offset the loss of discretionary income that now goes to pay for gasoline.

However, there are two potential problems with this scheme. Some might see this as subsidizing oil company profits. This is where most of the oil price spike has gone – to increased profits throughout the oil supply chain. (As I’ve made clear in the past, it’s because oil prices are high, not because oil companies suddenly decided to make more money). Some politicians have argued for windfall taxes on oil companies to pay for such a program, but that will be a politically tough sell.

The other issue is that it would be akin to a stimulus payment, which we’ve seen many times over the past few years. While these stimulus payments are not the main driver of inflation right now, they are certainly contributing to it. When people have more money to spend, they spend it. This helps to drive up inflation.

Ultimately, there are no easy financial tricks to lowering prices at the pump. The release of oil from the strategic petroleum reserve is likely to help. Consumers who reduce their spending in the face of high prices will be helpful. And the increasing production of American producers will help.

All of these factors will likely contribute to lower gasoline prices heading into the fall and winter. But don’t expect a quick fix with a gas tax exemption. It is unlikely to work as expected.

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Post expires at 7:37pm on Saturday July 2nd, 2022