Thursday, April 17, 2008

Want cheaper gasoline? Tax oil!

Want cheaper gasoline? Tax oil!

Most people understandably believe that if we tax oil it will harm the economy. The thinking is that the higher cost of fuel will dampen economic activity - something no one wants.

Reality however is more complicated. To make it easier to explain why I'm going to start by assuming that all the revenue from taxing oil is given directly back, divided equally, to all the adults in the country. Later we can discuss how that is not all that different from NOT giving the tax money back to the people.

The oil industry is very capital intensive. Oil rigs, refineries, pipelines and oil prospecting are all huge costs with a curious commonality, they are all mostly "fixed" costs. In other words, whether an oil company sells more oil or less oil, their costs do NOT change much. If the entire system of harvesting, processing and distributing the oil can handle X barrels of oil a day then there are two important consequences to note: 1. The system cannot produce more than X barrels a day and 2. Producing less than X barrels a day is inefficient and results in a higher per barrel cost of the oil product.

I'll illustrate with some simple made up numbers:

Prod     barrels per day    ;; number of barrels the system can make
 O        dollars per day    ;; total operating cost of the business
 S        dollars per barrel ;; sale price of a barrel of oil
 PC = O/X dollars per barrel ;; production cost per barrel
 P  = S-C dollars per barrel ;; profit per barrel
 Operating costs: 5000 dollars per day
 Oil sale price:   100 dollars per barrel

  Production       PC   Profit
  ----------   ------  -------
         100    50.00    50.00
          75    66.00    34.00
          50   100.00     0.00
          25   200.00  -100.00
          10   500.00  -400.00

Clearly for the oil industry keeping the system running at full production is very important. So, lets tax the oil and see what happens. We'll start with a $40 per barrel tax. After some time oil consumption would drop (even now this is happening with oil over $100/barrel). We'll assume consumption has dropped to 50 barrels a day. Looking at the table profits are now zero. How should the industry respond?

We don't have a supply/demand chart but we can explore what would happen if the oil company dropped their price to $60 per barrel.

 Operating costs: 5000 dollars per day
 Oil Sale price:    60 dollars per barrel

  Prod       PC   Profit
   ---   ------  -------
   100    50.00    10.00
    75    66.00    -6.00
    50   100.00   -40.00
    25   200.00  -140.00
    10   500.00  -440.00
At $60 per barrel and $40 in tax the per barrel cost to the consumer is $100. Consumption will rise to the same level as before, 100 barrels per day. The industry is now only making $10 profit. The tax revenue was $40 per barrel times 100 barrels per day, $4000 per day. Our hypothetical populace would have $1.46 million to share - and presumably spend.

So what happened? Using this simple model a portion of the value of a valuable natural resource, oil, was captured using taxes and delivered to the people. The "at the pump" cost did NOT change. With oil products costing no more than before the tax and extra money in their pockets the economy would do better than before the tax. A win-win for all except perhaps the oil executives.

Summary: Add substantial tax to oil (before refining) and you will get the following benefits:

  1. As a country you will pay less per barrel for the oil
  2. Use the revenues to displace existing taxes or give it back directly to the people. This makes the tax a net burden of zero!
  3. Oil derived products will increase in price. This will encourage people to find alternatives to oil based products and to use energy more efficiently. No need to put artificial impediments in place to mitigate inefficient usage. Even if you received a $5000 oil dividend recently, knowing that gasoline is $5/gal you'll be inclined to pocket the money and get the hybrid instead of the SUV.
  4. Fewer dollars will flow to the oil producing countries. Somehow I don't think too many people will shed tears for them.
Notes: This idea is closely related to the Georgist "One tax". Tax land and natural resources and you'll pretty much eliminate poverty.

For years there was a rant on the Opec site about how terrible oil taxes were. Uh, for who? Well - in this authors opinion the only harm is too those who are already rolling in cash. Everyone else wins.


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