Taxes and Prices

by on September 5, 2005 at 7:10 am in Economics | Permalink

Ask the man on the street what will happen to the price of gas if the gas tax is lifted and he will reply that the price will fall by the amount of the tax.  It's no wonder then that politicians are talking about (temporary) gas-tax relief.  The man on the street's answer, however, is wrong.   What determines prices is demand and supply.  If demand and supply don't change then neither does the price. 

Does the lifting of the tax change the demand for gasoline?  No.  Does it change the physical supply?  No.  At least not by much in the short run and especially not by much when the tax relief is known to be temporary.  Since neither supply nor demand change neither does the price. What does change is that with the tax the government collects the revenues, with the "tax relief" the suppliers of gasoline collect the (former) revenues.  Either way, no gain to the consumer. 

Permanent tax relief could draw more resources into the industry, thereby increasing supply and lowering price but this is a long run effect.  A permament policy to reduce gas taxes during crises could also have a beneficial effect but only for the next disaster. 

What could ameliorate prices now is the administration's plan to release oil from the strategic petroleum reserve.

Addendum: Jim Hamilton has much the same analysis of gas-tax relief and has more to say about the releasing oil from the SPR and a good idea from the EPA to (temporarily) reduce some environmental regulations.

Addendum 2: I am getting email about this already so if you are in doubt I have put another explanation in the extension.

Suppose there is an
auction for a pearl.  The person with the highest demand is willing to
pay $5000 the person with the next highest demand is willing to pay
$4999.  The winner must pay a tax of $1000 to the government.

With
the tax the two bidders bid until the price reaches $4000 at $4000
(note that $3999+$1000 tax= net of $4999) the low bidder drops out and
the high bidder wins.  Total price to the high bidder is $5000, $4000
to the seller and $1000 to the government.

Now with no tax a
price of $4000 leaves two bidders in the ring so the price must rise
higher.  In fact, the price must now rise to $5000 to get the second bidder
to drop out.  Final price to the high bidder is $5000 – the seller gets
$1000 more in revenues and the government gets nothing.

If one wants to challenge the gas-tax argument then to place to do so is to argue that a temporary reduction in the tax, leading to more profits for the oil companies, will stimulate supply enough to have a significant effect on reducing price.  Any other argument is incorrect.

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