Sunday, November 09, 2008

Does The Wall Street Journal's Explanation Of The Gas Tax Make Sense?

The article is Obama Builds Ties to 'Chicago School'. Here is the passage that puzzles me:

"Many economists were cheered in April when, amid higher gasoline prices, Mr. Obama opposed a gas-tax holiday -- an idea supported by Sens. John McCain and Hillary Clinton, who was competing with Sen. Obama for the Democratic nomination. Textbook economics said in response to the tax cut, demand would simply raise gas prices to their previous level, and so the benefit of the cut would flow to energy producers rather than consumers."

Here is what I think is going on (see the graph below). A tax on gas is what we call an excise tax. Since the seller must collect the tax, the supply curve shifts upwards by the amount of the tax. In the graph below the S2 line is 60 cents above the S1 line (so the tax is 60 cents a gallon). Now imagine the tax is eliminated, so we move from S2 back to S1. The price falls from $1.40 back to the original $1.00. The demand line does not move and the new equilibrium is at a lower price. The demand line is not going to move to the right (increase) to bring the price back to $1.40. Maybe some other factor will change to make that happen like incomes increasing, but that is not the issue here. It looks like that passage in the WSJ makes no sense.

I exchanged emails with the WSJ reporter. Here is what he had to say:

"Basically said, maybe could have taken more time explaining in the story that with inelastic supply, existing demand will take the price right on up to where it was before the tax holiday. Here's an old Krugman column that does it better:

Reckonings; Gasoline Tax Follies

"The quantity of oil available for U.S. consumption over the near future is pretty much a fixed number: the inventories on hand plus the supplies already en route from the Middle East. Even if OPEC increases its output next month, supplies are likely to be limited for a couple more months. The rising price of gasoline to consumers is in effect the market's way of rationing that limited supply of oil.

"Now suppose that we were to cut gasoline taxes. If the price of gas at the pump were to fall, motorists would buy more gas. But there isn't any more gas, so the price at the pump, inclusive of the lowered tax, would quickly be bid right back up to the pre-tax-cut level. And that means that any cut in taxes would show up not in a lower price at the pump, but in a higher price paid to distributors. In other words, the benefits of the tax cut would flow not to consumers but to other parties, mainly the domestic oil refining industry. (As the textbooks will tell you, reducing the tax rate on an inelastically supplied good benefits the sellers, not the buyers.)""

This could be the case, but I think it would mean that the short-run supply curve is vertical. You can't shift a vertical line straight down. If, however, the line is very steep, but not completely vertical, it still shifts down. In the new graph below, the lower red line is 60 cents below the upper line. The price is lower, but not by much (it falls from $1.20 to 1.00). And again, there is no movement of the demand line.


Anonymous said...

So gas has dropped tremendously lately, so that means demand should increase. due to limited supply, soon the price of gas will have to rise again so the market will be in equilibrium. Would you say that we are experiencing a Supply Shock at the moment? Perhaps due to a decrease in mileage driven while prices were two dollars more than they are now?

Cyril Morong said...


Demand does not increase when price falls. When price falls quantity demanded increases.

Gas has fallen in price because demand has decreased or shifted to the left. We have a demand shock