A Tax on Gasoline

During the 1980 presidential campaign, John Anderson, an independent candidate, proposed a 50 cent per gallon tax on gasoline. The idea of a gasoline tax, both to raise government revenue and to reduce oil consumption and U.S. dependence on oil imports, has been widely discussed since then, and became part of the Clinton Administration's 1993 budget package. Let's see how a 50 cent tax would affect the price and consumption of gasoline.

We will do this analysis in the setting of market conditions during the mid-die of 1986--when gasoline was selling for about $1 per gallon, and total consumption was about 100 billion gallons per year (bg/yr).¹⁹ We will also use intermediate-run elasticities (i.e., elasticities that would apply to a period of about three to six years after a price change).

A reasonable number for the intermediate-run elasticity of gasoline demand is -0.5 (see Example 2.4 in Chapter 2). We can use this elasticity figure, together with the $1 and 100 bg/yr price and quantity numbers, to calculate a linear demand curve for gasoline. (See Chapter 2, Section 2.5, to review how to do this.) You can verify that the following demand curve fits these data:

Gasoline is refined from crude oil, some of which is produced domestically and some imported. (Some gasoline is also imported directly.) The supply curve for gasoline will therefore depend on the world price of oil, on domestic oil supply, and on the cost of refining. The details are beyond the scope of this example, but a reasonable number for the elasticity of supply is 0.4. You should verify that this elasticity, together with the $1 and 100 bg/yr price and quantity, gives the following linear supply curve:

You should also verify that these demand and supply curves imply a market price of $1 and quantity of 100 bg/yr.

We can use these linear demand and supply curves to calculate the effect of a 50 cents per gallon tax. First, we write the four conditions that must hold, as given by equations (9.1a-d):

We can rewrite the last of the four equations as Pb = Ps + 0.50, and substitute this for Pb in the above equation:

Now we can rearrange this and solve for Ps:

Remember that Pb = Ps + 0.50, so Pb = 1.22. Finally, we can determine the total quantity from either the demand or supply curve. Using the demand curve (and the price Pb = 1.22), we find that Q = 150 - (50)(1.22) = 150 - 61, or Q = 89 bg/yr. This represents an 11 percent decline in gasoline consumption. Figure 9.21 illustrates these calculations and the effect of the tax.

The burden of this tax would be split roughly evenly between consumers and producers; consumers would pay about 22 cents per gallon more for the gasoline they bought, and producers would receive about 28 cents per gallon less. It should not be surprising, then, that both consumers and producers opposed such a tax, and politicians representing both groups fought the proposal every time it came up. But note that the tax would raise significant revenue for the government. The annual revenue from the tax would be tQ = (0.50)(89) = $44.5 billion per year.

The cost to consumers and producers, however, will be more than the $44.5 billion in tax revenue. Figure 9.21 shows the deadweight loss from this tax as the two shaded triangles. The two rectangles A and D represent the total tax collected by the government, but the total loss of consumer and producer surplus is larger.

Before deciding whether a gasoline tax is desirable, it is important to know how large the resulting deadweight loss is likely to be. We can easily calculate this from Figure 9.21. Combining the two small triangles into one large one, we see that the area is

19. Of course, this price varied across regions and grades of gasoline, but we can ignore this here. Quantifies of oil and oil products are often measured in barrels; there are 42 gallons in a barrel, so the 1986 quantity figure could also be written as 2.4 billion barrels per year.