Higher Oil Taxes Would Lift the Economy

President Barack Obama this week reaffirmed his desire to tackle the U.S. budget deficit through “a balanced mix of spending cuts and more tax reform.” As lawmakers in Congress search for ways to do this, they should take a new look at raising oil taxes. Even if they don’t believe that the U.S. consumes too much oil, they will find that incorporating higher oil taxes into a broader deficit package can make strong economic sense.

The U.S. levies small taxes on gasoline, diesel and jet fuel that add up to less than $10 on each barrel of oil consumed. Yet increasing any of these taxes has long been politically toxic. The result, once inflation is factored in, has been a steady drop in the tax rate on oil use.

Economists have argued that higher oil taxes would, in principle, be an efficient way to reduce deficits while curbing oil consumption. Yet few hard numbers have been attached to these claims. And the potential impact of higher oil taxes on economic growth and job creation in a weak economy -- a critical issue given today’s still-fragile conditions -- is largely unexamined territory.

Economic Model

We’ve looked into these questions with an economic model that uses quarterly data stretching back to 1952 to extract relationships among several hundred economic and energy indicators. (Our results were published this week by the Council on Foreign Relations.) We considered oil taxes in the context of the larger tax system, comparing a range of deficit-reduction packages containing only income-tax hikes and government-spending cuts with a dozen variations that incorporate oil-tax increases. And we found that including oil taxes can bring, through the end of this decade, stronger economic growth, lower unemployment and reduced oil consumption -- even while raising more money.

Consider, for instance, the budget plan recommended in 2011 by the Simpson-Bowles commission, designed to directly cut the deficit by about 4 percent of gross domestic product by 2020. It would do so through a mix of modest individual and corporate tax increases and considerably larger government-spending cuts.

If lawmakers altered that package to avoid some of the spending cuts, and added an appropriately sized oil tax, they could keep the same deficit-reduction target. A notional oil tax might rise to $50 per barrel by 2020, about $1.20 for a gallon of gasoline, producing revenue equivalent to about 1.5 percent of GDP.

Using an oil tax of this size to avoid spending cuts would lead to stronger economic output and a lower unemployment rate in every year through 2020 (the last year that we modeled). By the end of this decade, the U.S. economy would be almost 1 percent larger, and the unemployment rate more than 0.2 percent lower, than with the original deficit package. Oil consumption would also fall by almost 500,000 barrels a day, helping shield the U.S. economy from volatile world markets.

Why would this happen? Tax increases and spending cuts, by reducing demand for U.S.-made goods and services, can harm near-term economic performance. Raising oil taxes does far less to blunt near-term demand than cutting spending does, our model shows. This is because people change their behavior slowly in response to higher oil prices, whether by buying more efficient cars or moving closer to work; in contrast, cuts in government spending hit the economy immediately. It also helps that a large fraction of our oil is still imported.

We also find near-term (though smaller) economic benefits if part of the revenue from a higher oil tax is dedicated to avoiding any increase in individual taxes. This is largely because most of the proceeds from our notional oil-tax increase could still be used to avoid sharp spending cuts.

Suppressing Demand

On the other hand, when the oil tax is used mostly to avoid tax increases on individual and corporate income, we find that it usually worsens near-term economic performance. This is because oil taxes do more to suppress near-term demand than corporate taxes do. That said, higher corporate taxes, by reducing business investment, may create longer-term risks beyond the horizon of our model.

Any effort to increase taxes on oil would need to confront other potential problems. For one, oil taxes are regressive, because poorer people spend a greater share of their money on oil and gasoline than wealthier people do (though government-assistance programs that are indexed to inflation help blunt this). Yet our results suggest that even if this was addressed by using half of the revenue from an oil tax to provide rebates to consumers, the net benefits of a modest oil tax in a deficit-reduction package could still be positive, depending on how the remaining revenue was used. Another way to address the regressive nature of oil taxes would be to tailor any spending cuts or income-tax increases to reduce their effects on lower-income families.

Some people might wonder whether a rising oil tax would harm the current oil-production boom. Our modeling suggests that, because oil prices are set by global supply and demand, a $50-a-barrel tax would probably push pretax oil prices down by at most a few dollars. This wouldn’t make a big difference to U.S. oil producers’ bottom lines or their decisions on how much oil to produce.

To be sure, the results of any economic-forecasting model should be handled cautiously. If the past dynamics that were used to inform our model (developed by Daniel Ahn) turn out to be poor indicators of how the economy will function in the future, then the projections will be misleading. Similarly, to the extent that future conditions end up well outside the realm of experience, a model that draws heavily on economic history will be flawed. That said, since the oil tax that we model is well within the range of past oil-price volatility, the risk of this problem is limited.

Congress may decide not to raise taxes or cut spending much at all. Given that tax increases and spending cuts of any kind risk harming near-term output and increasing unemployment, that might be a wise choice, at least for now. But if lawmakers decide to go ahead with further deficit reduction, they would be remiss not to take a hard look at higher oil taxes as part of the deal.

(Michael Levi is the David M. Rubenstein Senior Fellow for Energy and the Environment at the Council on Foreign Relations and author of the forthcoming book “The Power Surge: Energy, Opportunity, and the Battle for America’s Future.” Daniel P. Ahn is an adjunct fellow for energy and national security at the Council on Foreign Relations. The opinions expressed are their own.)

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    To contact the writer of this article: Michael Levi at mlevi@cfr.org Daniel P. Ahn at danielpahn@gmail.com

    To contact the editor responsible for this article: Mary Duenwald at mduenwald@bloomberg.net

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