Case study 12.

3: Fuel taxes and optimality

How much petrol should be taxed?

The tax on petrol varies widely around the developed world. Americas gasoline tax is
currently about 40 cents an American gallon, equivalent to 7 pence a litre. Many Americans
are calling for it to be cut, as the summer increase in prices begins to make itself felt, and
reflecting a more general alarm about the countrys energy crisis. In Canada the tax is half
as big again as in America; in Australia it is more than double. In Japan and most of Europe,
the specific tax on petrol is around five times higher than in America, standing at the
equivalent of some 35 pence a litre. At the upper extreme is Britain, where fuel duty (paid in
addition to value-added tax) has risen in recent years to a punitive rate of just under 50 pence
a litre, seven times the American levy.

You would expect well-designed petrol taxes to vary from country to country, according to
national circumstances but not, on the face of it, by a factor of seven. In America it is taken
for granted that Europes petrol taxes, let alone Britains, are insanely high, and presumably
something to do with socialism. In Britain, on the other hand, it is taken for granted that
Americas gas tax is insanely low, part of a broader scheme to wreck the planet. Protests in
Britain last year showed that petrol tax had finally been raised all the way up to its political
ceiling but nobody expects or even calls for the tax to be cut to the American level.

America and Britain may both be wrong about the gas tax, but it seems unlikely that they can
both be right. So how heavily should petrol be taxed? A paper by Ian Parry of Resources for
the Future, an environmental think-tank in Washington, DC, looks at the arguments.

The most plausible justification for taxing petrol more highly than other goods is that using
the stuff harms the environment and adds to the costs of traffic congestion. This is indeed
how Britains government defends its policy. But the fact that burning petrol creates these
negative externalities does not imply, as many seem to think, that no tax on petrol could
ever be too high. Economics is precise about the tax that should, in principle, be set to deal
with negative externalities: the tax on a litre of fuel should be equal to the harm caused by
using a litre of fuel. If the tax is more than that, its costs (which include the inconvenience
inflicted on people who would rather have used their cars) will exceed its benefits (including
any reduction in congestion and pollution).

The pollution costs of using petrol are of two main kinds: damage to health from breathing in
emissions such as carbon monoxide and assorted particulates, and broader damage to the
environment through the contribution that burning petrol makes to global warming.
Reviewing the literature, Mr Parry notes that most recent studies estimate the health costs of
burning petrol at around 10 pence a litre or less. The harm caused by petrols contribution to
global warming is, for the time being, much more speculative. Recent high-damage scenarios,
however, put an upper limit on the cost at about $100 per ton of carbon, equivalent to 5 pence

1
a litre of petrol. Adding these together, you come to an optimal petrol tax of no more than 15
pence a litre.

High petrol taxes also help to reduce traffic congestion. However, they are badly designed for
that purpose. Curbing the number of car journeys is only one way to reduce congestion.
Others include persuading people either to drive outside peak hours or to use routes that carry
less traffic. High petrol taxes fail to exploit those additional channels. As a result, Mr Parry
finds, the net benefits of a road-specific peak-period fee (the gain of less congestion minus
the cost of disrupted travel) would be about three times bigger than a petrol-tax increase
calculated to curb congestion by the same amount. Still, if politics or technology rules out
congestion-based roadpricing, a second-best case can be made for raising the petrol tax
instead. According to Mr Parry, congestion costs in Britain might then justify an additional 10
pence a litre in tax.

This brings you to a total petrol tax of around 25 pence a litre. The pre-tax price of petrol is
currently about 20 pence a litre, so this upper-bound estimate of the optimal tax represents a
tax rate of well over 100% a high tax, to be sure. Yet Britains current rate is roughly
double this. On the same basis, of course, Americas rate is far too low (even a lower bound
for the optimal rate would be a lot higher than 7 pence a litre).

Britains rate, judged according to the environmental and congestion arguments, looks way
too high but plainly the British government has another reason for taxing petrol so heavily.
It needs the money to finance its plans for public spending. Politically, raising money through
the tax on petrol, protests notwithstanding, has proved far easier than it would have been to
collect the cash through increases in income tax or in the broadly based value added tax or,
for that matter, through congestion based road-pricing (always dismissed as politically
Impossible).

This seems odd. Supposing that actual and projected public spending justified higher
taxation, Mr Parrys analysis strongly suggests that the country would have been better off
paying for it through income taxes than through a punitive petrol tax. And the petrol tax is not
only wasteful in economic terms, if Mr Parry is right; it is also regressive in its distributional
effects, increasing the cost of living for poor car-owning households much more than for their
richer counterparts.

At last, Britain has found the political ceiling for the petrol tax. What is remarkable is just
how high it proved to be.

Summary:

The tax on petrol varies widely around the developed world. Americas gasoline tax is
currently about 40 cents an American gallon, equivalent to 7 pence a litre. In Canada the tax
is half as big again as in America; in Australia it is more than double. In Japan and most of
Europe, the specific tax on petrol is around five times higher than in America, standing at the
2
equivalent of some 35 pence a litre. At the upper extreme is Britain, where fuel duty (paid in
addition to value-added tax) has risen in recent years to a punitive rate of just under 50 pence
a litre, seven times the American levy. In America it is taken for granted that Europes petrol
taxes, let alone Britains, are insanely high, and presumably something to do with socialism.
In Britain, on the other hand, it is taken for granted that Americas gas tax is insanely low,
part of a broader scheme to wreck the planet. A paper by Ian Parry of Resources for the
Future, an environmental think-tank in Washington, DC, looks at the arguments. The most
plausible justification for taxing petrol more highly than other goods is that using the stuff
harms the environment and adds to the costs of traffic congestion. But the fact that burning
petrol creates these negative externalities does not imply, as many seem to think, that no tax
on petrol could ever be too high. Economics is precise about the tax that should, in principle,
be set to deal with negative externalities: the tax on a litre of fuel should be equal to the harm
caused by using a litre of fuel. If the tax is more than that, its costs (which include the
inconvenience inflicted on people who would rather have used their cars) will exceed its
benefits (including any reduction in congestion and pollution). Recent studies estimate the
health costs of burning petrol at around 10 pence a litre or less. The harm caused by petrols
contribution to global warming is, for the time being, much more speculative. Recent high-
damage scenarios, however, put an upper limit on the cost at about $100 per ton of carbon,
equivalent to 5 pence a litre of petrol. Adding these together, we come to an optimal petrol
tax of no more than 15 pence a litre. Mr Parry finds, the net benefits of a road-specific peak-
period fee (the gain of less congestion minus the cost of disrupted travel) would be about
three times bigger than a petrol-tax increase calculated to curb congestion by the same
amount. The total petrol tax should be around 25 pence a litre. The pre-tax price of petrol is
currently about 20 pence a litre, so this upper-bound estimate of the optimal tax represents a
tax rate of well over 100% a high tax, to be sure. Yet Britains current rate is roughly
double this. On the same basis, of course, Americas rate is far too low. It needs the money to
finance its plans for public spending. Politically, raising money through the tax on petrol,
protests notwithstanding, has proved far easier than it would have been to collect the cash
through increases in income tax or in the broadly based value added tax. Mr Parrys analysis
strongly suggests that the country would have been better off paying for it through income
taxes than through a punitive petrol tax. The petrol tax is not only wasteful in economic
terms, if Mr Parry is right; it is also regressive in its distributional effects, increasing the cost
of living for poor car-owning households much more than for their richer counterparts.

Question 1: What are the economic reasons for fuel taxes being different in different
countries?

3
Answer: The economic reasons for which fuel taxes are different in different countries are:

1. Subsidies
2. Exchange rate
3. Availability
4. Prices of substitutes, like gas price
5. To finance public spending and construction projects
6. Carbon tax
7. Tax of state and central government

Question 2: What additional factors are relevant in explaining why fuel taxes in the UK
are seven times the level in the USA?

Answer: The additional relevant factors which are relevant for UK are:

The most plausible justification for taxing petrol more highly than other goods is that
using the stuff harms the environment and adds to the costs of traffic congestion. This
is indeed how Britains government defends its policy.

The pollution costs of using petrol are of two main kinds: damage to health from
breathing in emissions such as carbon monoxide and assorted particulates, and
broader damage to the environment through the contribution that burning petrol
makes to global warming.

High petrol taxes also help to reduce traffic congestion.

Government needs the money to finance its plans for public spending.

Question 3: Why are fuel-taxes an inefficient way of reducing traffic congestion?

Answer: Curbing the number of car journeys is only one way to reduce congestion. Others
include persuading people either to drive outside peak hours or to use routes that carry less
traffic. High petrol taxes fail to exploit those additional channels. The net benefits of a road-
specific peak-period fee (the gain of less congestion minus the cost of disrupted travel) would
be about three times bigger than a petrol-tax increase calculated to curb congestion by the
same amount.

A higher fuel taxes or subsidizing transit fares as a short-run measure to mitigate congestion,
though it is recognized that these pricing schemes are inefficient than a congestion fee. Fuel
taxes raise the cost of all driving and therefore do not induce the efficient substitution off
congested roads onto other transport modes, or travel at off-peak periods. Similarly, transit

4
fare subsidies only affect the price of driving on congested roads relative to public transit, but
not the Prices qualified to driving on other roads or at off-peak hours.

Question: 4. Given that fuel taxes are higher in the UK than the rest of Europe, what
implications does this have for UK firms competing with European Ones?

Answer: The implications do this have for UK firms competing with European ones are
given below:

1. Greater quality. UK Firms are encouraged not just to compete on price but also in terms of
quality. They give quality products compare with European ones.

2. More choice: UK providers offer different types of service for their customer. As a result
their customer will satisfy.

3. UK government imposed tax on European products. As a result, European product price is

higher in UK market and UK firms competing with European Ones.