How a Price-Smoothing Oil Tax Could Help Make This the Last Oil Price Shock

It must be Groundhog Day. Events in Libya have pushed world oil prices over $100 a barrel yet again. Retail gasoline prices, usually low this time of year, are at an all-time seasonal high. Are we in for another round of the same-old, same-old? A replay of Jimmy Carter pledging, "Never Again!" and then doing nothing? Or is there some way we can make this the very last oil price shock?

Producing countries have already figured out how to cope with the curse of oil price volatility. Over the years, producing countries, from Norway to Saudi Arabia to Russia, have established national wealth funds that build up when prices are high and run down when prices fall. Meanwhile, consuming countries have done next to nothing.

The US Strategic Petroleum Reserve, designed to offer short-term protection against physical interruptions of supply, is not intended to serve the purpose of price stabilization, nor would it be capable of doing so. But there is a way. Now would be an ideal time to revive an old idea, a variable oil tax that would reduce price volatility and, at the same time, offset the national security and environmental harms of oil dependency.



A variable, price-smoothing oil tax would work like this. Congress would establish a floor oil price of X dollars per barrel. Whenever the world market price P fell below X, an oil tax T would come into effect to fill the gap: T=X-P. Whenever the price rose above the floor, the tax would be zero. Nothing could be simpler.

Why would it be a good idea? There are two parts to the answer, one making the case for an oil tax in general, and the second explaining why a variable tax would be better than one with a fixed rate.

The main argument for a tax of any kind is that oil consumption has adverse spill-over effects on third parties—effects that are not taken into account when bargaining between producers and consumers sets the price. Economists call those spillover effects externalities. The two most commonly cited externalities of oil consumption are effects on national security and effects on the environment. Imposing a tax on oil would be one way to mitigate them.

Consumption of oil has a negative impact on national security because so much of the world's oil comes from countries that are corrupt, authoritarian, anti-American, or all of the above. Any increase in US oil consumption pushes up the world price and enriches bad guys in exporting countries. Any reduction in oil consumption undercuts them. An oil tax would insert a wedge between the price paid by US consumers and the price received by foreign producers. To the extent it raised the US price at the pump, it would encourage conservation and investment in alternative energy. To the extent that it lowered the world market price,the tax would take money from the pockets of the bad guys.

An oil tax would be much more effective than the current US oil security strategy, which consists of buying as much as possible from friendly, nearby countries like Canada and Mexico. That strategy does provide some limited protection against a revolution or embargo that might cause a physical interruption of supply, but it does nothing to mitigate negative national security spillovers that operate through prices. The world oil market operates as one big pool. If something sends the price up, as is happening right now, it goes up for everyone. Canada and Mexico are our friends, to be sure, but they are not so friendly as to sell us their oil below its market price. If excess US consumption drives the world oil price higher, it drives it higher for bad-guy producers, too, even those from whom we do not directly buy any oil.

As for environmental externalities of oil consumption, they have been so widely discussed that there is little to add. In recent years, much of the discussion has focused on climate change from oil-related CO2 emissions. But even if you are a climate-change skeptic, don't forget there are other environmental effects, too. Low oil prices and high consumption mean more local smog and more traffic congestion, regardless of any effects on polar bear habitat. To the extent an oil tax cuts consumption, it improves the environment across several fronts.

Of course, national security and environmental objectives would also be served by a conventional, fixed-rate tax. Why would a variable tax would be better?

One reason is that a variable tax would provide an anchor for expectations about oil prices. During episodes of high prices, investments in conservation and alternative energy production become more attractive, but there is also a risk. If oil prices crater again, those investments will not pay off. Knowing that oil prices would not be allowed to drop below a stated floor would make it less risky for consumers to buy energy-efficient cars and entrepreneurs to build plants to produce biodiesel from pond scum. Greater investments in conservation and alternative energy, in turn, would help moderate the next upward movement of oil prices.

Second, a variable oil tax would help mitigate the impact of oil price spikes on the business cycle. James Hamilton has written extensively on that subject. (See here, here, and here.) He points out that most recent oil price spikes, including that of 2008, have been followed by US recessions, and argues that the depth of those recessions has been greater than would be predicted by the effects of higher oil prices acting alone. One reason seems to be that retail gasoline prices have such a high visibility that price spikes disproportionately undermine consumer confidence. Another is that oil price spikes disrupt the automobile market. They not only harm new cars in general, but also shift the mix from large to small cars. Widespread layoffs have followed at US auto companies, which have traditionally specialized in SUVs and light trucks. Finally, says Hamilton, it appears that high oil prices in 2008 exacerbated other factors that were undermining the housing market. As evidence, he cites the fact that the prices of homes in locations that required long commutes fell by more than those with short commutes.

A third advantage of a variable oil tax compared to a fixed one would be political, especially if it were  introduced at a time when oil prices were already above the chosen floor. Right now, for example, a tax with a price floor of, say, $85 per barrel would produce no immediate pain at the pump, but the knowledge that prices would never again fall below $85 would encourage long-term investments in conservation and alternative energy. Introducing a variable oil tax at a time when prices were already high could make an actual virtue of the often-lamented tendency of politicians to operate on a much shorter time horizon than business investors.

The idea of a variable, price-smoothing oil tax is not going to appeal to everyone. Let me close with two preemptive comments addressed to the most likely critics.

First, to those for whom all taxes are bad: Fine, for the sake of discussion, let's stipulate that all taxes are bad. Still, some taxes are worse than others. The worst taxes are those that discourage businesses from investing in the future while encouraging activities with negative spillovers on third parties. The least bad taxes are those that encourage sensible investment and discourage negative spillovers. Given the current state of the budget, even the most fanatical fiscal hawks concede that we need a federal revenue base of 19 or 20 percent of GDP to have any hope at all of averting fiscal catastrophe. So, if we need more than zero tax revenue, wouldn't it be better to replace really bad taxes, like our loophole-ridden corporate income tax, with less-bad taxes, like a variable oil tax?

Second, to the affordable energy crowd: I've said it before and I'll say it again, if there is one thing we can't afford, it's affordable energy. "Affordable energy" is really a code-word for holding the price of energy below its true cost to the economy. If we don't pay for oil at the pump, we pay for it through the back door, in the form of distorted investment decisions, pollution, and reduced national security. Artificially low energy prices make our economy weaker, not stronger. There Ain't No Such Thing as a Free Lunch. Never was, never will be.

Follow this link to view or download a brief slideshow about the variable, price-smoothing oil tax. Thanks to Henry Lee for comments on a draft of this post.