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Closing tax loopholes in the oil industry would have no effect on gas prices

What would be the effect on gas prices of $4 billion in closing tax loopholes for oil companies?

The short answer? There should be almost no effect on prices.

For background, we should briefly answer this question: when are taxes “bad”? It’s an imprecise question and so you’ll only get terrible answers unless we make it more specific. So for now, I’m going to define “bad” as “detrimental to overall economic well-being.” It turns out that taxes are only bad in this sense when people change their behavior in response for what would be better—more economically productive—behavior. Taxes are “good” when they discourage people from mutually destructive behavior, or encourage economically beneficially behavior.

So, if the loopholes that oil companies benefit from were closed, what would happen? I’ve heard people say it would lead to $4 billion in higher prices. This seems transparently and obviously wrong, even without any analysis. The only way you would get full pass-through of taxes to consumers is if the supply of oil were perfectly elastic—totally responsive to price. If that were the case, then if oil prices ever dropped at all, oil companies would have to stop producing oil entirely.

Another way to think about this: if somebody wants to buy your house, and you have some asking price, and they lower their offer, the only way you can avoid going below your asking price is if you are totally and absolutely willing to walk away for even a penny less than your hardline offer. The only way oil companies don’t swallow some of the taxes is if they’re perfectly price responsive—willing to abandon oil rigs and investments and liquidate immediately. That’s transparently not the case.

So what would happen? Well, we could look at this as a competitive market. In that case, there would be a split between producers and consumers. Whoever is more inelastic bears more of the cost. In the short run, consumer demand for gasoline is very inelastic, but so is oil supply. Over a longer time period, both supply and demand are more elastic. In the short run, then, maybe consumers and producers would evenly split the tax, but quantity would stay high. Over the longer time period, consumers and producers would both shift away from the oil market, and quantity would drop.

This is a good thing, by the way, because tax loopholes are really tax expenditures, meaning that they are artificial subsidies, and so the oil industry is inefficiently large. Reducing the size of the oil market would move money out of an inefficient market, restoring balance to the economy. It would move people into other markets, and lead to price more accurately representing the social value of our investments.

This analysis, by the way, assumes that the tax we are discussing is an excise tax—a tax on production. The tax loopholes in question are actually exemptions from a corporate profit tax. Eliminating the loophole then treats oil companies like other companies regarding this tax on profits.

Corporate profit taxes are nice because they do not change the underlying production decision. The optimal quantity remains the same, and it is only in the long run that firms will exit. The firms that do eventually exit are firms that should exit, because they are the ones that would not be making a profit if not for government subsidies.

In other words, government subsidies serve to pay inefficient firms to stay in business when they should really find another line of work.

Moreover, all of the above assumes that the oil industry is a competitive industry. Which it isn’t. It’s an oligopoly. That complicates the analysis of the optimal policy somewhat, but increasing the burden of a profit tax should still have no effect on prices–it just reallocates the surplus…which for an extractive industry seems to make good sense (but that’s me with my normative hat on).

When do subsidies make sense? We can talk more about that later. They certainly don’t make sense in the oil industry.

For a different, and quite good take on this, check out the great work done by the people at the Congressional Research Service: http://1.usa.gov/AnqXTZ

 

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