Gas prices, demand, and Carbon Taxes: no bounce

I am going to explain why a carbon tax on gasoline would most likely not significantly reduce consumption of gasoline and how it would not solve the problem of greenhouse gases produced by gasoline consumption. I feel it is valuable to explain this because a lot of people believe that in order to reduce carbon dioxide emissions, we should simply be taxed more to use products that emit CO2- the logic is that the more expensive gas is, the less of it we will buy. This is true to an extent but not to a great extent.

As the cost of an item goes up, typically demand goes down. The amount that the demand goes down in relation to the price is known as the "Price Elasticity of Demand." Here is a definition of PED from Wikipedia:

Mathematically, the PED is the ratio of the relative (or percent) change in quantity demanded to the relative change in price. For most goods this ratio is negative, but in practice the elasticity is represented as a positive number and the minus sign is understood.

In other words, if a good is perfectly elastic (having an elasticity of 1) then for every % increase in price you will have the same % decrease in the quantity of the good demanded. If gas demand were perfectly elastic, then the demand when the price went from $2.00 a gallon to $3.00 a gallon this past year would have diminished by 50% because the cost increased by 50%. This did not happen because the relationship between gas demand and gas prices is "relatively inelastic". In fact, short term PED for gasoline consumption is only 0.1. That means that if gas prices go from $2.00 to $3.00 (increase 50%), then demand only decreases by 5%. In the long term, people can adjust choices like vehicles purchased and miles commuted; long term elasticity increases to 0.4. If gas cost $2.00 and you applied a $1.00 carbon tax to it, you would only reduce demand by 5% short term and 20% long term. That is a lot of tax for a little reduction in demand. However, there is the possibility that gas demand may be more elastic above the $3.50 mark, where we have not yet seen it go.

Lots of people these days are advocating a carbon tax on gasoline- even Harvard Economists and Alan Greenspan. Where would the money from such a tax go? Most likely, a good chunk of the revenues from a Carbon Tax would go in part to administering the tax collection program and the disbursement of tax funds. I am not kidding. They might also go to the purchase of carbon offsets- but the government may find itself in the situation where there are not enough offsets available for the amount of money that it has -this is a very typical problem with fees paid in lieu of environmental protection. Or, it may find that the cost of offsetting greenhouse gases is a lot more expensive than the cost of preventing them in the first place, which means that it won't get much bang for its buck. Still, it would get the revenue from the tax and could spend it on things like programs to educate the public about greenhouse gas emissions. This sounds good until you remember that government spending is terribly inefficient and that education benefits are hard to quantify with a cost-benefit analysis. Taxes generate revenue and they are great for subsidizing pet projects (aka Pork). The truth is that traditional taxes are not effective at correcting the problems that are the reason for the tax.

Unfortunately, with a Carbon Tax on gasoline, the consumer would suffer- increased prices for gas would disproportionately affect the poor, who spend a greater portion of their dollar for things like transportation even if they buy less gas per person than the rich. And since all transportation costs would increase, then every consumer good including food would increase in cost, something we have seen with the recent hike in gas prices. This also disproportionately affects the poor. This type of impact on the poor from a tax is known as an "equity effect".

In some defense of Carbon Taxes, they can help the consumer to make choices that reflect a true cost of a good, including the cost of polluting the atmosphere. With only one choice for vehicle fuel, this cost difference may not affect purchasing behavior a great deal due to the relative inelasticity of demand to price. If there were other commonly available options for vehicle fuel besides gasoline, such as cellulosic biofuels, then the demand for gasoline would become more elastic. A product that is more environmentally friendly but that might cost more to produce may actually end up costing less than dirty fuel which is cheap to produce but has a heavy environmental cost. The added costs on highly polluting fuels like gasoline may favor products like biofuels produced with cellulose (such as switchgrass, still in development). According to Wiki:

Substitution serves as a much more reliable predictor of elasticity of demand than "necessity." For example, few substitutes for oil and gasoline exist, and as such, demand for these goods is relatively inelastic. However, products with a high elasticity usually have many substitutes.

High prices for gasoline could stimulate the development of alternative fuels and then favor the demand for alternative fuels. Carbon Tax funds could also be used as public investments in alternative fuel technology and infrastructure.

A Carbon Tax might also force the consumer to evaluate longer term choices such as the MPG of new vehicles; however, consumers often disregard operating costs when purchasing products and thus may not opt for the more efficient product simply because of fuel savings- remember that the long-term elasticity of demand to price for gasoline is still only 0.4.

I am not saying that carbon taxes for gasoline are a bad idea for revenue generation or for internalizing some environmental costs into consumer goods; but they do not do what everyone thinks that they do and they are not going to reduce consumption of gasoline enough to meet the stringent targets that are being discussed in Congress right now.