Why it’s time to reform US energy subsidies and taxes

World oil prices have been highly volatile during the last decade.   Over the past year they have fallen more than 50%.

Should we root for prices to go up, down, or stay the same?   The economic effects of falling oil prices are negative overall for oil-exporting countries, of course, and positive for oil-importing countries.  The US is now surprisingly close to energy self-sufficiency, so that the macroeconomic effects roughly net out to zero.  But what about effects that are not directly economic?   If we care about environmental and other externalities, should we want oil prices to go up or down?  Up, because that will discourage oil consumption?  Or down because that will discourage oil production?

The answer is that countries should seek to do both: lower the price paid to oil producers andraise the price paid by oil consumers.  How?   By cutting subsidies to oil and refined products or raising taxes on them.   Many emerging market countries have taken advantage of the last year of falling oil prices to implement such reforms.  The US should do it too.

Congress continues to shamefully evade its responsibility to fund the Federal Highway Trust Fund.  On July 30 it punted with a 3-month stop-gap measure, the 35^th time since 2009 that it has kicked the gas-can down the road!  There is little disagreement that the nation’s roads and bridges are crumbling and that the national transportation infrastructure requires a renewal of spending on investment and maintenance.  The reason for the repeated failure to put the highway fund on a sound basis for the longer term is the question of how to pay for it.  The obvious answer is, in part, an increase in America’s gasoline taxes, as economists have long urged.  The federal gas tax has been stuck at 18.4 cents a gallon since 1993, the lowest among advanced countries.  Ideally the tax rate would be put on a gradually rising future path.

Fuel pricing is a striking exception to the general rule that if the government has only one policy instrument it can achieve only one policy objective.   A reduction in subsidies or increase in taxes in the oil sector could help accomplish objectives in at least six areas at the same time:

1. The budget. It is estimated that energy subsidy reform globally (including coal and natural gas along with oil) would offer a fiscal dividend of $3 trillion per year. The money that is saved can either be used to reduce budget deficits or recycled to fund desirable spending, such as US highway construction and maintenance, or cuts in distortionary taxes, e.g., on wages of lower-income workers.
2. Pollution and its adverse health effects.   Outdoor air-pollution causes an estimated annual 3.2 million premature deaths worldwide.  A gas tax is a more efficient way to address the environmental impact of the automobile than alternatives such as CAFÉ standards which mandate fuel economy for classes of cars.
3. Greenhouse gas emissions, which lead to global climate change.
4. Traffic congestion and traffic accidents.
5. National security.   If the retail price of fuel is low, domestic consumption will be high.  High oil consumption leaves a country vulnerable to oil market disruptions arising, for example, from instability in the Middle East.  If gas taxes are high and consumption low, as in Europe, then fluctuations in the world price of oil have a smaller effect domestically.   It is ironic that U.S. subsidies to oil production have often been sold on national security grounds; in fact a policy to “drain America first” reduces self-sufficiency in the longer run.
6. Income distribution.  Fuel subsidies are often misleadingly sold in the name of improving income distribution.  The reality is more nearly the opposite.  Worldwide, fossil-fuel subsidies are regressive: far less than 20%  of them benefit the poorest 20% of the population.  Poor people aren’t the ones who do most of the driving; rather they tend to take public transportation (or walk).   As to producer subsidies, owners of US oil companies don’t need the money as much as construction workers do.

The conventional wisdom in American politics is that it is impossible to increase the gas tax or even to discuss the proposal.   But other countries have political constraints too.  Indeed some governments in developing countries in the past faced civil unrest or even overthrow unless they kept prices of fuel and food artificially low.  Yet some of them have managed to overcome these political obstacles over the last year.  The list of those that have recently reduced or ended fuel subsidies includes Egypt, Ghana, India, Indonesia, Malaysia, Mexico, Morocco, and the United Arab Emirates which abolished subsidies to transportation fuel subsidies effective August 1.

Besides raising taxes on fuel consumption, the US should also stop some of its subsidies to oil production.  Oil companies can “expense” (immediately deduct from their tax liability) a high percentage of their drilling costs, which other industries cannot do with their investments.  Most politicians know that sound economics would call for this benefit to be eliminated.  But they haven’t been ab le to summon the political will.  Among the other benefits given to the oil industry, it has often been able to drill on federal land and offshore without paying the full market rate for the leases.

Those politicians who complain the loudest about the evils of government handouts are often the biggest supporters of handouts in the oil sector. Political contributions and lobbying from the industry must be part of the explanation.  Even so, it is surprising that self-described fiscal conservatives see more political mileage in closing the Export-Import Bank – which earns a profit for the US Treasury while it supports exports – than in ending oil subsidies, which cost the Treasury a great deal.

A recent study from the IMF estimated that global energy subsidies at either the producer or consumer end are running more than $5 trillion per year.  (Petroleum subsidies account for about $1 ½ trillion of that. A lot also goes to coal, which does even more environmental damage than oil.)  US fossil fuel subsidies have been conservatively estimated at $37 billion per year, not including the cost of environmental externalities.

Leaders in emerging market countries have now recognized something that American politicians have apparently missed, that this is the best time to implement such reforms.  Oil prices have recently fallen to around $50 a barrel – down from a level well over $100 a barrel in the summer of 2014. So governments that act now can reduce energy subsidies or increase taxes without consumers seeing an increase in the retail price from one year to the next.

For the US and other advanced countries it is also a good time for fuel price reform from the standpoint of macroeconomic policy.  In the past, countries had to worry that a rising fuel tax could become built into uncomfortably high inflation rates.  Currently, however, central bankers are not worried about inflation except in the sense that they are trying to get it to be a little higher.

Congress will have to come back to highway funding in September. If other countries have found that the “politically impossible” has suddenly turned out to be possible, why not the United States?

This article is published in collaboration with Jeffrey Frankel’s Blog. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Jeffrey Frankel, a professor at Harvard University’s Kennedy School of Government, directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.

Image: The Washington Monument is seen with an American flag flying in the foreground in Washington, February 22, 2002. REUTERS/Molly Riley