Gas prices and global warming: what to tax?

Recently, Congress voted down a bill that would impose a Windfall Profits Tax (WPT) on the oil industry. Big Oil, awash in cash as the price of crude oil continues to rise, has seen its profits skyrocket. To put this into context, consider the following piece of trivia: if Exxon Mobil were its own country, its 2007 profit would exceed the gross domestic product of nearly two thirds of the 183 nations in the World Bank's economic rankings. Take that Swaziland!!

Of course, Big Oil's windfall earnings come at a time when the economy is slowing and many Americans, particularly in rural areas, are struggling with the price of gas. Senate Majority Leader Harry Reid recently summed up the dichotomy:

"Today, Republicans will have a simple choice: Will they continue to stand with [President] Bush, [Vice President] Cheney, and the modern-day oil barons? Or will they join us on the side of struggling American families who deserve better?"

So would a WPT work? It depends on your goals, but probably no. For people concerned about the price of gas, this is clearly a bad idea. The reasoning is similar to that used during the "gas-tax holiday" saga a few weeks ago. Paul Krugman explains it best:

"It’s Econ 101 tax incidence theory: if the supply of a good is more or less unresponsive to the price, the price to consumers will always rise until the quantity demanded falls to match the quantity supplied. Cut taxes, and all that happens is that the pretax price rises by the same amount. The McCain gas tax plan is a giveaway to oil companies, disguised as a gift to consumers."

With regard to the WPT, we can use this argument in reverse. Any tax on the oil companies will (at least in part) be passed onto consumers. The problem goes further, though. High prices and profits create an incentive to increase supply. As the price of oil increased between 2003 and 2006, oil companies increased their spending on improving existing oil fields and new field discovery by 43% and 67%, respectively. By taxing oil company profits, you dampen the incentive to invest in future production, thus decreasing future supply.

But what if, like many of us, your real concern is decreasing gasoline usage as part of a larger anti-global warming strategy? Isn't the WPT a Pigouvian tax? Well, sort of. Certainly the oil industry produces a great deal of carbon emissions. Thus taxing them may reduce their production (though it probably won't, for the reason mentioned above), which would reduce carbon emissions.

My real concern with the WPT, however, is that it sends the wrong message to the public. The public maintains many erroneous beliefs about economic policy, and opinions on gas prices are no different. According to a recent Gallup Poll, the American public cites "price gouging" as the biggest reason why the price of gasoline has increased in the past few years. While "supply and demand" did place second, other important factors like "the increased price of crude oil" (which would seem obvious) and "the decline in the value of the dollar" come in close to last. The price gouging explanation has emotional appeal, but doesn't make much sense empirically. If price gouging were a factor, why would the price of gas go up and down? And why would the worldwide price of gas go up, rather than simply the price of gas in the US?

Passing a WPT would send a dangerous political message to Americans, reinforcing their beliefs about the price of oil. But it would also be unfair to solely blame oil suppliers for the problem of pollution. People don't use oil because the oil companies exist; oil companies exist because people demand oil. As a result, taxing oil companies, rather than everyone (individuals and businesses) that uses oil (and thus directly producing carbon emissions) would be an ineffective measure for curtailing global warming. Alternatively, a carbon tax, which would tax the emission of CO2, rather than the production and sale of oil, would be a much more effective Pigouvian tax that would actually change people's behavior and would actually help the environment. Additionally, a carbon-tax does not have to be regressive. Rather, as Jason Furman notes, the carbon tax could be paired with reductions in other taxes, such as the payroll tax, so that low and middle-income taxpayers do not see their tax bills increase. That way we tax polluting behavior and not income.

The WPT is, at best, an ineffective half-measure and is, at worst, cynical political scapegoating. If we want to take global warming seriously, we need to tax polluting behavior; you do not need to have any sympathy for the oil companies to see that. And, yes, tax breaks and other incentives for oil companies are nothing more than "Conservative Nanny State" policies, which have to stop. But don't shed any tears for the WPT. As a measure for solving climate change, it won't work; as a means of scoring political points, it probably will.