Obama’s Gas Tax Rebate: A flip flop that’s just Bad Economics

I was some what surprised that Senator Obama proposed rebating consumers $1000 for gas purchases given that he heavily criticized both Senator Clinton and Senator McCain for this just months ago.  He criticized their plan as simple gimmicks that pandered to voters.  Well, it was probably just more symbolic than effective, but at least it did no harm.

Senator Obama’s suggestion appears to have a punishing impact on oil companies which I suppose has an added pandering punch.  My 18 year-old freshmen, first year, macro-economics students could tell you why this is just plain bad economics  If you take $1000 per consumer in taxes from Oil Companies and think you give it to consumers and it stops there, you need to go take some college economics.  This is a complete no-brainer that any entry level micro or macro student should be able to shoot down.  I’m going to try to explain this to you intuitively so you can shoot it down too.  I promise I’ll avoid the supply and demand curves in the process.

Any time you place a tax on a good or service, it is important to know how sensitive the demand for that good or service is to price changes.  This concept is called ‘elasticity’ of demand in microeconomics and it is one of the first things you learn as an entering freshmen in your economics 101 classes.  The demand for some goods are quite price sensitive and others are not.  It’s really dependent on a number of things, but the bottom line is just this:  Is it easy to live with out this good?

Perhaps the most price sensitive good is a drug that you are either addicted to or need to live.  There is absolutely no price that will stop you from demanding that good because it means death or extreme withdrawal.  This is why drug dealers frequently give their drugs away to start with, then gradually increase the price.  They know once your hooked, you’ll give up every thing else to maintain the high and eventually even steal or prostitute yourself to earn the money to by the drug.  If you’re a diabetic and you need a certain level of insulin to stay alive, you will have to do the same. You will die without the drug so consuming other goods and services come after what you have to do to pay for the insulin.

Oil does not have the same price sensitivity as an addictive drug or a drug you need to live, but in the short run, it is very price sensitive.  This is because most folks need to drive to get to their jobs, schools and errands.  You can’t just change to a more fuel efficient car immediately, because that is very expensive, so you have to adjust your behavior to pay for the increased cost of gas.  First you try to drive less.  Then you start giving up other things to buy the gas.  Still, you’re stuck with a certain number of miles you have to drive.  At that point, you just have to suck it up and pay for the gas.

If you tax these price sensitive goods, it’s just like raising the price of them.  This is because there is a certain amount the consumer must buy.  They are stuck with whatever cost the seller wishes to charge which can include a large portion of a tax placed on the seller. The tax on goods with demand that is insensitive to price just basically causes an increase in cost passed to the consumer.  This also means if there is a tax placed on the provider of this price insensitive or “inelastic” good, it is very easy for that provider to pass that tax on to the consumer.  This is because the consumer basically will not have that many alternatives other than to suck it up and buy that same amount of gas every week.  The consumer will have to forgo other goods and will put more of their income towards buying gas.

This is what will happen if Senator Obama’s gas tax on Oil Companies would come to fruition, which is highly unlikely even with a very democratic senate.  The cost of the tax to the producers will just be passed on to the consumers of gasoline in the form of higher prices. This means soccer moms, truck drivers, and truck fleets delivering goods to your local stores.  You may get the $1000 back in a check, but you will pay for it every place else in higher prices. How much that higher price is will depend on the sensitivity of your demand to that good.  For necessary items like gas and food, it will be a lot.  For goods you can live with out, like luxury items, it will be less.  So what this really does is transfer the ‘burden’ of the tax to the heavy users of the most necessary items.

I could use fancy graphs and models to show you how much this would cost.  I’m assuming probably some economists are doing this somewhere and you will hear shortly about the numbers they’ve come up with.  However, I just hope you’ll understand on a very basic level what a very bad idea this is; no matter how appealing it sounds.

I have to tell you that I do not have any sympathy for gas and oil companies which enjoy near monopoly power with a very price insensitive good.  I believe we need to do something with their market structure or place some demands on them if we grant them more drilling rights. However, the idea of taxing them to rebate money to consumers is not a good one.  In the long run, it’s just going to cost you and me.  It’s basically just giving with one hand and taking with the other.