Cheaper Cars Makes Economic Sense; Cheaper Gas Doesn’t

An acquaintance asked me the other week when I was going to bash Pakatan Rakyat’s Manifesto. I don’t know that bashing would be the right word – I’d prefer “constructive criticism” – but I suppose this post will come close.

One of the hotter topics to arise in the last six months has been the price of cars. In Malaysia, of course, the national car industry has been protected by an excise duty on imports and non-“national” cars, even those assembled locally.

Wherever you stand on the desirability of industrial policy, this has had the obvious effect on car prices – cars in Malaysia retail for more than in other countries. For example, the Honda Civic in Malaysia ranges from about MYR120k to over MYR130k, but goes for between USD18k to USD28k in the United States.

At today’s exchange rates, that amounts to a difference of between about 50% to 110% higher. Even allowing for differences in on-the-road pricing (engine variations, insurance, accessories, trim level etc), the difference still amounts to a hefty chunk of change. In this region, only Singapore has higher prices.

The duties would be more defensible in economic terms if they were applied evenly, but they are not. Duties on national car makes are lower than on non-national car makes; CKD duties are lower than CBU. This severely distorts the market for autos, and constrains consumer choice. By skewing the market to local brands and locally assembled imports, competition is reduced and we get a loss of consumer welfare.

The flip side of the argument is that differential tax treatment allows for the development of local heavy industry. But our experience over the last thirty years is that the spill-over effects from a national car industry have been disappointing, and any cost-benefit analysis would suggest that the game isn’t worth the candle.

In that sense, lifting excise duties on cars would restore competition to the market, reduce inefficiencies, and widen consumer choice (this would be true even without reforming the AP system). That such a move would also be popular among voters is beside the point.

From an analytical perspective, removing differential excise duties would shift the overall auto supply curve down and flatten it at the same time. There will be more consumer choice at any given budget constraint, more cars would be sold for any given level of demand, and more efficient producers will be rewarded for their efforts.

So far, so good. There’s nothing controversial here unless you’re an industrial policy fanatic – this is basic, and broadly accepted, micro-economic analysis.

I’ve got two issues with this however – one in relation to the desirability of having more cars on the road, and how reducing excise duties fits in with the Manifesto’s other policy proposals. I suppose this is where the “bashing” comes in.

The first, and obvious, problem is that reducing car prices would increase the number of cars on the road, at a time when traffic congestion is already bad and worsening. Cars are also polluting machines, which entails a cost on the environment and on human health.

These costs are high and non-trivial. While car purchase costs take into account cost of raw materials, R&D, and production while ownership of a car confers benefits through a stream of car services across time, these costs and benefits are private and do not account for the public costs of an individual’s car ownership, or what are called negative externalities.

Any welfare benefits from cheaper cars (a private benefit) would be offset by more time spent in traffic jams, poorer air quality, higher health risks, and greater long term damage to the environment from a higher output of greenhouse gasses (public costs). So what we get is largely a redistribution of social welfare, both in the present and for future generations, rather than an increase in it.

The correct and appropriate policy response would be to levy a tax equivalent to the public cost incurred, which would “internalise” the public cost into market prices.

But that’s hard to manage from taxing car ownership alone. A tax on car values (irrespective of make) doesn’t account for usage – a Lamborghini that spends 99% of the time in a driveway would be less polluting than a small car that’s used every day. A similar objection would apply to a tax on engine size – it doesn’t account for the actual public cost incurred.

Both such tax regimes are nevertheless possible options, which would reap the benefits of higher consumer choice and greater competition while somewhat imperfectly accounting for negative externalities because the burden of taxation is inequitably distributed.  A congestion tax would be more efficient, but also doesn’t really account for the environmental impact. But these are all second-best solutions.

The first best option is to tax car use directly – in other words, a tax on petrol. Estimates for the US on lost productivity through health problems and traffic congestion, as well as short and long term environmental damage from car use, roughly works out to about RM0.90 per litre. Mind you, this is without subsidised petrol prices.

Based on Malaysia’s per capita CO2 emission level relative to the US, the optimal tax rate for petrol at the pump should be about RM0.37, which is actually pretty close to the excise duty that the government charges for petrol but doesn’t collect.

On that basis, the economically correct policy would be to go ahead and cut excise duty on cars, but to simultaneously remove subsidies and reinstitute duty collection on petrol. If you want to be more precise about it, excise duty on petrol could be converted to an environmental tax that could be used to fund adoption of green technology, or even funding operations or improvements in public transport. From a fiscal standpoint, re-imposing duties on petrol should more than offset the revenue loss from removing excise duties on autos.

Needless to say, the Manifesto wants to increase subsidies on petrol instead, which doesn’t make economic sense on many levels. Just as cheaper cars would increase car ownership, cheaper petrol would increase car use and therefore increase the public costs incurred from same.

There would also be greater wastage, as prices lower than the market-clearing price reduces the incentive to use a resource efficiently. Adoption of alternative fuels and green auto technology would be set back. The public costs would well outweigh any private benefits from such a policy mix, even if you exclude the fiscal implications.

Moreover, cheaper petrol and cheaper cars would severely undermine the viability of an expansion in public transport, which both sides ostensibly support. Given the relative merits of private (convenience) versus public transport (cost saving), reducing the gap between the two makes the economic and financial case for public transport that much weaker. Public transport would turn into a publicly funded white elephant.

The economic case for removing excise duties on cars is clear – more competition, more consumer choice, greater efficiency. You only have to account for the negative externalities of car use.

The economic case for increasing subsidies on petrol is even clearer, because there isn’t one. Instead, both economic theory and global practice suggest that the optimum, social welfare-maximising policy is to tax petrol use, not subsidise it.

Put these together with the plan for public transport, and you have what can best be described as an inconsistent, even schizophrenic, approach to public and private transportation. The very same analysis that supports removing duties on cars provides the rationale for removing, not increasing, subsidies on petrol.

Reducing the private costs of car use, which are already low, will guarantee the failure of public transport policy. The public non-fiscal costs of reducing private costs of car use will also likely offset the private benefits involved.

From my point of view, this is simply not a good, or even coherent, policy mix.