Friday, October 21, 2011

The Argument For Taxing Energy

N. Gregory Mankiw points us to this article by Yale Professor William Nordhaus:

Energy: Friend or Enemy?
William D. Nordhaus

...The two faces of energy are the primary reason why energy policy is so controversial and tangled. We need national policies that address the enemies of pollution and global warming. But because energy is such a large part of consumer budgets and so central to our advanced economies, people are reluctant to allow energy prices to reflect the true social costs of energy consumption. We see this tradeoff play out in energy and environmental policy year in and year out...

...An externality is an activity that imposes uncompensated costs on other people. Externalities from energy use include the deadly air pollution emitted by cars and power plants, oil spills, radioactive emissions from nuclear power plants, sludge from coal mines, and congestion from overloaded streets and highways. More recently, scientists have focused on greenhouse gas emissions, such as the carbon dioxide that comes from burning fossil fuels, as a particularly dangerous externality...

...The table on this page summarizes the results from the National Research Council study. It shows the ratio of the estimated external or uncompensated costs of energy to the market price. For example, electricity generated from coal has an estimated external cost of 70 percent of its market price. Petroleum is used primarily for automotive fuels, and its social costs are one quarter of the price of gasoline. Electricity production from natural gas has among the lowest ratios of social cost to market price. It is important to note that the product itself is not harmful (electricity to power our computers is still our friend); rather it is the dirty production process that emits the pollution that ultimately causes the damages and is our foe...

...Two central points emerge from this calculation. If we look at actual taxes in the energy sector, they are far below the calculated external costs. In 2007, for which we have complete data, after discounting the net of energy subsidies, the money paid in total federal energy taxes was $21 billion, or less than one tenth of the level necessary to price energy at its social costs. Virtually all of these taxes were gasoline taxes—devoted to building roads so that cars could drive faster and farther! So Graetz is correct in his assertion quoted above that the US has failed to charge the full cost of its energy consumption; it is not even close.

A second point is that environmental taxes can play a central role in reducing the fiscal gap in the years to come. These are efficient taxes because they tax “bads” rather than “goods.” Environmental taxes have the unique feature of raising revenues, increasing economic efficiency, and improving the public health...

...The need for taxes on energy externalities such as carbon emissions is central to our ability to reduce the harmful side effects of economic growth. It is striking how the political dialogue in the US has ignored a policy that has so many desirable features. Perhaps, in the near future, faced with the deadline of a dire economic situation, negotiators will formulate such a policy. It would generate substantial revenues while bringing so many long-run economic and environmental benefits. Simply put, externality taxes are the best fiscal instrument to employ at this time, in this country, and given the fiscal constraints faced by the US.

If that 25% figure for auto gasoline use is right, the socially optimal and efficient price for petrol in Malaysia should be around RM3.70-RM3.80 based on current market prices, approximately double the current pump price.

Instead of spending RM17 billion on petrol and gas subsidies, the government might raise that much instead (I’ve no idea what the level of gas subsidies are, and too lazy to check). That kind of fiscal swing could cover three quarters of next year’s deficit – though probably at the cost of PR taking power.

Nevertheless it’s still the right thing to do. The damage to the environment is real. The threat to our biodiversity is real. The cost to our health is real. The loss of man-hours sitting in traffic jams is very, very real. If the one time costs are too much, we can phase out the subsidies slowly and tack on the tax as part of the program at the end. But sooner or later, shock therapy or slow evolution, this is a road we should travel.


  1. Yes, but if people spend that much on petrol taxes, they will have less to spend elsewhere. Wouldn't that be a negative effect on economic output? You would then have to shave off several percentage points on GDP and you'd be worse off, no?

  2. Rodger, yes they would individually, at first. But collectively they wouldn't - less healthcare costs, less congestion, less lost productivity, less environmental damage.

    That's the point of a Pigovian tax - you tax to the point that the social costs equals social benefit. As it is now, social costs are high and borne by everybody, but social benefits are lower and accrue only to users. There's two cars for every adult in this country - that's not a healthy situation. Who benefits the most from petrol subsidies? Clue: it's not the poor and low income groups.

    Since petrol use is inelastic in the short run, yes there would be a loss in measured GDP over the short term. But I would expect a higher growth path once people adjust.

  3. If you use Petronas, they post notices highlighting market price of fuel per litre and the amount subsidised. If I recall correctly, the indicated market price is in the RM3.80 range for RON95.

    A 25% petrol tax at market price would bring the price to RM4.75 assuming the price of oil doesn't keep increasing.

  4. tasstaafl,

    The market price was RM2.75 for RON95 a couple of weeks back, though with the recent gyrations in the oil price I suspect that's probably a few sen off.

  5. Hisham,

    Just visited a Petronas station. Apparently, the listed market price for October 2011 of RM3.33 (I think) on their notices includes an component called "tax forgone" amounting to about RM0.58 or thereabouts.

    Just FYI.

  6. Sales and service tax, plus excise duty. Yes, I'd forgotten that part. That means the free-market price would be RM2.75 or thereabouts.