Wednesday, March 13, 2013

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.


  1. Hisham, totally agree. In fact, I would go further to suggest that road tax should be pegged to emission. This will result in a single-standard tax structure, and encourage low-emission vehicle such as higher performance diesel, hybrid and other EEVs.

  2. Fully agreed, in fact the government should impose a carbon tax on all emission so that all of us will act accordingly to save energy. The money so raised can be used to reduce other form of taxes.

    Zuo De

  3. I think we can agree that the bit in the manifesto about increasing fuel subsidies is purely a vote buying exercise. However...

    Given that Pakatan have demonstrated in the shadow budget that they can afford this (based on efficiencies achieved in the states they gained and reformed in the last election), if we agree that fuel subsidies are not the best use of this money, what is a better use? Let's just give them this assumption and explore the possibilities. So say we have X billions of dollars free. Returning the cash to the people via tax cuts might be a bit regressive (as the bottom, I don't know, I hear, 25% don't pay tax?) so as a form of direct wealth transfers that isn't too regressive, we're left with subsidizing goods or providing services. In that light, increasing fuel subsidies doesn't seem like a particularly bad idea since it suppresses inflation and stabilizes prices, I'm not sure if it's, say, arguably that much worse than pumping more money into state education or state housing projects. Or you could go the BR1M route I guess. Actually, I'm pretty sure the BR1M route is worse, in Australia, direct cash handouts were studied and found a lot of it was spent on gambling. (we do have a problem with this in the lower socioeconomic group + retiree segment)

    Also... I don't think it's possible for Proton or Perodua to survive without the import duty protection, unless they merge with a larger company, or receieve heavy government subsidies. The economies of scale just aren't there for them, not when you are competing against companies like Toyota who can spread the 1 billion development cost of a new euro5 engine across 3 million units sold per year, or something. I'm not sure what Pakatan's plan for them is: maybe liquidation and sale of assets to another car maker.

    So just asking your opinion - if you were in the driver's seat, what would you do if the budget had a billion dollar surplus, and if you were serious about cutting import duties, what's your plan for Proton and Perodua?

    1. aetherfox,

      "Given that Pakatan have demonstrated in the shadow budget that they can afford this..."

      This point is, to put it mildly, rather debatable. Much of the cost "savings" in the Shadow Budget came from rather severe underestimation of non-discretionary spending such as salaries and pensions as well as unrealistic projections of subsidies, especially since PR is planning to increase, not decrease, subsidy outlay. Restructuring IPP contracts for instance, has no fiscal implications since gas subsidies are paid for by Petronas and TNB, not by the government.

      The biggest item of discretionary spending is in procurement, and while I do think there are potential efficiency gains here, I don't think savings will amount to any more than RM10b or so, and that's being wildly optimistic.

      They've also severely underestimated potential revenue collection i.e. there's problems on both sides of the cash flow statement.

      But on the hypothetical question:

      1. Tax cuts are highly regressive, because in Malaysia only the top 20% of income earners actually pay tax.

      2. The argument I've laid out in the blog post above is primarily non-fiscal i.e. I'm not looking at the fiscal impact at all. Whether you have the money or not in this sense is really irrelevant, as the environmental and economic argument against fuel subsidies (and for fuel taxes) is still compellingly strong. This would be true whether we had a budget surplus or a deficit, or money fell from the sky.

      3. The unspoken assumption you're using is that there is a fixed amount of money that has to be used. Why not just pay down outstanding debt? If a cost benefit analysis establishes that the returns on competing uses for those funds are less optimal than just returning the cash, then return the cash. Always bearing in mind the output gap, however.

      4. Proton and Perodua will have to sink or swim on their own. Just as there is no good economic argument for fuel subsidies, there is no good economic argument for company-level preferential tax treatment.

      The literature on industrial policy suggests picking "winning" industries is possible, but not picking "winning" companies. The best industrial promotion policies encourage development (aka protection) of particular industries, but maintain competitive pressures within those industries.

      In that sense, an excise duty structure that differentiated between local/local content manufacturers against CBU imports is economically defensible, but not one where there is duty differentiation between local and locally assembled makes. Equalising excise duty between CKD and local makes would thus be one potential transition regime.

  4. day by day, my understand of economic issues is getting better with your blog and certainly in this case i fully agree with your underlying principles for the measures so proposed.

    Zuo De

    1. Zuo De,

      I'm happy my ramblings have been of use to somebody!

  5. Yes, also, thanks for your wisdom =)

  6. Yes, fully agree on the stated policies. But unfortunately, there are forces that are both for & against decreasing the tax on cars as well as increasing the subsidies on fuel.

    What I think is the most important thing though, is to educate the public about the economic theory of taxes & subsidies. All I hear from the layman uncle is the constant complaining on rising fuel prices; and if the public repeatedly condemn anyone who takes away the fuel subsidies, how would there be a political will to move towards a purely competitive market?

    What I don't hear is that: "Hey, fuel prices and prices of basic necessities are all distorted, we should leave the market alone..."

    All too often, Economic policies are never an easy decision, and we only see the personal costs that affect our lives and disregard the costs to the public. What we need is actually a leader who is brave enough to endure public criticism yet has a vision far enough to boost Malaysia's Economy.

    Right now, I don't see any such leader present in any of the contending parties.

  7. The biggest problem of taxing petrol is it will increase the cost of transporting goods. The subsidies currently is also enjoyed by haulage company which as of now already squeezed to make any profit.

    The increase in cost will lead to increase in price of all consumer items which ultimately cause inflation.

    Following your policy then transport company will ultimately pay the highest amount of 'consumption' tax.

    My idea is to implement GST and transport companies can get reimbursement on tax paid, then we can differentiate between industry.

    For the lower income group BR1M can continue, or better to change it to food/goods coupons to prevent abuse.

    1. Amir,

      There are costs and benefits to any change in tax policy. The principle here however is that there are costs being borne by the whole of society that should ideally be borne by those who impose them. We have a net welfare loss to society that needs to be handled.

      Second, while costs will certainly increase, this should be a one time only affair, not an increase in the rate of inflation. This is borne out by previous research into similar policy moves.

      Third, I agree that we need a transitional phase, and that offsets to critical industries and the poor are alternative strategies (definitely in the case of the latter).

      However, I'm not inclined to agree with food or petrol coupons because that actually would penalise the poor. Direct cash transfers would be better welfare enhancing, or if coupons are given, those coupons should be transferable.

  8. If I'm not mistaken, there is no different in the tax structures between national cars and local CKDs or Asean CKDs. All of them are similarly taxed. But the tax structure is different with CBU cars where there is a 30% import duty on CBU cars. The import duty will be reduced to 0% by 2015? or 2016?

    I think, it is wrong to compare car prices or any prices with USA. This is due to their market size and competition, the manufactures in US (for any products) are forced to take minimal profit margin. They are targeting volumes.

    Honda Civic in US priced at US18K (RM55K) but if you look at Honda UK or Honda Australia, their prices are about the same with Honda in Langkawi. In UK Honda civic is priced between GBP18K - GBP27K (RM84K - RM125K) and in Australia, Honda Civic is priced between AUD22K - AUD34K (RM70K - RM108K)

    1. CheWal,

      Thanks for the info (and I like your blog post).

      For Australia and the UK, please note that both countries have GST/VAT (AU:10%, UK:20%), while the UK also has an additional tax levied at purchase calculated based on car emissions. So I think the comparison is still valid.

    2. Thanks HishamH and thanks for visiting my blog. I'm truly honored. Your blog will always be my reference for economic matters.

      yeah, you are right about the VAT in UK and GST in Australia. Without these taxes, the price different from US will be around RM 15K to RM20K and it will be even closer to Langkawi's price (Australia will be a bit cheaper than langkawi). Normally I would like to keep US price aside not only for cars but for other product as well.

    3. i think for CKD we still have extra 10% tax in form of sales tax. but still from the info that i get from industry players, the price for cars like Honda and Toyota has been marked up quite significantly by the companies like UMW Toyota. it happens because of the brand sentiment and most Malaysians are gullible enough to just buy it without question.

  9. The logic behind this concept is simple that when you buy a car at cheap price, you save a large amount of money at once.
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