Friday, May 9, 2008

hillary's gas problem: part 1

A week or so ago I came into a class where my students were engaged in a vigorous, but civil debate. No big surprise there, except the debate was about economics! Specifically, they were arguing about temporarily eliminating the excise tax on gasoline. Originally proposed by John McCain and then supported by Hillary Clinton (who got the most publicity out it), but opposed by Barack Obama, the tax cut became a political issue.

Finally they asked me whether or not it was a good idea. When I asked them what they thought this tax repeal was supposed to accomplish, they answered lower gasoline prices.

This was perfect. We had covered who bears the burden of a tax like this earlier in the semester. In fact, a few days before I had handed back a test with a question on this. Also the final exam was approaching where this would be covered. So I said to them, “You tell me. Come on, we just did this.” I put up on the board a simple supply and demand graph and we quickly reviewed “tax incidence.” [NOTE: I’ll have a more non-economics-major-friendly explanation in my next post, so don’t give up.] Most students knew placing a tax on producers would shift back the supply curve (visually move it vertically up by the amount of the tax), remembering how much of the tax was passed on to consumers depended on the relative responsiveness (what economists call elasticity) of supply and demand to price. I showed the familiar case where the demand responsiveness to price was equal to the supply responsiveness, implying tax incidence would be equal. That is, an 18-cent tax would cause consumer prices to increase by 9 cents. (This is very easy to show on a S&D graph.)

Of course they caught on that a tax cut would be the same thing only in reverse. We quickly agreed that both supply and demand were pretty unresponsive to price. However, the answer relies on their price responsiveness relative to each other. The important question becomes which is most unresponsive. Since U.S. refineries are operating at capacity and can’t produce much more, if any, we thought it would be quite likely that supply would be most unresponsive. We drew the graph, with the supply curve being steeper than the demand curve.

The answer became obvious. Less than half of the 18-cent excise tax reduction would be passed on to consumers in the form of a lower price.

When I came into class, they had been arguing about the pros and cons of whether an 18-cent reduction in the price of gasoline was worth the loss of tax revenue. This impact, as reported in the press, was relatively minor for an individual consumer. With a little economic analysis, they saw that the benefit to consumers would be only a fraction of the minor amount reported.

They also saw that the main beneficiaries of eliminating the gasoline tax would be the oil companies.

This is an example of why I love economics. Everyone “knows” how a tax cut will lower prices. Then you use a little economics to show the counterintuitive reality of the situation. The comfortable, pat answers are overturned. Intellectually, it pulls the rug out from under you. It messes with your mind. That can be fun. It is certainly fun to see students discover this as well.

Be blessed!

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