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«Chapter Title: The Taxation of Fuel Economy Chapter Authors: James M. Sallee Chapter URL: Chapter pages in book: ...»

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This PDF is a selection from a published volume from the National

Bureau of Economic Research

Volume Title: Tax Policy and the Economy, Volume 25

Volume Author/Editor: Jeffrey Brown, editor

Volume Publisher: University of Chicago Press

Volume ISBN: 0-226-07659-8

Volume URL: http://www.nber.org/books/brow10-1

Conference Date: September 23, 2010

Publication Date: September 2011

Chapter Title: The Taxation of Fuel Economy

Chapter Authors: James M. Sallee

Chapter URL: http://www.nber.org/chapters/c12220 Chapter pages in book: (p. 1 - 37) 1 The Taxation of Fuel Economy James M. Sallee, University of Chicago and NBER Executive Summary Policy makers have instituted a variety of fuel economy tax policies—polices that tax or subsidize new vehicle purchases on the basis of fuel economy performance—in the hopes of improving fleet fuel economy and reducing gaso- line consumption. This article reviews existing policies and concludes that while they do work to improve vehicle fuel economy, the same goals could be achieved at a lower cost to society if policy makers instead directly taxed fuel.

Fuel economy taxation, as it is currently practiced, invites several forms of gam- ing that could be eliminated by policy changes. Thus, even if policy makers prefer fuel economy taxation over fuel taxes for reasons other than efficiency, there are still potential efficiency gains from reform.

I. Why Do We Tax Fuel Economy?

In recent decades, the U.S. government has introduced several “fuel economy taxes”—that is, taxes or subsidies on the purchase of new con- sumer automobiles that depend on the vehicle’s fuel economy perfor- mance. These policies vary in detail. Some provide subsidies to vehicles that utilize a specific technology (e.g., hybrids), while others apply to all vehicles of a given fuel economy. Some levy taxes directly on auto- makers, while others operate through the personal income tax system.

All attempt to provide automakers and consumers with an incentive to choose more fuel economical vehicles so as to reduce the consumption of gasoline. The purpose of this paper is to review the motivation and struc- ture of these policies, describe their intended and unintended conse- quences, and distill lessons that may inform future policy.

The principal economic motivation for the taxation of fuel economy is to correct for externalities associated with fuel consumption. Fuel economy itself does not create externalities, but it indirectly determines B 2011 by National Bureau of Economic Research. All rights reserved.

978-0-226-07657-7/2011/2011-0003$10.00 This content downloaded from on Thu, 2 Jan 2014 11:29:37 AM All use subject to JSTOR Terms and Conditions 2 Sallee the consumption of gasoline, which affects local air quality, energy secu- rity, and global climate change.The goal of fuel economy taxation is to cause consumers to internalize these externalities by raising the price of fuel inefficiency.

Policies to reduce energy consumption in the personal transportation sector are an essential part of energy policy—the sector accounts for 20% of U.S. greenhouse gas emissions and 40% of petroleum consumption (Environmental Protection Agency 2007). Globally, personal vehicles will play an expanding role in coming decades because there is a strong relationship between wealth and vehicle ownership. The extreme is the United States, which had 248 million registered motor vehicles in 2008— equivalent to 1.2 vehicles per driver (U.S. Department of Transportation 2009). This contrasts sharply with ownership in lower-income countries.

In 2007, for every 1,000 residents, the United States had 820 registered vehicles, whereas China had 32 (World Bank 2010). As countries like China grow, vehicle ownership will rise rapidly, and policies aimed at mitigating related externalities will become even more important than they are today. What role should fuel economy taxes play in limiting the consequences of growing vehicle ownership? What lessons from the U.S. experience can inform future policy, both here and abroad?

Several lessons emerge from an analysis of the U.S. experience in fuel economy taxation. First, fuel economy taxation does have an impact on fleet fuel economy. Research on existing policies shows that taxing inefficient cars and subsidizing efficient ones does influence the market share of targeted vehicles.

The second lesson, however, is that fuel economy taxation is a less efficient policy for reducing gasoline consumption than would be direct taxation of gasoline. Fuel economy taxation shares the weaknesses of fuel economy regulation in that it induces a “rebound effect” by lowering the cost of driving, which erodes gasoline savings and increases congestion and accident externalities. In addition, fuel economy taxation and regulation both influence only new vehicles, rely on imprecise fuel economy rating systems, and maintain a distinction between passenger cars and light trucks, all of which are disadvantages relative to direct gasoline taxation. Auxiliary justifications sometimes used to make the case for fuel economy taxation—like consumer fallibility, technological spillovers, or network effects—currently lack strong empirical evidence.

The third lesson is that fuel economy taxation can be reformed to reduce inefficiencies related to policy gaming, by which consumers and This content downloaded from on Thu, 2 Jan 2014 11:29:37 AM All use subject to JSTOR Terms and Conditions The Taxation of Fuel Economy 3 producers improve the tax treatment of vehicles in ways that have little or no impact on actual fuel consumption. Gaming takes the form of shortrun timing changes—where transactions are accelerated or delayed in order to take advantage of temporary tax treatments, medium-run vehicle design—where automakers tweak vehicles to achieve large tax improvements for small fuel economy changes, and long-run relabeling of passenger cars as light trucks—where automakers can improve tax treatment by designing vehicles to achieve more generous regulatory classification. Policy makers could limit gaming on all three of these margins through straightforward policy reform.

The balance of the paper is as follows. Section II briefly describes an efficient policy for gasoline-related externalities, a Pigouvian tax.

Section III describes the various fuel economy tax policies that have been used in the United States, with some attention to related policies in Canada. Section IV then reviews econometric evidence on the effects of these policies on vehicle sales and prices. Section V lays out arguments regarding the inefficiency of fuel economy taxation relative to direct gasoline taxation. Section VI reviews the evidence on gaming in transaction timing, vehicle tweaking, and vehicle reclassification.

Section VII describes the difficulty of designing fuel economy taxation that puts a consistent price on the conservation of gasoline and the consequences for efficiency. Section VIII considers alternative rationales for fuel economy taxation. Section IX draws lessons for policy and concludes.

II. The Pigouvian Solution to Gasoline Externalities

Before analyzing the actual practice of fuel economy taxation, it is helpful to establish the ideal solution to the problem that fuel economy taxation is intended to solve. The canonical theory of taxation to correct for externalities dates back to Pigou (1932), who showed that the first-best allocation of resources in an economy could be provided by a free market given a tax on the externality-generating good equivalent to the marginal external damages at the optimal quantity.

To illustrate, consider the case of manufacturers who leach toxic dyes into waterways as part of their production process. In the absence of policy, all firms will leach dyes if it lowers their production costs. The Pigouvian policy is to directly tax the externality—toxic dye. Facing a dye tax, all firms who can modify their production process to eliminate dye contamination at a cost below the tax will do so. Firms for whom

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eliminating dye contamination is more expensive than the tax will continue polluting and pay the tax (or go out of business).

If the tax is set equal to the marginal damage to society of dye contamination, then this arrangement will be efficient—manufacturers will stop polluting if and only if doing so is less costly to society than continuing to pollute. Critical to this efficiency is that every individual agent faces the same price for the externality.

Gasoline consumption, the target of fuel economy taxation, is slightly more complicated because it generates three distinct externalities. First, greater demand for gasoline may threaten energy security, which can have political consequences and increase economic volatility. Second, gasoline consumption releases carbon dioxide into the atmosphere, which contributes to climate change. Third, gasoline consumption releases local air pollutants that have environmental and health implications.

In the first two cases, a Pigouvian solution is a direct tax on gasoline, because the externality is directly proportional to the gallons of gasoline consumed, regardless of who consumes it or how they do so. In the case of local air pollution, however, different vehicles emit different levels of emissions depending on engine technology and driving conditions.

Thus, the Pigouvian solution to local air externalities is a tax on emissions, but this is impractical given current technologies. While a gasoline tax is therefore not fully efficient, Fullerton and West (2000) estimate that a gasoline tax achieves about two-thirds of the benefits of the optimal tax on emissions, which represents the lion’s share of the benefits achievable under the best feasible policy. As a result, the gasoline tax will be used here as the efficient benchmark for all gasoline externalities.

In spite of these efficiency arguments for fuel taxation, gasoline taxes are low in the United States. This is usually explained as a result of political constraints—raising the gasoline tax is politically unpopular and therefore infeasible. Instead, the United States relies on other policies for reducing gasoline consumption, including fuel economy regulation and fuel economy taxation. To mimic the efficiency of a gasoline tax, fuel economy policy would need to place a uniform price on the consumption of gasoline that applied across all vehicles, automakers, consumers, and time periods. Unfortunately, as argued below, fuel economy taxation cannot, in theory, achieve this parity, and it has not, in practice, been as efficient as might be possible. After reviewing the structure of fuel economy tax policies and the estimates of their impacts, the second half of the paper returns to the issue of efficiency relative to this Pigouvian benchmark to assess the merits of fuel economy taxation.

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III. How Do We Tax Fuel Economy?

This section reviews the main fuel economy tax policies in the United States and Canada, highlighting features that are relevant for further analysis.

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Fuel economy taxation started in the United States with the Gas Guzzler Tax, which levies an excise tax on passenger cars that have fuel economy below a certain level. The tax, which took effect in 1980, was introduced at the same time as Corporate Average Fuel Economy (CAFE) standards and the official fuel economy rating program that was necessary to administer these programs.

The tax phased in between 1980 and 1991, and it has not changed since.

But, because it is not adjusted for inflation, the real value of the tax has gradually fallen over time. The minimum tax is $1,000 on passenger cars that get below 22.5 miles per gallon (mpg), and any vehicle getting above that fuel economy is free of taxation. The maximum tax is $7,700 for any vehicle with a combined fuel economy rating below 12.5 mpg. The tax schedule is a step function, as shown in figure 1. Manufacturers remit the tax, and the tax is included as a line item in the sticker price visible to consumers.

Fig. 1. The U.S. Gas Guzzler Tax and Canadian Feebate in 2008. Source: Sallee and Slemrod (2010). Figure includes nominal values. The exchange rate was close to 1 for much of 2008.

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Importantly, the tax applies only to passenger cars, not to light trucks.

In practice, this means that the tax is levied on vehicles that are very expensive and generally low volume. Table 1 shows that, in 2006, 6.2% of vehicle configurations that are separately rated by the Environmental Protection Agency (EPA) were subject to a tax but that these vehicles held only a 0.7% market share. As a result, the tax raises a modest amount of revenue, around $200 million in recent years. The taxed models are overwhelmingly made by foreign manufacturers.

B. Income Tax Benefits for Clean Vehicles

Other fuel economy taxes operate through the personal income tax code.

From 2000 to 2005, consumers who purchased a qualified clean fuel vehicle were able to take a $2,000 above-the-line tax deduction under the Clean Fuel Vehicle Tax Deduction. In principle, a qualifying clean fuel vehicle was one that used any of several alternative fuels, including compressed natural gas, liquified natural gas, liquified petroleum gas, hydrogen, or electricity. In practice, the only vehicles that qualified were gas-electric hybrid vehicles, like the Toyota Prius.

This credit was replaced in 2006 by the Hybrid Vehicle Tax Credit, which afforded new car buyers a credit, worth up to $3,400 depending on a vehicle’s fuel savings. The subsidy was the sum of two components, a fuel economy credit and a conservation credit. The fuel economy credit provided up to $2,400 in $400 increments for a hybrid based on the percentage increase in its city fuel economy rating relative to the average city fuel economy for vehicles in the same inertia weight class, the categorization used for emissions testing. The conservation credit provided

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