Inflation, Gas Taxes, and Ukraine

A number of states and the federal government are, or are considering, lowering gasoline taxes to offset the impact of inflation on consumers. Assuming that the gas taxes made sense in the first place, and that this is intended to be temporary, this is bad public policy.

What Causes Inflation?

Supply chain problems, surging demand as the global economy recovers from Covid and the impact of the war in Ukraine are all causes of relative price increases. As some commodities become harder to obtain, the price of the affected goods can be expected to rise relative to the price of other goods. These things are not in themselves the root causes of inflation. Absent accommodating monetary policies from central banks, like the Federal Reserve Bank (Fed) in the U.S., these price shocks would be accompanied by declines in the prices of other goods or an overall reduction in economic activity, rather than inflation.

Doesn’t Lowering Gas Taxes Reduce the Pain of Inflation?

Ok, you say, lowering gas taxes may not address the root causes of inflation, but doesn’t it reduce the pain to consumers?

Lower gas taxes can be thought of in two ways.

One, absent an increase in other forms of taxation, it is an economic stimulus payment, the exact opposite of what is needed in a period of escalating inflation.

Two, it is a relative price subsidy. If you subsidize the consumption of a commodity you get greater demand for it. One of the problems in persuading European countries to boycott Russian oil and gas exports is that the global demand and supply of oil and gas are highly inelastic, in the short run. That means that the quantity of oil and gas demanded and supplied does not change very quickly in response to price changes. As a result, even small changes in supply (or demand) result in very large changes in price, in the short run. By lowering gas taxes, the United States is subsidizing the purchase of oil and making the global demand for oil even more inelastic than it would otherwise be. That will mean that the pain of boycotting Russian oil and gas will be even higher in Europe than it would otherwise be.

Impact on OPEC Incentives.

A variable tax on oil imports was considered, in the 1970’s, but was rejected because, by reducing the elasticity of demand, a variable tax actually increases the incentive for OPEC to reduce supplies to drive up oil prices.

So What Should We Do?

What we should be doing, to lower inflation, is what we should have been doing for months. The Fed needs to end its open market purchases of bonds and begin raising interest rates. How far should this go? At least far enough that short and long-term interest rates meaningfully exceed the expected rate of inflation.