Why A Gas Tax Holiday Probably Won’t Work

I believe many of our political leaders have a comic book view of how gasoline prices are set. They envision oil companies adding up all of their input costs, and then tacking on a profit margin. Oddly, sometimes the oil companies are really generous and sell gasoline for under $2.00 a gallon. Other times, the belief must be that they are super greedy and sell it for $6.00 a gallon.

Adding to all of the input costs and profit margins are the taxes. State and federal governments get a cut of each gallon of gasoline sold. Since 1993, the federal portion of the gasoline tax has been 18 cents a gallon. Add on the costs, profit margin, and taxes, and you end up with the price of gasoline. Or, so the belief goes.

Some politicians have floated the idea of a gas tax holiday to help ease prices at the pump. President Biden is reportedly weighing this idea now.

One of the problems in such a scheme is that these taxes help fund the country’s transportation infrastructure, like highways and bridges. If that money stops coming in, that will mean either a cut to those programs, more deficit spending, or the revenue will have to be made up elsewhere.

But there is a more fundamental problem. Gasoline isn’t actually priced according to the notion floated above. In fact, gasoline is a commodity that is priced in the market. Instead of adding up the inputs, including a profit margin, and then adding in the gas taxes, the profit margin floats up and down with the price, which is based on supply and demand. That’s a fundamentally different model, which also explains why oil company profit margins are so volatile.

What would happen under such a model if gas taxes were cut? If you assume that gasoline is priced based on supply and demand, cutting gas taxes does nothing to address supply, and potentially increases demand. Thus, you could easily see gasoline prices quickly rebound back to where they are now following a gas tax cut. It’s just that the 18 cents that is currently captured by the federal government would just move elsewhere in the supply chain. It would improve the profits of the retailer, refiner, and oil producer to varying extents.

Don’t get me wrong. I love lower taxes. It is just that in this case, a commodity like gasoline that operates on supply and demand isn’t going to respond as expected to a gasoline tax cut.

Consider that on June 1st, the state of New York suspended its motor fuel tax of 8 cents a gallon, as well as its 4 percent sales tax up to $2 a gallon. According to data from AAA, on June 1st the average retail price of gasoline in New York was $4.93 a gallon. Two weeks after the roughly 16 cent per gallon tax holiday went into effect, the average price in New York was $5.04 a gallon. (Of course, the underlying price of oil has a big impact on gasoline prices, but the point is consumers there haven’t seen a drop in gasoline prices despite the significant tax cut).

If cutting gas taxes won’t work, then what might work? Another idea floated has been rebate cards. That might work, as long as the rebate cards aren’t specific to gasoline. If they are, it’s the same dynamic as with the gas tax cut. It doesn’t address supply, but may increase demand.

If, instead of a gas rebate card, consumers simply received a rebate card they could spend anywhere, then that might have the intended effect. In this case, there is still an incentive to consume less (and produce more), because gasoline prices remain high. But then money would be available for consumers to make up for the loss of discretionary income that is now going to pay for gasoline.

However, there are two potential problems with that scheme. Some might see this as subsidizing oil company profits. That’s where the bulk of the spike in oil prices has gone — to increased profits up and down the oil supply chain. (As I have made clear in the past, that’s because oil prices are high, and not because oil companies suddenly decided to make more money). Some politicians have advocated for windfall profits taxes on the oil companies to pay for such a scheme, but that will be a difficult sell politically.

The other problem is that this would be akin to a stimulus payment, which we have seen multiple times over the past few years. Although these stimulus payments aren’t the primary driver of inflation right now, they certainly contribute. When people have more money to spend, they spend it. That helps drive inflation higher.

The bottom line is there aren’t any easy financial gimmicks for reducing prices at the pump. The release of oil from the Strategic Petroleum Reserve is likely to help. Consumers cutting back in the face of high prices will help. And growing production from U.S. producers will help.

All of these factors will likely help ease gasoline prices as we head into the fall and winter. But don’t hold out hopes for a quick fix with a gas tax holiday. It is not likely to work as anticipated.