Daniel l. Rubinfeld

14 Part 2 Producers, Consumers, and Competitive Markets
4 Individual and Market Demand 1 5
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part to conserve energy and in part to raise revenues, the U.s. goverru11ent
has often considered increasing the federal gasoline tax, In 1993, for example,
a modest 7 1/2-cent increase was enacted as part of a larger budget-reform
package. This increase was much less than the increase that would have been
necessary to put U.s. gasoline prices on a par with those in Europe. Because an
important goal of higher gasoline taxes is to discourage gasoline consumption,
the gm'emment has also considered ways of passing the resulting income back
to consumers. One popular suggestion is a rebate program in 'which tax revenues
would be returned to households on an equal per capita basis. \Vhat
would be the effect of such a program
Let's begin by focusing on the effect of the program onr a period of five
years. The relevant price elasticity of demand is about -05. 1 Suppose that a
low-income consumer uses about 1200 gallons of gasoline per year, that gasoline
costs 51 per gallon, and that our consumer's armual income is 59000.
Figure 4.9 shows the effect of the gasoline tax. (The graph has intentionally
been drawn not to scale so that the effects we are discussing can be seen more
clearly.) The original budget line is AB, and the consumer maximizes utility (on
indifference ClU've UJ by cons LUning the market basket at C, buying 1200 gallons
of gasoline and spending 57800 on other goods. If the tax is 50 cents per gallon,
price will increase by 50 percent, shifting the ne\,,' budget line to AD.2 (Recall
that when price changes and income stays fixed, the budget line rotates around
a pivotal point on the unchanged axis.) With a price elasticity of -0.5, consumption
will decline 25 percent, from 1200 to 900 gallons, as shown by the
utility-maximizing point E on indifference curve U 1
(for every I-percent
increase in the price of gasoline, quantity demanded drops by 1/2 percent),
The rebate program, however, partially counters this effect. Suppose
that because the tax revenue per person is about 5450 (900 gallons times
50 cents per gallon), each consumer receives a 5450 rebate. Hmy does this
increased income affect gasoline consumption The effect can be shown
graphically by shifting the budget line upward by 5450, to line FI, which
is parallel to AD. How much gasoline does our consumer buy now In
Chapter 2, we sa,v that the income elasticity of demand for gasoline is approximately
0.3. Because 5450 represents a 5-percent increase in income
(5450/59000 = 0.05), we would expect the rebate to increase consumption by
L5 percent (0.3 times 5 percent) of 900 gallons, or 135 gallons. The new utilitymaximizing
consumption choice at H reflects this expectation. (We omitted the
indifference curve that is tangent at H to simplify the diagram.) Despite the
rebate program, the tax 'would reduce gasoline consumption by 286.5 gallons,
from 1200 to 9135. Because the income elasticity of demand for gasoline is relatively
low, the income effect of the rebate program is dOlninated by the substitution
effect, and the program with a rebate does indeed reduce consumption.
In order to put a real tax-rebate program into effect, a variety of practical
problems would need to be resolved. First, incoming tax receipts and rebate
1 We sa\\' in Chapter 2 that the price elasticity of demand for gasoline \'aried substantially from the
short run to the long run, ranging from -011 in the short run to -117 in the long run,
e . To simplify the example, we ha\'e assumed that the entire tax is paid by consumers in the form of a
higher price .. A broader analysis of tax shifting is presented in Chapter 9
Expenditures
on Other
Goods (5)
After
Gasoline
Tax
After Gasoline Tax
Plus Rebate
U
1 / Original Budget
~ Line
B
Gasoline Consumption (gallons per year)
A aasoline tax is imposed when the consumer is initially buying 1200 gallons of
ga~oline at point C. After the tax takes effect, the budge~ line s~ts from A~ to AD
and the consumer maximizes his preferences by choosmg E, WIth a gasolme consumption
of 900 gallons. However, when the proceeds of the tax are rebated .to the
consumer, his consumption increases somewhat, to 913.5 gallons at H. D~spite the
rebate program, the consumer's gasoline consumption has fallen, as has his level of
satisfaction,
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expendihlres "vould vary from year to yeaI~ making it difficult to plan the budgeting
process, For example, the tax rebate of 5450 in the first year of the program
is an increase in income. During the second year, it would lead to some
increase in gasoline consumption among the low-income consumers that we
are studvina, With increased consumption, however, the tax paid and the
rebate re~ei\~d bv this individual will increase in the second year, As a result, it
mav be difficult t~ predict the size of the program budget.
Figure 4.9 reveals that the gasoline tax program makes this particular lowincome
consumer sliahtly worse off because H lies just below indifference
b •
cun'e U" Of course, some low-income consumers might actually benefit from
the program (if, for example, they consume less gasoline on average than the
group of consumers whose consumption determines the selected rebate).
Ne\'ertheless, the substihltion effect caused by the tax will make consumers, on
a\'erage, worse off.
Why, then, introduce such a program Those who support gasoline taxes
argue that they promote national security (by reducing dependence on ~oreign
oil) and encourage conservation, thus helping to slow global warmmg by
reducing the buildup of carbon dioxide in the atmosphere. We will further
examine the impact of a gasoline tax in Chapter 9.
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