Petrol taxes and inflation

At Kiwiblog there is mention of Don Brash stating that we should think about allowing the Reserve Bank to increase and reduce the petrol tax. This is something that the Reserve Bank has actually suggested itself (at the same time they suggested a floating GST rate).

As far as I can tell they want to do it as during a boom asset prices drive consumption, so if you tax petrol you introduce a negative income effect which lowers consumption – opposite for a recession. This works because demand for petrol is inelastic (as there are few substitutes for driving your car), and as a result the amount a person spends on fuel will increase with the price – leaving them less to spend on other stuff. This will reduce demand-pull inflation, and allows the RBNZ to keep a fund of money that they can inject into the economy when a recession is threatening. A benefit is the fact that the administration costs of the tax are low, as the institutions are already in place.

Problems are:

1. Efficiency in the goods market, if the relative price was socially efficient (say that the neutral rate involved the efficient Pigovian tax), increasing it is not.

2. Petrol is an input to production, as a result increasing the price will create cost/push inflation

3. As poor people spend a greater proportion of their income of petrol, an increase in petrol taxes will be regressive during a boom. Furthermore, low income labour are only paid their reservation wage, if an increase in petrol taxes increases their reservation wage it will lead to further cost/push inflation.

4. In legislative terms, allowing the RBNZ to adjust a tax is dodgy (no tax without representation).

So what does everyone else think?

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  • Menu costs? I have no idea how much it costs to change gas taxes or the GST by a cent, but I bet it’s greater than epsilon.

  • Hi Andrew,

    Old menu costs. I am sure that they are there, but in relation to other potential instruments the menu cost on fuel prices will be small. This belief comes from the fact that petrol price seem to adjust to, well, just about anything – in the case where prices aren’t sticky its likely that menu costs are trivial.

  • Hi Matt,

    I doubt the current tax is efficient anyway, so that doesn’t bother me too much. Having a regressive tax DOES bother me though. Ordinarily I’d say that the revenue could be redistributed to offset the regressive impact, but then the RBNZ is taking on a role that should really be reserved for the government. Ultimately, it might be a normative judgment over what the role of the RBNZ should be, rather than whether it would be an effective policy instrument.

  • “Having a regressive tax DOES bother me though. Ordinarily I’d say that the revenue could be redistributed to offset the regressive impact, but then the RBNZ is taking on a role that should really be reserved for the government”

    The tax is regressive during a boom, and progressive during a recession. If we assume that the poorest benefit most during a boom and suffer most during a recession (given their liquidity constraints – and thereby their inability to smooth consumption) then this tax could be rather ‘fair’.

    Furthermore, redistributing the income is a bit pointless – as our goal is to remove inflationary pressure from the economy. If we put the income back in as soon as we take it out we probably aren’t doing much to inflation.

    “Ultimately, it might be a normative judgment over what the role of the RBNZ should be, rather than whether it would be an effective policy instrument”

    I would say that any policy decision requires normative elements. However, that should not prevent us exploring whether there are efficiency reasons that might support such a tax. Once we understand whether there is a reasonably objective efficiency argument for such an instrument we can look at the trade-offs in social terms.

  • Weeellllll, ‘fair’ is a value judgment. The prevailing opinion seems to be that a progressive tax scheme is fair (since most Western countries implement one). I’d call a tax scheme that isn’t uniformly progressive unfair by that measure.

    Redistribution doesn’t need to disburse all revenues gathered. It just needs to do enough to prevent poor people from being penalised.

  • “Weeellllll, ‘fair’ is a value judgment.”

    Yes, ergo inverted commas.

    “I’d call a tax scheme that isn’t uniformly progressive unfair by that measure.”

    I think thats an overstatement. If a tax was progressive in 90% of the states of the world and regressive in 10% of states could this not still fit into the ‘western’ view of fairness.

    “Redistribution doesn’t need to disburse all revenues gathered. It just needs to do enough to prevent poor people from being penalised.”

    Poor people have a higher propensity to spend than the wealthy. We know that in order to compensate the poor we would need to give them more income than we initially taxed off them (as we have changed the relative price of products, and at the compensated level the person has to be able to buy more of ‘other goods’ than they could previous – as a result of our convex indifference curves). If this is the case, we are taking income off wealthy people who, during a boom will be saving, and giving it to people who will spend it (note the expenditure on ‘other goods’ rises in our indifference curve analysis when we compensate them) – this sounds pretty inflationary to me.

  • CPW

    The regressiveness is at the margin of course, no realistic level of petrol tax is going to change the fact that the NZ tax system is progressive overall.

    Don’t people argue that regular monetary policy is regressive anyhow since poor people have relatively more debt and less income earning assets? Although Matt’s rebuttal applies to that argument too.

    Not that I support the petrol tax idea.

    Forgive me for trolling, but is that the fact that its the status quo really the best argument for the fairness of a progressive tax? I could make fairness arguments for flat or poll taxes. I think what you mean to say is that most people accept that the rich should pay more for social services, but even a regressive tax (in rates) accomplishes that goal.

    How would you guys reconcile support for progressive taxes with the blog’s general support for things to be taxed/subsidised to reflect their true cost to society? It would seem that the direct result of all progressive tax systems is that social services are underpriced relative to their cost to society. And high value labour is overtaxed relative to its value to society.

  • “Forgive me for trolling”

    You don’t seem to be trolling. Isn’t trolling when you constantly pick up on a single sentence and someones argument and argue against it, even if it doesn’t matter?

    “How would you guys reconcile support for progressive taxes with the blog’s general support for things to be taxed/subsidised to reflect their true cost to society?”

    I think this boils down to the objective vs subjective distinction we try to keep clear. You are completely right that given our relatively objective ‘efficiency’ type arguments a progressive tax system doesn’t make sense. However, maximising social welfare involves a trade-off between efficiency and equity. In order to make this argument we have to state that the equity effect dominates – which is in itself a normative assumption.

    If our belief about the shape of the welfare function is correct (which it is unlikely to be 🙂 ), then we can state that the price charged to labour is in fact ‘efficient’ in a social sense. This requires a belief that people are willing to trade some income in order to help those who are worse off – another normative assumption.

    Ultimately, I believe the best way to analyse this policy is to split the analysis between:

    a) Looking at the effectiveness of the instrument to achieve its policy goals,
    b) Other costs and benefits of the instrument.

    When we look at other policies in this blog we have tended to focus on part a. That is not to say that part b is not important, it is more to say that we don’t have the normative tools with which to approach that section of policy analysis effectively. Of course, just because I can’t do it doesn’t mean its not important, I hope I haven’t given that impression 😉

  • “If a tax was progressive in 90% of the states of the world and regressive in 10% of states could this not still fit into the ‘western’ view of fairness.”

    Possibly. It’s obviously impossible to give any definitive answer since fairness is an ephemeral concept; however, the inability of the poor to consumption smooth suggests that some people may consider regressiveness over 10% of states to still be too much. I wouldn’t want to advance an opinion on the matter.

    “…this sounds pretty inflationary to me.”

    Could be. Surely it depends on the relative marginal propensities to consume of rich and poor people. It also depends on how much disbursement would be required in order to compensate for the taxation to gain ‘fairness’. On the former, you have far more knowledge than me and I’d leave the empirical estimation to a more qualified person, such as you. On the latter, both empirical estimation and value judgments are required and so, again, I wouldn’t know how exactly it would fall. If it is your informed judgment that the tax would prove ineffective, if it were not regressive over some states, then I’m willing to accept that 🙂

  • “Could be. Surely it depends on the relative marginal propensities to consume of rich and poor people.”

    I assumed that the marginal propensity to consume was higher for the poor when I said “Poor people have a higher propensity to spend than the wealthy”. This argument relies on the fact that the poor are liquidity constrained in some manner, and as a result don’t smooth income inter-temporally. I guess its a tenuous assumption 😉

    “It also depends on how much disbursement would be required in order to compensate for the taxation to gain ‘fairness’”

    I thought that you meant to completely compensate the poor, which would of course require more of an injection of $$$ than the initial tax takes off them. Partial compensation does indeed rely on your view of fairness.

    However, if we are giving poor people money to compensate them when petrol taxes are high, are we going to take income off them when petrol taxes are low? Otherwise we are introducing additional progressivity during a recession (as compared to our current tax system).

    “If it is your informed judgment that the tax would prove ineffective, if it were not regressive over some states, then I’m willing to accept that”

    I wouldn’t trust me 🙂

  • “…is that the fact that its the status quo really the best argument for the fairness of a progressive tax? I could make fairness arguments for flat or poll taxes.”

    That’s true, but I wasn’t making an argument for fairness: my claim is that its widespread adoption in representative democracies indicates a preference for it. As you say, the reason for that is likely to be some equity concern that people tend to have.

    “How would you guys reconcile support for progressive taxes with the blog’s general support for things to be taxed/subsidised to reflect their true cost to society?”

    I support Matt here, but I think that the analysis should be the other way around from the way he states it. The problem we face is how to most efficiently provide social services, given that a minimum level must be provided to everyone. There is clear evidence that people want a minimum level provided; no normative judgment is needed to establish that as a reasonable constraint on our efficiency analysis. From that starting point we can look at how best to create institutions that maximise welfare given that constraint. The existence of the constraint inevitably distorts outcomes away from perfect allocative efficiency, but I don’t think we need to obfuscate at all to reconcile support for efficient intervention with progressive taxation.

  • “I assumed that the marginal propensity to consume was higher for the poor when I said “Poor people have a higher propensity to spend than the wealthy”.”

    Yes, I did read what you said. I meant that it would depend on the particular numbers. It seems to me that generalised “this goes up, this goes down” analysis isn’t enough to reach a definitive conclusion on the matter.

    “if we are giving poor people money to compensate them when petrol taxes are high, are we going to take income off them when petrol taxes are low?”

    Well, this goes to specific implementation. I presume that this rebate thingy would be implemented through the current social welfare system. If so then it’s not odd to link the movement in their benefit to the change in taxes is it?

  • “From that starting point we can look at how best to create institutions that maximise welfare given that constraint”

    Something I find interesting to think about is, is this a constraint or a preference. Surely we could come to the same result by including a welfare function where society values progressivity at a certain rate. Doing this we could derive some sort of estimate of the opportunity cost of this progressivity, in order to work out how much society as a whole truly values it.

    I do agree with your revealed preference way of explaining normative judgments. However, I think it is important to try and understand ways in which society and government differ when looking at optimal policy, or else we end up with a ‘supporting the status quo’ bias.

  • I think it would be great if we could incorporate preferences that resulted in models which matched observations. Until our models are sophisticated enough to allow it, I think that using a revealed preferences approach is second-best.

  • CPW

    Don’t disagree with anything you said Matt, but my question is really: why is a progressive income tax the best method for reconciling the efficiency and equity goals?

    Depending on your definitions, I suppose you could call any tax and spending system that achieves redistribution in final allocations “progressive”, but I don’t see it as obvious that a steadily progressive income tax rate necessarily maximizes either objective.

    To answer my own question, I’d be happy with much more user-pays (efficiency), flat marginal income tax rate (or even better consumption tax for consumption/savings neutrality), and redistribution through either general lump sum or targeted cash transfers. Although our existing system is fairly good by global standards, I think the system I’ve described is much sounder from a theoretical point of view. I love the idea of a flat tax rate from a public choice point of view (no more fiscal drag to finance spending!).

    Can I also make the point that economists tend to prefer revealed preferences as opposed to stated preferences, and I’m not certain that these suggest that people are as wild about redistribution as they claim to be. I’m thinking of the relatively low levels of charitable contributions.

  • “It seems to me that generalised “this goes up, this goes down” analysis isn’t enough to reach a definitive conclusion on the matter”

    But I said two things:

    1) The poor get compensated with more than they put in
    2) The rich, who have a lower MPC, pay the difference.

    In this case, we can tell that both factors drive up the demand for ‘other goods’ from the poor than in the case with no compensation. This implies that we have to either increase the petrol tax by more than in the previous case, or accept a higher inflationary outcome.

    Ultimately, our discussion was about redistribution right. This petrol tax will take funds off the poor when they are ‘wealthy’ and give them back to them when they are ‘not wealthy’ in employment terms. If anything, this seems akin to consumption smoothing and should be good for them. If we ‘redistribute’ by giving them money when they are well off and taking it off them when the are doing poorly, we are surely making things worse. Not only that, but this ‘redistribution’ makes our inflation problem worse!

  • CPW

    Ha, i wrote that revealed preferences thing before I read your last comments.

    Still not quite happy with your explanation rauparaha. Saying that representative democracies prefer a certain tax system for redistribution seems analogous to saying that representative democracies prefer extensive trade restrictions to raise welfare. Is it surprising that the median voter in democracies prefers a tax system that sends money their way?

  • “This implies that we have to either increase the petrol tax by more than in the previous case, or accept a higher inflationary outcome.”

    Yes, the rich will pay more than the difference and the government will pocket the rest. Although, on reflection, I think any scheme that didn’t reduce the progression of the current tax schedule would be sufficient; petrol taxes wouldn’t need to be progressive themselves. However, the total change in consumption spending is not obvious from this analysis, is it?

    “If we ‘redistribute’ by giving them money when they are well off and taking it off them when the are doing poorly, we are surely making things worse.”

    Well, that’s only relative to having a petrol tax with no redistribution. We’re talking about ensuring that money is not taken from them relative to their situation without any tax or rebate.

  • “Saying that representative democracies prefer a certain tax system for redistribution seems analogous to saying that representative democracies prefer extensive trade restrictions to raise welfare.”

    Hmmm, I’m not sure that they are analogous. Preferences over levels of redistribution reveal normative judgments. Preferences over trade restrictions reveal misconceptions about how to increase the size of the pie, about which we can make positive statements using economics models. If we know that their intention is to increase total welfare, but they’re choosing a sub-optimal mechanism then we can substitute a better mechanism without disregarding their preferences.

  • “Although, on reflection, I think any scheme that didn’t reduce the progression of the current tax schedule would be sufficient; petrol taxes wouldn’t need to be progressive themselves.”

    But wouldn’t this involve successfully knowing whether there will be a boom or a recession, or tying the benefit directly to petrol taxes. In this case why don’t we just make the benefit adjustable instead of the petrol tax eg. a traveling supplement, like an accomodation supplement.

    “However, the total change in consumption spending is not obvious from this analysis, is it?”

    You are right there, it is not (compared to the non-tax non-redistribute case). However, it would produce significantly more inflationary pressure than the non-redistribute case – I just wanted to make sure that was clear.

    “We’re talking about ensuring that money is not taken from them relative to their situation without any tax or rebate”

    If we have a petrol tax and no rebate then they lose money in a boom and get it back in a recession – as I severely doubt that the petrol tax will be so high that a person has less income during a boom than a recession, this is equivalent to income smoothing. Redistribution moves us away for this.

    Note this assumes that the poor do not save or borrow much – I realise that this is a tenuous assumption at best, however if people do not realise they are at the top or bottom of an economic cycle they may act this was. That is why DSGE models incorporate a agent which acts in a liquidity constrained manner (and accounts for approx 50% of the economy).

  • I seem to have got tied to a redistribution argument I’m not particularly fond of.

    Ultimately, there may be cases where redistribution could make sense, however I expect that if we did some more complicated modeling, we would find it to be suboptimal. I agree with this statement I made earlier:

    “I would say that any policy decision requires normative elements. However, that should not prevent us exploring whether there are efficiency reasons that might support such a tax. Once we understand whether there is a reasonably objective efficiency argument for such an instrument we can look at the trade-offs in social terms.”

    Start with the efficiency reasons – if they stack up lets look at the other factors which require more explicit value judgments.

  • CPW

    I think most voters probably do have misconceptions over the cost of taxation (and I doubt the errors cancel). Politicians talk about how much programmes cost in dollar terms, not in terms of the dead-weight loss from the taxation. Likewise the public doesn’t tend to appreciate that in-kind transfers are worth less than their dollar cost. Either failure would lead you to demand too much in the way of goverment transfers and spending.

    I’m not going to argue that people don’t in general have a preference for transfers to themselves, or from someone else. But all the election results tell us is that progressive tax schemes (probably) maximize social welfare for 51% of the voting population. I don’t see what bearing that result has on the question of what kind of tax system maximizes societal welfare in total. In fact, I’m going to go further and claim that the fact that progressive rate systems are so universal in democracies, despite there being very little (as far as I’m aware) theoretical or empirical evidence to suggest their efficiency, suggests that these systems’ popularity has much more to do with their electoral success than their objective merits.

    I suspect that if you took a sample of economists from around the world and asked them to design an ideal tax systems from scratch, a very small proportion of the results would look much like the existing tax systems of their country. And I don’ t think that normative preferences would be the key driver of the divergence between existing and ideal.

  • The idea of a petrol levy was one we were kicking around in 2006. We were looking at why the RBNZ had been looking at cutting interest rates, then raising interest rates as the year progressed. I commentedabout the RBNZ’s flop flop here :http://kiwitrader.blogspot.com/2007/03/how-reserve-bank-should-manage-monetary.html

    One of my first comments on my new blog!

    Anyway we realised that fuel prices rose steeply and the RBNZ was reacting to that move. They were more comfortable about inflation being contained as prices rose, as it was taking cash out of peoples pockets. Then as the oil prices fell in the second half of the year, their rhetoric switched as they began to be worried that there was more cash available due to lower petrol prices.

    So we figured cut out the interest rate reaction and comment and simply give the RBNZ the power to set the price of fuel over the market price set by the oil companies. The RBNZ “margin” would speed and slow the economy directly and the funds would flow to the RBNZ using the current tax collection system.

    In times of recession, the RBNZ could subsidise the fuel price to help things along, and vice versa.

    This would not replace the OCR, but would be a more direct lever and not one that people could easily protect against, (apart from big corporates, who hedge fuel anyway) as they can with fixed mortgage interest rates.

    And the bonus was that the currency would not be impacted, thus not driving the carry trade and hurting exporter revenues.

    Anway, I had lunch with Don last year, and pitched it to him and he liked it!

    Much better for him to run with it publically as he is so much better known and I prefer to remain anonymous.

    The point is, we never looked at it as a tax, but merely another monetary policy tool, whose affects over time would be neutral. When monetary policy tightening, RBNZ margin increases, when easing RBNZ margin decreases, to zero, or in a recession, goes negative.

    At the time, we were looking for an instrument other than interest rates, and this seemed to fit the bill!!

  • Hi Kiwi Trader,

    Good on you for selling your idea. I think the reacceleration of the housing market, and the increase in capacity pressures (capacity utilisation in September 06 was greater than it was now!) were big factors in the RBNZ’s ‘flip flop’ – also the terms of trade boost, that gave them a hell of a surprise.

    I will comment on your post tomorrow sometime, I know the post is almost a year old but a comment won’t hurt 😉

    Hi CPW,

    “In fact, I’m going to go further and claim that the fact that progressive rate systems are so universal in democracies, despite there being very little (as far as I’m aware) theoretical or empirical evidence to suggest their efficiency, suggests that these systems’ popularity has much more to do with their electoral success than their objective merits”

    Well progressive taxes aren’t based on efficiency, they are based on some social concept of equity. As you said you believe you would only pay a small amount out of kindness – however that is not the only positive externality associated with progressive tax systems. Lower crime, more robust social institutions etc, these sort of factors play a part in the choice of the system.

    However, I agree that a democratic system does not ensure that we have a government that satisfies societies social welfare function – however, it probably gets closer than a dictatorship or any other form of government as it collaberates more information.

  • CPW

    Matt, to address your points: I meant efficiency in satisfying the social welfare function. I also didn’t say anywhere I would “only pay a small amount out of kindness”. In theory, if not in practice, progressive taxes shouldn’t be based on a social concept of equity but the belief that progressive taxes are the most efficient means of achieving equity goals. I doubt you have any evidence for “lower crime, more robust social institutions”, you’re being platitudinous.

    To make my point a different way, what if we greatly increased social spending through much higher taxes, but made the tax system regressive (e.g. a 40% tax rate but 0% marginal rate after 200k). Such a system could achieve much greater equity than NZ’s current system despite being regressive. So why would this be unfair, and why, a priori, would it be less efficient that the same amount of spending funded with a progressive tax?

    To tie this back to the original discussion, you get the objection that a policy is regressive quite often, but is it really much of an argument? All government spending is going to have some effect on income distribution (often ambiguous, depending on what kind of inequality you have in mind, and who you think benefits). But it’s not an accepted fact that the status quo in NZ is the perfect level of progressivity. If we have no idea of whether more or less progressive is desirable from an social welfare standpoint, then criticizing a policy for being regressive is solely a normative statement.

    My dictatorship would better, naturally. 🙂 You’ve read Bryan Caplan, don’t democracies “collaberate” all the wrong information?

  • “In theory, if not in practice, progressive taxes shouldn’t be based on a social concept of equity but the belief that progressive taxes are the most efficient means of achieving equity goals”

    Yes, but those ‘equity goals’ should be based on social optimisation. Work out if a policy is technically efficient first, and then apply a normative judgment on equity outcomes and see what sort of instruments can best provide that – and what the trade-off in terms of technical efficiency is.

    What instrument would provide equity goals more efficiently then progressive taxation, or in co-operation with progressive taxation.

    “I doubt you have any evidence for “lower crime, more robust social institutions”, you’re being platitudinous”

    I like that word ‘platitudinous’, I had to look it up on google. I don’t have any evidence, you are right but there has been a lot of research on the issue that I haven’t read: http://scholar.google.co.nz/scholar?q=crime+and+income&hl=en&lr=&btnG=Search

    I thought the claim made sense, after all the greater your income the less incentive you have to rob people (diminishing marginal utility and all of that). The robust institutions call was differently an out of the blue claim- it just comes from the assumption that people prefer to be around people of similar income, so if incomes are more closely tied together people will be more social – better social cohesion gives more robust institutions (insofar as we have better solutions to the prisoners dilemma game).

    “criticizing a policy for being regressive is solely a normative statement”

    I agree completely. When we first look at a policy we need only look at efficiency. If it passes that test we have to look at the equity trade-off (as it is normative, and it is good to separate normative analysis from the more objective part), which is where discussions about ‘regressiveness’ come into play.

    “My dictatorship would better, naturally. 🙂 You’ve read Bryan Caplan, don’t democracies “collaberate” all the wrong information?”

    I haven’t actually read the book. Will it teach me more than Arrow’s impossibility theorem?

  • CPW

    Caplan’s point is not about the efficiency of a democracy, but that voters have systematically biased beliefs that results in inefficient policy outcomes.

    Believe it or not, I’m not taking some kind of wingnut stand on this one. The economic literature really is quite uncertain about the optimal income tax structure. To quote the intro of one of the first search results for those terms on google:

    The analysis of nonlinear income taxation pioneered by Mirrlees (1971) has
    characterized a number of properties that the optimal tax must possess (see e.g. Myles (1995) for a survey of these). The theoretical results though do not answer all the questions that are raised about income taxation. The most hotly-debated practical issue is the behavior of the marginal rate of tax, in particular whether the optimal income tax should be progressive – a property that the tax systems of all developed countries possess. The theory has so far not fully resolved this question. It is well- known that the marginal tax rate should be zero for the highest skill consumer, so the tax function cannot be progressive everywhere. But this end-point results provides no information on the behavior of the tax schedule on the interior of the skill distribution.1 This is a significant gap in our knowledge.

  • “The economic literature really is quite uncertain about the optimal income tax structure”

    I completely agree, there are significant gaps in our knowledge, and I never thought your stand was crazy (in blogs I often argue things just for the sake of having that point of view on the blog- not because its what I necessarily believe). However, this implies that, with some type of value judgment we could justify most tax structures. As long as a progressive tax system is not ‘pareto inefficient’ we can’t definitively say anything.

    I think the one thing we have discovered is that CPW, rauparaha, and matt all have different beliefs in terms of what normative statements are more important/true. Thats healthy.

  • CPW

    I just read this which is also relevant:

    The comparative experience thus suggests that for inequality reduction, it is the quantity of taxes rather than the progressivity of the tax system that matters most.

    Via Mark Thoma.

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