The Energy Tax Policy Conundrum: Do We Want To Reduce Fossil Fuel Prices Or Increase Them?

State and federal lawmakers are debating an extraordinary range of often-contradictory energy-related tax changes. These inconsistencies have existed for years, but they rarely have been more apparent than today.

We are at a time when climate experts increasingly are warning of the growing risks of unchecked fossil fuel use. Yet, we also are confronting a rapid and steep rise in oil prices that creates political pressure for lawmakers to soften the blow for consumers. While Ukraine-related oil price increases have reversed themselves in recent days, prices remain close to $100/barrel.

What is the goal?

The result: A head-spinning cacophony of tax-related energy policies. Is the goal to lower oil prices and increase consumption? Or is it to raise prices and lower consumption? Does government want to encourage oil companies to drill more and increase production? Or does it want to eliminate production tax subsidies in ways that risk further reducing output?

For example, if states continue to suspend motor fuel taxes, they may temporarily reduce prices, yet at the margin they’ll increase consumption of fossil fuels.

Congress could respond to higher energy company profits with new taxes. But, as my Tax Policy Center colleague Thornton Matheson recently wrote, a poorly-designed tax on oil company profits could further reduce oil supplies at a time consumers already are facing shortages.

Some Democrats are simultaneously demanding that oil companies produce more without making more profits and produce less to battle climate change. You don’t have to be an oil company executive to be confused.

Or Congress could adopt President Biden’s proposals to eliminate tax subsidies for fossil fuel producers and boost tax breaks for alternative energy. This decision also could quickly cut domestic supply as producers respond to the loss of tax benefits. Some of that loss could be replaced by imports, though how much is uncertain in the current market.

A timing mismatch

In the short run, oil price changes have little impact on consumer demand. But in the longer run, more subsidies for green energy and fewer for fossil fuel production would encourage consumers to buy, say, electric vehicles. But today, due to supply chain problems, there are relatively few cars to buy and those that are on dealer lots are enormously expensive.

California is one example of this incoherence. It has taken the lead in the US with a modest, but important, carbon pricing system aimed at raising the cost of fossil fuel and lowering consumption. Yet, as gas prices in his state topped $6/gallon, Gov. Gavin Newsom proposed giving consumers $400 tax rebates for each car they own. Better than a gas tax holiday, but still dissonant.

At the heart of many of these conflicting policies is a significant timing mismatch. Transitioning from a carbon-based economy to one more reliant on alternative energy sources without economic disruptions is a challenge.

For more about all this, watch my interview with Third Way senior resident fellow Ellen Hughes-Cromwick here.  

Supply Shocks

Today’s geopolitical supply shock forces us to confront that timing problem. Fossil fuel producers may reduce production quickly in response to tax increases. But it will take years or even decades to develop sufficient solar, wind, or nuclear power to decarbonize the economy. Similarly, it will take years to convert enough vehicles from gasoline to electric to materially affect the climate.

That transition leaves us vulnerable to oil supply shocks and the price increases they produce. This is a particular problem because over the last half century geopolitical price shocks have been, well, routine.

Prices spiked due to the 1973-74 Organization of the Petroleum Exporting Countries (OPEC) oil embargo, the beginning of a war between Iran and Iraq in 1982-83, the 1991 Gulf War, a decision by oil producing companies to cut production in the face of an explosion in demand in the early 2000s, another OPEC production cut in 2010, and the Arab Spring in 2011. One might say we were due for yet another once-a-decade supply shock.

And due to Russia’s invasion of Ukraine and the Western world’s response to it, here we are again.

What is your goal?

The real policy question is: How should today’s oil price shock motivate energy-related tax policy?

Do we want to use tax cuts to mitigate fossil fuel price increases? Or do we want to keep after-tax prices high to accelerate the transition to alternative energy?

Do we want to use tax policy to cut the supply of fossil fuels, a step that could further increase oil prices but also accelerate the shift to alternatives?

Do we want to introduce a carbon tax, which could gradually reduce demand by raising prices but without creating its own supply shock?

Fundamentally, should lawmakers look at Russia’s invasion of Ukraine as an opportunity to rethink our continued reliance on fossil fuels or should they see it as an immediate political challenge that should be met with a short-term tax response?

I suspect economists and politicians would give you very different answers to all those questions.






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