Efficient Combination of Taxes on Fuel and Vehicles.

• Author: Bjertnaes, Geir H.M.

1. INTRODUCTION

   Road transport is essential to maintain an efficient fow of goods, services and people, but generates costly negative externalities in the form of C[O.sub.2] emissions, local air pollution, accidents, congestion and noise. Many countries have implemented taxes on fuel combined with tax exemptions or subsidies for fuel-efficient vehicles to curb externalities linked to both fuel and mileage. However, the gain in terms of reduced externalities per liter of fuel is diminished by the fact that households avoid the mileage-related tax component by purchasing more fuel-efficient vehicles, according to the highly influential study by Parry and Small (2005). Their optimal US and UK tax rates on gasoline are reduced accordingly. A range of other studies have adopted their method to calculate optimal tax rates on fuel in other countries; see e.g. Anton-Sarabia and Hernandez-Trillo (2014), Lin and Zeng (2014).

   An alternative strategy consists of imposing a tax on fuel-efficient vehicles which cancels out the gains of this avoidance. This strategy has implications for the optimal fuel tax, as avoidance resulted in a lowering of the optimal tax rate on fuel in Parry and Small (2005). Their optimal tax rate on gasoline also includes a revenue-raising Ramsey tax component. However, according to Jacobs and de Mooij (2015) the Ramsey tax component is excluded from a welfare-maximizing tax system. Hence, more research is required to reveal how taxes on fuel and vehicles should be designed to curb externalities from road traffic.

   The present study explores whether this alternative strategy is desirable. The study develops a new model framework which calculates optimal tax formulas for combinations of taxes on fuel and vehicles. The theoretical foundation for these tax formulas is based on pioneering contributions by Innes (1996) and Fullerton and West (2002). However, the results of these studies are difficult to transform into optimal real-world taxes on fuel and vehicles. Significant progress is made in the present study, which develops these theories into operational tax formulas that are comparable with current taxation of fuel and vehicles. Scenarios with myopic behavior and electric vehicles (EVs) are included. The study shows that the tax rate on fuel in both the US and the UK is less than optimal, and that the tax on fuel-efficient vehicles should exceed the tax on fuel-intensive vehicles.

   The rest of the paper is divided into four sections; Section 2 provides a literature review, Section 3 presents the model and Section 4 compares optimal taxes on fuel and vehicles with current taxes on fuel and vehicles. Section 5 provides a conclusion.

2. LITERATURE REVIEW

   Parry and Small (2005) show that the optimal uniform tax rate on gasoline in the United States is more than twice the current rate, while that for the United Kingdom is about half the current rate. Their optimal tax rate on gasoline consists of an adjusted Pigouvian tax component which includes damage from carbon emissions and other driving-related externalities, a Ramsey tax component designed to raise tax revenue, and a congestion feedback component which captures welfare gains as labor supply increased as congestion decreases. Driving-related externalities due to congestion and accidents as well as the Ramsey tax component are dominant, while global warming and congestion feedback are modes. Anderson and Aufhammer (2014) estimate higher accident-related externalities, which suggests that the UK gasoline tax is closer to the optimal level than the US tax. Several objections can be made to the methodology in Parry and Small (2005), however. First, differentiated taxes on purchase of vehicles are as mentioned not considered, even though Innes (1996), Fullerton and West (2002, 2010) and De Borger (2001) show that restrictions on taxes on the use of vehicles imply that taxes on the purchase of vehicles are desirable. Indeed, subsidizing substitutes for polluting goods might be desirable when governments are unable to tax emissions directly, according to Sandmo (1976). Second, their optimal tax rate on gasoline includes a Ramsey tax component. However, according to Atkinson and Stiglitz (1976), a general set of assumptions excludes the Ramsey tax component from a welfare-maximizing tax system. Indeed, Jacobs and de Mooij (2015) show that a Pigouvian tax on polluting goods is part of a welfare-maximizing tax system within a Mirrlees-economy framework. Third, the tax theory adopted by Parry and Small (2005) is unable to generate a unique optimal tax rate on polluting goods according to Fullerton (1997). The explanation is that the allocation of resources is unchanged when a uniform tax increase on consumer goods is combined with a proportional, revenue-neutral reduction in taxation of income. Hence, welfare is unchanged even though the tax rate on polluting goods is increased.

   Innes (1996) and Fullerton and West (2002, 2010) study the optimal design of taxes on both fuel and vehicles. Innes (1996) shows that optimal vehicle taxes, or their regulatory equivalents, approximately equal the social cost of a vehicle's predicted emissions less the portion of costs that is internalized by a uniform gasoline tax. Fullerton and West (2002) extend his analysis and explore tax combinations that implement the social planner choices of mileage, engine size, pollution control equipment, and fuel type. They find that vehicles with bigger engines should be subsidized (taxed) if the tax rate on fuel, which equals the marginal damage per gallon of fuel, more (less) than completely internalizes the impact of engine size. According to their study, empirical investigations are required to determine whether to tax or subsidize vehicles with large engines. Fullerton and West (2010) extend the analysis in Fullerton and West (2002) with vehicle age and simulate different scenarios. They find that the three-part instrument involving a gas tax, an engine-size subsidy, and a new-car subsidy maximize welfare. The engine-size subsidy does not increase welfare significantly, however.

   These insightful studies leave several questions unanswered. First, Fullerton and West (2002) do not investigate how the optimal tax rate on fuel should be designed when households avoid the mileage-related component of fuel tax by purchasing more fuel-efficient vehicles. In contrast, the optimal tax rate on fuel in Parry and Small (2005) is reduced due to such avoidance. Second, the optimal engine-size subsidy is desirable if the tax on fuel is unable to completely internalize the impact of engine size. However, they are unable to determine the size or the sign of the subsidy. Hence, these results are hard to transform into optimal real-world taxes on fuel and vehicles. Third, several empirical studies find that households have rational expectations when purchasing vehicles; see Sallee et al. (2016) and Busse et al. (2013). Some studies find support for myopic behavior, however; see Grigolon et al. (2014) and Allcott and Wozny (2014). Myopic behavior is not considered by Innes (1996) or Fullerton and West (2002, 2010).

   These weaknesses in Parry and Small (2005) concerning their omission of taxation of vehicles, their Ramsey tax component, and the lack of a unique tax rate, and issues in Fullerton and West (2002, 2010) concerning the lack of operational tax estimates, the impact of tax avoidance, and failure to consider myopic behavior are resolved in this study. The study contributes by developing a new model framework which calculates optimal combinations of taxes on fuel and vehicles which are comparable to real-world taxes. Tax estimates for scenarios with myopic behavior are included. Avoidance of mileage-related taxes on fuel through the purchase of fuel-efficient vehicles, and taxation of fuel-efficient vehicles to combat such avoidance, is incorporated into the model framework. The Ramsey tax component is excluded, as optimal taxes on fuel and vehicles are obtained by balancing the efficiency cost of tax distortions against the welfare gain of reduced externalities. The Pigouvian solution in Jacobs and de Mooij (2015) is not attainable, however, when policy instruments are restricted to a uniform tax on fuel and differentiated taxes on vehicles. The optimal tax difference between fuel and non-polluting goods includes optimal combinations of tax rates on fuel and non-polluting goods, and hence resolves the objection concerning the lack of a unique optimal tax rate. The optimal tax difference between fuel and non-polluting goods is compared with current tax differences in the US and the UK. The study also compares optimal and current taxes on vehicles in these countries.

3. THE MODEL FRAMEWORK

   3.1 Households

   Households choose driving distances and types of vehicle with varying fuel-efficiencies. Household i's utility, [u.sub.t], net of externalities is given by the quasilinear utility function

   [mathematical expression not reproducible] (1)

   when a fuel-intensive vehicle is chosen. [b.sub.i] equals zero if a fuel-efficient vehicle is chosen. The utility, [u.sub.i] , is determined by driving distance measured in kilometers, [km.sub.i], consumption of a non-polluting consumer good, [c.sub.i], and the utility associated with owning a fuel-intensive vehicle instead of a fuel-efficient vehicle, [b.sub.i]. The marginal utility of additional driving distance is positive, u' > 0, but declines as the driving distance increases, u''

   [mathematical expression not reproducible] (2)

   where j = high, low indicates fuel-intensive and fuel-efficient vehicle, respectively. Consumption of the non-polluting good, [c.sub.i], equals a fixed income, y, plus government transfers, k minus costs of fuel, [mathematical expression not reproducible], minus the tax on the chosen vehicle, [mathematical expression not reproducible], minus the price of the chosen vehicle, [mathematical expression not reproducible]...