Fuel duty makes little sense as a carbon tax

TOMORROW is National FairFuel Day, when people will lobby MPs to reduce duty on fuel. It’s a tricky issue for economists. Fuel duty demonstrates the standard economic response to a situation where social costs exceed private costs. If the price of a gallon of petrol fails to reflect the total cost of consuming such a pollutant then economists propose a tax to close the gap. It is called a Pigovian tax (after the English economist Arthur Pigou). Gregory Mankiw, for one, has made a reasonable case for joining the Pigou club: “an elite group of economists and pundits who have publicly advocated higher Pigovian taxes, such as gasoline taxes or carbon taxes”.

It is elegant in theory, but also naive.

I drive a 2003 Toyota Corolla and wondered what the “optimum” tax rate should be. According to TerraPass.com my driving habits generate around 5,000lbs of CO2 a year, which would cost £18.75 to offset. I then used the petrol bills calculator on thisismoney.co.uk to find that my annual fuel bill is £1,160.31, of which just £465.14 is the cost of fuel. VAT accounts for £193.39, and the rest is duty.

Of course there are other externalities in addition to carbon emissions and fuel duty has existed long before talk of a specific Pigou tax. But as the graph (right) shows, existing fuel duty is 26 times higher than the supposed externality.

There are a number of reasons why Pigou taxes are naive. As economist Edward Lopez has pointed out, “the knowledge of which things are good or bad, in which circumstances of time and place, and to what dollar amount, are beyond the reach of anyone including policymakers; but even absent the knowledge problem, the incentive problem ensures that the enacted policies would be diverted by compromise from what little we do happen to know of the public interest.”

Even if policymakers were able to calculate the actual level of the externality (my calculations are merely illustrative estimates), then how can we trust them to apply it? Most advocates of Pigovian taxes argue based on theory – the idea that an optimal Pigovian tax exists in theory is sufficient grounds to attempt to apply it. But in the real world there is simply no rational basis to engage in such calculations. Call me a fatalist, but the genuinely elegant solution acknowledges what little we know, and how that situation is ripe for abuse.

Anthony J. Evans is associate professor of economics at London’s ESCP Europe Business School. www.anthonyjevans.com

Email him at: anthonyjevans@gmail.com