“The issue of economics is not something I’ve understood as well as I should,” professed John McCain earlier this year. After hearing his “gas tax holiday” proposal, one must conclude that McCain was not merely being modest; he really does not understand basic economics.
In every introductory economics class, students learn the fundamentals of determining tax incidence. The key concept is that tax burden does not depend upon whom the government levies the tax against (consumer or producer). Instead, tax incidence depends upon the elasticity of supply and demand.
The McCain/Clinton proposal would suspend the federal excise tax on gasoline, which is a charge of 18.4 cents per gallon that is included in the price consumers pay at the pump. While the tax is levied on consumers, we must examine the elasticity of market forces to determine who bears the actual tax burden.
As Princeton economist Paul Krugman points out, the supply of gasoline for the summer season is inelastic. Krugman explains:
Is the supply of gasoline really fixed? For this coming summer, it is. Refineries normally run flat out in the summer, the season of peak driving. Any elasticity in the supply comes earlier in the year, when refiners decide how much to put in inventories. The McCain/Clinton gas tax proposal comes too late for that. So it’s Econ 101: the tax cut really goes to the oil companies.
Still not convinced? Harvard’s Gregory Mankiw, a former Chairman of the Council of Economic Advisers during the Bush administration, offers a similar assessment:
What you learn in Economics 101 is that if producers can’t produce much more, when you cut the tax on that good the tax is kept . . . by the suppliers and is not passed on to consumers.
More from Mankiw, courtesy of Reuters:
If you want to provide households tax relief, a direct rebate … is more effective. Not all of the tax relief from a gas tax holiday will be passed on to consumers. Some will likely be kept by refiners.
The Oregon Economics Blog illustrates the effect of a tax cut in a market with perfectly inelastic supply:
Clearly, suspending the gas tax is not an effective way to assist individuals experiencing economic hardship.