Case Study 4 and 6 Questions Need to Be Answered

Applied Economics Letters, 2010, 17, 325–328

Are demand elasticities affected by

politically determined tax levels?

Simultaneous estimates of gasoline

demand and price

Lennart Flood*, Nizamul Islam and Thomas Sterner

Department of Economics, School of Economics and Commercial Law,

Göteborg University, Göteborg, Sweden

Raising the price of fossil fuels is a key component of any effective policy

to deal with climate change. Just how effective such policies are is decided

by the price elasticities of demand. Many papers have studied this without

recognising that not only is there a demand side response: quantities are

decided by the price but also there is a reverse causality: the level of

consumption affects the political acceptability of the taxes which are the

main component of the final price. Thus prices affect consumption and

consumption levels, in turn, have an affect on taxes and thus consumer

prices. This article estimates these functions simultaneously to show that

there is indeed an effect on the demand elasticity.

I. Introduction

Global carbon emissions from fossil fuels are around 7 Gtons Carbon per year whereof transport fuels in the OECD account for over 1 Gton. Effective policy instruments to deal with climate change will have their main effect through higher fuel prices. To reach any of the scenarios discussed in for instance the Stern or IPPC reports, very large reductions (50–90%) – and thus large price increases will be needed. The exact extent of the necessary rise in prices to reach any particular target hinges on the long-run demand elasticities for fuel. Such elasticities are also of interest for transport economists and market forecasts.

As a result there are few areas that are so well studied particularly after the oil price hikes of the 1970s. The total number of individual studies

is several hundred and even the number of surveys is quite large, (Drollas, 1984; Oum, 1989; Dahl and Sterner, 1991a, b; Goodwin, 1992; Hanly et al., 2002; Graham and Gleister, 2002, 2004). While a range of estimates is found, the consensus is that the long-run price elasticity of demand is around �0.8, while the long-run income elasticity is about one. Typically the short-run (one year) elasticities are about a third of the long-run values. Differences between countries are typically moder- ate but there are differences depending on the type of model and data used. Estimates that only build on time series data for one country tend to give somewhat lower elasticities than studies that include cross-section evidence.

In a recent article which surveys new developments in the field, Basso and Oum (2006), identify a number of important methodological issues not

*Corresponding author. E-mail: [email protected]

Applied Economics Letters ISSN 1350–4851 print/ISSN 1466–4291 online � 2010 Taylor & Francis 325 http://www.informaworld.com

DOI: 10.1080/13504850701735864

sufficiently explored. One of these was the use of more complexes, structural rather than reduced-form

models. All earlier studies are founded on the idea that we are indeed estimating a simple demand curve and this is what we are questioning here. The kinds of data used are shown in Fig. 1.

Gasoline has low transport costs and a standar- dized international price. The differences in consumer

price observed are due almost entirely to differences in taxation. In Fig. 1 we see that countries with higher taxes and prices have lower demand per capita. It is this type of data that underlies the demand elasticities mentioned earlier.

However, Hammar et al. (2004) point out that the causality could be the reverse. There is an apparent

paradox that it appears more difficult to raise the gasoline taxes in low tax countries like the USA than in European countries that already have high taxes. In searching to explain this, Hammar et al. show that taxes themselves appear to be determined by

consumption levels in a form of political feasibility relationship: In countries where almost everyone is dependent on the car and consumption levels are high it is politically almost impossible to raise the gasoline tax level. In countries where fewer people use a car and

consumption levels are lower it is politically easier. These results have consequences that have not yet

been explored for the way we ought to model fuel demand and for the design of taxes in the area of vehicle fuels. A full model of the fuel market must have both a demand equation and a tax setting equation. The question we seek to address here is whether the

inclusion of this supply side or tax setting equation will change the magnitude of the demand elasticities.

II. Model

The simplest and most frequently used dynamic model

1 is the lagged endogenous where the data

might be pooled cross section time series data, assuming a common intercept and slope parameter which can be defined as

Qit ¼ aþ�Qi, t�1 þ�1Pit þ�2Yit þ uit ð1Þ

where Q is gasoline per capita consumption per country i¼1, 2 , . . . , N at time t¼1, 2 , . . . , T. P is deflated gasoline price and Y is deflated per capita income (GDP). All variables are in logarithms

allowing the parameters to be interpreted directly as elasticities. The coefficients �1, �2 and � capture the effects of price, income and lagged consumption respectively and the last term u is a disturbance term with E[uit]¼0 and Var uit½ � ¼ �2u.

Another model is one in which we impose common slopes, but allow for varying intercepts (country effects) and time effects. This represents the simplest type of panel data models, known as the ‘fixed effects’ or ‘within’ estimator. In the fixed effects setting, the procedure involves running the ordinary least square (OLS) regression, the long-run effects of P (price) and Y (income) on Q (gasoline consumption) is then calculated by �1/(1��) and �2/(1��), respectively.

As mentioned, our goal is to take into account the reverse causality from consumption to price through a politically decided tax variable for this reason we specify the following simultaneous equation model

Qit ¼ aþ�Qi, t�1 þ�1Pit þ�2Yit þuit Tit � Pit �ðIPÞit Tit ¼ cþ ��Qi, t�1 þ ��Ti, t�1 þ ��3Cit�1

þ��4ðQCÞit�1 þ ��5ðTSÞit þ �it

8 >>>< >>>:

9 >>>= >>>;

or

Qit ¼ aþ�Qi, t�1 þ�1Pit þ�2Yit þuit Pit ¼ bþ �Pi, t�1 þ�3Cit�1 þ�4ðQCÞit�1

þ�5ðTSÞitþ�6ðIPÞit þ�it

8 >>< >>:

9 >>= >>;

ð2Þ

where the price P is a function of the International price IP (which is almost the same in all countries) and domestic tax T.

2 The tax T is assumed to be

a function of gasoline consumption(Qt�1) in the previous period (as a proxy for lobbying or median

Fig. 1. Price on gasoline and gasoline consumption per

capita during 1978–2003

1 See Sterner (1990, 2007) or Graham and Gleister (2004) for an overview of models.

2 When we assume that Tit � Pit �ðIPÞit we effectively measure the effective tax as the difference between the domestic and

international prices. Thus we ignore any small differences in profit margin for petrol stations and differences in transport costs between countries.

326 L. Flood et al.

voter pressure), 3 Ct�1 number of passenger cars in

the previous period (per capita), (QC)t�1 Gasoline

consumption per passenger car in the previous

period, and TS tax as share of GDP. ��it and �it are error disturbances. In the fixed effects setting,

Equation 2 can be estimated using 2SLS.

III. Data

The data used in this article consist of 23 OECD

countries 1978–2003. Total gasoline consumption, 4

Price 5 and International price,

6 are taken from IEA

statistics 2006 and GDP 7

from National

Accounts of OECD Countries. We also use data on

transport-related variables including number of

passenger cars. 8

IV. Results

The results are shown in Table 1. The single equation

results give high long-run price elasticities, while the

simultaneous equation estimates give more conven-

tional though still high values. The fact that

the values are high could possibly be explained by

the inclusion of more years and of a large number of

fairly diverse economies. Earlier studies (such as

Hanly et al., 2002) have found some tendency for

higher elasticities over time. For our purposes

the most interesting result is that the inclusion of

a tax-setting equation gives somewhat lower demand

elasticities. Table 2 shows the results from the price equation

in (2) which are of more secondary interest in this

context but we see for instance that the larger the

number of cars the lower the price – which we assume

to be an expression of the lobbying (or voting) power

of the automobile owners.

V. Conclusions

Current estimates of fuel elasticities assume that the

demand relationship is the only one present in the

data. However, there may be political factors

determining the setting of fuel taxes such that it

becomes politically more difficult to raise taxes in

those countries with many cars and high consump-

tion – which are of course in turn the very countries

where fuel taxes are low and thus where the need

to raise them is the highest. The tax levels become

Table 1. Elasticity estimates with single and simultaneous equations model for 23 OECD countries (1978–2003)

Estimation techniques SR price elasticity

LR price elasticity

SR income elasticity

LR income elasticity

Lag endogenous R

2

Single equation (fixed effect OLS) �0.117 (0.012) �1.08 (0.112) 0.073 (0.018) 0.675 (0.164) 0.892 (0.012) 0.995 Simultenous equations (fixed effect 2SLS) �0.077 (0.014) �0.884 (0.134) 0.071 (0.018) 0.818 (0.208) 0.913 (0.012) 0.996

Notes: SE are in parenthesis. All specifications include time dummies. All estimates are for 23 OECD countries (1978–2003) using lagged endogenous model.

Table 2. Estimates of price equation in simultaneous equations model for 23 OECD countries (1978-2003)

Estimation techniques Lag(P) Lag(C) Lag(QC) TS IP

Simultenous equations 0.757 (0.028) �0.022 (0.025) 0.047 (0.028) 0.093 (0.013) 0.133 (0.023)

Notes: SE in parenthesis. Time dummies included but not shown.

3 We strive for simplicity. The model could easily be made more complex to include further determinants of the tax rate and

fuel demand, see Hammar et al. (2004) or Fredriksson (1997). 4 Asoline consumption is in 1000 metric tonnes.

5 Price is total end-use prices for households in US dollars using PPPs. It is weighted average of Premium Leaded, Regular

Unleaded, Premium Unleaded. 6 International price for Rotterdam, are average of high and low quotes for spot purchases of oil products.

7 GDP is from National Accounts of OECD Countries, Volume 1, 2005 and converted using the yearly average 2000

purchasing power parities see Purchasing Power Parities and Real Expenditures, GK Results, Volume II, 1990, OECD 1993. 8 Data on number of cars from the International Road Federation (World Road Statistics). A few missing values were

generated using exponential interpolation.

Are demand elasticities affected by politically determined tax levels? 327

self-perpetuating or at least we can think in terms of different trajectories where countries which start with fairly low tax and high use levels find it hard to raise the tax while high tax level countries find they can continue to raise the tax (since people are beginning to find ways to lower their consumption and thus become less dependent on the fuel which lowers resistance to further rounds of tax increase and lower consumption).

We tested this hypothesis by estimating the same gasoline demand equation either in isolation or in a system of equations where the other equation embraces the reverse causality through which the process of tax (and thus price) setting depends on consumption levels. We find that the demand elasticity is decreased moderately although not trivially, by the inclusion of the political tax equation. This implies we have to somewhat reduce our estimates of the direct efficiency of fuel taxes as an instrument of policy. It implies policies need to be tougher: taxes or prices need to be raised more in order to attain a given level of demand reduction (and thus corresponding carbon emissions). On the other hand we also find that there is a further political feedback which implies that fuel taxes are more efficient than normally believed: The reason is that the higher a tax and the lower the consumption levels, the smaller the resistance to future tax increases may be. Thus it may be important to start a policy which eventually gathers momentum as more and more consumers adapt and thus find the policy acceptable. In some sense the policy leads to the building of lobbies that then continue to expand the policies while the lobbies that resisted the policy are successively weakened.

References

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328 L. Flood et al.

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