‘The Amazing Hillary’

Hurry, hurry, hurry! Step right up, ladies and gentlemen, and see the Diva of Deception, the Impresario of Illusion — THE AMAZING HILLARY!! Watch her make the federal gas tax SEEM TO DISAPPEAR!! But in fact, you’ll still be paying the same price for gas! Even the media can’t figure out this trick!! She’s remarkable! She’s astounding! So hurry right in and see the First Lady of Legerdemain, the Mistress of Magic!

That’s what Hillary Clinton’s campaign managers should be barking about her joining John McCain in proposing to suspend the federal gasoline tax for the 2008 summer driving season. Says Candidate Clinton, the move would “immediately lower gas prices.”

What makes her proposal a true work of wizardry is that, she claims, it would not reduce government tax revenues. Whereas McCain says he would reduce government spending to make up for the lost tax money (an example of magical thinking?), Clinton would implement “a windfall profits tax on the big oil companies” to close the revenue gap.

Did you catch The Amazing Hillary’s trick? Did you see why consumers would still pay the same price for gasoline? No? OK, let’s watch the sleight of hand in slow motion:

The price of any good is ultimately set by just one factor: the equilibrium of supply and demand. If demand for a good increases, consumers will bid against each other to obtain it, driving up the price. The higher price encourages producers to supply more of the good and allows them to use costlier means of production. The higher price also incentivizes consumers to moderate their demand. This dynamic operates until a new equilibrium price is reached. Similar dynamics occur if demand falls, or if supply increases or falls.

Taxes affect prices by reducing the supply of a good. Most goods (including gasoline) can be furnished in a variety of ways from a variety of inputs. Some of those supply lines are more expensive than others, and producers will only operate lines that are profitable. If a tax takes away some of the revenue that producers receive for their goods, the producers will idle the lines that are unprofitable given the post-tax revenues. The decrease in supply will push up the price until it reaches a new equilibrium between supply and demand.

Let’s apply this specifically to gasoline. Gas can be produced from many different supplies of oil, ranging from cheap-to-extract-and-refine Saudi light crude to more-expensive Texas crude and oil pumped from shallow-water wells in the Gulf of Mexico, to even-more-expensive oil from deep-water wells, or from the frozen ground of Prudhoe Bay, or from the oil sands of Canada. That oil can then be transported by a variety of methods to different refineries with different operating costs. The resulting gasoline is then transported to consumers through countless routes in the global supply chain.

Gasoline suppliers, like all other suppliers, will use only the lines that are profitable and idle lines that are not. A tax on gasoline — assessed either as a sales tax or as a corporate excise tax — will reduce the profits of different supply lines. Some of those lines will become unprofitable and be idled by suppliers, reducing overall supply. The result is that consumers pay a higher price that should produce more supply, but suppliers receive lower revenue that prompts them to decrease supply. (The difference between what should be supplied at a given price and what actually is supplied underlies what economists refer to as a “deadweight loss.”)

Deadweight losses from taxation are undesirable, but they are tolerated because government provides important services. One of the virtues of the gas tax, specifically, is that it acts (ostensibly) as a user fee for roads and other services that motorists need. Now, there certainly are more efficient ways to finance roads, but the fuel tax isn’t half bad.

However, there is something wrong with assessing a tax but claiming that it’s not there. Candidate Clinton’s “trick” is to swap the gas tax for a special tax on oil companies. Because she intends for the windfall profits tax to generate the same revenue as the gas tax, the windfall profits tax will have the same effect on gasoline supply, demand, and price as the current gas tax. The only difference is that the gas tax is transparent to consumers while the windfall profits tax is not. Voilà — the gas tax seems to disappear, but gas prices stay the same and the government still gets its money.

Theoretically, there are ways to construct a windfall profits tax so that it doesn’t suffer this problem. One way would be to levy a one-time lump sum tax — that is, to pass legislation mandating that, in 2008, the oil companies will hand over a specific amount of dollars to the federal government regardless of profit or production levels. Another theoretical windfall profits tax would apply only to lines of supply that are low-cost and would remain profitable and continue to operate despite the tax. If either of those taxes were substituted for the current gas tax, it would lower gas prices and increase supplies by getting rid of the gas tax’s deadweight loss.

However, windfall profits taxes are much easier to construct in theory than in reality. The United States tried the “low-cost supply” tax in the 1980s and found that it produced little revenue but it had some unpleasant unintended consequences. Conversely, the lump sum tax would set off one amazing (and costly) legal and political battle.

So far, I can find no information on the design for Clinton’s windfall profits tax. Perhaps The Amazing Hillary has figured a way to make the tax work. More likely, it’s just hocus-pocus.

So, in the battle of presidential rivals, give McCain a little credit for having a less illusory gas tax proposal. But the real credit should go to Sen. Barack Obama, who has dismissed the idea entirely as a “short-term, quick-fix” proposal. What Obama said last week about the very small monetary gain of McCain’s call for suspending the tax also covers Clinton’s nicely: “A half a tank of gas — that’s [their] big idea.”