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Is a 56.2 MPG Fuel Economy Standard Really a Good Idea?

According to news reports, the Obama administration is talking to automakers about raising the Corporate Average Fuel Economy standard for passenger cars to 56.2 miles per gallon by 2025, more than double the  27.5 MPG in force for the 20 years up to 2010. Economists, even those like myself who favor policies to reduce fuel use, have argued that CAFE standards are a bad idea. Has anything changed to make stricter fuel economy standards look better now than in the past?

The fundamental problem with CAFE standards is that they attack the negative externalities of motor fuel use (pollution, national security concerns, highway congestion, accidents) only partially and indirectly. As a result, the cost of achieving a given reduction in fuel use via CAFE standards is higher than it would be if the same result were achieved more directly through an increase in the federal gasoline tax.

To understand why, we need to consider the various ways consumers can cut back on fuel use. In the short run, they they can buy an efficient hybrid instead of a gas-guzzling SUV, they can reduce discretionary driving, or they can shift some trips from their Ford F-250 to their Honda, if they happen to have one of each in the driveway. Given more time to adjust, they can make work and lifestyle changes like moving closer to public transportation, work and shopping, changing jobs, or working at home.

Higher fuel prices directly affect all of these choices. They encourage people to make whatever marginal adjustments best suit their circumstances. A recent New York Times article gave these examples of how people were reacting as gasoline approached $4 per gallon in May, 2011:

  • An upstate New York customer relations manager moved to a new apartment that cut her daily commute from 50 miles to 8 miles. She preferred that to trading her beloved truck for a low-mileage vehicle.
  • Traffic on San Francisco’s bridges fell while ridership on buses and ferries rose.
  • New York-based Topical BioMedics switched to cloud computing to make it more convenient for employees to work from home.
  • A Los Angeles hair products business found more workers taking advantage of a long-standing offer of a 20-cent per mile bonus for car pooling.

 

The problem with higher CAFE standards is that they encourage fuel saving only with regard to the choice of what car to buy. Once a consumer buys a low-mileage vehicle, the cost of driving and extra mile goes down, thereby reducing the incentive for fuel-saving measures like moving closer to work, working at home, riding the bus to work, or consolidating errands.

The tendency of more fuel-efficient vehicles to induce additional driving is known as the “rebound effect.” For example, suppose that the elasticity of demand for driving with respect to fuel-cost per mile is -0.3. That means a 10% increase in fuel efficiency would cause a 3 percent increase in driving. The increased miles driven would partly offset the increase in miles per gallon, so that total fuel consumption would decrease by only about 7%.

Even taking the rebound effect into account, higher CAFE standards are still somewhat helpful in reducing those externalities that are proportional to the quantities of fuel consumed, including externalities of pollution and national security. However, the rebound effect causes an absolute increase in those externalities that are proportional to miles driven, including road congestion and traffic accidents. It also increases the cost of road maintenance, because the wear and tear from more miles driven is only partly offset by the lower average weight of high-mileage vehicles.

The very fuel-saving strategies that CAFE standards discourage, like moving closer to work or consolidating errands, are often the ones that have the lowest costs. That is why the total cost of reaching a given national fuel-saving target will be greater when achieved through CAFE standards than when induced by an increase in fuel taxes. A 2004 study from the Congressional Budget Office concluded that an increase in the federal gasoline tax would achieve a given reduction in fuel economy at a cost 27 percent less than that of an equivalent tightening of CAFE standards. Furthermore, its effects would be felt more quickly, because they would not have to wait for the gradual turnover of the national motor vehicle fleet. Over the 14-year time horizon of the CBO study, the gas tax increase would save 42 percent more total fuel.

The variable most critical to the size of the rebound effect, and therefore to the relative merits of CAFE standards vs. fuel taxes, is the price-elasticity of demand for fuel. The less elastic is demand, the stronger is the case for CAFE standards; the more elastic, the larger the rebound effect and the stronger the case for raising fuel taxes. So what do we know about price elasticity?

Of all the many elasticity studies, the most widely cited is a 1996 meta-analysis by Molly Espey. She concluded that the best estimate for the price elasticity of gasoline demand was -0.26 in the short run and -0.58 in the long run. Those estimates strongly undermine the case for CAFE standards. However, Espey’s results, which are based on data from 1936 through 1986, have been challenged by more recent estimates that show a decrease in elasticity in the early years of the 21st century.

In particular, a 2006 NBER working paper by Jonathan E. Hughes, Christopher R. Knittel, and Daniel Sperling found evidence that the short-run price elasticity of gasoline for the period 2001-2006 had fallen to a range of -0.034 to -0.077. That finding would seem to strengthen the case for higher CAFE standards.

The authors of the NBER study suggest several reasons that the elasticity of demand for fuel may have fallen during the period studied. One is that the real price of gasoline and its share in household budgets was below its historical average in those years. A second possible reason is that suburban sprawl and longer commuting distances meant that a lower proportion of all driving was discretionary. A third explanation was that after more than a decade in which CAFE standards had remained unchanged at 27.5 MPG, there were fewer opportunities for saving fuel by trading in an older car for a new one or shifting driving from one car to another within the family fleet.

But not so fast. Still more recent studies seem to show that the factors at work in 2001-2006 were temporary, and that after hitting a low, elasticity is on the rise again. A study by Todd Litman of the Victoria Transport Policy Institute, released just last month, provides a comprehensive review of the literature. His conclusion is that long-run fuel price elasticities have returned to a range of -0.4 to -0.8. In Litman’s view, the rebound of the rebound effect (as he puts it) has occurred in part because rising fuel prices and stagnating incomes have once more increased the share of fuel costs in consumer budgets. Also, as a larger share of the population reaches retirement, a higher percentage of driving becomes discretionary, and therefore more sensitive to fuel prices.

It is worth noting that much of the observed variation in fuel prices on which the elasticity studies draw are market-driven, and therefore expected by consumers to be transitory. Elasticity is not only likely to be higher in the long run than in the short run, but also higher in response to changes in fuel prices that are expected to be permanent, such as those that would result from tax increases. The expectation effect would be even greater under a variable, price-smoothing oil tax of the type discussed in this earlier post. Such a tax would put a permanent floor under retail gasoline prices, providing maximum incentive to make the behavioral changes needed for long-run fuel economy. The effectiveness of higher fuel prices in mitigating externalities of automobile use would greater still if they were backed up by modern, time-of-day pricing policies for road use and parking, as well.

To be sure, not everyone will be convinced by elasticity studies. They are just numbers. Some people will continue to believe that prices have no effect on driving behavior, that people will just drive whatever and wherever they want regardless. Here is a picture, then, that is worth a thousand meta-analyses. Taken from the Litman study cited above, it shows a convincingly tight relationship between fuel prices and fuel use across OECD countries. Can it really be just coincidence that the United States, with the lowest fuel prices, also has the highest fuel consumption?

All this leaves one last question. If CAFE standards are such a bad idea, why do they remain so popular? If you are an economist, choosing higher fuel taxes over CAFE standards looks like a no-brainer, but if you are a politician, fuel taxes have an obvious drawback. Fuel taxes make the cost of reducing consumption highly visible. You see the big dollars-per-gallon number right there in front of you every time you drive up to the pump. CAFE standards, in contrast, hide the cost. You pay the price of a higher-mileage car only when you buy a new one, and even then, the part of the price attributable to the mileage-enhancing features is not broken out as a separate item on the sticker. You may notice that your new car costs more than your old one did, but there are lots of other reasons for that besides fuel economy.

It is a classic case of the TANSTAAFL principle—There Ain’t No Such Thing As A Free Lunch. If you try to make something look like it’s free, it only ends up costing more in the long run. If you are a politician, you may well prefer a big hidden cost to a small visible cost. If you’re a friend of the environment, you should know better.

 

10 Responses to “Is a 56.2 MPG Fuel Economy Standard Really a Good Idea?”

TomJuly 15th, 2011 at 11:37 am

One secondary effect of higher CAFE standards that I've been thinking about recently is the effect on car prices. If car prices go up as a result of CAFE standards, what effect will it have on fuel consumption. People will delay new car purchases for longer, which will increase fuel consumption and pollution, but they will also be more likely to reduce the numbers of cars they own and make greater use of public transit. This will reduce congestion and reduce fuel use. I don't know what the net effect will be, but it probably should not be ignored.

Ed Dolan EdDolanJuly 15th, 2011 at 2:05 pm

You're right, Tom, the effect on car prices is important. I think it's not simple, though. For one thing, we have to remember that CAFE targets fleet average economy and doesn't actually prohibit production of low-mileage vehicles, but just imposes a charge ($55 X total cars produced X MPG shortfall for the fleet average). That means companies have an incentive to lower prices of high-mileage cars, even to the point of selling below cost, and raise prices of low-mileage cars. Presumably, an increase in the CAFE target, with given technology, would increase the incentive to skew pricing. If so, an important question would be relative price elasticity of demand at the high-mileage and low-mileage ends of the spectrum. The situation is even more complicated if inter-company MPG-credit trading is allowed. (My understanding is that it is allowed now, but not done often, although I'd like to know more about it.) Maybe the folks at the Victoria Transport Policy Institute should have a go at figuring out all the net effects.

Morgan_DJuly 15th, 2011 at 10:14 pm

Absolutely great article!

I also would support an increase to the national gas tax rather than increasing the CAFE target.
I believe that the federal gas tax hasn't been raised since 1997. Good point about the drop in consumption, It would be best to wait for an (actual) recovery in the economy before increasing the federal gas tax. Still, gas is more expensive in many more countries (including about 33% more in Canada, the US' largest foreign supplier), so higher gas prices wouldn't completely ruin an economy.

Two points that would also support an increase in the federal tax rather than the CAFE target:

1. An increase in revenue that an increase in the federal tax would bring in, whereas I would tend to doubt the CAFE brings in very much money currently, as the car companies are struggling enough without having to pay penalties. (Increased revenues would be good because I think I read somewhere recently that Congress is considering debating over the budget and helpful ways to raise revenue might be appreciated). For those who prefer to continue driving at the same amounts (i.e. those people who ignore elasticity studies), then the result is a large increase in revenue, but the majority of Americans will begin to drive less. I would still believe that net revenues will increase as the gain from the higher tax will be greater than the loss from the lower amount of gas purchased.

2. An increase in the federal gas tax would essentially have the same effect as an increase in CAFE eventually anyway. As gas prices increase, consumers demand for more fuel efficient cars will increase. In theory, the market will determine that it is in the best business interests of car companies to make more fuel efficient cars, as consumers will prefer them knowing that a permanent increase in gas prices have occurred. The gas tax will theoretically be a permanent increase rather than a temporary shock, where consumers might not be more willing to purchase a more fuel efficient car, since gas prices usually fluctuate and will eventually come down. Essentially, this would be letting markets determine that it is in the best interest of car companies to make more fuel-efficient cars, rather than have government regulation try to determine the exact amount of an increase that is necessary. Incentives to look at gasoline alternatives would also be stronger rather than trying to get down to a certain CAFE number. It is possible that car companies try so hard to hit the CAFE requirement that we are stifling innovation to go beyond that number or use some alternative. An increase in gas tax would promote innovation to avoid using gas as much as possible rather than simply engineering cars to hit a certain MPG. Maybe in 2025, technology will be such that 56.2 mpg is actually low, and cars could actually get a much higher mileage with the right incentives to do so.

MacAaronJuly 16th, 2011 at 3:09 pm

Of course, using governmental FORCE to achieve goals is always the best option.. whether through CAFE or taxes.

How about we just remove government from the issue altogether? The reason oil costs are so low is because of the heavy subsidization that same government gives them. So perhaps a lot of the problem is actually government, making adding more of it not much of a solution.

Just the military protection given to oil in the Middle East amounts to up to .30/gallon. That's a 2007 number. It's likely more now.

Ed Dolan EdDolanJuly 17th, 2011 at 7:33 am

MacAaron– You're right, of course, government use of force should be the last resort, and even when used for good purposes (protecting property, enforcing contracts, etc.) it should take the form that does the least collateral damage.

I agree, a good place to start would be by removing all government subsidies from motor fuel, including the indirect defense-related subsidies you mention as well as more direct ones like depletion allowances, sweetheart lease deals, and so on. Next get rid of government subsidies for roads and other transportation infrastructure, wherever possible, through tolls, parking fees, time-of-day congestion charges, and so on. Privatize (Dulles Greenway, Indiana toll road) where you can.

Even when you're done with all that, you're still left with the problem of how to protect property from damage by pollution. What are your choices? (1) Let people pollute however much they want ("Don't Tread on Me"), (2) wait for development of some utopian system where private courts, bodyguards, and insurance companies bring polluters to account (nice, but a long wait), or (3) accept that pollution control is an area where even small government folks allow a role for their small government. If you choose (3), which is my choice, then gas taxes are better than CAFE.

MacAaronJuly 17th, 2011 at 11:30 am

How about 4) property rights reign and thus those who are polluted against get to fight back.

The problem here is that you're imposing a tax on a commodity purely because it "pollutes." Everything pollutes in one way or another. Even the compost in my garden is sending off pollution. Will you tax that as well?

What about farmers? They pollute rivers and streams with fertilizers and indirectly through support of the mining industries that dig up potash. Tax that too?

By the time you're done, you've literally taxed everything and.. we're right where we are now – in a climate where most commodities and goods in this country are taxed multiple times before seeing a consumer.

Morgan_DJuly 20th, 2011 at 1:48 pm

MacAaron-
I disagree with your comment
"The problem here is that you're imposing a tax on a commodity purely because it 'pollutes.'"

Reducing pollution is a positive side effect of increasing (not imposing) the federal gas tax, it is not "purely" the reason for increasing the tax. There are many reasons to increase the Gas tax besides reducing pollution.

This is not solely an issue of pollution as it is an issue of providing economic incentive to easily change the American Economy and its dependence on gas prices. The U.S. Economy is very sensitive to supply shocks in oil and any price increase that could affect corporate and consumer habits. One way to change this is to raise the federal gas tax, which would in turn lead to a decrease in the amount of gas used in the U.S., and then eventually lead to an increase in fuel efficiency of cars in the U.S. This would reduce the impact that gas prices can have on an economy. The Fed recently noted that the slowdown in the recovery and lack of stimulation in AD has been caused by temporary factors, namely high gas prices. The ability of gas prices to affect the economy would be mitigated.

A very substantial gas tax increase could be applied, and we still would not have gas prices as high as most of Europe. Canada, the largest exporter of oil to the U.S., has gas prices about 33% more expensive than in the U.S. Meanwhile, an increase in the gas tax could be a needed revenue boost for the U.S., without raising income or corporate tax rates.

On top of this, an increase in the gas tax will lead to a reduction in the demand for gas. Simple Supply and Demand will likely cause OPEC and other oil producers to lower their price for oil when (by far) their biggest consumer (the U.S.) reduces its demand for their product. As a result, oil prices will not shift very much in the long run, and instead a transfer in profits from oil-exporting nations to U.S. revenue might occur. Republicans would argue this revenue can easily justify the extension of tax cuts farther into the future, while Democrats can argue that this extra revenue can support the nation through an increase in spending. Either way, America as a nation benefits from an increase in the gas tax.

Many other possible positive externalities can come from higher gas prices. In much of Europe, bicycle travel is popular in cities, while U.S. cities rarely travel by bicycle. If higher gas prices lead to greater exercise in the U.S., as the concentrated populations in cities tend to walk or bike more often, obesity rates could start to decline and health care costs would decrease along with it.

There are many possible side effects of increasing the gas tax besides simply that it would reduce pollution. It also makes good economic sense for the nation.

MacAaronJuly 20th, 2011 at 2:06 pm

Those are not the reasons given for raising the gas tax, Morgan. While they are nice little economic theories, they ignore a lot of reality. First, CHINA is fast becoming the world's largest importer of oil (they are currently #2 and grow their use by 7x what we do). Second, any increase in taxes has an overall negative effect on the economy because taxation is NOT a "gain" for anyone and is instead a clear drain on resources. Contrary to Keynesian economic theory, taxes do not increase productivity, they kill it.

To move away from oil as our primary source of just about everything (only about 19% is made into gasoline), we have to have some kind of replacement. So far, we have bupkiss. Tout all the electric yadda yaddas you want, but they aren't even a drop in the market and are priced out of the pocketbook of most people. I refuse to spend $30,000 on a car that goes less than 100 miles before needing a recharge. I also would not benefit from the tax credit because, frankly, I don't pay anywhere near that in taxes (I'm self-employed and nearly always pay only the AMT). So federal "incentives" are useless to me. I live in a state with no state income tax and therefore no state incentives for green vehicles.

Oh sure, some of these might available "in the near future" or whatever and might even be boosted were a gas tax imposed, but in the mean time.. what? The Fed has come up with a million reasons for our failure to recover. It's my opinion that most of their reasons are bullshit straw men. The real reason is that government is standing in the way of markets and won't allow a recovery. Start up your own business and see how much red tape is required to get it going legally and you'll understand why business (and therefore production) in this country is failing. Adding on more taxes will not fix that. More government jobs are not "new" jobs boosting the economy, they're yet more drains on the economy because government produces nothing of value for the economy. Go ask the airline manager how much good the TSA has done to boost his business..

Morgan_DJuly 20th, 2011 at 2:55 pm

MacAaron-
The US is the largest consumer of gas, and you are correct that China is #2. However, the US consumes almost a quarter of all oil in the world, and although China is growing fast, it is still a couple of years away from consuming Half as much oil as the US .

Your point on how expensive electric cars are and how little tax breaks help give you incentive to buy them are exactly why we need an increase in the gas tax. Right now, the majority of cars sold to Americans are heavier and larger than they need to be, or than they are in other countries for that matter. And there isn't much of a reason for car companies to put forth the R&D necessary to make lighter, more efficient cars to be sold in the U.S. With our cheap gas, Americans are happy to continue to purchase cars with poor gas mileage, because that is cheaper than paying for a more expensive hybrid etc. Car companies are happy to charge higher prices for the small segment of the market willing to pay more for efficient cars, as only higher gas prices (or higher CAFE standards: problems noted above) will create an incentive to make cars more efficient.

The debate over the effectiveness of taxes is a debate for the ages, with many great minds on both sides. I personally view the federal gas tax as a pigovian tax which would not only decrease oil consumption, but also have other side effects listed above. I assume you are referring to the deadweight loss sometimes associated with taxes, but it is more than obvious that taxes can still benefit the country as a whole (one small example of how taxes can help includes the hundreds of studies on the benefits of an even income distribution). The debate is over how much taxation is necessary in order to continue to benefit the nation as a whole.

And I will say this about your example: Any airline manager will tell you that after September 11, airline travel almost came to a halt as business stalled, and airline company layoffs following that period will prove that customers stopped traveling in airplanes in response to the possibility of another security threat. Although most airline managers will admit the TSA has been a nuisance, their improved security has undoubtedly increased consumer confidence in air travel and restored faith in air travel, thus increasing revenues again. Not all government is purely evil.