Fuel Taxes

A fuel tax is commonly-used for pricing the externalities of fuel-consumptive activities and promoting fuel conservation. Fuel taxes often pertain to the transportation sector—as a gas or petroleum tax—but can be applied to any fuel used to generate heat or energy in buildings, industry, or the power sector. Fuel taxes can be designed to reduce greenhouse gas emissions and enhance air quality by tying their value to the estimated social cost of pollution.

Fuel taxation is the economist’s choice for a sector-level policy—assuming the absence of an economy-wide carbon tax—because it internalizes the external cost of pollution by applying a predictable fee on fuel. Ideally, a fuel tax induces rational actors to choose more fuel-efficient products¹ (vehicles, appliances, industrial equipment, etc.) and use them less, both of which result in fewer emissions. Charging fuel taxes or lowering fuel subsidies to levels that account for the costs of pollution is similar to imposing a carbon tax policy. The effect of fuel taxes hinges on consumers’ sensitivity to fuel prices, the extent to which they correctly account for expected future fuel costs and savings, and the availability of alternatives.

In addition to the effects on individual rational actors, fuel taxes encourage private sector innovation by pushing manufacturers to market more fuel-efficient products and invest in R&D aimed at improving the fuel efficiency of their products’ future models. Where fuel-efficiency standards are in place, fuel taxes can offset the “rebound effect,” which refers to the incentive to increase fuel consumption that may arise from a scenario where higher efficiency reduces the cost of valuable energy services, inducing even greater demand for those services.

Fuel taxes have some drawbacks, however, and are unlikely to achieve sufficient emissions reductions in the absence of complementary economy-wide policies. In the real world, using taxes to correctly price fuel to account for pollution externalities is not sufficient for substantially improving a product’s efficiency. This is because consumers appear to systematically underinvest in efficiency (i.e., they are relatively insensitive to fuel price changes). Studies have shown that consumers could privately benefit from owning more fuel-efficient products, but they still do not make these rational investment decisions. Of course, ending fuel subsidies and including a tax in fuel prices would influence purchasing decisions and use patterns for fuel-intensive products in the long-term. However, the effect on efficiency will be smaller than if consumers fully valued expected savings.

In this case, product refers to anything that consumes fuel to operate, from vehicles and homes to appliances and industrial equipment.

For a more detailed discussion, see the applicable chapter of Designing Climate Solutions, our book on smart energy and climate policy design.