Rafi Mohammed

Well…Actually Illinois’ and Indiana’s 2000 Gas Tax Holiday Lowered Prices at the Pump

Posted on May 29th, 2008 (0 Comments)

Last week I discussed why economic theory predicts that a gas tax holiday will have no effect on prices at the pump. This week I want to share the results of a great article ($2.00 Gas! Studying the Effects of a Gas Tax Moratorium) by Joseph Doyle and Krislert Samphantharak. The authors studied what happened to gas prices when both Illinois and Indiana temporarily repealed their state gas taxes during the summer of 2000.

In summer 2000, gas prices had risen sharply in the Midwest reaching highs of $2.11 (Illinois) and $1.78 (Indiana) in June. At least 5 investigations were launched to discover why prices were rising. The consensus was gas was in short supply because refiners were in the process of reformulating gas for the summer (different additives are used to control emissions during warm weather months).

Responding to these price hikes, the governor of Indiana suspended its 5% gas tax from July 1 until October 1. Some have wondered whether it was pure coincidence that this tax holiday occurred during an election year…but I digress. Illinois also repealed its 5% gas tax from July 1 until January 1. The authors analyzed gas prices at the pump prior to, during, and after the holiday with data from Wright Express Financial Services. This service reports retail prices at up to 120,000 gas stations each day.

The results were interesting. They found that on average, 70% of the tax savings were passed on to consumers. And when the tax was re-implemented, 80% - 100% of the tax was added to the retail price. The state of Indiana estimates that during the holiday it lost $46 million in taxes while the state of Illinois puts its loss at $157 million.

So here’s the million dollar question: why are economists claiming that a gas tax holiday won’t lower prices at the pump when this study (published in a well respected journal) clearly demonstrates that such a holiday did lower prices?

I spoke with economists around the country about this issue. The answer goes back to basic demand and supply. When supply is fixed – following the logic of last week’s blog (100 umbrellas to sell), a tax holiday results in no retail price change. Sellers have absolutely no incentive to lower prices. However, if more supply is available – sellers now have a reason to lower prices (hence pass along the tax savings) to sell more.

The reason why prices spiked during 2000 was due to a shortage – refineries were at max capacity. But later in the summer (during the tax holiday) – refinery capacity increased and more gas became available. With this additional supply, oil companies & gas stations realized they could make more money by selling more gas. Therefore, to increase sales, pump prices were lowered (thus giving back some of the tax savings to customers).

So why did a gas tax holiday work in 2000 and but economists don’t think it will in 2008…it all comes down to supply. Many believe that today’s gas supply today is fixed (refineries at max capacity). As a result, since gas stations can’t sell more, there is no incentive to lower prices.

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