Does Britain or the United States Have
the Right Gasoline Tax?
Ian W.H. Parry and Kenneth A. Small
March 2002 (rev. Sept. 2004) • Discussion Paper 02–12 rev.
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Does Britain or the United States Have the Right Gasoline Tax?
Ian W.H. Parry, Resources for the Future
and
Kenneth A. Small
Abstract
This paper develops an analytical framework for assessing the second-best optimal level of gasoline
taxation taking into account unpriced pollution, congestion, and accident externalities, and interactions
with the broader fiscal system. We provide calculations of the optimal taxes for the US and the UK under
a wide variety of parameter scenarios, with the gasoline tax substituting for a distorting tax on labor
income.
Under our central parameter values, the second-best optimal gasoline tax is $1.01/gal for the US and
$1.34/gal for the UK. These values are moderately sensitive to alternative parameter assumptions. The
congestion externality is the largest component in both nations, and the higher optimal tax for the UK is
due mainly to a higher assumed value for marginal congestion cost. Revenue-raising needs, incorporated
in a “Ramsey” component, also play a significant role, as do accident externalities and local air pollution.
The current gasoline tax in the UK ($2.80/gal) is more than twice this estimated optimal level. Potential
welfare gains from reducing it are estimated at nearly one-fourth the production cost of gasoline used in
the UK. Even larger gains in the UK can be achieved by switching to a tax on vehicle miles with equal
revenue yield. For the US, the welfare gains from optimizing the gasoline tax are smaller, but those from
switching to an optimal tax on vehicle miles are very large.
Key Words: gasoline tax, pollution, congestion, accidents, fiscal interactions
JEL Classification Numbers: H21, H23, R48
Contents
I. Introduction......................................................................................................................... 1
2. Analytical Framework........................................................................................................ 5
3. Parameter Values.............................................................................................................. 15
4. Empirical Results.............................................................................................................. 25
5. Conclusion ......................................................................................................................... 30
References.............................................................................................................................. 32
Appendix: Analytical Derivations for Section 2................................................................. 40
Resources for the Future
Parry and Small
Does Britain or the United States Have the Right Gasoline Tax?
Ian W.H. Parry and Kenneth A. Small
∗
I. I
NTRODUCTION
Recent demonstrations in Europe against high fuel prices heightened interest in the appropriate level of
gasoline taxation. Excise taxes on fuel vary dramatically across countries: Britain has the highest rate
among industrial countries and the United States the lowest (see Figure 1). In Britain the excise tax on
gasoline is about $2.80 per US gallon (50 pence per liter), nearly three times the 2001 wholesale price,
while in the United States federal and state taxes together amount to about $0.40/gal.
1
The British government has defended high gasoline taxes on three main grounds. First, by
penalizing gasoline consumption, such taxes reduce the emissions of both carbon dioxide and local air
pollutants. Second, gasoline taxes raise the cost of driving and therefore indirectly reduce traffic
congestion and traffic-related accidents. Third, gasoline taxes provide significant government revenue: in
the UK, motor fuel revenue is nearly one-fourth as large as the entire revenue from personal income taxes
(Chennells et al. 2000). This third argument finds an intellectual basis in Ramsey’s (1927) insight that
taxes for raising revenue should be higher on goods with smaller price elasticities. Gasoline taxes have
also been defended on other grounds, such as a user fee for the road network (its primary role in the US)
and as a means to reduce dependence on oil supplies from the Middle East.
As these arguments suggest, several important externalities are associated with driving. Each
potentially calls for a corrective Pigovian tax, although the ideal tax for each would be on something other
than fuel. Only for carbon dioxide does a fuel tax closely approximate a direct Pigovian tax. For local air
∗
Kenneth Small thanks the University of California Energy Institute for financial support. We are grateful to
Howard Gruenspecht, Klaus Conrad, Larry Goulder, Charles Lave, Don Pickrell, Richard Porter, Paul Portney, Mike
Toman, and Sarah West for helpful comments and suggestions and to Helen Wei for research assistance.
1
Gasoline is also subject to sales taxation in the United States and value-added taxation in European countries.
However these other taxes apply to (most) other goods, and therefore do not increase the price of gasoline relative to
other goods (except insofar as they are levied on top of the fuel-tax component of price).
1
Resources for the Future
Parry and Small
pollution, a direct tax on emissions would provide better incentives to improve pollution abatement
technologies in vehicles. As for congestion, fuel taxes affect it through reducing total vehicle miles
traveled (VMT), whereas peak-period congestion fees would also encourage people to consider avoiding
peak hours and the most highly congested routes. An ideal tax to address accident externalities would
charge according to miles driven rather than fuel consumed, and would vary across people with different
risks of causing accidents.
2
Nonetheless, ideal externality taxes have not been implemented for political, administrative, or
other reasons. They raise objections on equity grounds, they require administrative sophistication, and
they run counter to attempts to reduce geographical differences in taxes and insurance rates. The fuel tax,
by contrast, is administratively simple and well accepted in principle, even at very high tax rates in some
nations. Therefore it is entirely appropriate to consider how externalities that are not directly priced
should be taken into account in an assessment of fuel taxes.
As for revenues, a well-developed public-finance literature rigorously compares the efficiency of
different tax instruments for raising revenues. Recently, this literature has been extended to compare
externality taxes with labor-based taxes such as the income tax.
3
One of its key insights is that by raising
the cost of living, externality taxes have a distorting effect on labor supply similar to that of labor-based
taxes. It is now feasible to bring the insights of this literature to bear on a tax, such as the fuel tax, that is
partially intended as an imperfect instrument for controlling externalities.
A number of previous studies attempt to quantify the external costs of transportation.
4
Typically
these studies estimate external costs per distance traveled rather than per volume of fuel consumed.
However the implications for the optimal fuel tax have rarely been rigorously spelled out; as our
formulation makes clear, the importance of distance-based externalities in the optimal fuel tax is
2
For further discussion of the efficiency of gasoline taxes at reducing externalities, see Walters (1961), UK Ministry
of Transport (1964), De Borger and Proost (2000), Parry (2001) and Fullerton and West (2001).
3
See for example Bovenberg and van der Ploeg (1994), Bovenberg and Goulder (1996), Parry and Oates (2000).
4
For example, Lee (1993), US OTA (1994), Peirson et al. (1995), Mayeres et al. (1996), Quinet (1997), ECMT
(1998, ch. 3), Porter (1999), Litman (1999), Rothengatter (2000), and various papers in Greene et al. (1997).
2
