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The Petroleum-Tax Giveback—A Commentary by Thomas W. Merrill and David M. Schizer

The following commentary was published in Commentary Magazine in October 2009.

The Petroleum-Tax Giveback
By Thomas W. Merrill and David M. Schizer

Is anyone in the United States happy, satisfied, or even comfortable with the national approach to energy? Michael Moore on the radical Left, Martin Peretz in the dead Center, Charles Krauthammer on the reasonable Right, and Ron Paul on the radical Right are as one when it comes to the deeply held conviction that the United States imports far too much oil from the Middle East and that the American oil “addiction” (a word all four men have used) has distorted American foreign, fiscal, and environmental policy. Environmentalists, led by former Vice President Al Gore, believe the promiscuous use of carbon fuels, primarily by the United States, is leading the planet itself into chaos and eventual ruin. Conservatives who express skepticism about Gore’s climate-change beliefs have little or nothing good to say about energy policy as it now stands; they want domestic oil production increased so that the United States will not be beholden to the vagaries of Middle Eastern politics and social upheaval.

As with the Bush administration before it, the Obama administration came into office determined to make significant changes. Here, too, there was and is a commonality in the shared belief that radical alterations in the national approach were necessary. But the policy prescriptions were and are different. Bush sought to exploit the nation’s store of oil more effectively, especially with respect to the potentially massive reserves under the Alaska National Wildlife Refuge, but he failed utterly in securing his objective. Obama has a grand vision of using energy policy as a means of containing and controlling global climate change through an approach that has come to be known as cap-and-trade. Rather than reduce the nation’s dependency on foreign sources, Obama seeks to reduce the use by Americans of any and all energy sources that may trap greenhouse gases in the atmosphere, and he seeks to do so through a complex system of financial chits, credits, swaps, and penalties. A bill to do just that passed the House of Representatives by a razor-thin margin, 219-212, at the end of June; a Senate version will be debated in the fall. The intensity of the new administration’s focus on cap-and-trade suggests that, for Obama, global climate change is the only energy problem that matters.

That should not be the case. Indeed, by staking the future of his energy policy on this increasingly controversial legislation, whose successful passage would have a brutalizing effect on the economies of the Rust Belt states in particular, Obama may find himself without an energy policy at all should it ultimately fail to reach his desk.

A more sensible energy strategy would rank national security and economic stability high among its objectives. There are profound and immediate dangers to the nation from insecure sources of supply and the economic threat of renewed oil-price spikes. We ignore them at our collective peril. The Obama administration is ignoring them and missing an extraordinary opportunity to redirect national policy.

ENERGY THREAT:
Supply

In formulating any comprehensive policy, the first step is to identify the objectives. What threats demand our attention? Three are especially critical and should serve as the centerpiece of any national energy policy.

The first is the growing insecurity of America’s energy supplies. The need to establish “energy independence” received significant rhetorical support from both presidential candidates during the 2008 campaign, but the theme has largely disappeared in the first year of the Obama administration. In this respect, it is simply following the lead of the American public. The spike in oil prices in the summer of 2008—which translated into gasoline prices in excess of $4 per gallon—induced widespread hand-wringing about America’s reliance on imported petroleum fuels and its vulnerability to supply disruptions from hostile or unstable foreign sources. With the ensuing collapse in oil prices, and the corresponding drop in pump prices, the public has been lulled back into complacency about America’s dependence on foreign oil.

This complacency is understandable but irresponsible. Cheap oil leads to more consumption, which only increases America’s dependence on foreign suppliers. Low oil prices have resulted in the cancellation or postponement of countless domestic projects seeking to find or produce new sources of oil. The collapse of oil prices in late 2008 has made the security of oil supplies a more urgent problem than it was last summer.

After World War II, the United States obtained all its energy from domestic sources. Today the U.S. has abundant reserves of coal and significant reserves of natural gas, but it imports nearly two-thirds of its petroleum fuel. Canada and Mexico, our two largest foreign suppliers, are reasonably reliable trading partners. But after that, the picture is disturbing. Our next largest sources are Saudi Arabia (519 million barrels per year), Venezuela (416 million barrels per year), Nigeria (381 million barrels per year), Iraq (202 million barrels per year), Angola (130 million barrels per year), and Algeria (130 million barrels per year). These are all countries experiencing war or significant internal discord, led by dictators, or overtly hostile to the interests of the United States.

Americans transfer hundreds of billions of dollars each year to oil-producing countries, many of which use these funds to undermine America’s foreign-policy interests. Although Russia and Iran do not supply oil directly to the U.S., our enormous consumption of imported oil helps prop up world oil prices, which in turn enriches these countries and encourages them to act more belligerently toward the U.S. and its allies.

It would be naive to think that America can regain energy independence. But the degree of our dependency and the direction of change both matter. If the United States is perceived to be ever more dependent on foreign sources of oil, then countries hostile to the U.S. will be more emboldened to take actions contrary to our national interests. If American dependence on foreign sources is perceived to be stable or decreasing, then the balance of power will shift in the opposite direction. For example, an American threat to impose an embargo on oil imports from oil-producing countries would become more credible.

Thus far the Obama administration has not offered a proposal that, either by reducing domestic demand for petroleum fuels or by increasing domestic supplies of oil, would diminish our dependence on insecure foreign sources of oil in any way. To the contrary, in response to standard objections from environmental groups, one of the administration’s first actions was to freeze President George W. Bush’s executive orders directing that new offshore fields be opened for exploration.

ENERGY THREAT:
Price Shocks

A second critical goal that should animate our energy policy is to address the risk to the American economy presented by oil-price shocks. This concern is related to the first, since historically oil-price shocks have been caused by disruptions in foreign supplies. The Arab oil embargo following the 1973 Yom Kippur War brought on a price spike in 1974; the Iranian hostage crisis and related oil embargo triggered a price spike in 1979. The price spike of 2008 was more driven by rising demand in Asia than by an effort to interrupt supply. But supply disruptions or the prospect of disruptions due to political unrest in Nigeria, instability in Iraq, the prospect of a possible war with Iran, and Russia’s invasion of Georgia did play a role.

Oil-price spikes bring on American recessions. The oil-price spike of 1974 led to the recession of 1974-75, and the spike of 1979 triggered another. The current recession has many causes, including the bursting of the real-estate price bubble and the credit crisis. But we should not forget that the United States did experience a major oil-price shock in the first eight months of 2008. The suddenness and the magnitude of the price shock traumatized ordinary Americans, most of whom are highly dependent on auto transportation to get to jobs, do their shopping, and go about their daily lives. Budgets of lower- and middle-income households were stretched to the breaking point, discretionary spending plummeted, and sales of autos—especially large inefficient vehicles favored by domestic auto producers—entered a free fall. The price shock of 2008 certainly played some role in the crisis of consumer confidence that made the economic meltdown burn even more scorchingly.

To reduce our exposure to price spikes, we need to reduce our dependence on petroleum fuels. So far the Obama administration has presented no general policy proposal to do so. The stimulus bill doles out generous subsidies to alternative energy producers and new motor-vehicle technologies. But even if these targeted subsidies yield major breakthroughs, it will take decades before these new technologies begin to produce a significant diversification. We cannot wait that long.

ENERGY THREAT:
The Environment

The third major goal of a workable energy policy can broadly be described as environmental. In a complete accounting, we would include here not just climate change but also a variety of externalities associated with excessive petroleum-fuel consumption, including the generation of conventional pollutants like smog and the productivity losses and accident costs associated with traffic congestion. The Obama administration appears to care only about climate change. Its massive stimulus package includes huge amounts of federal funding for projects designed to combat the phenomenon, such as $5 billion for home weatherization, $3.4 billion in subsidies for carbon capture and sequestration projects, and $300 million for the federal government to purchase a new fleet of hybrid vehicles. And then there is the cap-and-trade proposal, which, if adopted in anything like the form contemplated, would have real bite in a matter of years in pushing up energy costs.

This approach has created an economic conundrum for the administration. Even if the best possible policy for reducing greenhouse-gas emissions is to raise prices to discourage energy consumption, it is not sensible to impose such a policy on an economy struggling to emerge from the most complicated economic crisis the nation has faced in seven decades.

The Obama administration’s energy proposals appear to be partially sensitive to this constraint. The first phase of the energy plan is embodied in the stimulus package, which grants some $60 billion in subsidies for alternative technologies, smart electric grids, weatherization programs, and so forth—all of which, presumably, will have some stimulative effect. But its cap-and-trade legislation calls for the government to begin issuing new permits that energy producers will have to buy to pay for the release of emissions. This will lead producers to raise the price of electricity and other commodities, with an inevitable depressive effect on the American economy.

In short, the administration’s energy policy is alternatively inflationary and deflationary. What it gives with one hand it takes away with the other. This can be reconciled only by the assumption that the economy will recover by 2011, so that what amounts to a huge new tax on energy in 2012 will not push the country back into recession.

Obama is gambling on an unknown future in another way. It is true that we may ultimately develop technological innovations that reduce our consumption of petroleum and other carbon fuels without any sacrifice in our standard of living. At this point, however, no one knows which new technology will turn out to be most promising: solar, thermal, wind, biomass, ethanol from switch grass, or some other scheme that has yet to be invented. In the face of this uncertainty, it cannot be credibly argued that government officials have the information needed to make reliable predictions about which technologies or practices will prove most successful. Elected politicians and their advisers do not have the expertise to assess whether solar or wind energy is more promising, or whether consumers will prefer electric cars to hybrids, high-efficiency diesels, or natural-gas cars—or, more precisely, which type of consumer would prefer which product.

In addition to these information problems, government officials also may not have the proper incentives to make the right decisions. If a powerful interest group backs a technology, government may end up supporting it without regard to its intrinsic merit. The nation’s quarter century of experience with ethanol -offers a profoundly sobering example. Ethanol’s appeal is far more dependent on its support among farm-state senators and the relentless lobbying efforts of Archer Daniels Midland than on its contribution to energy independence or reductions in greenhouse gases. Ethanol is expensive, requires a great deal of energy to produce (once the energy needs of farmers and delivery vehicles are considered), and drives up food prices.

There is no sign that the Obama administration appreciates the inherent limits on government as manager of technological change. On the contrary, the Obama team and its allies in Congress appear supremely confident in their ability to direct a transition to a “clean energy future” using targeted subsidies and regulatory mandates. They propose to devote billions of taxpayer dollars to subsidizing smart electric grids, carbon-sequestration projects, and wind- and solar-power sources, even as they pile up regulatory barriers to nuclear power (the Obama administration supports cancellation of the Yucca Mountain nuclear-fuel reprocessing facility located in Majority Leader Harry Reid’s home state of Nevada), new offshore oil exploration, and the development of oil-shale gasification plants in Colorado and Wyoming. Evidently, no “green” technology is too speculative to warrant massive governmental support, whereas no technology disfavored by environmental groups is sufficiently important to get a reprieve from regulatory strangulation.

Government subsidies for basic research on energy alternatives do make sense. And government can and should create incentives that move society away from petroleum and carbon fuels toward better alternatives. But at this point, the Obama energy policy appears to be grounded in a hubristic belief that government has the capacity to pick technological winners and losers, which is contrary to all experience and reason.

Oil Should Be the Focus

A proper energy policy for the United States should focus on reducing consumption of petroleum fuels. Why only petroleum rather than other forms of energy, like coal? Because petroleum is the only energy source that combines all three elements any serious energy policy must address. Two of them—reducing national dependence on imported oil and tempering the threat to economic prosperity from periodic oil-price spikes—are confined to the oil market. The third objective—addressing environmental harms and demonstrating America’s commitment to moderate climate change—also implicates the consumption of petroleum fuels, since petroleum combustion is a major source of the carbon dioxide that traps heat in the atmosphere.

But how can such a policy be implemented without causing general economic woe? That is a difficult question, especially at this perilous economic moment. The best instrument would be one that increases the price of petroleum fuels in an unambiguous fashion and injects any generated revenues back into the economy. A price increase coupled with a clear commitment that prices would not fall appreciably in the future would create powerful incentives to conserve.

Consumers would respond in countless ways, including not just decisions about what kind of vehicle to drive but also how much to drive and whether to carpool. Manufacturers would respond by developing new vehicles. Government and private industry would respond with new public-transportation alternatives. Investors would respond by pouring more funds into potentially promising alternative fuels. All this would be achieved without the government picking technological winners and losers or attempting to dictate appropriate behavior through subsidies and regulatory mandates.

The big question that remains is whether a revenue-neutral system of price increases in petroleum fuels can be achieved in some way other than a conventional tax. It can. The answer is what we call the petroleum-fuel price-stabilization plan.

The Plan

The basic idea is to impose an additional charge on the wholesale price of refined petroleum products that would fluctuate up and down in inverse relationship to the world price of oil. Thus, when oil prices are high, the charge would shrink and might even be zero. But when oil prices fall, the charge would kick in and, in effect, impose a floor under the wholesale price, which would translate into higher prices at the pump. Any revenues collected under the plan would be refunded to consumers on a per capita basis, perhaps in quarterly payments.

Under this plan, the federal government would not be charged with raising petroleum prices, only with ensuring that they do not fall. Prices would inevitably go up over time, owing to market forces. They will go up whether our plan is adopted or not. What the plan would do is ensure that prices do not crash back down once they have risen. The most likely way to implement this would be through an automatic reset mechanism that would start with a price floor somewhat below current prices (say 10 percent below). It would then reset at higher levels when and if prices rise in the future, again at a price floor somewhat below then current prices (10 percent again). After a certain target price floor is reached, say $3.50 per -gallon of gasoline, the reset mechanism would be turned off. At that point, retail prices would never fall below roughly $3.50 per gallon.

The plan would have incentive effects similar to imposing a significant new tax on petroleum fuels. This would especially be true if it were adopted at a time when oil prices are high. But even if the plan were put in place when prices are hovering around $70 per barrel (and pump prices around $2.75 per gallon), it would send a clear message to consumers, producers, and alternative-energy suppliers that petroleum prices will not fall any further. There has been speculation from some energy experts that, with a prolonged world recession and accumulating inventories, world prices could fall as low as $20 a barrel. This would severely undermine incentives for conservation and the development of energy alternatives. At a bare minimum, the plan would prevent this from happening.

The refund feature of the plan would not undermine its incentive effects. This is because the additional funds consumers would pay would be based on their (energy-consuming) behavior, whereas the refunds would be distributed to every consumer automatically. Consequently, everyone would have an incentive to change their behavior in ways that would consume less petroleum fuel, in order to reduce the outflow of funds. Reducing the outflow would not affect the inflow (in the form of refunds), so the more energy-conscious the consumer, the more net gain he or she would realize from the plan.

Because of the refund feature, there would be no aggregate transfer of funds from consumers to the government, so the plan would not interfere with economic recovery. There would be other effects. Money would flow from persons who consume high levels of petroleum fuels to persons who consume low levels of petroleum fuels—thus creating the incentive to conserve.

It is doubtful that there would be any distribution from poor persons to rich persons. Indeed, if the rich tend to have higher-than-average levels of fuel consumption— because they have more cars in each family, are less likely to carpool, take more airplane trips, or own pleasure boats—then there would be some redistribution from rich to poor. One concern is that there would be some distribution from rural and suburban residents to urban residents because rural and suburban residents typically drive longer distances to work or to shop. If this becomes a serious political impediment to the plan, some adjustment in refunds based on population density could be considered.

Another virtue of the plan is that it could be adopted without creating a new government bureaucracy. The charges could be collected through the same system that currently collects excise taxes on petroleum fuels. The refunds could be administered by the IRS, using systems developed for distributing tax refunds or stimulus payments.

We would not want our plan to give producers cover to raise prices to a level just below the floor, and thus to expropriate the refund checks that consumers would otherwise receive as prices decline. If the floor is $3.50 per gallon, gas stations might be tempted to set the price at $3.49, even if the pre-charge price should fall to, say, $2.50. Fortunately, they could not get away with this as long as the floor is pegged to global crude prices instead of local retail prices. Crude producers, meanwhile, could not prop up the price either, as long as the rest of the world does not adopt our proposal. Crude producers would still have an incentive to let the price fall outside the United States (in order to sell more oil there) and could not maintain a separate propped-up price for the United States alone.

A critical question is whether voters would dismiss the plan as just another tax. For two basic reasons, we think the plan is in keeping with the president’s guarantee that new taxes will not be imposed on anyone making less than $250,000 per year—and the prudent understanding that raising taxes at a moment like this is economically suicidal. First, a tax is designed to generate revenue for the government. The charges we propose would be fully refunded to consumers and would generate no revenue for the government. Moreover, because the amounts collected under the plan would fluctuate inversely with oil prices, the plan would not produce a reliable source of revenue that might tempt politicians to turn it into a tax.

Second, the plan would never cause gasoline prices to rise and would only prevent them from falling. This is very different from an excise tax or a sales tax, which is added to the market price of goods or services. The plan would not take money out of consumers’ pockets. It would only deprive them of the benefit of future declines in fuel prices.

IS this plan politically viable? There is no way of knowing. It has never been attempted. But if there were ever a time for trying something new, we are living in it. We are lost in a policy muddle when it comes to energy, and the president’s approach thus far offers us no way out. The plan we propose offers common ground for the president, Democrats, Republicans, and everyone else concerned about America’s unquenchable thirst for the black gold that bubbles up from under some of the least stable and most politically and ideologically noxious places in the world.

Thomas W. Merrill is professor of law at Yale Law School. David M. Schizer is dean of Columbia Law School.