The Office for Budget Responsibility has said that the UK Treasury will face a shortfall of £13bn in motoring taxes within a decade. Although car usage continues to rise putting increasing pressure on the road infrastructure, the greener and more fuel efficient cars being produced are driving down the tax revenues generated from motoring.
A report by the IFS has put forward the case for replacing the existing system of taxes on cars and fuel by a new road charging system. If no such change occurs, the IFS has forecast that with more electric cars and hence lower revenues raised from fuel and vehicle excise duties, the shortfall facing the Treasury would require an increase in fuel duty of some 50%. Instead of this, the solution could be to charge individuals for every mile of road they use, with the ‘price’ varying depending on the degree of congestion. For example, at peak times the price would be higher, where as for those in the countryside where roads are traditionally much quieter, charges would be lower. The IFS said:
‘Such a move would generate substantial economic efficiency gains from reduced congestion, reduce the tax levied on the majority of miles driven, leave many (particularly rural) motorists better off, and provide a stable long-term footing for motoring taxes without necessarily raising net additional revenue from drivers.’
Government policy across the world has been increasingly focused on climate change, with targets for emissions reductions being somewhat ambitious. However, many car manufactures who were told to reduce emissions significantly are on the way to meeting these targets and this success is a key factor contributing towards this new road ‘crisis’ that could soon be facing the government. The following articles consider the possibility of a road charging scheme.
Report
The road ahead for motoring taxes? Institute of Fiscal Studies (link to full report at the bottom of the page) (May 2012)
Articles
Compelling case for UK road charging, IFS study says BBC News (15/5/12)
Fears tax shortfall may lead to road tolls Sky News (15/5/12)
Who’s going to pay to update Britain’s infrastructure? Guardian Business Blog (15/5/12)
Motoring taxes: a future headache for the Chancellor Channel 4 News (15/5/12)
For whom the toll bills – less traffic hurts M6 toll road owner Guardian, Ian Griffiths and Dan Milmo (14/5/12)
Charge motorists per mile, says IFS Independent, Nigel Morris (15/5/12)
Green cars to drive down tax receipts Financial Times, Mark Odell and John Reed (15/5/12)
Questions
- Illustrate the effect of a tax being imposed on petrol. What happens to the equilibrium price and quantity?
- Despite fuel duty pushing up the price of petrol, why has there been such a small decline in the quantity of petrol individuals use?
- Evaluate the case for and against a road charging scheme.
- Why are tax revenues from motoring expected to decline over the next decade?
- Climate change has become an increasingly important focus of government policy. To what extent is the current road ‘crisis’ a positive sign that policies to tackle climate change are working?
- If a road charging scheme went ahead and prices were varied depending on traffic, time etc, what name would you give to this strategy?
- Why would it be possible to charge a higher price at peak times and a lower price for cars using country roads?
- Is there an argument for privatising the road network? Is it even possible?
A weekly expense for most families is filling up their car(s) with petrol, but this activity is becoming increasingly expensive and is putting added pressure on lower and middle income families in particular. For those families on lower incomes, a tank of petrol represents a much larger percentage of their income than it does for a higher income household. Assuming that petrol for a month costs you £70 and your monthly income is £500, as a percentage of your income, a tank of petrol costs you 14%. Whereas, if your income is £900, the percentage falls to 7.7% and with a monthly take-home pay of £2000, the cost of a month’s petrol as a percentage of your income is just 3.5%. This is a stark indication of why those on lower incomes feel the burden of higher petrol prices (and indeed, higher prices for any essential items) more than other families.
The price of petrol will today be debated by MPs, following an e-petition signed by more than 100,000 people and having the support of more than 100 MPs. When in power, the Labour government proposed automatic fuel-tax increases, but these were scrapped by the Coalition. However, in January, the government plans to increase fuel duty by 3p a litre and further increases in prices are expected in August in line with inflation. This could mean that the price of unleaded petrol rises to over 1.40p per litre.
And it’s not just households that are feeling the squeeze. The situation described in the first paragraph is just as relevant to firms. The smaller firms, with lower turnover and profits are feeling the squeeze of higher petrol prices more than their larger counterparts. Any businesses that have to transport goods, whether to customers or from wholesalers to retailers etc, are seeing their costs rise, as a tank of petrol is requiring more and more money. To maintain profit margins, firms must pass these cost increases on to their customers in the form of higher prices. Alternatively, they keep prices as they were and take a hit on profitability. If prices rise, they lose customers and if prices are maintained, profitability suffers, which for some companies, already struggling due to the recession, may not be an option.
Mr. Halfon, the Tory MP whose motion launched the e-petition said that fuel prices were causing ‘immense difficulties’ and the Shadow Treasury Minister Owen Smith has said:
‘With our economic recovery choked off well before the recent eurozone crisis, we need action.’
With inflation at 5.2% (I’m writing an hour or so before new inflation data is released on 15/11/11), higher prices for many goods is putting pressure on households. This is possibly contributing towards sluggish growth, as households have less and less disposable income to spend on other goods, after they have purchased their essential items, such as groceries and petrol. A criticism leveled at oil companies is that they quickly pass on price rises, as the world price of oil increases, but do not pass on cuts in oil prices. The issues raised in the debate and how George Osborne and David Cameron respond, together with inflation data for the coming months, may play a crucial role in determining just how much a tank of petrol will cost in the new year.
MPs to debate motion calling for half in petrol prices BBC News (15/11/11)
Petrol price rise: David Cameron faces Commons revolt after No10 e-petition Guardian, Cherry Wilson (15/11/11)
David Cameron faces backbench rebellion over fuel price hike Telegraph, Rowena Mason (14/11/11)
Petrol prices may be slashed by Rs 2 per litre on November 16 The Economic Times (15/11/11)
Paying the price as fuel costs rise BBC News (15/11/10)
Oil barons the big winners from soaring pump prices, ONS figures reveal Daily Mirror, Graham Hiscott (15/11/11)
Scrap rise in petrol duty: 100 MPs demand Osborne abandon planned 3p increase Mail Online, Ray Massey and Tim Shipman (15/11/11)
Questions
- As the price of petrol rises, why do people continue to buy it? What does it suggest about the elasticity of this product?
- Why do higher prices affect lower income families more than higher income families?
- What are the arguments (a) for and (b) against George Osborne’s planned 3p rise in petrol duty?
- Do you think that higher prices are contributing towards sluggish growth? Why?
- What type of tax is imposed on petrol? Is it equitable? Is it efficient?
- Why can the oil companies pass price rises on to petrol stations, but delay passing on any price reductions? Is there a need for better regulation and more pressure on oil companies to change their behaviour?
The law of demand tells us that when the price of a good falls, quantity demanded will rise. But, firms want to know much more than this. They need to know by how much quantity demanded will rise – we refer to this as the price elasticity of demand (PED) and we can categorise it as relatively inelastic or elastic, depending on by how much demand changes relative to the change in price. The price elasticity of demand is crucial for a firm to know, as it gives them vital information about the best price to charge and getting the price right is probably the most important element in a successful business. As Warren Buffett said in a meeting with the staff from the Federal Crisis Inquiry Commission:
‘Basically, the single most important decision in evaluating a business is pricing power. You’ve the power to raise prices without losing business to a competitor, and you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you got a terrible business.’
The grammar may not be entirely correct, but hopefully you get the gist! Should a firm increase price or reduce it? Whatever action it takes, there will be an effect on demand, total revenue and profit. The key question is: what will be the effect? The answer depends on the PED.
If a firm is selling a product for which there are no close substitutes, we would expect demand to be relatively inelastic. This means that the firm can increase the price it charges without seeing any large fall in quantity. On the other hand, if a firm faces a lot of competition and hence there are many substitutes for a product, then demand becomes much more elastic – any increase in a firm’s price will lead to a proportionately larger decrease in the quantity demanded, as customers will simply switch to a cheaper alternative. The article below looks at the concept of price elasticity of demand and how it is used in practice by competing firms.
The importance of pricing power: PEP, CPB Guru Focus (16/10/11)
Pricing strong for Philip Morris in Q3, but volumes also encouraging; dividend yield attractive MorningStar (7/11/11)
Questions
- How do we define price elasticity of demand and what formula can we use to calculate it?
- If a firm faces an PED of –5, is its demand relatively inelastic or elastic and what does it mean about the responsiveness of customer demand to a change in price?
- If a firm faces demand that is (a) relatively inelastic (b) relatively elastic, (c) perfectly elastic (d) perfectly inelastic, what should it do to its price? Explain your answers.
- In the article, ‘The importance of pricing power’, is demand for the ‘Daily Racing Forum’ relatively inelastic or elastic? Explain your answer and what it means in terms of the company’s ability to change price.
- Is demand for cigarettes likely to be inelastic or elastic? Explain your answer. What does this suggest about a firm’s ability to pass on taxation and excise duties to its customers in the form of higher prices?
- Based on the data given in ‘The importance of pricing power’ about the change in demand for Campbell’s Soup and PepsiCo, what conclusions can we reach about PED? How could these firms use this information to set prices and maximise revenue and profit?
- Following a change in supply (due to a factor other than price), when will the impact on equilibrium price be larger than the impact on equilibrium quantity?
Through new legislation, the Ministry of Justice is aiming to make ‘offenders … take personal responsibility for their crimes’. The idea is to cut the wages of prisoners who work in communities, with the objective of raising £1m a year for victim support services. Any prisoner earning above £20 a week after tax, national insurance, child support payments etc, will face a 40% deduction in their pay. The money raised will be used to ‘repair the damage done by crime’ and begin to remove the burden from the general taxpayer. Critics, however, argue that this legislation will create a disincentive effect and discourage prisoners to work in the community before their release. It may also create additional bureaucracy for the external firms that employ them and at the end of the day may not even affect most prisoners, as many receive earnings, after all deductions, below £20 and so would not be liable. The following articles consider this policy.
Prisoners’ wages docked to fund victim support Associated Press (26/9/11)
Prisoners’ wages to help crime victims BBC News (26/9/11)
Prisoners to pay victims of crime The Press Association (26/9/11)
Victims handed £1m as prisoners suffer wage cut Independent, Nigel Morris (26/9/11)
Questions
- To what extent do you think the above policy is (a) equitable and (b) efficient?
- What might be the adverse effects of such legislation, from the point of view of both prisoners and the firms that employ them?
- What are the income and substitution effects in the context of a worker’s decision to work more or less hours?
- Using indifference analysis, explain how a fall in the prisoners’ net pay (due to this latest deduction) might have an impact on their desire to work more or less.
- Using your analysis from the previous question, explain the importance of the income and substitution effects.
Taxes are a key element in redistributive policies: taxes on the rich can be spent on benefits to the poor. The more progressive the taxes (i.e. the more steeply they rise with rising incomes), the bigger will be the redistributive effect and hence the more equal will post-tax incomes be.
But high and steeply progressive taxes can act as a disincentive to work longer, or to go for promotion or to move to a better paid job. High corporate taxes and income taxes can act as disincentive to inward investment and may encourage a ‘brain drain’ and capital flight with people and capital leaving the country for lower tax regimes abroad.
Raising taxes has two effects. First there is the substitution effect: people may work less and substitute it with leisure – after all, work is now less rewarding. People may also substitute working abroad for working at home. But the second effect works in the opposite direction. This is the income effect. As taxes are raised and people’s take-home pay is thereby reduced, they may feel the need to work longer hours or try harder for promotion in order to make up the lost income and maintain their living standards. Thus the effect of higher taxes is not clear-cut. It is an empirical question of which of the two effects is the stronger.
One important determinant of the effects of different tax rates is their relative position compared with other countries. Another is the international mobility of labour and capital. The greater the mobility, the greater the elasticity of supply with respect to changes in tax rates.
The following report and articles look at relative tax rates between different countries and the effects on output and factor movements
Articles
Wide tax gaps among countries, UHY study finds UHY International, Press Release (10/6/11)
Britain’s most talent workers flee to avoid high tax rates The Telegraph, Myra Butterworth (13/6/11)
UK tax rate ‘one of the highest’ Belfast Telegraph (13/6/11)
Data
Tax Rates Around the World – Comparison UHY Worldwide-tax.com
Effects of taxes and benefits on household income National Statistics
(see especially Data: The effects of taxes and benefits on household income, 2009/10)
Questions
- Why may relative income tax rates between countries give only a partial picture of the international competitiveness of these countries? What else would need to be taken into account?
- Does making taxes more steeply progressive necessarily act as a disincentive to output? Explain.
- What factors are likely to determine the relative size of the income and substitution effects of tax changes?
- How progressive are income taxes in the UK compared with other countries? Give examples.
- What externalities (positive and negative) might result from steeply progressive income tax rates?
- What determines the international elasticity of supply of labour?
- What is the Laffer curve? How will the shape of the Laffer curve be affected by the international mobility of labour and international tax rates?
‘Such a move would generate substantial economic efficiency gains from reduced congestion, reduce the tax levied on the majority of miles driven, leave many (particularly rural) motorists better off, and provide a stable long-term footing for motoring taxes without necessarily raising net additional revenue from drivers.’