Governments
around the world
are cutting taxes on petrol or fuel, including in
Germany, Italy, Spain and Canada. The UK government has come under
pressure to do the same, which is hardly surprising as the crisis
may leave
the typical British household £500 worse off. But the problem with
this approach should be pretty obvious. Prices are rising because
there is a reduction in the amount of oil and gas being produced.
Prices therefore need to rise to discourage the demand for oil and
gas to avoid physical shortages. If governments take measures to
subsidise prices by taxing fuel less, then demand is discouraged less
and prices will need to rise further, or there will be rationing.
Each
individual government is tempted to cut taxes on fuel, because if
they alone did so then their consumers would benefit, and other
countries would only suffer a small increase in global prices. But if
all countries do the same the policy is self-defeating: prices simply
rise further to offset the government subsidy. If many states cut
taxes on fuel, consumers in the remaining countries face
significantly higher prices as the global price tries to match demand
to supply, or there is rationing.
In
principle a much better way of protecting consumers from the impact
of higher energy prices is to let those prices rise, and compensate
consumers for some of their loss in real income by transferring cash to
them. Consumers still have an incentive to economise on energy, but
the hit to their real income is reduced. As
I argued
during the previous energy price hike, this approach seems natural if
the excess profits of energy producers and electricity distributors
[1] can be taxed, effectively transferring from the small number of winners to the many losers of the price hike.
However
I suspect most
economists
would
ask
why the government needs to cushion the impact of higher energy and
food prices for those who can afford those higher prices. Most would
agree that it makes sense for the government to protect those who
would suffer real hardship as a result of higher prices, but why go
beyond that? If we abstract from issues of supporting aggregate
demand, any government subsidy today has to be paid for by raising
taxes or borrowing, and why should the government do either to shield
consumers from higher prices?
That
is my own instinctive position on government subsidies in response to
a hike in energy and food prices. Yes, the government should protect
those most in need, but otherwise it should not provide any
compensation, and the government certainly shouldn’t cut fuel
taxes. I think that is the right position if the government could
direct help perfectly to those who need it. The problem arises
because the government cannot easily do that.
As
this
instructive study from
Levell, O’Connell and Smith at the IFS notes, those most affected
by energy price hikes are not just those on low incomes. Indeed the
correlation between hardship following an energy price increase and
low incomes is pretty low. That makes the government’s normal
benefits system a poor vehicle for supplying assistance to those who
need it following an energy price hike.
So
one justification for the government providing compensation for
everyone is that you can be sure of getting help to those that really
need it. The problem, of course, is that you are providing help to
many more who don’t need it, and so the compensation is very
expensive. This is what the last UK government under Sunak did during
the previous energy price hike, and it cost a great deal of money. A
better alternative is to attempt to use what data the government has
to proxy household needs, but did the government put any
resources into trying to do that after the last energy price hike?
Of
course the most effective way of getting help to those who need it is
to directly subsidise the price of fuel. As we have already noted,
that has obvious costs (what economists call efficiency costs) in
terms of preventing consumers switching away from using energy. The
IFS study noted above finds those efficiency costs to be large,
partly because they also find that consumers do manage to economise
quite a lot on energy use when prices rise. But despite this, they
still find that optimal policy involves some degree of direct price subsidy
from the government, and of course how much that subsidy should be
depends on how effectively the government can target those who really
need help by other means.
All
this implies that, in the absence of an effective way of targeting
those most in need after an energy price hike, there is an economic
case for both income compensation and even some energy price subsidy.
Yet I suspect that while this matters for economists it has rather
le…
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