Oil Taxes and the Budget

My colleagues Daniel Ahn and Michael Levi are out today with a new look at the case for an oil tax.  While an oil tax has little traction on the Hill, many economists favor it.  Arguments for the tax usually include its efficiency (demand is relatively insensitive to price in the near term and it can be broadly applied) and its ability to account for environmental externalities.

Levi and Ahn take the analysis further in two ways.  First, they consider the effects of the tax as part of a comprehensive deficit reduction package.  Second, they focus on how the results might change when the economy is starting from a weak position, with significant economic slack.

Their model provides support for the notion that an oil tax can be an effective part of grand bargain, by preventing even deeper and more painful cuts to spending and other tax hikes. They show that, in an environment of weak demand, an oil tax that softens the cuts to government spending can be particularly effective.  As CBO’s new outlook (out yesterday) reminds us, recent deficit reduction measures have done little to address our longer-term fiscal challenges.  Ultimately, very tough choices are needed.  Having an oil tax as part of the long-term package may beat the alternatives.