Election season brings much tax talk. Yet there is precious little discussion of the lessons learned from the one new tax that our economy has experienced in spades during the past three years. That, of course, would be the Oil Tax which is far from trivial.

With oil around $90, this tax is running about $60 per barrel more than whatever an economist might have calculated it to be in 2003 based on $30 oil. Since America consumes about 21 million barrels per day, that $60 represents about $1.26 billion per day or about $460 billion per year in additional oil tax during 2007 alone, or about $3,500 per American family per year. In total from 2004 through 2007, the tax imposed by oil prices above $30 has probably consumed about $835 billion. Again, not trivial.

The Oil Tax is paid by Americans every day in obvious and hidden ways. The clearest impact, of course, is in the price of gasoline, but it is also acts like an invisible VAT tax paid on nearly every purchase by every consumer or business since oil is an input to virtually every product and service.

What makes the Oil Tax even more potent than its size alone is its quality; most of the tax immediately leaves our country. We import 2/3 of our oil, so nearly all of that part of the tax goes overseas and does not benefit our economy in any way. The other third goes to producers of domestic oil who also spend large amounts of it on activities outside the U.S.

Thus, unlike a tax that is paid to the U.S. Government and which is then spent very largely on Americans in America and for America’s benefit, the Oil Tax is nearly all wasted in terms of having any positive impact on the American economy. In fact, some argue convincingly that part of the Oil Tax actually finances America’s Muslim fundamentalist adversaries, which adds to American defense costs. So not only is the Oil Tax very large in comparison with most changes to the U.S. tax code, it is also arguably much more destructive to the U.S. economy – and U.S. interests - than any other tax.

Impact on the Taxpayer

Republicans often say any tax is destructive to the economy.  If they were right, you’d think that the $835B Oil Taxes we paid during 2004 – 2007 might have made that a difficult economic period for the U.S.  Au contraire. Our economy grew smartly without great inflation during 2004 – 2007. It took a different exogenous event – the subprime mortgage mess and credit crunch – to slow down the growth rate of the American economy.  So the experience of the past three years’ Oil Tax invalidates the Republican theory that higher taxes are death to economic growth.

The bludgeon of “tax and spend” that has has been wielded by Republicans to defeat Democrats and to paralyze the ability of Congress to enact useful social programs such as health insurance is, to continue the weapons analogy, a dud. It’s simply wrong.  The Oil Tax proves beyond a doubt that taxation – even a large tax in the most venal and pernicious form that the Oil Tax embodies – does not necessarily lead to lower economic growth.

To get a sense of how incorrect the Republican theorists are about taxation, just imagine what the American economy might have done over the past few years if this $835 billion of Oil Tax had been collected not by oil companies but by our own government.  In that case it would have reduced our deficit resulting in lower interest rates and/or it would have been spent mostly in America on projects like improving our infrastructure or our educational systems. The economy would have been even better than it was - in the face of a huge tax.

Impact on the Tax Collector

The other side of the oil tax coin is that oil exporting Tax Collector countries have been experiencing windfall profits. Saudi Arabia and Russia, the two largest Tax Collectors, have each reaped an average of about $130 billion per year of incremental oil profits over the past three years, a gain that is now more than doubled on a going forward basis at current oil prices. This fiscal windfall has allowed the Tax Collectors’ economies to grow at a rate in the 5 -8% per year range.

As the Tax Collector economies grow, their internal use of oil expands more rapidly than an OECD economy would  because the Russian and Saudi economies are so much more oil-intensive.   Whereas oil represents about 3% of the OECD GDP, it is twice that or more among the Tax Collector countries.  

With rising internal use of oil, the ability of Tax Collecting countries to export oil is reduced and, given their increased revenues, the need for them to export oil is also reduced.  For both reasons the economic growth of the Tax Collecting countries tends to reduce their oil exports and thereby increase the price of oil itself. This in turn hikes their Tax Collections further, which increases their economic growth rate and their internal oil use. And so on.

This phenomenon is known by economists as a virtuous circle. Of course, seen from the U.S. vantage point this circle is hardly a good thing. 

When a Tax Matters

There seems to be a bit of a logical conundrum here. On the one hand, the U.S. has experienced an enormous tax outflow - $835 billion over three years - with minimal if any economic impact until the mortgage crisis came along. On the other hand, Russia and Saudi Arabia, with “only” about $390 billion each of tax revenue inflow over three years – have seen extremely positive economic impacts. How can the oil tax be effective in Russia and the KSA but not effective in the U.S.?

I suspect you are ahead of me here. The obvious answer is the different scale of the U.S. vs. the Russian or Saudi economies. The $13.1 trillion U.S. economy is so enormous that $835 billion over three years does not have much impact. It is about 2% of GDP. On the other hand, the Russian GDP is about $765 billion per year, so their additional oil tax collection has been more than 17% - thus having a very real economic impact. The Saudi economy is just a fraction of the size of Russia’s, of course but it is also more centrally managed and so less subject to market forces.

Economists may argue that a 2% impact on the U. S. economy is not trivial. That is true, and clearly there were other offsetting U.S. macro-economic trends during 2003 – 2007 such as cheap imports and healthy exports. But isn’t it always the case that there are many economic forces acting on our economy at the same time? And, in a sense, is that not really the point? Politicians love to draw direct lines between one tax or fiscal policy and the behavior of the U.S. economy. But that argument is such an over-simplification that it becomes a form of demagoguery.

Conclusions

American politicians should level with voters and stop their implausible exaggeration of the impact of U.S. tax policies on the economy. In fact, none of the tax increases – or decreases – that either party might want to take credit or blame for will have or have had much impact on the American economy because the economy is so huge in relation to the effects of the policies.  Remember: despite all the New Deal spending programs, it took WW II to turn around the Depression.

On the other hand there are limits that must be observed.  It may not matter very much if the top tax rate is 35% or 40%.   But if it were to go to 90%, as was the case under Eisenhower, it might stunt the economy.  In the same way, the Oil Tax by itself has not yet been a threat to the vitality of the American economy.  But the combination of the Oil Tax and the mortgage market debacle could bring the U.S. to an inflection point in its place in history, particularly if the Oil Tax grows larger and persists. This coming U.S. recession could mark the point in time when the U.S. began to stop dominating the world economically. The fall of the dollar could mirror the fall of America’s global economic impact.

Ultimately, economic size and political influence are related.  As the virtuous circle for the Tax Collectors and the vicious circle for the U.S. and other oil importers continues to play out and the price of oil continues to increase for these and other reasons,  it is possible that change of monumental proportions is underway in the global economy and among global political relationships.   Within a few years America may no longer be financially capable of encircling the globe with military forces that attempt to influence the policies of many foreign countries.  

Tags: energy investments

This entry was posted on Wednesday, January 16th, 2008 at 12:04 pm and is filed under Investment Ideas, Price of oil, oil demand. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.