The inflation increase is particularly pronounced for energy products and fuel, with prices up by nearly 27% over the last twelve months (compared to 2.9% for the CPI as a whole). Should we therefore reduce fuel taxes to relieve the households’ budget? This is in fact not a good idea: the gain would ultimately not go to households. A targeted aid for low incomes households would be more appropriate.
Who benefits from a tax cut?
While at first glance the buyers benefit, it is actually not that simple. The figure below gives a simplified representation of the market in the absence of any tax and subsidy. The price paid by the consumers goes entirely to the producers (considering that there is initially a tax that is then lowered does not change the message). Demand is given by the green line and supply by the red line. The central point is that we consider a set supply, with a quantity Q whatever the price. This choice is motivated by the fact that in the short run the supply of energy products reacts little to prices.
The market equilibrium is given by the intersection of the two lines (point C), for a price P_1 and a quantity Q. The figure also shows the well-being (surplus) of consumers (triangle CDE) and the profits of producers (square ABCD, assuming for simplicity that the cost of production is zero).
Now consider a subsidy that makes the price paid by consumers lower than the price received by producers. The figure then changes as shown below, with the price received by producers on the vertical axis. The central point is that demand shifts from the green line to the blue line, because a given price to producers then corresponds to a lower price for consumers, and thus a higher demand.
The new equilibrium is at the intersection of supply and new demand, the point G. At this point the quantity is unchanged, and the price received by producers has increased from P_1 to P_2. The price paid by consumers has not changed (P_1), because in order to absorb the fixed quantity on the market, consumers have to take the same amount out of their pockets as before. The difference between P_2 and P_1 is the subsidy.
Who benefits? Not consumers, because their well-being is unchanged (triangle FGH, identical to triangle CDE). Producer benefits because their profits increase (square ABGF). In addition to the payment received from consumers (square ABCD as before) they receive the subsidy from the state (square CDFG).
In the end, the subsidy amounts to a transfer from the State to producers, without changing anything for consumers. The reason is simply that the quantity is fixed by the supply, and that the price will adjust so that consumers eventually absorb this supply. To do this, they must face an unchanged effective price, and so the subsidy is fully offset by an increase in the producer's price.
Considering a vertical supply line may seem extreme. However, the reasoning is similar if we take a supply that increases with price. The key point is then to contrast the sensitivities of demand and supply to price (a high sensitivity corresponds to a flatter line). As long as demand is more price sensitive than supply, the subsidy benefits producers more than consumers. In other words, there is no point in supporting demand when the bottleneck comes from supply.
What other measures could we consider?
While the tax cut misses its target, the problem of high inflation remains. Since it is not possible to avoid this problem as a whole, as it reflects geopolitical tensions, the appropriate response is to limit the impact on those households least able to cope.
Two points should be kept in mind. First, food and energy costs represent a larger share of the budget of low-income households. Second, these households already have relatively low savings and can therefore hardly finance their expenses by saving less.
The appropriate response is then a direct support to the lowest-income households. This is basically similar to the logic of unemployment insurance, which targets people who lose purchasing power. The fact that the loss comes from a rise in prices rather than a fall in income does not change the logic.
The best option is a transfer tied to income, rather than to expenditure categories. But if we still want to target expenditures such as fuel, then we can do better than a tax cut. The tax, after all, benefits more the heavy energy users, who are not the worst-off households.
An alternative would be to temporarily reduce the annual vehicle registration tax in inverse proportion to the engine size. The support would then go to smaller vehicles which are less energy intensive, and most often owned by modest households.
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