WPRI Report Cont'd:

The Truth Behind Wisconsin's Oil Company Tax:
Why You'll Pay More at the Pump

By George Lightbourn, Christian Schneider, and Benjamin Artz

THREE REASONS THE TAX WILL BE PASSED ON TO CONSUMERS

I. THE REALITY OF ECONOMIC FORCES

To understand what is likely to occur when a new tax is enacted, it is instructive to review economic research. Specifically, to what extent is gasoline supply and demand affected by the tax? In a nutshell, research consistently shows that demand for gasoline is very inelastic, meaning that short-term consumption is relatively unaffected by price. We complain about the price of gasoline, largely because we know we have no option but to purchase it. Conversely, the supply of gasoline is relatively inelastic, meaning it is very sensitive to price. Relatively small price changes on the spot market will change where wholesalers choose to sell their product.

The no-pass-through provision in the Governor's budget is an attempt to reverse the flow of economic theory. The expectation is that the oil companies will pass none of the new tax on to consumers, even though consumer demand is somewhat price insensitive. Further, the budget assumes that oil companies will not alter the supply of gasoline to Wisconsin, even though they have ready options (surrounding states) where the cost of doing business will be lower.

Let's back up and examine economic theory and research. Economists have long studied the impact of taxes on the sale of goods and services. The government uses these taxes in order to raise revenue to pay for publicly provided goods and services that cannot be traded in markets. However, there is certainly an impact on consumers and sellers alike and the impact is generally unpleasant. A gross receipts tax on oil companies is no exception.

Graph A shows the before-tax market for gasoline in Wisconsin. The demand curve represents how much gasoline consumers are willing and able to purchase at various price points. As economic theory states, when the price of gasoline increases, consumers are willing and able to purchase less gasoline; but how much less? As it turns out, demand for gasoline is unique in that consumer behavior is not very sensitive to changes in the price of gasoline. According to economic research,⁸ the short-term elasticity of demand for gasoline is between 0.03 and 0.07. This means that if the price for gasoline would double, consumers would only purchase between 3% and 7% less gasoline in the short term. This unwillingness to purchase less gasoline stems from the lack of close substitutes for gasoline. By comparison, beef has an elasticity of demand equal to 1.37⁹, which means that a 10% increase in the price of beef will result in a 13.7% reduction in beef purchases. Consumers are quite sensitive to changes in beef prices due to close substitutes such as poultry. Since gasoline has few, if any, substitutes, consumers do not sacrifice gasoline consumption. Therefore, the demand curve in graph A is very steep to mirror this unwillingness to give up consumption of gasoline in the short term regardless of the price:

Graph A

The supply curve in Graph A above represent the willingness of sellers to provide product at any given price. Textbook economic theory holds that as the price of gasoline increases, the quantity of gasoline that sellers provide will increase, since higher prices yield higher profits. However, unlike the demand curve for gasoline, the supply line is relatively flat. Suppliers of gasoline are very sensitive to changes in the price. At one end of the supply chain this reflects the ability of oil refineries to easily switch to manufacturing other derivatives of oil whenever gasoline becomes less profitable. At the wholesale level, this reflects the ability of suppliers to divert product to states and localities where business costs are lower and profits higher. Therefore, the flat slope of the supply curve in Graph A mirrors the greater sensitivity of sellers to the price of gasoline. Where demand and supply meet determines the efficient market quantity of gasoline that will be sold, and also the price at which it is sold.

Graph B

Graph B shows how a tax impacts both the quantity of gasoline sold and the price that consumers must pay for gasoline. The gross receipts tax makes the product less profitable to sell at any market price. As a result, the supply of gasoline to Wisconsin will fall, effectively shrinking the market. This will increase the overall price of gasoline and, since the demand curve is so steep, consumers will pay nearly all of the price increase. Consumers will simply be less willing than sellers to change their behavior. Thus, they will bid up the price of the smaller market quantity of gasoline available.

However, advocates of the no-pass-through provision promise a different outcome. By imposing a legal requirement that sellers pay all of the tax, the Wisconsin initiative runs completely counter to what economic theory and evidence show. Even if the accountants could enforce the provision, sellers will still reduce their output in Wisconsin due to gasoline's lower profitability here. Since government intends to artificially restrict suppliers' ability to bid up the price of gasoline, in the long run supply to Wisconsin retailers will be restricted, which will elevate the price consumers are pay for gasoline. At the end of the day, a two and one-half percent gross receipts tax - which equates to approximately five cents per gallon - will ultimately result in nearly all of the increase showing up in the pump price of gasoline - not as a reflection of a pass-through of the tax, but as a reaction to restricted supplies.

The intent here is not to overstate the potential impact of the Wisconsin price control. It is unlikely that state motorists will see rationing or substantial price spikes. Nor is it likely that oil companies will do anything other than abide by the letter of the law. However, even in the absence of nefarious actions on the part of oil companies, the tax will have a noticeable impact at the pump - if not in the short term, certainly in the long run.

According to industry experts¹⁰, approximately seventy-five percent of oil products in Wisconsin are sold under long-term contracts that exist between oil companies and retail contractors. Most of these contracts are between the large oil companies and their contractors that sell their product in retail markets. These contracts generally run three-to-five years and guarantee that retailers will be allocated a certain level of supply. Most of the major oil company outlets operate under this arrangement.

The remaining twenty-five percent is sold on the spot market. This is where the large oil companies sell product in excess of what is required to fulfill their commitments with retailers. It is also where independent wholesalers sell oil products. The spot market is the more volatile segment of the market and is the supply source for most of the independent retail outlets. On the spot market, wholesalers can sell to outlets either in Wisconsin or other states. It is on the spot market where the no-pass-through provision will have an immediate impact. Since wholesalers will be precluded from including the cost of the gross receipts tax in the price charged to buyers in Wisconsin, they are more likely to sell their product outside of Wisconsin. This will cause those Wisconsin outlets dependent on the spot market to go further afield to purchase product. This will effectively alter the supply of gasoline and increase the price they pay. Whatever benefit Wisconsin consumers realized by having less expensive fuel available at independent outlets will evaporate. Whether they like it or not, consumers will see prices rise when this tax is implemented.

A second short-term impact of the no-pass-through provision will be seen in the wholesale market throughout the upper Midwest. The Wisconsin tax will increase the cost of doing business, and since the oil companies are precluded from passing the tax along to Wisconsin outlets, they could resort to incorporating it into the price structure for outlets in other states. This is the phenomena the courts anticipated when they have found similar restrictions to violate the Commerce Clause.

In the longer run, the major oil companies are likely to push for shorter-term contracts with Wisconsin retail marketers and would reduce the volume they would guarantee to provide retailers. It would simply be more profitable to sell more of their product in states where the profit margin is higher. Of course the impact of a lower volume of gasoline being committed to Wisconsin retailers would have the effect of driving price up. As noted above, given the elasticity of demand for gasoline, as supplies shrink, consumers would be willing to pay a slightly higher price for gasoline. The net effect is that most or all of the cost of the gross receipts tax would show up in higher pump prices.

II. LITIGATION OF NO-PASS THROUGH LAWS

In explaining the legal basis for the no-pass-through provision, the Doyle administration relies on a 1988 U.S Supreme Court case. In that case, the Puerto Rico Department of Consumer Affairs argued in support of its imposition of a no-pass-through provision associated with an excise tax on refiners.

From 1973 until 1981, the federal government imposed price controls on petroleum products under the Emergency Petroleum Allocation Act (EPAA). A provision in that act preempted state and local government regulation of the supply and price of petroleum products.

In 1986, Puerto Rico enacted an excise tax and authorized the Department of Consumer Affairs to issue regulations. One of those regulations prohibited refiners from passing the tax on to retailers. The department also set maximum profit margins for wholesalers. As expected, the oil companies challenged the no-pass-through provision on the basis that the previous federal act (EPAA) had preempted state and local governments from regulating petroleum products. While the oil companies prevailed in District Court, the U.S. Supreme Court overturned the decision, thus ratifying Puerto Rico's no-pass-through provision. The Court found that Puerto Rico's law was not subject to preemption by the federal statute, and held that when the federal government withdrew from price regulation, the preemption provision was dissolved.

While the court did authorize the no-pass-through provision, it is important to understand the basis for the finding. In that Puerto Rico case, the issue decided by the court was preemption as it related to the EPAA. The Court was asked to rule on whether the former federal law preempted Puerto Rico from enacting the rule it enacted. It did not consider the impact of the no-pass-through provision on the Commerce Clause. Perhaps that owes to the remote location of Puerto Rico.

A separate 1983 case decided in New York State Court also dealt with a no-pass-through provision. However, in that case the Commerce Clause constituted the crux of the case. Under the Commerce Clause of the U.S. Constitution, Congress is assigned power to regulate commerce in the U.S. States are precluded from taking action to limit trade, including discriminating against out-of-state business.

In 1980, New York passed a 2% gross profits tax on oil companies and included a provision that precluded the oil companies from including the tax in the retail price of gasoline. The New York law was eerily similar to the provision forwarded by Governor Doyle.

In 1983, a New York Appellate Court found the anti-pass-through provision to be in violation of the Commerce Clause. The logic of the decision was that the State of New York was effectively adding a cost to the oil companies that, while not affecting prices in New York, would result in higher prices in other states. The court recognized the reality that oil companies would recoup the cost of the New York tax by increasing prices in other states. The burden of the tax would fall to non-New York consumers. Before this court ruling took effect, the New York law was changed to eliminate the anti-pass-through provision. However, the tax remained.

This court case is outlined in a memorandum prepared for Wisconsin Speaker of the Assembly Mike Huebsch by the Wisconsin Legislative Council.¹¹ The Legislative Council memo notes that, while the New York decision is not a precedent for purposes of reviewing the proposed Wisconsin law, it is "indicative of how a Wisconsin court would assess a Commerce Clause challenge to the constitutionality of the anti-pass-through provision of Senate Bill 40" (the budget bill). There are undoubtedly other potential challenges to the proposed no-pass-through provision.

It is notable that the Puerto Rico case did not address the Commerce Clause. Therefore, relying on that case alone to support the Wisconsin initiative is quite tenuous. The proposed no-pass-through provision will undoubtedly be challenged, on the basis of the Commerce Clause and other factors. At best the legal basis for the new tax is murky.

Furthermore, the gross receipts tax on oil companies is a key revenue feature of the Governor's budget. Without the $272 million generated by the tax, the transportation budget would have to be significantly reduced in order to stay in balance. The practicality is that, if the no-pass-through provision is successfully challenged in court, the Governor and the Legislature would likely do what was done in New York: delete the no-pass-through language and keep the tax. No matter how badly the legislation is crafted, in New York and in Wisconsin, the motorists will see the tax reflected in the price at the pump.

III. ADMINISTRATIVE REALITY

The difficulties in administering the technical aspects of the pass-through provision are illustrated in a memo prepared by the Department of Revenue (DOR) dated January 30, 2007. This memo indicates that DOR recognized inherent difficulties of enforcing the pass-through provision.

There are two components of any budget; the fiscal component and the statutory component, or the actual language required to carry out the budget. In the course of preparing the budget, staffs from various agencies routinely interact with the attorneys at the Legislative Reference Bureau, who actually draft the statutory language. This interaction is an essential step to ensure the soundness - especially the administrative soundness - of legislation. The notes maintained by the attorney drafting each piece of legislation are retained and available to the public once the legislation has been introduced. The interaction between agency staff and legislative bill drafters are largely devoid of political considerations, and instead focus on the nuts and bolts of administering laws.

In analyzing the oil company gross receipts tax, DOR raised a number of concerns, nearly all of which were addressed in the final version of the legislation. One item not addressed was a concern over the anti-pass-through provision. Specifically, the note from the staff at the Department of Revenue said:

Arbitrary Nature of Audits 

Sec. 77.9982(4) provides that no supplier shall take any action to increase or influence the selling price of motor vehicle fuel in order to recover the amount of the assessment. A supplier could argue that any number of factors other than oil company assessment were the cause of a price increase. Prices are determined by a complex, interdependent set of economic factors. The Department's auditors may have no rational basis to isolate the cause of a price increase as the oil company assessment. The supplier may recover the assessment from purchasers by a gradual increase in the price and in some cases may not be able to bread down all the reasons why the price is increased. Therefore, actions to penalize suppliers for passing the tax through to purchasers may not be sustained.

The administration chose to ignore the advice of the Department of Revenue in the budget bill delivered to the Legislature. The Department of Revenue staff saw the inherent difficulty of administering the intent of the provision. The futility of the task is apparent in the communication to the bill drafter. However, the political attractiveness of the no-pass-through provision apparently outweighed the viability of the provision, and another shaky law was added to the state statutes.

SUMMARY

In Wisconsin, budget after budget has been assembled with a fiscal slight-of-hand. Moneys have been shifted from one year to the next, funds have been taken from "segregated" funds and one-time funds have been used to paper over long-term structural problems. As a result, state government is carrying a $2.2 billion deficit on its books. Addressing state government's finances in an honest, forthright manner has been a rarity.

The oil company gross receipts tax and its no-pass-through provision as proposed by Governor Doyle is the latest in a series of questionable fiscal maneuvers. But no one should be fooled; the proposal is a gas tax increase of five cents per gallon. The legislative consideration of the Governor's transportation budget must be based on this premise. Any thought of acquiescing to the Governor's proposed tax must be considered an endorsement of a five-cent per gallon increase in the tax on gasoline.

ENDNOTES

[2] Ibid.

[3] Much of the discussion here of state gas taxes is taken from information produced by the American Petroleum Institute.  The institute routinely tracks tax data.  The most recent summary was prepared by the institute in March 2007.

[4] The Economic Review, www.economicreview.com

[5] For a detailed discussion of the different impact on old oil and new oil see Economic Amnesia the Case against Oil Price Controls and Windfall Profit Taxes, Cato Institute, January 12, 2006

[6] Federal Trade Commission Press Release, Gasoline Price Controls Would Likely Harm Hawaii’s Consumers, January 28,2003

[7] World Net Daily, Gas-Price Controls Backfire in Hawaii, February 19,2006

[8] Hughes, Knittel and Sperling (2006), Chouinard and Perloff (2003)

[9] McConnell and Brue (2008)

[10] The discussion of the operation of gasoline markets in Wisconsin is based on interviews with representatives of the petroleum industry in Wisconsin.

APPENDIX A

Motor fuel rates by state, March 2007 (American Petroleum Institute)

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