Fighting Dragons in the Oil Glut : Price Drop Can Be Used Against U.S. Trade, Budget Deficits

The drop of oil prices to $20 a barrel presents a golden opportunity to make headway against the United States’ twin dragons of trade and budget deficits. The price even may drop to about $15 while markets adjust to the international oil glut, but it is realistic to anticipate the price holding at the $20 range.

There are three principal reasons for this phenomenon:

First, industrialized nations have become much more energy-efficient: By 1984 the United States was 26% more energy-efficient and 34% more oil-efficient than it was in 1973. Further substantial gains in energy efficiency can be expected, even with lower oil prices. The most important mechanism for this will be the continued replacement of old, fuel-inefficient automobiles with high-m.p.g. models (despite the recent relaxation of federal standards for 1987-88).

Second, there has been a substantial enlargement of non-oil energy supplies. Between 1978 and 1984 the use of coal, natural gas and nuclear and hydroelectric power increased by the equivalent of 16 million barrels per day. Even a substantial decline in oil prices will not curtail this flow of non-oil energy resources, because the investments needed to produce these supplies have already been made.

Finally, economic growth in the less-developed countries will be slower than anticipated until their debt burdens are substantially reduced. Thus they will not contribute a big increase in demand for energy, as is usually assumed.

In response to the price decline, it would be to the United States’ advantage to impose a variable-rate tax on all oil consumed in this country. The principal goal of the tax would be to reduce the federal deficit without having to be governed by the idiotic formulas of Gramm-Rudman, or having to rely on the miracle of the Administration and Congress resolving their impasse on spending and taxes.

The tax could be set to keep U.S. oil prices at the $28-per-barrel level that the economy has become accustomed to. Thus, if the energy glut caused oil prices to hold for a year at $18, a $10-per-barrel tax would earn the Treasury about $51 billion--only $5 billion short of the 1987 deficit cut required by Gramm-Rudman.

Cutting into the budget deficit wouldn’t be the oil-consumption tax’s only virtue. It also would strengthen America’s commitment to energy conservation and the development of oil substitutes. And it would help our trade deficit.

Like any other deficit-reduction policy, the oil tax would reduce the U.S. need for foreign capital, and thus put downward pressure on the exchange value of the dollar, which in turn would stimulate exports and discourage imports. A unique feature of the oil tax is that it would allow America to reduce its locomotive role in the world economy without causing a worldwide recession: Falling oil prices would stimulate the West German and Japanese economies enough to offset the drag of a less expansionary U.S. fiscal policy. Getting Germany and Japan to adopt more expansionary fiscal policies has been a U.S. goal for more than a year. The enactment of a U.S. oil tax would cause the German and Japanese engines to move toward the front of the international economic train.

The three most common objections to such a tax are easily dismissed. Economists might argue that it would distort resource allocation, making the economy less efficient. Therefore, if one wanted to reduce the deficit, economic theory would dictate increasing income taxes so as not to change relative prices. However, political reality, in the form of the President’s repeated promise not to raise income taxes, makes this option a poor bet. And, since the income-tax system also distorts resource allocation, an income-tax increase might actually lead to more inefficiencies than an oil-consumption tax would.

Business people might argue that an oil-consumption tax would put U.S. industries at a competitive disadvantage in the world marketplace. This argument implies that American industry had an oil-based competitive advantage during two recent periods: in the mid-1970s, when U.S. oil prices were kept below world oil prices, and from 1981 to February, 1985, when our competitors had to pay for oil with ever-more-costly U.S. dollars. A quick review of America’s trade performance during those years leads to the conclusion that such an oil-based advantage could not have been very important (if it existed at all), and that an oil-consumption tax is unlikely to create any noticeable disadvantage.

Skeptics might argue that such a tax would not significantly reduce our budget and trade deficits because oil prices will not fall by very much, or for very long. Given the long-term structural causes of today’s oil glut, as well as the urgent revenue needs of Mexico, Nigeria and even Saudi Arabia, it is not too optimistic to predict that oil prices will stabilize in the $20-per-barrel region. Thus an oil-consumption tax would be effective in attacking America’s twin deficit dragons.