Strategic incentives for car fuel taxes and fuel efficiency standards

1. Wim Benoot Centre of Economic Studies KU Leuven (Belgium) Co-author: Stef Proost Strategic incentives for car fuel taxes and fuel efficiency standards 22thJune2011 IAEE Conference, Stockholm

2. Outline • Introduction • Building up the model • (TheoreticalAnalysis) • (Numericalexample) • Conclusions • Further Research

3. STARTING POINT Widelydivergingfueltaxes Comparison of fuel taxes and subsidies worldwide Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research Source: International Fuel Prices 2005, Dr Gerhard P. Metschies. Deutsche GesellschaftfürTechnischeZusammenarbeitGTZ GmbH. (www.gtz.de/fuelprices)

4. STARTING POINT widely diverging fuel efficiency standards Comparison of actual and projected fuel economy for new vehicles Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research Source: An, F., and A. Sauer. 2004. Comparison of Passenger Vehicle Fuel Economy and GHG Emission Standards Around the World. Pew Center on Global Climate Change, Washington, DC; Updated data obtained from www.pewclimate.org, July 2010.

5. Introduction Existingliterature Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research Existing car market models focus on modelling imperfect competition and the effect of standards/taxes • In either US or EU • Very detailed econometric models of differentiated products in the car industry (Verboven, 2002, Goldberg) • But we are lacking the role of governments that set gasoline taxes and set subsidies for car manufacturers that sell in different countries • Environmentalpolicy as a trademechanism • The effect of strategic games betweengovernment

6. Introduction some intuition 1 Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research Price Car use Demand for cars Foreign monopolist selling cars in Belgium but WTO does not allow to tax foreign cars P° Foreign π Env tax Env damage Marg cost Quantity cars

7. Introduction some intuition 2 Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research Price Car Demand for cars Foreign monopolist selling cars in Belgium P° Foreign π “Higher” env tax Env tax Env damage Marg cost Quantity cars

8. Introduction some intuition 3 Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research Price Car Demand for cars Foreign monopolist selling cars in Belgium Loss in CS P° Foreign π Gain Tax revenue “Higher” env tax Env tax Env damage Marg cost Quantity cars

9. Introduction Research Questions Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research • What are significant factors for a government to determine its optimal fuel and R&D policy(subsidies) taking into account • Environmental concerns • Trade concerns (profits of home producers, consumer surplus etc.) • Can environmental concerns be used as an excuse to use fuel taxes to extract more surplus from foreign car producers? • How should gasoline taxes react to • Changes in spillovers of R&D? • Changes in the valuation of environmental damage ? We opted for the extension of a simple “strategic model” à la Ulph and Ulph (2007) where governments and monopolistic firms take decisions

10. Model Approach Stage 1: Each government decides on optimal taxes and subsidy, for given policy by other governments Max ( CS home + PS domestic comp –total env damage - domestic cost of abatement) • Stage 2: Companies decide on abatement level for given tax levels and abatement by competitors, based on expectations on output stage • Stage 3: Firms decide on output levels in both countries, taking the output of the other as given  Solving backwards to find an optimal tax and optimal subsidy – we do the analysis first for the optimal tax Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research

11. Model Setup Government 1 Government 2 Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research Subsidy on R&D of home firm R&D spillovers Firm 1 Firm 2 Sell a standard car Fuel Tax Fuel Tax Domesticcarmarket Foreigncarmarket Pollution spillovers

12. Model Assumptions Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research • Both firms sell only 1 (homogeneous) car, that can differ only in the pollution level e per unit of production – output levels y1,y2 • Fixed mileage per vehicle. • Firms and governmentsdetermineoptimalpolicyforgivenpolicy of the otherfirm/government • Market: • Linear demand: • 1 priceforboth gasoline and car! Marketprice p FuelTax FuelTax Carprice Carprice Firm 1 Firm 2

13. Model Assumptions Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research • Emissions & Costs • Each car has an initial pollution level ε (consider it as gasoline) • A firm can lower the emissions by abatement effort x. The final emission are given by (where knowledge spillovers δ xj also help) • Cost of R&D is fixed: • Environmental cost: • Government instruments • Tax on emissions • Subsidy on fixed R&D

14. Outline • Introduction • Building up the model • (TheoreticalAnalysis) • (Numericalexample) • Conclusions • Further Research

15. Analysis Stage 3 Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research Output Decisionyij • If government policies and abatement levels of both firms are given, a firm maximizes profit • The outcome in this stage is a Cournotequilibrium in output, in function of abatement and policy OUTPUT IN FUNCTION OF ABATEMENT AND POLICY

16. Analysis Stage 2 Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research Choosingfuel efficiency xi • The outcome in this stage is a Cournotequilibrium in output, in function of abatement and policy • We assume that the direct effects dominate, and thus tax increase leads to :higher abatement, higher fuel cost, lower output on the domestic market and higher output on the foreign market OUTPUT AND ABATEMENT IN FUNCTION AND POLICY

17. Analysis Stage 1: governments set fuel taxes Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research • Governments take into account their influence on the firm’s decisions • For given foreign tax policy, a government maximizes: • Consumer surplus • Profits in the domestic market • Profits in foreign markets • Total abatement cost of home firm • Total pollution cost of emissions

18. Analysis Result Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research • Interpretation • A government sets a tax equal to marginal damage if no strategic effects or other market imperfections (LHS) • Taxes reduces consumer surplus (less output, higher price) • Governments care about tax income and pay attention to the taxation of the profits of foreign car producers • Governments care about the profits of the home firm abroad, not about consumer surplus abroad

19. Analysis Optimal subsidy s for fuel efficiency R&D as extra instrument Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research • Optimal subsidy levels are given by • Interpretation • Compared to a fuel tax, a subsidy allows to directly reduce the costs of the home company, improving its market share at home and abroad • Subsidies have also no negative effect on the consumer surplus (we assume marginal cost of collecting tax revenue somewhere else =1)

20. Numerical illustration Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research • Numerical example as an exploratory exercise • Compare cooperative and non cooperative equilibrium • Comparative statics of different parameters: • Differences in estimation of pollution damage • Some countries care about global warming, others don’t • Number of firms • R&D spillover intensity

21. Numerical illustration Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research • selected parameters: • Each car uses 5l of gasoline to drive 100km • In equilibrium, both firms sell 4000 cars in each market at a price of 16000 € . • Production cost equals 12000 € • Cost of pollution • Local pollution : 0.40 €/l • Global pollution: 0.40€/l • Abatement cost: 3 200 000€ * x2

22. Numerical illustration Benchmark equilibrium – only fuel taxes, no subsidies Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research

23. Numerical illustration Sensitivity study on relative spillovers and assessment of pollution damage – only tax no subsidies Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research

24. Numerical illustration Sensitivity study – with and without subsidy instrument Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research

25. General Conclusions Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research • Fuel (environmental) tax can be used as a disguised trade policy instrument • Multiple policyinstrumentsdecrease overall welfare as tradeincentives are more significant • Market position of domestic companies influences tax incentives • Differences in country characteristics can lead to very distinct policy measures

26. Limitations Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research • Difficult to distinguish different effects • What are the specific drivers of taxation? • No dynamic comparison • Technology policy can be beneficial over time • No comparison with other instruments • Standards

27. Further research Government 1 Government 2 Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research Subsidy on R&D of home firm R&D spillovers Firm 1 Firm 2 Standards Standards Sell a standard car Fuel Tax FuelTax Domesticcarmarket Foreigncarmarket Pollution spillovers

28. Model Setup Government 1 Government 2 Introduction Model Theoretical Analysis Numerical example Conclusions Limitations Further research Subsidy on R&D of home firm R&D spillovers Firm 1 Firm 2 Sell a standard car Fuel Tax Fuel Tax Domesticcarmarket Foreigncarmarket Pollution spillovers

29. Marketprice p FuelTax FuelTax Carprice Carprice Firm 1 Firm 2