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The Independent Institute

Prop. 87: Paying at the Pump and Misdirecting Innovation

Californians pay an average of more than $3.20 per gallon for regular unleaded gasoline. Many consumers are agitated because prices have increased more than a dollar per gallon since the beginning of the year. British Petroleum’s Alaskan shutdown has only increased concerns. Unfortunately, if passed, Proposition 87, the Clean Alternative Energy Act (CAEA), would only make matters worse. The Act would increase gas prices and our dependence on foreign oil, while creating a vast new bureaucracy that is unlikely to speed the successful development of alternative fuels.

Prop. 87 would place a tax on oil production in California, to fund a new bureaucracy charged with encouraging the development and adoption of alternative fuels. The new agency would be mandated to exist for a minimum of 20 years, and be required to spend $4 billion within its first ten years of existence.

Supporters of Prop. 87 claim it will not increase gas prices for Californians, because it is a tax on oil company profits—not production. The proposition goes so far as to mandate that no costs may be passed on to consumers. But the authors of this proposition are no more able to repeal the laws of economics than they are able to legislate away the laws of gravity. University of Oregon professor Philip Romero estimated that after the tax is fully implemented and has been in place for several years prices would rise by as much as 13 percent.

Taxing profits from oil extraction discourages the activity—production—that generates those profits. Oil production in California fell by 3.8 percent in 2005, and production has decreased every year since 1996. Taxing oil production will accelerate this trend, by discouraging new oil exploration and encouraging the premature closing of existing oil fields. As a field ages, its oil becomes more expensive to extract. Most fields have oil remaining in them when they are closed down, because it is too expensive to extract. When these fields are taxed, the optimal time to shut down production occurs sooner, and more oil is left in the ground.

Consumers would still be able to purchase oil at the world market price, but not as cheaply as Californian oil. A barrel of Saudi Arabian oil must be transported to California. A barrel of Californian oil is already here, so producers don’t need to pay the same transportation costs. Proposition 87 claims that it will decrease our dependence on foreign oil. Yet paradoxically, it will increase our dependence foreign oil since it would decrease oil production in California.

While the tax would increase prices for consumers, the new government agency would probably not encourage the market to efficiently develop and adopt alternative fuels. This bureaucracy would be run by political appointees and have guaranteed funds, regardless of its performance. If the new agency makes no meaningful advances in alternative fuel development, nothing in Prop. 87 would limit its funding. This is a recipe for waste. However, the problem runs deeper than the structure of the proposition. Government bureaucracies inherently lack the same incentives, selection mechanisms, and access to information that private markets have.

In the market, those making the decision of which alternative fuel technology to invest in are basing their decision on the expected profitability of the investment. It is their own money that’s at risk if they are wrong. Those with the funds to make the investments are those who have been successful in making these types of decisions before. In contrast, government bureaucrats are selected by political processes; do not risk their own money; and do not have the same profit–and–loss feedback mechanism that private businesses do.

The most useful ways to adopt alternative fuels are not known in advance. They must be discovered. This takes flexibility, innovation, and constantly changing plans as new information is discovered. Not exactly words that jump to mind when thinking of government bureaucracies.

Market participants have already begun researching and adopting alternative fuel technologies. As oil becomes scarcer and fuel prices increase, consumer demand for alternative fuels will also increase. Automobile companies, venture capitalists, and inventors will all have the incentives they need to develop alternative fuel transportation that will best serve consumer demands. A California bureaucracy dispensing billions of dollars to researchers will only distort those incentives, and will likely drive the market away from serving consumer demands.

Proposition 87 is a bad deal for oil producers, consumers, and those who want efficient alternative–fuel vehicles developed. By the taxing of oil production, consumers will be forced to pay more at the pump. Meanwhile, the new bureaucracy is more likely to hamper the development of efficient alternative fuel technology than it is to help it.

For further information, please see the Independent Institute books Taxing Energy, Re-Thinking Green, A Poverty of Reason, and Cutting Green Tape.
Benjamin Powell is a Senior Fellow at the Independent Institute, Director of the Free Market Institute at Texas Tech University. He Independent Institute books include The Economics of Immigration: Market-Based Approaches, Social Science, and Public Policy, Housing America: Building out of Crisis, and Making Poor Nations Rich.

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