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Backgrounder #1386 on Energy and Environment

July 19, 2000

Overtaxed at the Pump: What's Behind the High Gas Prices

By and

Rising gasoline prices have become a key issue across America this election year. Nationwide, prices for all grades of gasoline jumped 41.7 percent just since June of last year, reaching a record high average of $1.71 per gallon by the middle of June 2000.2 In some regions, particularly in the Midwest, motorists struggled with even greater price hikes as the price for regular gas rose to $1.87 per gallon last month. Dramatic price increases and the variation in prices among the states have intensified public concern and led many to demand that their legislators find out what is driving the price of gasoline higher and how soon prices will decline.

Contrary to the Clinton Administration's highly charged rhetoric blaming oil companies for conspiring to keep prices high, there is an easy answer to the first question. Supply and demand for gasoline and crude oil as well as inventory levels are the most significant determinants of the average range of prices for a gallon of gas. Demand is rising in the United States and around the world, while the supply of oil (of which more than half--56.5 percent--is imported) has declined for most of the past year. Yet Washington has failed to establish a policy that addresses these fluctuations.

Other factors such as distribution and refinery problems, as well as changes in federal environmental mandates, contribute to the price variations between regions in the short run. Both the Congressional Research Service and the Department of Energy's own Energy Information Administration have repeatedly affirmed that these are the principal factors contributing to the spike in gasoline prices. In addition, differences in the state and local taxes added to the price of a gallon of gas drive regional price differences over the long run.

Figuring out when prices will decline is much more difficult. Unfortunately, as recently as July 13, 2000, the Energy Information Administration has testified before a Senate committee that another price run-up at the pump is possible because inventories remain low, refineries are operating at full capacity, and supply disruptions remain unpredictable.3

The increases in the price of gasoline have hit Americans hard--especially low-income families and the elderly--and they have the potential to turn into an election issue. Everyone, it seems, is looking to Congress and the President for relief. The upward spiral of prices has led Congress once again to contemplate a number of policy options, including what to do about the federal gas tax. Federal and state taxes make up the largest component of the retail price of gasoline beyond the cost of a barrel of crude oil. Taxes can add between 26 cents and 53 cents to the retail cost of a gallon of gas.4 The total annual gasoline tax bill for motorists is $53 billion per year.5

Some states not only recognize the burden these high gas prices have placed on American families, but also have taken steps to reduce their gas tax. They find these taxes hard to justify at a time when their treasuries are overflowing with budget surpluses. Congress should follow their example and reduce the federal gas tax to help American families, especially those on limited budgets who struggle to make ends meet.

Reducing the federal gas tax is one of the fairest and most sensible steps that Congress and the President could take to provide immediate relief to Americans who are being squeezed by the high prices. Indeed, suspending the federal tax on gasoline and diesel fuel for just three months would save motorists $4.4 billion.6

Safeguarding the nation's energy security is a policy imperative that both the Administration and Congress should adopt. The nation's energy resources must be expanded to reduce America's dependence on foreign sources. In the short term, Washington, which expects to amass a record-breaking $4.6 trillion surplus of tax overpayments--or nearly $40,000 per family--over the next 10 years, should take immediate steps to return at least a tiny portion of that surplus to American families by reducing the gas tax.

STATE TO STATE, NOT THE SAME TAX RATE

One of the reasons Americans are clamoring for Washington to fix the problem of rising gas prices is that they believe there is an irrational variation in prices across the country. Data from the Energy Information Administration indicate that the average retail price for a gallon of regular gasoline reached $1.68 per gallon last month--about 56 cents higher than the price just one year ago. By July 10, 2000, the average price for a gallon of regular gas had declined to $1.59, but it ranged from $1.53 in the Gulf Coast and Lower Atlantic Districts to $1.68 in the West Coast District7--a difference of 15 cents per gallon. (See Table 1.)

The largest increase since last summer occurred in the Central Atlantic District, where motorists saw prices rise by 50 cents to $1.65 per gallon. Chicago motorists suffered prices well over $2.00 a gallon just last month because of supply and distribution problems triggered by the June 1, 2000, phase-in of new reformulated gas requirements issued by the U.S. Environmental Protection Agency (EPA).8 Because it took several weeks to correct the supply/demand imbalances generated by those new requirements in the Midwest, prices spiked, though they have begun to come down over the past few weeks.9

The average price of regular gas also varies by state. According to the American Automobile Association, just last week the average price for a gallon of regular gas ranged from $1.89 in Hawaii to $1.49 in Georgia and South Carolina.10 Michigan, at $1.79, had the highest average price across the lower 48 states. Over the past year, prices increased the most in Michigan (63 cents), South Dakota (57 cents), and Iowa (57 cents), and increased the least in Washington State (24 cents) and Oregon (24 cents).11

The state-by-state variation in price is due primarily to differences in the state tax on gasoline. States that have the lowest tax rates also have prices for regular gasoline that are below the national average. But in the short run, gas prices in the states also are affected by distribution and refinery problems, inventory levels, and changes in environmental standards.

Regulations issued by the EPA affect the price of regular gasoline in each state. For example, according to the Energy Information Administration, the average retail price of a gallon of regular gas in New England states ranges from $1.62 wherever conventional gasoline is sold to $1.76 wherever reformulated gasoline is sold (in areas that do not comply with EPA's ozone and carbon monoxide standards). In Gulf Coast states, the price range is much narrower--from $1.52 a gallon for conventional gasoline to $1.54 for reformulated gasoline.

Understanding Variations in the Price of Gas

The retail price of a gallon of gasoline has four major components:

  • The cost of crude oil,
  • Refining costs and environmental requirements,
  • Distribution costs, and
  • Taxes.

The two largest components of the price are the cost of crude oil and the added taxes--which account for 43 percent and 28 percent of the retail price, respectively. (See Chart 1.) The major reason for the increase in gasoline prices over the past year has been the rise in crude oil prices set by the Organization of Petroleum Exporting Countries (OPEC).12 Because OPEC, which floundered after the 1986 collapse of oil prices, regained production discipline and restricted production in 1999, the demand for oil has outstripped supply and driven up prices.

The resulting low inventory levels of both crude oil and refined gasoline have significantly affected prices. But as noted above, the degree to which prices rose also has been affected by refining costs, U.S. environmental regulations, and distribution problems.

Crude Oil Costs and Inventories. The price of a barrel of crude oil makes up the largest portion of the retail price of a gallon of gasoline. As prices increased in 1999, the crude oil share of the retail price rose from 37 percent to 43 percent. The most recent gasoline price increases are due in part to the cuts OPEC made in crude oil production in 1999. In addition, higher demand from recovering Asian economies increased competitive bidding for crude oil supplies and helped to drive up the prices.

Crude oil and imported gasoline prices also vary by location. For example, according to the Energy Information Administration, in June 2000, the spot price (without taxes) for imported conventional regular gasoline varied from 96 cents per gallon in the Gulf Coast District to $1.01 per gallon in Los Angeles.

U.S. inventories of crude oil have fallen sharply since the beginning of 1999. The stock of crude oil is currently 20 million barrels under the normal range for the summer months, which represents only a two-day supply for refineries.13 The expected growth in demand this year, though small by historical standards, should keep inventory levels lean and prevent prices from falling rapidly for the remainder of the year, unless crude oil production increases significantly.

Refining Costs. On average, the cost of refining crude oil accounts for around 20 percent of the price of a gallon of gasoline, an increase from its 13 percent share in 1999. Refinery costs include crude oil processing and oxygenate additives, reformulating gasoline, shipping and storage, oil-spill fees, advertising, the purchase of gasoline to cover shortages, and profits. As an official of the Energy Information Administration recently told the Senate Committee on Energy and Natural Resources, "the U.S. refinery system has little excess capacity, and continuing growth in the number of distinct gasoline types that must be delivered to different locations increases the potential for temporary disruptions and increased volatility."14

U.S. refineries are currently running at a 97.4 percent utilization rate, up from 93.8 percent a year ago, and Midwest refinery utilization rates are around 99 percent. There is little margin for error given these utilization rates. Unexpected refinery outages, which occur more often at high utilization rates, can have a significant impact on regional prices in the short run, particularly with today's low gasoline inventories. The refining industry also suggests that burdensome Clean Air Act requirements tied to upgrading or building new refineries slow its ability to move rapidly to respond to such situations.15 In fact, the nation's newest major oil refinery was constructed nearly 25 years ago.

Environmental Requirements and Reformulated Gas. Some areas of the country are required to use specially refined gasoline to meet more stringent air pollution requirements. The 1990 Clean Air Act Amendments mandate the sale of reformulated gasoline in 10 metropolitan areas: Baltimore, Chicago, Hartford (Connecticut), Houston, Los Angeles, Milwaukee, New York City, Philadelphia, Sacramento, and San Diego.16

About 30 percent of the gasoline sold in the United States is reformulated. On June 1, 2000, new federal requirements for Phase II of the reformulated fuel program took effect, making it more difficult and costly to make reformulated gas, especially with ethanol. The EPA estimates that the cost of the Phase II requirements will add 5 cents to 8 cents to the price of a gallon of gasoline, although it admits that "retail prices may be higher and more changeable at the start of the Phase II program."17 A recent Congressional Research Service report found that 25 cents of the recent gasoline price spike in the Chicago/Milwaukee area could be attributed to the new federal environmental standards.18

The state of California implements its own reformulated gasoline program with more stringent requirements than those issued by the federal government. California's prices are more variable than others, since there are relatively few supply sources for its unique blend of gasoline outside the state. Moreover, California refineries need to be running near their fullest capacities in order to meet the state's fuel demands. If two or more of its refineries experience operating difficulties at the same time, California's gasoline supply becomes very tight and prices soar.19

Supplies could be obtained from the Gulf Coast and foreign refineries; however, California's substantial distance from those refineries means that any unusual increase in demand or reduction in supply will result in a large pricing response in the market before the relief supplies can be delivered. The farther away the necessary relief supplies are, the higher and longer the price spike will be.

The number of reformulated gasoline specifications also affects gas prices. The American Petroleum Institute reports that the United States has become a nation of boutique fuels. For example, 10 different types of reformulated gas are sold east of the Rocky Mountains.20 The result is that refiners and distributors have less flexibility to move supplies around the nation to respond to local or regional shortages.

Moreover, the wide variety of gasoline makes storage and distribution more difficult and increases the potential for temporary supply disruptions. This spring, refiners were forced to reduce inventories to near zero in order to change over from winter grades of gasoline to summer grades. In addition, the refining industry estimates that it will be required to comply with at least a dozen major regulatory requirements over the next 10 years, including reductions in gasoline sulfur content and on-road diesel sulfur and the phasing out and/or introduction of certain oxygenates. This has the potential to complicate even further the supply and distribution of gasoline.21

Distribution Costs. Distribution, marketing, and retail station costs combine to make up 9 percent of the cost of a gallon of gasoline, down from 14 percent in 1999. Most service station outlets are independent dealers who are free to set their own prices. The price on the pump reflects both the retailer's cost to purchase the product and other costs incurred in operating the service station. It also reflects local market conditions and factors such as the desirability of the location and the marketing strategy of the owner. Consumers in remote locations may face a trade-off between higher local prices and the inconvenience of driving some distance to find a lower priced alternative.

Areas farthest from the Gulf Coast--the source of nearly half of the gasoline produced in the United States and, thus, a major supplier for the rest of the country's gasoline inventories--tend to have higher prices. The proximity of refineries to crude oil supplies can even be a factor, as well as the cost of shipping (by pipeline or waterborne) from the refinery to market. Two oil pipelines serving the Midwest recently experienced operational problems that disrupted supply and contributed to recent price increases. The Congressional Research Service estimates that 25 cents of the recent gasoline price spike in the Midwest District could be attributed to distribution problems.22

Federal, State, and Local Taxes. On average, federal, state, and local taxes account for the second largest portion of retail gasoline prices after the price of crude oil--41 cents per gallon, or 28 percent of the cost, as of May 2000.23 Federal taxes add 18.4 cents per gallon, while state taxes add an average of 22.6 cents. Local taxes add, on average, another 2 cents per gallon. American motorists' annual gasoline tax bill adds up to a stunning $53 billion per year--$22.6 billion in federal taxes and $30.1 billion in state taxes.

State gasoline excise taxes vary considerably, from a low of 8 cents per gallon in Alaska to 34.7 cents per gallon in New York--a difference of 26.7 cents per gallon. (See Table 2.) The 10 states with the lowest tax rates also have regular gasoline prices that are below the national average.

Most state tax rates do not change very often; however, 10 states adjust their tax rates on an annual, semiannual, or quarterly basis.24 Four states--California, Nevada, Oklahoma, and Tennessee--have provisions in their statutes that will increase the state motor fuel tax rates if the federal tax rate is reduced.

Five states also apply a sales tax on top of their excise tax. Together, these states--California, Georgia, Hawaii, Michigan, and New York--account for almost one-fifth of the motor fuel sold in the United States. Worse, four of these states--California, Georgia, Michigan, and New York--even tax the taxes on gasoline by applying their sales tax to state and federal gasoline excise taxes.

A SHORT-TERM FIX: REDUCE THE FEDERAL TAX

Because gas taxes represent the second largest component of retail gas prices after the cost of crude oil, cutting the federal gas tax would be one of the fairest, most significant, and most sensible ways to reduce the price of a gallon of gas in the short term to give American families much-needed relief. In the long term, Congress and the President must develop a coherent and workable energy policy that would restore and guarantee the nation's energy independence.

A number of bills (such as H.R. 3849, H.R. 3982, S. 2262, and S. 2285) have been introduced in the 106th Congress to cut, either temporarily or permanently, the federal gas tax, which is one of fastest growing federal taxes. The proposals range from permanently cutting the 1993 increase in the gas tax of 4.3 cents (H.R. 3848 and H.R. 3982) to suspending the entire 18.4 cent federal tax for up to 9 months (S. 2262 and S. 2285). On July 13, 2000, the Senate voted (40 to 59) to defeat an amendment offered by Senators Spencer Abraham (R-MI) and Peter G. Fitzgerald (R-IL) to suspend the entire 18.4 cent federal tax for 150 days.

Many Members still defend the tax, claiming that reducing it would result in lost revenue that otherwise could go to states and local communities for planned highway projects. But Washington has a long legacy of wasting billions of gas tax dollars on questionable pork-barrel projects that include museums, historic train station renovations, and parking garages.25 Citizens Against Government Waste has identified $1 billion in transportation pork-barrel spending in fiscal year 2000.26 And as the size of the tax surplus continues to expand, such claims are increasingly greeted by the public with considerable skepticism.

The Burden on Families and Businesses

As noted above, Congress could suspend the federal tax on gasoline and diesel fuel for just three months and save motorists $4.4 billion. Most of America's consumable goods are carried to their local destinations by the more than 7 million trucks--many owner-operated by a head of a household--on America's roads today. Meanwhile, many businesses are operating on profit margins of just 2 percent to 4 percent.

Small companies have been especially hurt by the high gas taxes; those that consume 50,000 gallons of diesel fuel per month spend an average of $40,000 more each month on fuel than they did last year, just because of the increase in the price of gas over the past year. The additional costs they incur from these rising fuel prices are often added to the price of goods and services. Reducing the cost of fuel by just 4.3 cents a gallon would save small companies more than $2,000 each month.

If the price of oil remains high for too long, the vibrant U.S. economy will suffer. According to an analysis by The Heritage Foundation's Center for Data Analysis, if the price of oil remains at $30 per barrel for the remainder of the year, economic growth would decrease over the next two years.27 High oil prices without any tax relief would reduce real disposable income for an average family of four by $1,324, decrease consumer spending by $79.6 billion, and reduce the number of job opportunities by almost 500,000. Higher prices and slower economic growth would reduce federal tax revenues by $12.4 billion over the next three fiscal years.

States Act to Cut Gas Taxes

While Washington continues to debate the issue of reducing gas taxes, some states already have taken action to do just that. On July 1, Illinois suspended its sales tax on gasoline for six months and Indiana suspended its gas tax for 60 days. Both of these states took action with an understanding that their budget surpluses had made it hard to justify not providing relief to lower-income Americans and those who make their living driving. A number of other states, such as Michigan and Wisconsin, are also considering temporary reductions in their gas taxes.

The fact that states impose their own gas tax begs the questions: Should not the states determine how much to tax gasoline use in order to maintain infrastructure? Why should citizens be forced to send more money through Washington only to have it cycle back to their states and local communities for transportation projects? Washington's penchant for wasting federal gas tax revenues on unnecessary pork projects highlights the need for Americans to demand that the federal government get out of the way and do what is fair by giving control of federal highway programs back to states and local communities.

CONCLUSION

Washington's failure to establish a long-term domestic energy policy that guarantees and protects America's energy independence is largely to blame for the high gas prices Americans pay at the pump. In the long term, Congress and the President must address the nation's dependence on foreign oil that leaves the economy and national security vulnerable.

In the short term, Washington has one important way to mitigate the impact of high gas prices--reduce the federal gasoline tax. As the surplus of tax overpayments in the Treasury continues to break records, what better opportunity than now will Congress or the President have to provide some much-needed relief to lower-income Americans, the elderly, families, and those who make their living driving?

Americans want good highways, and they want Washington to lower the price of fuel. Maintaining the nation's highways is not dependent on the federal gas tax. Cutting this tax--even temporarily--would be a good and fair step that would immediately help Americans who find it increasingly difficult to make ends meet.

D. Mark Wilson is a former Research Fellow in, and Angela Antonelli was the Director of, the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.


1. The authors would like to thank Christopher Summers, Research Assistant at The Heritage Foundation, for his contributions to this paper.

2. The average was taken for the week of June 19, 2000. All data are from the U.S. Department of Energy's Energy Information Administration, unless otherwise noted. Data are available at www.eia.doe.gov  (July 11, 2000).

3. Statement of John Cook, Director, Petroleum Division, Energy Information Administration, before the Committee on Energy and Natural Resources, U.S. Senate, 106th Cong., 2nd Sess., July 13, 2000, p. 4.

4. Heritage Foundation calculations based on data from the Federal Highway Administration. See Table 2.

5. Heritage Foundation calculations based on data from the U.S. Department of Energy.

6. Ibid.

7. The United States is divided into seven Petroleum Administration for Defense Districts. The Gulf Coast District includes Alabama, Arkansas, Louisiana, Mississippi, New Mexico, and Texas. The Lower Atlantic District includes Florida, Georgia, North Carolina, South Carolina, Virginia, and West Virginia. The West Coast District includes Alaska, Arizona, California, Hawaii, Nevada, Oregon, and Washington State. The other Districts are the Rocky Mountain District (Colorado, Idaho, Montana, Utah, and Wyoming); the New England District (Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island, and Vermont); the Central Atlantic District (Delaware, District of Columbia, Maryland, New Jersey, New York, and Pennsylvania); and the Midwest District (Illinois, Indiana, Iowa, Kansas, Kentucky, Michigan, Minnesota, Missouri, Nebraska, North Dakota, South Dakota, Ohio, Oklahoma, Tennessee, and Wisconsin).

8. Statement of John Cook, p. 3.

9. Ibid. , p. 4. "Finally, with few alternative sources of readily available supply, it took time for the supply/demand imbalances to be resolved. The RFG [reformulated gas] markets in the Chicago/Milwaukee areas and California are alike in that they are isolated and use unique gasoline blends. Less than 10 refiners supply the Chicago/Milwaukee areas. They responded to the incentive for more supply by arranging for blending components to be brought in from the Gulf Coast--a process that took several weeks."

10. American Automobile Association, "Daily Fuel Gauge Report," at http://208.13.208.31/sbsavg.asp  (July 11, 2000).

11. Ibid.

12. The Organization of Petroleum Exporting Countries is a cartel of 11 countries that collectively produce about 40 percent of the world's oil and hold more than 77 percent of the world's proved oil reserves. OPEC meets on a regular basis to determine the level of production for each country. Its production quotas have helped to increase the price of a barrel of West Texas Intermediate crude oil from $17.92 in June 1999 to $31.82 in June 2000.

13. Lawrence Kumins, "Midwest Gasoline Price Increases," Congressional Research Service Memorandum , June 16, 2000, p. CRS-5.

14. Statement of John Cook, p. 4.

15. Statement of Bob Slaughter, General Counsel, National Petrochemical and Refiners Association, before the Committee on Energy and Natural Resources, U.S. Senate, 106th Cong., 2nd Sess., July 13, 2000, Addendum A.

16. Parts of 13 other states have voluntarily joined the reformulated fuel program.

17. U.S. Environmental Protection Agency, Phase II Reformulated Gasoline: The Next Major Step Toward Cleaner Air , EPA420-F-99-042, November 1999.

18. Kumins, "Midwest Gasoline Price Increases."

19. In 1999, West Coast refinery outages reduced the short-term supply of gasoline in California and started a run-up in wholesale and retail prices in that state.

20. American Petroleum Institute, "Current Summer Gasoline Requirements," at www.api.org/consumer/gasmap1.jpg  (July 11, 2000).

21. Statement of Bob Slaughter, pp. 2, 8.

22. Kumins, "Midwest Gasoline Price Increases."

23. American Petroleum Institute, "Fuel Tax Facts," at www.api.org/consumer/taxfacts.htm  (July 7, 2000), and U.S. Department of Energy, Energy Information Administration.

24. These states are Delaware, Florida, Kentucky, Massachusetts, Nebraska, New York, North Carolina, Rhode Island, West Virginia, and Wisconsin.

25. See Angela Antonelli and D. Mark Wilson, "Why Congress Should Cut the Gas Tax," Heritage Foundation Executive Memorandum No. 664, March 21, 2000.

26. Citizens Against Government Waste, "1999 Congressional Pig Book," at www.cagw.org/publications/pigbook/pigbook-summary/pig-summary-transport.html  (July 13, 2000).

27. Antonelli and Wilson, "Why Congress Should Cut the Gas Tax."

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