Fuel Excise Taxes as Shock Absorbers: Reducing Inflation Volatility Amid Global Oil Price Surges

The IMF working paper by JaeBin Ahn demonstrates that higher fuel excise taxes can mitigate the impact of global oil price shocks on domestic inflation, reducing inflation volatility and enhancing economic stability. The study, using data from 28 OECD countries, shows that higher fuel taxes significantly lower the pass-through rate of oil prices to both retail fuel prices and CPI inflation.

In a recent working paper by the IMF, JaeBin Ahn investigates whether carbon taxes, specifically fuel excise taxes, can reduce inflation volatility by acting as a buffer against global oil price shocks. The research utilizes data from 28 OECD countries over the period from 2014 to 2021, focusing on the variation in fuel tax rates and their impact on domestic inflation.

Fuel Taxes as a Buffer Against Price Shocks

The core idea is that a specific per-unit tax on fuel absorbs part of the product price, making it less susceptible to cost shocks. This hypothesis is supported by empirical evidence showing that countries with higher fuel taxes experience a smaller pass-through of global oil prices to domestic inflation. For instance, differences in fuel tax rates explained about 30% of the variation in annual headline CPI inflation rates between the U.S. and the U.K. during the 2021 inflation surge. The study finds a significant negative relationship between fuel tax rates and the degree of oil price pass-through to retail fuel prices. Higher fuel taxes lead to a smaller portion of retail prices being affected by crude oil prices, thereby dampening the effect of oil price shocks on retail fuel prices. This, in turn, translates to lower inflation volatility. For example, in countries with fuel tax rates close to one dollar per liter, the pass-through rate of oil prices to retail fuel prices in USD is about 20%, compared to 50% in countries with near-zero fuel tax rates.

Impact on Headline and Core CPI Inflation

The research highlights the role of fuel taxes in moderating the impact of oil price shocks on headline and core CPI inflation. The pass-through rate to headline CPI is estimated to be around 1.5% on average but can be as high as 2.8% in countries with low fuel tax rates and as low as 0.5% in those with high tax rates. Similarly, for core CPI inflation, the pass-through rate is about 0.4% on average, with substantial variation based on fuel tax levels. The empirical analysis begins by estimating the pass-through of global oil prices to retail fuel prices across different countries. This is done using simple ordinary least squares (OLS) and autoregressive distributed lag error correction models (ARDL-ECM). The results indicate a strong negative relationship between fuel tax rates and the sensitivity of retail fuel prices to oil price changes. Countries with higher fuel taxes exhibit lower pass-through rates, suggesting that fuel excise taxes act as a buffer against global oil price shocks.

Robust Evidence Through Empirical Analysis

To validate these findings, the paper also employs a panel regression with interaction terms between global oil prices and country-specific fuel tax rates. The results from this analysis confirm that higher fuel tax rates significantly reduce the pass-through of oil price shocks to retail fuel prices. For instance, in countries with zero fuel tax rates, the pass-through rate of oil prices to gasoline prices is about 50%, whereas in countries with one dollar per liter fuel tax rates, it is only about 20%. Furthermore, the paper uses local projection methods to analyze the dynamic effects of oil price shocks on retail fuel price inflation. The impulse response functions derived from these models show that the response of retail fuel price inflation to oil price shocks is significantly smaller in countries with high fuel taxes compared to those with low fuel taxes. In high fuel tax countries, the impact of a one percentage point increase in global oil prices on retail fuel price inflation is about 0.2 percentage points smaller than in low fuel tax countries. This differential effect persists for up to two months after the shock.

Wider Implications for CPI Inflation

The study also extends the analysis to headline and core CPI inflation. The pass-through of global oil prices to headline CPI inflation is found to be largely driven by the direct effects on retail fuel prices. Countries with higher fuel tax rates show lower pass-through rates to headline CPI inflation. For example, the average pass-through rate to headline CPI is about 1.5% but ranges from 2.8% in low fuel tax countries to 0.5% in high fuel tax countries. The analysis of core CPI inflation, which excludes volatile items like fuel, reveals that higher fuel taxes also reduce the indirect effects of oil price shocks on other components of inflation. The pass-through rate to core CPI is about 0.4% on average, but it is negligible in countries with high fuel taxes.

Quantifying the Benefits: A Case Study

To illustrate the practical implications of these findings, the paper provides a back-of-the-envelope calculation for the recent global inflation surge in 2021. During this period, crude oil prices increased by 50%, contributing to varying degrees of inflation across countries. The lower fuel tax rate in the U.S. (13 cents per liter) compared to the U.K. (80 cents per liter) explains a significant portion of the difference in headline CPI inflation rates between the two countries. Specifically, the higher pass-through rate in the U.S. accounts for about 30% of the observed difference in inflation rates. Overall, the paper provides robust evidence that higher fuel excise taxes can act as a shock absorber, reducing the pass-through of global oil price shocks to domestic inflation and thereby lowering inflation volatility. This finding supports the case for higher fuel taxes not only for environmental and fiscal reasons but also for enhancing macroeconomic stability. The research contributes to the ongoing debate on the role of carbon taxes in climate change mitigation and their broader economic implications. By demonstrating that fuel excise taxes can help stabilize inflation, the paper adds a new dimension to the discussion, highlighting the potential of green policies to contribute to economic resilience.