Erich Muehlegger on Regulation

Changes in government policy can often elicit unexpected responses from affected citizens and institutions. Erich Muehlegger is assistant professor of public policy whose research is focused on how individual consumers and organizations respond to environmental regulation and the effect of regulation on illegal activity. He is the faculty chair of the Regulatory Policy Program and a fellow of the Harvard Environmental Economics Program and the Harvard University Center for the Environment.

Q: Much of your research investigates the role environmental regulation of gasoline content plays in gasoline price volatility and the extent to which price spikes in gasoline markets could be mitigated by uniform regulation. What are some of the most salient findings in this research?

Muehlegger: There are many cases where states set very different regulations. Gasoline is a great example – California requires the composition of gasoline meet unique specifications to reduce pollution. One of the consequences of allowing states to set unique regulations is that gasoline sold in other states cannot be easily moved to California, even if California’s gasoline prices are very high.

In my early research, I examined whether allowing states to set incompatible regulations led to more volatile gasoline prices. In particular, I examined how much gasoline prices rose following unexpected events – like refinery fires – that increase gasoline prices locally. I estimated that 70 percent of price spikes following refinery fires in California were due to California’s unique regulations. Absent the environmental regulations, suppliers would have been able to move gasoline from other states and would have mitigated most of the price increase.

Q: In addition, you have a paper examining fuel taxes. Do fuel taxes create similar challenges?

Muehlegger: Yes. In a recently published paper with my coauthor Justin Marion, we find that state and federal diesel taxes create strong incentives for illegal activity. Diesel taxes fund road construction projects. As a result, only fuel sold at retail stations is taxed. If diesel is used to heat a home, run a tractor on a farm or as fuel for a factory, no taxes are paid. Historically, this created a strong incentive for firms to claim they were using or selling diesel for untaxed use, but actually sell it to retail stations. Rather than paying the highway taxes to the government, the firm could keep the taxes itself.

In the paper, we are able to quantify how much tax evasion was occurring by looking at a change in how the federal government enforced fuel taxes. Beginning in October of 1993, if a company didn’t pay taxes when it bought diesel fuel, the federal government required the wholesaler to add red dye to the fuel. If taxes were paid, no red dye would be added. This small change made it much easier for government officials to check and see if a retail station was selling untaxed fuel. If diesel fuel sold at a station or found in the tank of a semi had any red dye, the official knew that some of the fuel was illegal. 

This small change had a big impact on illegal activity. In the month in which the requirement began, taxed sales rose by approximately 30 percent, and sales of untaxed fuel fell by a similar amount. Moreover, the change was bigger in states that had high state diesel taxes and was smaller in states that had low state diesel taxes. In total, we estimate that approximately $2.8 billion / year of taxes were evaded in the pre-dye period.

Q: With high gas prices and a growing environmental sensitivity, many consumers are now switching to hybrid automobiles. Please discuss the findings of your recent study examining how incentives can drive consumers to the show room floor.

Muehlegger: Beginning with the Prius and Insight, many states experimented with different types of incentives for people purchasing hybrid vehicles, varying from waiving state sales taxes to giving tax income tax credits to allowing hybrid vehicle owners to drive in carpool lanes. In this paper, my co-authors and I examine which of these incentives have the greatest impact on hybrid vehicle adoption. By comparing how hybrid sales change post-incentive, we find that consumers respond most to sales tax waivers. In fact, a sales tax waiver has more than ten times the impact of an income tax credit of equal value. The intuition is that sales taxes are very present in a car purchasers mind when they are making the decision, whereas an income tax credit is received in the future, requires more effort and needs to be well understood before going to the dealership.

We do not find consistent evidence that allowing hybrids in carpool lanes increases sales – while sales rise in Virginia where hybrid owners can commute easily to DC, sales do not change significantly in other states. We also examine the effects of rising gasoline prices. We find that as gasoline prices increase, sales of the hybrid vehicles with the highest fuel economies, like the Insight and Prius, also increase. Sales of hybrid SUVs or hybrid cars with lower fuel economy do not increase.

Q: What are the overarching public policy questions/concerns driving your research?

Muehlegger: In many cases, government regulation is very beneficial. Regulation reduces pollution, promotes safety and can encourage fair competition. In many situations, though, regulations also have counterproductive or unanticipated consequences. Local environmental regulations, while improving air quality and providing health benefits, encourage dirty firms to move unregulated locations. Taxing goods like cigarettes or gasoline generates revenue and promotes conservation, but also encourages smuggling and tax evasion. This tension between the beneficial impacts of regulation and the counterproductive impacts are crucial to understand when designing policy.

Q. How important is it for students of public policy to study regulation and the impacts of regulation and to understand how integral regulation in the making, execution, and results of public policy?

Muehlegger: Understanding the impact of regulation is crucial. There are many situations in which well-designed and well-meaning regulation ends up having unanticipated consequences, very counterproductive consequences. We see this in environmental regulation, we see this in financial regulation, we see this in tax policy – both income taxes and taxes on different goods – all of these regulations, while they might be very well-meaning and they might have some benefits to them – the fact that they are creating incentives for particular individuals or particular firms also have a lot of other consequences. It’s crucial to be able to understand and to think very carefully about both what the beneficial impacts of regulation are going to be, but to also essentially put yourself in the shoes of either an individual or a firm that’s facing [regulation] and think about what other incentive this creates for behavior. In many cases, when we think about challenges that the U.S. faces or that the world faces, regulation is a very common way that we think about how to address those challenges. But really it’s only with well-designed regulation that we can hope to overcome some of the environmental challenges in particular that we face. 

Interviewed by Doug Gavel, February 22, 2010.

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