For more than 30 years, auto companies have done just enough to improve fuel economy of vehicles in order to lower tax rates and increase rebates imposed by governments in the United States and Canada, according to a study by Joel Slemrod, professor of business economics at the University of Michigan’s Ross School of Business, and colleague James Sallee, assistant professor at the University of Chicago’s Harris School of Public Policy.
In response to federal policies to boost gas mileage, manufacturers have changed vehicle weights, improved tire-rolling resistance and added aerodynamic features to push fuel-economy rates past government-mandated thresholds. In their study, Slemrod and Sallee focus on “car notches”—where small changes in behavior lead to large changes in tax liability or the amount
of a subsidy—in policies intended to encourage the production and use of fuel-efficient vehicles.
Car notches are the small trigger points in the numerical values of fuel economy (say, the difference between 22.5 mpg and 22.4 mpg) that lead to large changes in tax liability or the amount of a subsidy.
In spite of having a bad reputation among economists, policy notches are ubiquitous. They induce actors to change their behavior just enough to be situated on the beneficial side of a notch. In the case of car notches, a vehicle manufacturer may have an incentive to marginally re-engineer its cars so as to just qualify for a more advantageous policy category.
—Joel Slemrod
| “[Car] notches imply large, capriciously varying, local incentives to make small changes in behavior for relatively large private, but not social, rewards. Such behavioral responses erode the intended welfare benefits of policies, whose notch features are presumably justified by the increased salience and administrative convenience of policies that appear as step functions rather than smooth, continuous schedules.” |
| —Sallee and Slemrod |
Slemrod and Sallee studied the behavioral responses to the US Gas Guzzler Tax of 1978, which penalizes cars with low fuel economy, and the Canadian “feebate” program of 2007, a set of taxes and rebates that together act to encourage the purchase of more fuel-efficient vehicles. They also addressed another notch-like aspect of fuel economy—publicly disclosed and highly visible integer fuel economy ratings that provide information to prospective car buyers.
Under the US Gas Guzzler Tax, the amount of the tax is a notched schedule in fuel economy, so vehicles with very small ratings differences may be subject to discretely different taxes. For example, a car with an 18.5 mpg US (12.7 L/100km) rating is subject to a $2,100 tax, while a car with an 18.4 mpg (12.8 L/100km) rating is subject to a $2,600 tax, so that a tax increase of $500 is triggered by a decrease of just 0.1 mpg. Under the Canadian feebate program, cars that get 43 mpg, for example, qualify for a $2,000 rebate, while cars that get 42 mpg receive a $1,500 rebate. Likewise, vehicles getting less than 18 mpg are taxed up to $4,000.
Using data from Corporate Average Fuel Economy (CAFE), the US Environmental Protection Agency (EPA), Internal Revenue Service (IRS) and the Canadian government, the researchers found that automakers produce and sell a significant number of “extra” vehicles with fuel economy ratings just on the tax-favorable side of a notch than otherwise would be expected—and more than those cars just below a notch that are subject to a higher tax.
We observe this behavior not only in response to explicit notches in tax and subsidy policies, but also in response to implicit presentation notches, where government policy dictates what information a firm must provide to consumers.
—Joel Slemrod
Slemrod and Sallee say that since automakers are required to round off mpg values on fuel economy labels for consumers, this results in a presentation notch at every .5 mpg (permitting automakers to round up in their calculation of fuel economy).
The researchers say that automakers can boost fuel economy by producing lighter-weight vehicles of the same model to create a better fuel economy rating or by simply modifying a vehicle to improve its fuel economy by recalibrating the engine, using low-friction lubricants, modifying the tires or making small aerodynamic changes. All of this behavior is perfectly legal, they add.
Key aspects of American and Canadian vehicle fuel economy policy are designed with notches,
so that many vehicles face no incentive to incrementally improve fuel economy, but others face
large and varying incentives for improvement. In this paper we show that the policy notches
have real consequences, as there are significantly more vehicles produced (and purchased) just
on the policy-beneficial side of the notches than otherwise would be expected. We observe
this behavior not only in response to explicit notches in tax and subsidy policies, but also in
response to implicit presentation notches, where government policy dictates what (coarse)
information a firm must provide to consumers. We develop a simple framework within which
the negative welfare effects of local manipulation can be calculated, a framework which may
prove useful in a variety of contexts as it can be utilized with only ex post data.
Future fuel economy policies are likely to increase the importance of notches. The state of
California recently explore [sic] a comprehensive feebate program with notches, and similar legislation has been introduced in the U.S. Senate. The EPA is considering the adoption of a letter
grade system with grading notches that would rate vehicles by fuel economy and emissions.
Recent CAFE reforms have dramatically tightened its standards in a way that increases the
value of moving vehicles over the light-truck classification notch. Policy notches may have administrative or salience benefits, but for notches to be warranted, these benefits must outweigh
the substantial inefficiency costs that we document here.—Sallee and Slemrod
Resources
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James M. Sallee and Joel Slemrod (2010) Car Notches: Strategic Automaker Responses to
Fuel Economy Policy