Gasoline taxes are widely perceived as the most efficient instrument for reducing gasoline consumption because they exploit all behavioral responses for reducing fuel use, including reduced driving and improved fuel economy. At present, however, higher fuel taxes are viewed as a political nonstarter. Pay-as-you-drive (PAYD) auto insurance, which involves replacing existing lump-sum premiums with premiums that vary in proportion to miles driven, should be more practical, since they do not raise driving costs for the average motorist. We show that when impacts on a broad range of motor vehicle externalities are considered, PAYD also induces significantly higher welfare gains than comparable gasoline tax increases, for fuel reductions below 9%. The reason is that under PAYD, all of the reduction in fuel use, rather than just a fraction, comes from reduced driving; this produces a substantial additional efficiency gain because mileage-related external costs (especially congestion and accidents) are relatively large in magnitude.(This abstract was borrowed from another version of this item.)

This paper develops an analytical framework for assessing the second-best optimal level of gasoline taxation taking into account unpriced pollution, congestion, and accident externalities, and interactions with the broader fiscal system. We provide calculations of the optimal taxes for the US and the UK under a wide variety of parameter scenarios. Under our central parameter values, and with the gasoline tax substituting for a distorting tax on labor income, the second-best optimal gasoline tax is $0.95/gal for the US and $1.29/gal for the UK. These values are moderately sensitive to alternative plausible parameter assumptions. The congestion externality is the largest component in both nations, and the higher optimal tax for the UK is due almost entirely to a higher assumed value for marginal congestion cost. Revenue-raising needs, incorporated in a “Ramsey" component, also play a significant role, as do accident externalities and local air pollution. However, we also find that a shift in taxation off gasoline and onto vehicle miles can produce much larger welfare gains than those from implementing second-best optimal gasoline taxes.