Sharp surges in oil prices have preceded nearly all global recessions since World War II, and the expectation is that plunging oil prices will have the reverse effect — that is, act like a giant fiscal stimulus that boosts the global recovery. Most estimates place the effect of a 50 percent fall in oil prices in a range of 0.5 percent to 1 percent faster global growth in 2015. But the expansionary effect of lower oil prices may not live up to its billing if lower oil prices are not allowed to pass through to consumers and final users.

As it turns out, there are a number of reasons — very good reasons, in fact — why the pass-through of lower oil prices to prices of gasoline and other products could be and indeed should be limited this time around. Countries, developing and advanced, are contending with larger budget deficits and higher debts in the wake of the financial crisis and many should take the opportunity to increase taxes on oil products. From Malaysia to Jordan to India, countries are cutting energy subsidies, which often amount to 5 percent of their gross domestic products (GDP) and mainly benefit the relatively better off. Lower oil prices also work against policies to reduce carbon emissions and the use of coal and other polluting fuels, whose prices are correlated with oil. They also reduce the incentive to invest in renewable energy. 

Uri Dadush
Dadush was a senior associate at the Carnegie Endowment for International Peace. He focuses on trends in the global economy and is currently tracking developments in the eurozone crisis.
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But how to address these fiscal and environmental concerns while also ensuring that the demand boost from cheaper oil happens? In countries that can afford to do so, the answer is to cut income taxes and increase transfer payments to consumers rather than allow the prices of oil products to fall.

The design of such a policy must take two big considerations into account.

First, the demand boost from lower oil prices is likely to be time-bound and soon reversed, probably within a year or two. Lower oil prices boost global and national aggregate demand at first by redistributing income from producers toward consumers with a higher marginal propensity to spend, but there is a payback later as producers and oil exporters react with spending and investment cuts. This pattern is already very visible in the United States, where consumer confidence and gasoline consumption is way up, while energy companies are cutting jobs and investment. While the real income gains of oil consumers, and the corresponding losses of oil producers, will remain so long as oil prices stay low, the demand stimulus from lower oil prices is by its nature temporary. Since the current global recovery is fragile, it is important to make sure that a sizable part of the oil windfall accrues to consumers.

Second, lower oil prices will stimulate demand for oil and deter investments and almost certainly cause markets to tighten again. The nature and vigor of the policy response must therefore be based on the answer, however tentative, to a crucial question: How long will prices stay low? If lower oil prices are here to stay for many years — which many (though not all) experts believe, and I believe — then a correspondingly bigger adjustment is warranted. Even a cursory review of the evidence suggests that the recent plunge in oil prices is not an aberration, but the result of forces that have built up over many years of high prices. These include a massive and steady decline in the oil use/GDP ratios, which are now half what they were after the first great oil shock from 1973 to 1975; new technologies such as fracking and horizontal drilling which have helped expand non-OPEC oil supply by some 10 million barrels per day over the last 15 years; and substitution of oil by other fuels, from renewables to natural gas.

As the World Bank has argued, such shifts are not quickly reversed. According to the bank, the current oil price plunge resembles most closely the one of 1986, which was the result of building supply and oil conservation following the big price surges of the 1970s rather than those associated with a global recession as in 1991, 2001 or 2008. When oil prices fell by some two-thirds in 1986, they stayed low for 15 years. While it seems unlikely that we will see oil prices stay so low for that long this time — both because the supply of new unconventional oil is more elastic (shale oil wells can be brought on stream faster than conventional oil and they deplete much faster) and the long-term marginal cost of many relatively new sources of supply such as Canadian tar sands is very high, in the $70 to $80 per barrel range, it does seem likely that it will take many years for low investment to be reflected in significantly lower supply.

If one assumes, in line with many analysts, that oil prices will rebound a bit but remain at levels 30 percent or so lower than they were at their recent peak, and if also one assumes that such low prices persist over the next seven years, half as long as the period of low oil prices following the collapse of 1986, then oil-exporting nations will have to face big spending cutbacks. Oil-importing nations, on the other hand, are proportionally less affected, and will have a little more spending space than they had before. For example, a country such as Russia, whose net oil exports represent 20 percent of GDP, would expect a fall in its national wealth of roughly 40 percent of GDP (equal to 30 percent oil price decline times 20 percent of GDP times 7 years). If the rate of return on Russia’s wealth is 4 percent, its spending should be reduced by somewhere near 1.6 percent a year permanently. Similarly, an oil importer such as Morocco, whose net oil imports represent about 10 percent of GDP, might be able to increase spending indefinitely by some 0.8 percent of GDP.

These shifts in spending would apply to the economy as a whole, with the burden or the benefit to be shared between the government and the private sector depending on the country's fiscal situation. Countries suffering from high unemployment should err on the side of spending a larger part of the windfall. If this does not happen, then the net effect on global aggregate demand as well as on demand in individual countries will be very small and could conceivably soon become negative, as oil exporters and producers cut back and investment in energy is deterred.

The United States is among the countries whose national wealth is least affected by lower oil prices, since it is a big oil and energy producer as well as consumer and its net oil imports only amount to about 1.5 percent of its GDP and are moreover on a declining long-term path. Even if oil prices behave as assumed above and stay low for seven years, its national spending should only increase by some 0.1 percent of GDP permanently. In other words, unlike Russia and Morocco, the size of the American pie, to be divided between the public and private sector, is unlikely to change much. At the same time, the federal government's deficit is now within reasonable bounds, so there is no compelling reason to limit the pass-through of real income to consumers. Given the fragility of the world recovery, it is a very good thing that U.S. consumers are already seeing the fruits of lower oil prices. Yet, for environmental reasons, and to better prepare for the next big hike in oil prices, it would be much better if those fruits took the form of income tax cuts rather than lower gasoline prices. The politics of raising fuel taxes and simultaneously giving American households an income tax break may be impractical, but the economic logic of doing so remains compelling.

This article originally appeared in The Hill. It is a short version of an OCP Policy Brief.