Fuel for thought: the what, why and how of motoring taxation

Private transport costs make up some 13% of the average household budget, and it is estimated that in 2011/12 motoring-related taxes (fuel duties and Vehicle Excise Duty, VED) will raise more than £38 billion, or almost 7% of total revenues. The benefits of a well-designed system of motoring taxes are therefore potentially substantial. This report provides a detailed examination of the current system of motoring-related taxes in the UK, assesses how well these taxes match up to the economic principles underlying good tax policy, and makes a number of suggestions for reform.

The key insights are that motoring taxes are justified primarily by the external costs ('externalities') generated by road use. These costs are not taken into account in private choices of how much to drive. Without policy action, this leads to excess motoring from the perspective of society as a whole. Taxes on motoring can increase the private costs - 'internalise the externality' - and correct this problem. Ideally, these corrective taxes should be targeted on the externalities directly (or on a close approximation to them), and set at a level equal to the marginal external cost at the socially optimal level of demand.

However, we conclude that the current tax system does a poor job at targeting these external costs. In particular, fuel taxes are completely unable to capture variation in external costs by time and location - most notably the costs of congestion. A system of road pricing or congestion charging which is able to take such variation into account more accurately would be preferable. This conclusion is not one which is new or surprising, and policymakers have shown little appetite to act on it before. However, as our findings here make clear, real impetus for reform may come from fiscal considerations. Without action, there is likely to be a long-term erosion of the motoring tax base. Road use, though, is expected to continue to increase. Road pricing not only targets the external costs of motoring more precisely, generating the potential for significant welfare gains, but also provides a more robust revenue source.

See this presentation for a summary of the some of issues raised in the report.