How Higher Gas Prices Hurt Less Affluent Consumers and the Economy

With rising gas prices now rivaling unemployment as a key issue in this year’s election, both the president and his Republican opponents have been speaking out about what, if anything, should be done. Republicans argue that the nation needs more domestic oil and gas production while the president notes that oil is produced and sold on world markets, meaning that domestic supplies have a small impact on prices. That said, rising gas prices do affect both consumers and the economy adversely, and they are especially harmful to lower- and moderate-income households.

One assumption is that these households do not all own cars, that many use mass transit instead. Looking at all households with annual incomes less than $50,000, it turns out that the vast majority (80%) do own cars, and a significant portion (over a third) own more than one car. Of course, even if they do not own cars, higher gas prices can affect mass transit riders as well once higher costs show up at the fare box, although this undoubtedly occurs with more of a lag.

Among low-to-moderate-income households that do own cars, they drove about 10,000 miles and spent about $1,500 on motor fuel during 2010 when the average price of gasoline was about $2.80. Gas prices are now approaching $3.80 a gallon, and some observers believe they could reach $5.00 by this summer. Every dollar increase, holding the number of miles driven constant, would cost these moderate- and lower-income households an extra $530 per year. For a family with an annual income of $20,000, this is an additional 2.7% of their total income. Although higher gas prices eventually encourage consumers to cut back on driving or switch to more fuel-efficient vehicles, in the short-run they may have few options but to cut back on other expenditures in the family budget. Since low- and moderate-income families’ spend most of their income on average, in the very short run they can only choose between spending less on other items and going further into debt. In addition, less spending on other items operates much like higher taxes in slowing an incipient recovery. In other words, higher gas prices drain purchasing power from the economy. That means that these families get hit twice: once by the direct impact on their household budgets but a second time when higher prices retard the economic recovery. In a paper published (PDF) in the Brookings Papers on Economic Activity on the contribution of oil price shocks to past U.S. recessions, James D. Hamilton finds that they slowed GDP growth significantly, often enough to tip the economy into a recession. Goldman Sachs estimates that just the oil price increase since December will shave between a quarter and a half of a percentage point off of real GDP growth over the next year, and the effects could be more dire if oil prices continue to rise.

To be sure, in the longer term, consumers will adjust how much they drive and how much they spend on gas in response to higher prices at the pump. Research suggests that in the short term — less than a year — the so-called price elasticity of demand for gas is about -0.25, meaning that if the price of gas goes up 10%, consumers will demand 2.5% less gas. In the long term, the elasticity is closer to -0.6. If we apply these numbers to the gas expenditure figures above, I estimate that a $1.00 increase in the price of gas will result in low- and moderate-income families spending about $350 more on gas in the short term. These estimates represent an average for all low- and moderate-income families. Certain households, such as those living in rural areas without access to public transportation and thus no way to get out of their cars, will be hit even harder.

Rising gas prices produce a level of hardship for a group that is already suffering from high levels of unemployment and stagnant or declining real wages. Even in good times, but especially in recessions, the least skilled are far more likely to be unemployed. In January 2012, the unemployment rate was 4.2% for those with a college degree, 8.4% for those with only a high school degree and a staggering 13.1% for high school dropouts. Similarly, a 2011 report by the National Employment Law Project found that since the start of the recession, while workers in higher-wage occupations saw 0.9% real wage growth, mid-wage workers’ wages fell by 0.9% and low-wage workers experienced a 2.3% decline in real wages.

Most experts do not believe there is much that government can do to reduce oil price spikes caused by unrest in the Middle East or other short-term factors. But the government can at least cushion such effects by providing unemployment insurance benefits, payroll tax cuts or other assistance to lower-income households to help offset the impact of higher gas prices on both their pocketbooks and the strength of the economic recovery.