In a recent Joint Center Working Paper, Gerard and Lave respond to our recent work critiquing proposed increases in existing Corporate Average Fuel Economy (CAFE) standards. Gerard and Laveassert that, at least in the right environment, there is a place for CAFE standards. We suggest, however, that Gerard and Lavehave not really made any dent in our arguments, and have not provided any rationale for the CAFE program to exist. Indeed, much of the Gerard and Lave'sargument is self-contradictory.

Kleit, Andrew N.

Lutter, Randall

English

Research Papers in Economics

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The attached material is posted on regulation2point0.org with permission.  
JOINT CENTER  
AEI-BROOKINGS JOINT CENTER FOR REGULATORY STUDIES 
 
 
Increasing CAFE Standards: Still a Very Bad Idea 
 
 
Andrew N. Kleit and Randall Lutter
* 
 
Regulatory Analysis 04-04 
June 2004 
 
 
                                                           
* Andrew N. Kleit is a Professor of Energy and Environmental Economics at the Pennsylvania State 
University. Randall Lutter is the Chief Economist in the Office of Planning at the Food and Drug 
Administration. The results expressed herein are solely those of the authors and not necessarily those of 
the Food and Drug Administration.  
 
J   O   I   N   T     C   E   N   T   E   R 
AEI-BROOKINGS JOINT CENTER FOR REGULATORY STUDIES 
 
 
In order to promote public understanding of the impact of regulations on 
consumers, business, and government, the American Enterprise Institute and the 
Brookings Institution established the AEI-Brookings Joint Center for Regulatory 
Studies.  The Joint Center’s primary purpose is to hold lawmakers and regulators 
more accountable by providing thoughtful, objective analysis of relevant laws and 
regulations. Over the past three decades, AEI and Brookings have generated an 
impressive body of research on regulation. The Joint Center builds on this solid 
foundation, evaluating the economic impact of laws and regulations and offering 
constructive suggestions for reforms to enhance productivity and welfare. The 
views expressed in Joint Center publications are those of the authors and do not 
necessarily reflect the views of the Joint Center. 
 
 
 ROBERT W. HAHN 
Executive Director 
  ROBERT E. LITAN 
Director 
 
 
COUNCIL OF ACADEMIC ADVISERS 
KENNETH J. ARROW 
Stanford University 
  MAUREEN L. CROPPER 
University of Maryland  
 PHILIP  K.  HOWARD 
Covington & Burling 
 
        
PAUL L. JOSKOW 
Massachusetts Institute 
of Technology 
 DONALD  KENNEDY 
Stanford University 
 ROGER  G.  NOLL 
Stanford University 
        
GILBERT S. OMENN 
University of Michigan 
 PETER  PASSELL 
Milken Institute 
 RICHARD  SCHMALENSEE 
Massachusetts Institute 
of Technology 
        
ROBERT N. STAVINS 
Harvard University 
 CASS  R.  SUNSTEIN 
University of Chicago 
  W. KIP VISCUSI 
Harvard University 
 
All AEI-Brookings Joint Center publications can be found at www.aei-brookings.org 
 
© 2004 by the authors.  All rights reserved. Executive Summary 
 
In a recent Joint Center Working Paper, Gerard and Lave (2003, hereafter GL) respond to 
our recent work (Kleit 2002, forthcoming, Lutter, 2002, and Lutter and Kravitz, 2003) critiquing 
proposed increases in existing Corporate Average Fuel Economy (CAFE) standards.  GL assert 
that, at least in the right environment, there is a place for CAFE standards.  We suggest, 
however, that GL have not really made any dent in our arguments, and have not provided any 
rationale for the CAFE program to exist.  Indeed, much of the GL argument is self-contradictory.   1
 
Increasing CAFE Standards: Still a Very Bad Idea 
Andrew N. Kleit and Randall Lutter 
 
1. Introduction 
 
  In a recent Joint Center Working Paper, Gerard and Lave (2003, hereafter GL) respond to 
our recent work (Kleit 2002, forthcoming, Lutter, 2002, and Lutter and Kravitz, 2003) critiquing 
proposed increases in existing Corporate Average Fuel Economy (CAFE) standards. GL assert 
that, at least in the right environment, there is a place for CAFE standards. We suggest, however, 
that GL have not really made any dent in our arguments, and have not provided any rationale for 
the CAFE program to exist. Indeed, much of the GL argument is self-contradictory. 
  In Section II of this note, we will review the GL arguments about congestion and the 
need they assert for an increase in the gasoline tax. Contrary to what GL assert, our position does 
not necessarily support an increase in the gasoline tax.  Section III examines GL’s contention 
about the “rebound effect,” the empirically supported application of the first law of demand, that 
consumers in more fuel efficient vehicles will drive more. Section IV examines arguments about 
the possible divergence in private and social discount rates. Section V examines GL’s concluding 
remarks. 
 
2. External Effects and “Corrective Taxes” 
 
In our analyses of increases in the current CAFE standards, we point out that, given that 
consumers will drive more miles if induced into more fuel efficient vehicles, this will increase 
congestion, accidents, and pollution. We then attempt to quantify those costs on a per mile basis. 
Taking account of such externalities is both realistic and important. As GL (at 8) report, “[B]y 
including these external costs, even modest incremental increases in the CAFE standards seem 
absurd.”   
  Yet then GL take our analysis further, asserting that its logical implications are the 
imposition of an increase in the gasoline tax of approximately $1.75 per gallon. We would not be 
embarrassed to support a higher gasoline tax to reduce identifiable externalities, as recent   2
 
important work has suggested may be appropriate (Parry and Small, 2002). But that is not what 
our analysis implies; and it surely does not lead to a tax as large as $1.75 per gallon. 
  A person gets in their car and drives onto a crowded road. By driving, that person 
imposes externalities on the other drivers on the road. A gasoline tax at an appropriate level 
might solve this problem, if all driving imposed the same externality. But all driving does not 
impose the same externality. 
  Assume Lutter decides to drive his car from Beltsville to Bethesda, Maryland on 
Interstate 95 at 5PM on a Monday. It is highly likely he will be creating a congestion externality. 
Ideally, policy should seek to discourage such behavior. 
  But now assume Kleit decides to drive his car from Bedford to Bald Eagle, Pennsylvania 
on Interstate 99 at just about any time.  It is quite unlikely that he will cause any congestion at 
all. Given this, should he pay the increase in gasoline tax that GL suggest? 
  A better policy might be to focus on congestion pricing. As the Congressional Budget 
Office (2002, Chapter 5) states, “[p]olicies that target the cost of peak-period driving directly, 
such as tolls levied during those periods, are better suited for addressing congestion problems.” 
(For a description of congestion pricing options, see Holtz-Eakin, 2003.) 
  In any event, the GL assertion that our analysis implies support for higher taxes is simply 
not relevant. We analyzed CAFE standards under current conditions. Higher CAFE standards 
would be less onerous given a $1.75 increase in the gasoline tax for the simple reason that they 
would be less likely to be binding. But this is not the world in which we currently reside.  
 
3. The Rebound Effect 
 
As discussed above, the “rebound effect” is an important consideration in weighing the 
costs and benefits of CAFE standards. According to the first law of demand, as the price of 
something declines, more of it is consumed.  
  The first law of demand is easily applied to the impact of CAFE standards. By design, 
CAFE standards place consumers in more fuel efficient cars than they otherwise would be in. 
Thus, CAFE standards will cause these consumers to drive more. The relevant question is: how 
much more?   3
 
  In a perhaps somewhat rambling discussion, GL (at 8-10), while agreeing that (at 10) “the 
rebound effect is real,” attempt to argue that it is perhaps very small. The core of the argument 
seems to be stated at page 9: 
 
Driving a vehicle more implies either that a vehicle is scrapped at an earlier age or 
that they [drivers] put more miles on a vehicle before scrapping it. This leads to 
the question of when and why consumers scrap vehicles. If consumers scrap 
vehicles purely because they become unfashionable, then we expect that miles 
driven would increase. If, on the other extreme, vehicles were “one-hoss shays,” 
that disintegrate into dust at 150,000 miles, then no additional miles would be 
driven with this vehicle. 
 
Perhaps better stated, the existence of the rebound effect implies that either consumers drive their 
cars more miles, or they purchase cars more quickly after driving their vehicles more intensely. 
The second hypothesis seems somewhat unlikely, given that automobile manufacturers do not 
generally support higher CAFE standards.  
  It is an open empirical question as to how the rebound effect manifests itself. At this time, 
however, it is not an open empirical question that the rebound effect is large and important. 
There have been literally dozens of studies showing an important rebound effect in gasoline, 
albeit with a range in the estimates.  GL (at 5) summarize this literature accordingly: 
 
Because CAFE reduces marginal driving cost and encourages more driving, there 
are costs associated with the CAFE-induced vehicle miles traveled. An average 
point estimate is that a 10 percent increase in fuel economy (or decrease in fuel 
prices) leads to a two percent increase in driving [citing to Greene, Kahn, and 
Gibson, 1999]. 
 
Thus, GL join with the Congressional Budget Office and the National Highway Traffic Safety 
Administration in concluding that 20 percent (2% over 10%) is the appropriate measure of the 
rebound effect. This is the same number for the rebound effect that Kleit uses in his studies.   4
 
  GL ask “How Big is the Rebound Effect?” Yet they and we agree. The proper measure of 
the rebound effect, given the current state of the literature, is 20 percent. There is no actual 
argument here.  
 
4. The Impact of the Discount Rate 
 
To evaluate the demand for fuel efficiency, it is necessary to discount the future stream of 
benefits consumers receive from fuel efficiency. Kleit (forthcoming) and Lutter and Kravitz 
(2003) assume that consumers may discount future fuel economy at relatively high rates—
ranging from 20 percent in the former to 7 to 10 percent in the latter. GL assert that the 
difference between these relatively high rates and “social” discount rates constitutes a rationale 
for higher CAFE standards. GL’s position is incorrect. 
   First, note that using higher discount rates is not necessary to obtain high costs for the 
CAFE program. The original Kleit study (2002) used a discount rate of 4 percent and obtained 
largely the same results as Kleit (forthcoming, as discussed in footnote 14). The discount rate 
question was a small part of the Lutter and Kravitz critique.  
  But one cannot draw welfare conclusions based on differing discount rates without 
understanding  why  the consumer discount rate is relatively high. Orazio, Goldberg, and 
Kyriazidou (2000) show that many automobile purchasers are liquidity constrained, and 
therefore face implicit discount rates much higher than the market level. Thus, forcing these 
consumers into more fuel efficient vehicles would impose real increased costs on them—they 
cannot obtain credit to pay for the additional costs of the more fuel efficient vehicle, and so have 
to self-finance or forego the purchase.  
A complementary line of analysis arises from the irrevocable commitment aspect of 
purchasing an automotive. Such a commitment requires the purchaser to forego other options, 
such as waiting for more favorable purchase conditions. Real options analysis, along the lines of 
Dixit and Pindyck (1994), implies that such commitments should attain higher rates of return, 
and therefore higher interest rates should be used in policy analysis to evaluate such 
commitments. Following along this line, Sutherland (2000) suggests that discount rates for these 
types of purchases should be raised far above market levels.    5
 
  More broadly, there is the question of why relatively high consumer discount rates create 
a market failure that should be addressed by government policy. Assume the government adopts 
a policy that induces a consumer to buy a more fuel efficient vehicle (or energy efficient 
appliance).  By assumption, that consumer is worse off. Who in society is better off? Perhaps if 
there is some externality in the consumption of energy, someone else in society is better off. But 
that is not the argument GL are making. They assert that the divergence in discount rates, by 
itself, constitutes a rationale for public policy. This paternalistic position is incorrect. 
 
5. Conclusion 
 
GL agree with us in the current world that higher CAFE standards induce more 
congestion, that the rebound effect is real, and that the best estimate of the value of the rebound 
effect is 20 percent. They note that the presence of congestion costs and other externalities 
induced by higher CAFE standards makes such standards prohibitively expensive.  In all this, we 
agree with them. 
GL incorrectly assert that the existence of congestion costs implies that a higher gasoline 
tax should be levied. This is not quite true. They also assert that the divergence in discount rates 
constitutes a rationale for the CAFE program. This is incorrect. To reach this conclusion, one 
needs to show the reason why such a diversion exists. Then from that rationale, an analyst needs 
to show how the relevant regulatory policy creates net benefits for society. 
GL assert that, if gasoline taxes were greatly increased, CAFE standards would be 
efficacious policy. We do not agree, but for the present the issue is unimportant. Our analyses 
were based on current conditions. If gasoline taxes are indeed raised, we would be happy to 
rejoin GL on this issue. In the meantime, policy makers need to deal with the world in which we 
all live.  
  GL are clear about the harms of increases in the current level of CAFE standards. 
According to them (at 15) “… the CAFE program will continue to create distortions and generate 
social costs unless accompanied by an increase in prices.” They agree (at 6) with Crandall (1992) 
that “[G]asoline taxes achieve the same fuel consumption level at costs that are seven to ten 
times less than those of the CAFE program.” They assert that the externalities from raising 
CAFE standards will swamp any benefits.    6
 
Yet despite all this they contend (at 14) that, even without an increase in gasoline taxes, 
“[a] CAFE increase would be better than no action.” They make no rational case for this 
assertion, and much of their paper contradicts their own conclusion. 
We stand by our analysis. An increase in the current CAFE standard makes no economic 
sense in the current environment. Nothing in what GL presents contradicts this position, and 
much of their argument actually supports it. 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
   7
 
References 
 
Congressional Budget Office, “Reducing Gasoline Consumption: Three Policy Options,” 
November 2002 http://www.cbo.gov/ showdoc.cfm?index =3991&sequence=0. 
 
Dixit, A. K., and R. S. Pindyck. Investment Under Uncertainty. Princeton, 1994. 
 
Gerard, David, and Lave, Lester, “The Economics of CAFE Reconsidered: A Response to CAFE 
Critics and A Case for Fuel Economy Standards,” AEI-Brookings Joint Center for 
Regulatory Studies, Regulatory Analysis 03-10. (October 2003) http:// 
www.aei.brookings.org/ ta_search.php. 
 
Greene, D.L, J.R. Kahn, and R.C. Gibson. “Fuel Economy Rebound Effect for U.S. Household 
Vehicles.” Energy Journal 20, 1999, 1-31. 
 
Holtz-Eakin, Douglas, Director, Congressional Budget Office, ”Congestion Pricing for 
Highways” Statement before the Joint Economic Committee, U.S. Congress May 6, 2003 
http://www.cbo.gov/showdoc.cfm?index=4197&sequence=0. 
 
Lutter, Randall “CAFE: The Numbers Behind the Story”,  AEI-Brookings Joint Center for 
Regulatory Studies, Policy Matters 02-12, April 2002, http://www.aei-
brookings.org/policy/page.php?id=84 
 
Lutter, Randall, and Kravitz, Troy, “Do Regulations Requiring Light Trucks to Be More Fuel 
Efficient Make Economic Sense? An Evaluation of NHTSA’s Proposed Standards,” AEI-
Brookings Joint Center for Regulatory Studies, Regulatory Analysis 03-2. March 2003 
http://www.aei.brookings.org/publications/abstract.php?pid=312. 
 
Kleit, Andrew N., “Impacts of Long-Range Increases in the Corporate Average Fuel Economy 
(CAFE) Standard,”  AEI-Brooking Joint Center on Regulation Working Paper 02-10, 
October, 2002, http://www.aei.brookings.org/publications/abstract.php?pid=284.  
 
Kleit, Andrew N., “Impacts of Long-Range Increases in the Corporate Average Fuel Economy 
(CAFE) Standard,” Economic Inquiry, 42(2) 279-94, Forthcoming, 2004 
 
Parry, Ian, and Kenneth Small, “Does Britain or the U.S. Have the, Resources for the Futures 
Discussion Paper 02-12, March 2002, http://www.rff.org/Documents/RFF-DP-02-12.pdf 
 
Orazio, A., P. Goldberg, and E. Kyriazidou. “Credit Constraints in the Market for Consumer 
Durables: Evidence from Micro Data on Car Loans.” NBER Working Paper W7694, 
2000. 
 
Sutherland, R.J. “”No Cost” Efforts to Reduce Carbon Emissions in the U.S.: An Economic 
Perspective.” Energy Journal , 21, 2000, 89-112. 

CAFE: The Numbers Behind the Story”, AEI-Brookings Joint Center for Regulatory Studies, Policy Matters 02-12,

Director, Congressional Budget Office, ”Congestion Pricing for

Fuel Economy Rebound Effect for U.S.

Impacts of Long-Range Increases in the Corporate Average Fuel Economy (CAFE)

Investment Under Uncertainty.

No Cost” Efforts to Reduce Carbon Emissions in the U.S.:

Office, “Reducing Gasoline Consumption: Three Policy Options,”

The Economics of CAFE Reconsidered: A Response to CAFE Critics and A Case for Fuel Economy Standards,” AEI-Brookings Joint Center for Regulatory Studies, Regulatory Analysis 03-10.

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Increasing CAFE Standards: Still a Very Bad Idea

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