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Turning Off Russia’s Tap

Summary:
Current demand and supply dynamics mean that a punitive tax on Russian oil would be both onerous for Russia and profitable for the rest of the world, making it more credible and sustainable than an embargo. The idea deserves considerably more attention than it has received. CAMBRIDGE – As I write, Russia’s army has entered Ukraine’s capital, Kyiv. It is clear now that the threat of sanctions did not dissuade Russian President Vladimir Putin from launching his invasion. But making good on the threat can still play two other roles: Sanctions can limit Russia’s capacity to project power by weakening its economy, and they can create a precedent that might influence Putin’s future behavior vis-à-vis other countries such as Georgia, Moldova, and the Baltic states. One reason why

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Current demand and supply dynamics mean that a punitive tax on Russian oil would be both onerous for Russia and profitable for the rest of the world, making it more credible and sustainable than an embargo. The idea deserves considerably more attention than it has received.

CAMBRIDGE – As I write, Russia’s army has entered Ukraine’s capital, Kyiv. It is clear now that the threat of sanctions did not dissuade Russian President Vladimir Putin from launching his invasion. But making good on the threat can still play two other roles: Sanctions can limit Russia’s capacity to project power by weakening its economy, and they can create a precedent that might influence Putin’s future behavior vis-à-vis other countries such as Georgia, Moldova, and the Baltic states.

One reason why the threat of sanctions might not have prevented war is that Russia did not regard them as credible. If imposing a sanction is costly, the political will to do so may be weak or evaporate over time. For example, Western consumers are already upset at the high energy costs. An embargo on Russian oil will reduce the global energy supply and send prices even higher, potentially triggering a backlash against the policy.

That may be why Western countries have not imposed it, opting instead for financial sanctions that have, so far, been underwhelming. After all, arguably the most significant sanction to date – the suspension of the Nord Stream 2 pipeline that would have delivered Russian natural gas directly to Germany – will strain Europe’s already tight natural gas market.

Sanctions are more effective and credible if they impose large costs on the intended target but entail small costs or even benefits for those imposing them. Finding such sanctions is easier said than done, as the Nord Stream 2 project shows. So, what instruments does the West have in its arsenal?

One that has received surprisingly little attention is punitive taxes on Russian oil and gas. At first sight, imposing a tax on a good must increase its price, making energy even more expensive for Western consumers. Right? Wrong!

At issue is something called tax incidence analysis, which is taught in basic microeconomics courses. A tax on a good, such as Russian oil, will affect both supply and demand, changing the good’s price. How much the price changes, and who bears the cost of the tax, depends on how sensitive both supply and demand are to the tax, or what economists call elasticity. The more elastic the demand, the more the producer bears the cost of the tax because consumers have more options. The more inelastic the supply, the more the producer – again – bears the tax, because it has fewer options.

Fortunately, this is precisely the situation the West now confronts. Demand for Russian oil is highly elastic, because consumers do not really care if the oil they use comes from Russia, the Gulf, or somewhere else. They are unwilling to pay more for Russian oil if other oil with similar properties is available. Hence, the price of Russian oil after tax is pinned down by the market price of all other oil.

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