Rapid increases in pump prices have sparked renewed debate on the level of fuel duties, with calls for the Chancellor to cancel April's planned real-terms increase in the forthcoming Budget. There is also continued speculation about the prospect of a "fair fuel stabiliser" (FFS) - a formal mechanism to cut duties at times of high oil prices (and to raise duties when oil prices fall). During Prime Minister's Questions on March 2, David Cameron made it clear the FFS was still under consideration, saying: "...we will look at the fact that extra revenue comes to the Treasury when there is a higher oil price, and see if we can share some of the benefit of that with the motorist. That is something that Labour never did in all its time in government." What are the facts and how should we assess these proposals?

Day-to-day changes in fuel prices are highly visible and fuel is an important share of spending for many households, so the salience of the issue is unsurprising. In 2009, vehicle fuel made up on average 4.9% of household spending, and more than one in five households spent over 9% of their budget on fuel. As prices have risen since 2009, fuel's prominence in household budgets has probably grown further.

In real terms, fuel prices are now about 17% higher than they were in autumn 2000, the period of the fuel price protests. Taxes now make up around 61% of the price of a litre of diesel and 63% of the price of petrol (for petrol, 46% of the price is duty and 17% VAT). The total tax paid for a litre of petrol amounted to around 80.2p in January 2011 following rises in both duty and VAT, though this is below the real-terms peak of 82.5p/litre seen in July 2000.

Fuel duties are set to rise by one penny above inflation each April up to 2014-15 as part of a duty escalator introduced by Labour in the 2009 Budget and extended in the March 2010 Budget. Even with no real increase, duties would rise by just over 2p/litre to reflect inflation (the inflation rate used is the expected RPI in the third quarter following the Budget , currently forecast at 3.5% by the Office for Budget Responsibility, OBR). Cancelling the one penny real increase would cost about £500 million. Freezing duties in cash terms would cost just over £1.5 billion. The latter figure would be higher if inflation forecasts for the third quarter are revised upwards in the Budget (RPI inflation was 5.1% in January 2011). If oil prices remain high, future planned increases in duties would also come under pressure. Cancelling all the real rises to 2014-15 would leave revenues about £2 billion lower each year from then. Cancelling all inflation-adjustments as well would leave revenues about £6 billion lower.

Given the scale of the deficit, the government has little room for manoeuvre to make any concessions on tax that are not paid for through tax rises elsewhere, or deeper than planned spending cuts. One particular consideration for fuel taxes must be that reductions in fuel duties would also make the government less likely to meet its objective to raise the share of total receipts generated from environmental taxes.

Beyond the fiscal issues, there are two particular problems with a FFS:

1. In order to stabilise fuel prices around their long-run trend, the government will need to distinguish between short-term blips in prices around the trend and shifts in the trend itself. This is likely to be difficult, and large adjustments to duties may be needed if mistakes were apparent only with a significant lag. There could also be a political 'ratchet effect', in which popular cuts to duty when prices were high were easier to implement than unpopular increases when oil prices fell again. If the government decides to adopt a FFS, it should have a clearly proposed mechanism for how and when duties would be adjusted, how the assumed trend in oil prices is determined and updated, and what the target trajectory for pump prices will be.
2. The claim that the Treasury receives a windfall gain when oil prices rise that it can "share" with motorists is incorrect. Estimates published by the OBR last September suggested that a temporary £10 increase in oil prices would generate a revenue gain of £100 million in the year of the shock, and a net revenue loss of £700 million in the year after. This need not prevent a FFS being adopted, but it could only be done so by injecting more uncertainty into the public finances rather than less. If the Treasury disagrees with the OBR's analysis, it should provide robust evidence to back up its view.

That said, one could argue that while no formal fuel stabiliser policy has been in place before, the previous Labour government did informally help to stabilise pump prices with their fuel taxation policy. The chart shows real-terms petrol pump prices and duty rates between January 1990 and January 2011. Aside from the autumn 2000 protest period, there was a relatively steady upward trend in pump prices throughout much of the 1990s and 2000s. This was caused first by the previous duty escalator introduced in 1993.During this period oil prices were relatively low and stable and so higher prices were driven by higher taxes. The escalator was abandoned in 1999 as oil prices began to rise, and duties were frozen in cash terms for a number of years, meaning higher prices were driven by the pre-tax cost of fuel.

Source: Calculated from DECC energy price statistics (http://www.decc.gov.uk/assets/decc/statistics/source/prices/qep411.xls)

It may be that a formal stabiliser policy would be preferable to ad-hoc adjustments to duty rates made Budget by Budget, adding (hopefully) more transparency and predictability to the process. But it should not be sold on the basis that it would stabilise the public finances: a formal stabiliser would - at least according to the OBR's estimates - lock in even more uncertainty to the overall fiscal position.