Back in the 1980s, a rumor emerged in the hot-rod marketplace: that government restrictions on emissions-compliant vehicle modifications would inevitably lead to a "sealed engine bay" policy that forbid modifications of any kind. Thankfully, that never happened; however, increasingly complex computer controls created a market for a more visual, more chassis-focused take on customization. There's still no such thing as a free lunch where modifications like taller or shorter tires are concerned; but, like every other part of your car, there's always some room for compromise and improvement.
The Basic Principle
The link between tire size and fuel economy is a long-established one, and the evidence is all around -- even if it seems a little anecdotal. It doesn't take an engineer to notice that jacked-up pickup trucks that get 12 mpg often have very tall tires, and that compact cars have tiny little tires that make the chassis look like a goofy, rolling skateboard. It's easy to chalk that up to the fact that, of course, the tires on a smaller car are going to be smaller -- it's just a matter of proportion. But consider this: A monster truck and the average locomotive engine both produce around 2,200 horsepower. A million-pound train moves a ton of cargo about 470 miles on a gallon of fuel; a gallon of fuel in a 12,000-pound monster truck will move a ton of its mass about 24 miles. So, a train, with its tiny wheels, is about 145 times more fuel efficient than Grave Digger sitting on huge, monster-truck tires. The vehicles' obviously aren't the only factor here, but that comparison certainly is telling.
Pro -- Reduced Horsepower Production
Most drivers intuitively understand that cruising along with an engine revving at 7,000 rpm isn't going to return stellar fuel efficiency. There are two main reasons for that. The first is that every horsepower your engine makes requires a certain amount of fuel; it takes twice as much fuel to make 20 horsepower as it does 10 horsepower. To a point, the higher your engine revs, the more horsepower it produces; so, lower rpm is always -- to a point -- going to return better fuel economy. That's especially true when you consider the fact that a typical sedan only needs about 10 horsepower to maintain 60 mph, and a big SUV only needs about 25 horsepower. Any power production over that and you're just burning fuel for nothing but the sake of better throttle response. Taller tires are larger in circumference and travel more distance per revolution; that effectively lowers the vehicle's gear ratio and drops engine rpm.
Pro -- Reduced Pumping Losses
There's another engine factor at play here as well, and this one has to do with pumping losses in the engine. When your engine's throttle blades are almost completely shut, the pistons pull very hard against them to suck air into the cylinders. Creating that vacuum takes a great deal of energy -- enough so that an engine operating at part-throttle can use almost twice as much fuel as one running at full throttle. Yes, it seems counterintuitive, but engines are are their most efficient when you're flooring the gas pedal. Flooring the gas pedal opens the throttle blades all the way, which drops manifold vacuum and all but eliminates pumping losses. In first gear, you only have to apply a little bit of throttle to get moving because the transmission gears make the engine's job easier. Taller tires, because they do effectively lower the car's gear ratio, force you to open the throttle further to get the same acceleration. That decreases pumping losses, which in turn nets better fuel economy.
Con -- Greater Frontal Area
Up to this point, it would seem as though big tires are nothing but good for fuel economy. However, assuming all else remains the same, every two-inch increase in tire diameter results in a one-inch increase in ride height. That increases the vehicle's frontal area -- its size when viewed from the front. The vehicle's frontal area -- which looks like the vehicle's shadow cast on a wall behind the rear bumper -- dictates how much air it has to push out of the way, and it's the single most important factor in aerodynamics. That matters at anything over about 50 mph. Imagine a typical sedan is 60 inches tall by 60 inches wide; at 60 mph, it might get 36.1 mpg. Increase vehicle height to 61 inches with taller tires, and the increased frontal area alone will drop fuel economy by about 0.5 mpg. A big pickup switching from 24-inch street tires to 44-inch off-road tires could easily lose 2.5 mpg from a frontal area increase via the increased tire diameter alone. And that's just the tires -- it's not even counting for any increase in frontal area from the required suspension lift.
Con -- Increased Wheel Inertia
Larger tires can decrease fuel economy at high speeds via aerodynamics, but they can also sap fuel economy at low speeds. If you've ever seen a ballerina doing a pirouette, you've likely noticed that she pulls her arms inward to speed up, and flings them outward to slow down. You also might have noticed that sledgehammers have very long handles. That's because of rotational inertia: the further mass is away from the center of rotation, the more energy it takes to accelerate it. City cars typically have tiny tires because those short tires don't take much energy to accelerate; that helps the car to make more efficient use of its fuel in stop-and-go traffic. Bigger tires would have the opposite effect. Because the tread -- the heaviest part of the tire -- is further away from the axle hub, the engine has to put more fuel into accelerating the car. An interesting note here is that large-diameter wheels will do the same thing: aluminum and steel are heavier than rubber and air. That's why you don't see economy cars rolling out of the factory on dubs.
What it Comes Down To
Taller tires can help to increase fuel efficiency in some cases. True, you could stand to lose some due to aerodynamics and increased wheel inertia, but the gearing-down effects will almost certainly offset those losses if the vehicle needs lower gears. By "needing lower gears," we mean that the engine is too big and produces far more power than it needs to cruise even while in top gear. Dropping engine rpm and reducing pumping losses will make a noticeable difference in those cases, but only to a point. Below a certain rpm, engine efficiency drops off and you start losing fuel economy. Even under ideal circumstances, larger diameter tires are just a crutch when it comes to fuel efficiency: you can get the same gearing effects from just changing the rear axle gear ratio, and that doesn't come with a penalty in terms of frontal area of wheel inertia. For most vehicles, the best case scenario is that the gearing effect just offsets the gain in frontal area and wheel inertia, and you break even on fuel economy. Go too tall, though, and you're guaranteed to wind up with a gas-guzzling slug that accelerates and brakes almost as badly as it handles.