Windfall Profits Tax

The Senate is debating S. 3044 today. This bill is called the Consumer-First Energy Act of 2008. Among other things, this bill would impose a "windfall profits tax." You can read the text of the bill for yourself by going here. So what is in the bill, and specifically what is this "windfall profits tax?"

`(a) In General- In addition to any other tax imposed under this title, there is hereby imposed on any applicable taxpayer an excise tax in an amount equal to 25 percent of the excess of--

`(1) the windfall profit of such taxpayer, over

`(2) the excess of--

`(A) the amount of the qualified investments of such applicable taxpayer for such taxable year, over

`(B) the average of the qualified investment of such applicable taxpayer for taxable years beginning during the 2002-2006 taxable year period.

`(b) Applicable Taxpayer- For purposes of this chapter, the term `applicable taxpayer' means any major integrated oil company (as defined in section 167(h)(5)(B))."

The Associated Press article on this includes:

With gasoline prices topping $4 a gallon, Senate Democrats want the government to grab some of the billions of dollars in profits being taken in by the major oil companies.

Senators were to vote Tuesday on whether to consider a windfall profits tax against the five largest U.S. oil companies and rescind $17 billion in tax breaks the companies expect to enjoy over the next decade.

"The oil companies need to know that there is a limit on how much profit they can take in this economy," said Sen. Richard Durbin of Illinois, the Senate's No. 3 Democrat, warning that if energy prices are not reined in "we're going to find ourselves in a deep recession."

So this is a bill that is supposed to be a response to the high prices for petroleum and gasoline. There has recently been quite a bit of political rhetoric from the Democrat presidential primary candidates who both said they support the idea of a windfall profits tax. Reuters reports that Senator Obama said this yesterday:

"I'll make oil companies like Exxon pay a tax on their windfall profits, and we'll use the money to help families pay for their skyrocketing energy costs and other bills,"

Before discussing what we could expect to be the result of imposing a windfall profits tax, just a couple of thoughts. First, Senator Durbin's comment in the Reuter's article just doesn't sound like economic liberty to me. The Senator's threat to use government's force to take some of the profits of 5 of the country's corporations makes our Congress appear to be quite a predator rather than a protector of individual liberty and freedom.

Second, just a picky little point about the Constitution and Senator Obama's claim that he will make oil companies pay. Mr. Obama cannot, on his own, make oil companies do anything, either as a member of the Senate or as President. The Constitution gives the power to tax to Congress, not to the Senate, and most certainly not to the President.

Now, what should we expect to be the result of imposing a windfall profits tax? To put this question in context, we should also ask why the prices of oil and gasoline have been increasing recently. There are probably several factors involved in explaining the recent price increases, but basic economic ideas suggest just a couple of general possibilities. Basically for a price to increase, other things constant, either the demand is increasing or the supply is decreasing, or both. With respect to the price of a barrel of oil, it seems to me that price is increasing both because demand is increasing (a good part of this is increasing demand from people and businesses in China and India) and because supply is decreasing or at least not increasing. With respect to the price of a gallon of gasoline, oil is an input into the production of gasoline, and we can expect an increase in the price of an production input to result in an increase in the price of the output, or the price of gasoline in this case.

Ordinarily, economics suggests to us that when profits are above "normal" in an industry that this is a signal or an incentive for businesses to increase supply. And, ordinarily, we would expect that over time, sometimes over a very short period of time, that the above "normal" profits would be bid away by new businesses and by increased supplies by existing businesses. Of course, all of this means that the existence of above "normal" profits can be expected to lead, over time, to increased supply and to a LOWER PRICE. In this case, we could expect above "normal" profits for oil suppliers and for gasoline suppliers to lead over time to lower prices both for oil and for gasoline as supplies for both increase.

But, the Senate, and perhaps then the House and even the President, will decide to intervene in all of this by imposing a "windfall profits" tax on U.S. oil producers. Will a "windfall profits" tax result in increased supplies and lower prices for oil and gasoline? This is not what I would expect to happen. Such a tax should decrease the incentive to produce new oil supplies if for no other reason than that such a tax would be a signal that there was less money to be made in oil production and this would lead to less effort to find new sources of oil and also to less effort to increase production from existing sources.

In other words, we should expect that imposing a "windfall profits" tax will result in higher prices for oil and for gasoline than would otherwise be the case. Wouldn't you like to see lower prices for oil and gasoline? If so, then you might want to support policies that would free producers of these products to respond with increased supplies over time.

There is perhaps a bit of irony in this last point. Congress has for some time now imposed moratoria on both new off shore oil production as well as the production of oil shale. If Congress ended these moratoria we would expect increased production of oil and this should lead to a lower price per barrel of oil which would of course then be expected to lead to a lower price per gallon of gasoline. In political terms, it seems to me the very politicians who support a windfall profits tax because of the "excess" profits due to a high price per barrel of oil are also, mostly, the politicians who support these moratoria on production. Is it ironic that the profits these politicians want to take are, at least in part, due to their own choice to restrict U.S. oil production below what it could, and would, be? Or, are they crazy? Or, do these politicians have another agenda that is promoted by decreased supplies and higher prices for oil and gasoline?