Windfall Profits Tax Wrong for American Energy

March 21, 2022

No policy idea is ever truly gone. 

As oil prices have skyrocketed, Sen. Sheldon Whitehouse (D-RI) and Rep. Ro Khanna (D-CA) have introduced a bill targeted at oil company profits. While billed as a Windfall Profits Tax, the proposal is really an excise tax. The United States has implemented such a tax before, in 1980, and it resulted in lower domestic production and higher reliance on imports. Punishing domestic production is the last thing we’d want to do in the current crisis. 

The bill would impose a 50 percent tax on the difference between the current sale price of a barrel of oil and the average price of a barrel of oil from 2015 to 2019, which was roughly $66 per barrel. It would apply to sales by companies that produce or import at least 300,000 barrels of oil per day (or did so in 2019). 

To show the problems with this tax, consider the most basic questions of investing: risk and reward. For an investor to make a risky investment, they need a higher expected reward. And energy is a high-risk sector. Even before the pandemic, energy was the most volatile sector of the stock market in the 2010s. And when the pandemic arrived, more than 100 oil companies went bankrupt and the major producers significantly rolled back their operations. 

That sort of shock, in addition to the 2014 shale crash and regulatory uncertainty, has made oil companies more hesitant about major capital spending. The balance to these high risks is the potential for high rewards, with some years bringing in big profits. If there’s a tax targeted at picking off those supposedly excess profits, there’s little reason to accept all the risks associated with investment and new production in the first place. The arbitrary selection of 2015 to 2019 to calculate the “normal” price of oil only underscores the design problems with this tax.

This proposal is also not an untested idea—we have seen this policy tried before, and seen the negative consequences. The tax is similar to the Windfall Profits Tax introduced by Jimmy Carter in 1980. That established an excise tax of 70 percent on the value of oil sales exceeding $12.81 (in 1980 dollars). 

Several analyses of the 1980 Windfall Profits Tax have found it reduced domestic production and increased reliance on imports. A Congressional Research Service paper found that the tax reduced domestic oil production by between 1.2 and 8.0 percent, and increased reliance on foreign oil by between 3 percent and 13 percent between 1980 and 1988 (when the tax was eventually repealed). A 2018 paper in Economic Policy found that the tax reduced domestic production, largely by reducing total output of wells already in operation. The paper noted that such a tax could not be modeled as simply a tax capturing the rents (in layman’s terms, excess profits) of oil producers, but rather would reduce incentives to produce at the margin. However, the current proposal is not perfectly analogous to the 1980 Windfall Profits Tax. The 1980 policy did not include imports, while the current policy does, a choice that the aforementioned Congressional Research Service paper suggests could mitigate such a tax’s impact on foreign oil reliance.

Going back further, during both World War I and World War II, the U.S. enacted so-called “excess profits taxes” across the board, not just on oil. While these taxes were actually corporate profits taxes, rather than the excise tax branded as a windfall profits tax today, they didn’t have a coherent way to differentiate between normal profits and “excess” profits. As such, they created much the same distortions as regular corporate income taxes, while further complicating the tax system. 

Ultimately, politicians might see oil company profits as a well to drill for money. But it’s a high-risk industry, and high returns in some years balance out huge losses in others. Punishing the high returns (with the high risks still in place) would be a huge mistake when energy has become a central concern for the United States and its allies in global affairs. 

 


Related Articles

A tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.

A windfall profits tax is a one-time surtax levied on a company or industry when economic conditions result in large and unexpected profits. Inheritance taxes and taxes levied on lottery winnings can also be considered windfall taxes on individual profits.

An excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections.