Windfall Profits Taxes Won’t Lower Price at the Pump

April 28, 2008

Presidential candidate Barack Obama is using the high price of gasoline to try to get voters to support a windfall profits tax on oil companies based on the price of oil. The issue has not been explored too heavily in the economics literature, but here’s some thoughts:

A windfall profits tax on oil companies would not lower the price at the pump.

A windfall profits tax initially would be borne by shareholders of the companies, whose net worth would fall. The economic profits (i.e. super-normal profits) that the oil companies are earning would be reduced, thereby leading to a decline in the net present value of those future rents. That in turn, reduces the current value of their stock. A question of equity is likely in store here given that the initial stockholders who profited from the windfall profits may be long gone.

If the oil companies are truly earning rents on a long-term basis due to some restriction on entry into the market (say for example from ever-increasing returns to scale, control of essential resources in a market with few substitutes, or supply collusion), then a tax on those rents may not have as large a distortionary effect as some other taxes on capital. And to the extent that oil companies have made investments in exploration and have borne the fixed costs of those investments already, a tax on the profits derived from those assets would have little efficiency loss. The truth is that we are likely dealing with an industry that does face some competition from new innovation, and that the return is composed of all three returns to capital: risk-free return, risk return, and rent.

But taxing the rents on oil companies only would seem pretty unfair. There are plenty of other rents that individuals in our economy benefit from that are not heavily taxed, including in the labor market. Many of these rents are even government-created such as is the case with occupational licensing, government contracts, and laws ensuring labor union control.

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