Proposals for a Windfall Profits Tax Are Damaging Even if Never Enacted

By Benjamin Zycher of AEI.

"In the wake of the midterm election results, President Biden has made it clear that “I’m not going to change,” in particular with respect to his view that “the oil companies are really doing the nation a real disservice.” 

Accordingly, it is easy to predict a continuation of the incoherence of the Biden stance toward conventional energy: a policy environment reducing investment in future discovery, production, and ancillary capital assets (e.g., pipelines), on “net-zero” climate grounds, combined with a desperate pursuit of increased production and lower prices in the here and now, on political grounds. Biden repeatedly has demanded that the fossil fuel producers cut their prices, and has threatened to seek to impose a “windfall profits” tax on them should prices remain high.

Put aside the observation that the earlier Biden argument was that high energy prices are the fault of Vladimir Putin, and that, therefore, the fossil fuel producers are engaged in “war profiteering.” Now that the midterm elections are past, with an overall outcome vastly more favorable to Biden and his political allies than commonly predicted beforehand, it is not difficult to predict that the priority of lower prices in the short term will decline relative to that of the administration’s climate obsessions.

Which brings us to the threat to seek a “windfall profits” tax on the fossil fuel producers. It has disappeared from the news reports, largely because of a widespread (and correct) perception that it would never pass Congress, and that, therefore, it is irrelevant. 

Not so fast. Because “profits” in Beltway-speak are an accounting artifact — they have little to do with “profits” (that is, returns to investment) as defined in a rigorous economic sense — a windfall “profits” tax in reality would take the form of an excise tax on crude oil, natural gas, and other fossil fuels the prices of which are deemed by Beltway politicians to reflect some sort of “windfall.” That was the reality for the “windfall profits” tax enacted during the Carter administration, which was an excise tax of up to 70 percent of the difference between market prices and a lower price specified in the law. By the time it was repealed in 1987, revenues from that tax totaled about $80 billion in then-year dollars, or roughly $185 billion in year 2021 dollars.

That the threat of a “windfall profits” tax was seen as a political winner by the Biden administration, even given the near-zero prospect that it actually would be enacted under current political conditions, reflects the larger reality that the prospects for such a tax at some unknown future time are not trivial, in particular given that just such a tax was enacted and maintained for years within living memory. Can anyone fail to see that the more such a tax is threatened the greater the disincentive to make investments in the here and now?

Notice also that no one advocates a “windfall losses” subsidy for fossil fuel producers when “profits” (or prices)are low due to market conditions. (The common argument that fossil fuel producers receive large subsidies is a lot of hooey, in particular in contrast with unconventional energy.) The threat of “windfall profits” taxes combined with the absence of proposals for “windfall losses” subsidies means that expectationally there is a reduction in upside price potential for the fossil fuel producers, but no corresponding reduction in downside price risks. In other words, the entire statistical distribution of expected net prices — returns to investment — shifts downward. 

The net effect is a decline in investment and therefore a decline in future production, with a corresponding increase in future prices. Because existing reserves can be produced during the current time period or a future one, an increase in expected future prices creates an incentive to produce less currently in anticipation of higher prices later, thus increasing prices immediately, so that the expected price path rises at the market rate of interest.

And so we arrive at a conclusion subtle but obvious: The threat to seek a “windfall profits” tax on fossil fuel producers is damaging in terms of future energy availability, and therefore prices both current and prospective. Aggregate production from existing oil and gas wells declines at roughly 6 percent per year; continuing investment is needed to preserve the supply of conventional energy. That energy, by the way, is a form of national wealth; once produced, that wealth is shared among investors, workers, landowners, and governments in rough proportion to competitive market evaluations of their respective contributions to productivity.

Many Beltway policymakers — in particular those with constituencies benefiting from the production of the national wealth embodied in fossil fuels — understand this reality, even if only instinctively. Such proposals as the windfall profits tax are purely punitive, and because they have the effect of reducing national wealth and the size of the aggregate economy, the punishment will not be limited to the producers of fossil fuels."