By William Essuman & Emmanuel Adu Sarfo
Senator Sheldon Whitehouse (D-RI) and Representative Ro Khanna (D-CA) have called for an energy windfall tax. In a written statement, Khanna said, “Senator Whitehouse and I have been calling for a windfall profit tax on Big Oil for months, and I’m thrilled to see President Biden publicly consider this approach.” Senator Elizabeth Warren has long supported this. In an earlier tweet, Warren said, “Big Oil’s first priority is to maximize profits. We can’t let them use Putin’s invasion as an excuse to pad their bottom line with war-fueled profits.”
The rationale for a windfall tax is concurrent with inflation. The inflation rate has been far outstripped by profits, with many energy companies exceeding profits far above the inflation rate. The idea that windfall profits can fuel inflation has become a respectable view among central bankers like US Federal Reserve Vice Chair Lael Brainard and Isabel Schnabel, an executive board member of the European Central Bank. Nobel laureate economists like Paul Krugman have also acknowledged the link. The windfall tax targets energy companies lucky enough to benefit from something they were not expecting.
Whatever the politics or ethics, we should accept that enacting a windfall tax is unlikely to produce desired results. Most disastrously, it will decrease domestic energy production at a time when energy security is needed to support decarbonization. Larry Summers, American economist and top adviser to Presidents Bill Clinton and Barack Obama, warns, “If you reduce profitability, you will discourage investment which is the opposite of our objective.” In 1980, President Jimmy Carter enacted a windfall profits tax on most oil produced in the U.S. The non-partisan Congressional Research Service paper found that this punitive tax led to domestic oil production declining by as much as 8% and imports increasing by a whopping 13%. A 2018 paper in Economic Policy found that the tax reduced domestic production, largely by reducing the total output of wells already in operation.
Everything from the minerals needed in electric cars to the balsa wood used in wind turbines will experience shortages, and the private sector will need to create solutions. The incentive to address the intermittent nature of decarbonization will be diminished if even clean energy companies have their profits confiscated. And as economies transition to net zero, there needs to be enough investment in renewable energy. If the most innovative companies are concerned that their earnings could be taken when their risks pay off, then it is a fantasy to imagine that the massive investments required will occur.
A sound tax system should state how an individual or entity will be taxed in advance. Stability is key to promoting investment and spending, which drive economic growth. Predictable and constant regulations are identifiers of a society governed by the rule of law. The windfall taxes compound uncertainty and distract from the need to pursue well-thought-out reform to deal with the challenges ahead. Potential new entrants into the energy industry can choose to use their capital in some other way and not enter an industry subject to an unstable tax policy.
If energy prices were to collapse, energy company profits would do so too. Windfall taxes on energy companies are asymmetric and judgemental. Now, energy companies suffering a one-off tax might call for a one-off subsidy. There may have been calls for windfall taxes in the past, but if energy companies make losses due to falling global energy prices, there may be few calls to provide funds to support them. In addition, there is the question of how to determine that some particular level of profit is ‘normal’ and some higher level of profit is ‘excessive’. In one sense, that arbitrariness of the definition adds to the idea of economic efficiency – the company does not know beforehand what profit level will be judged to be excessive and so cannot adjust its behavior to that.
Windfall taxes are not, in principle, unacceptable tools. However, like all tools, they should be carefully employed in the proper circumstances. It may fill us with righteous indignation toward tax profiteers, but it is not a productive economic policy. Much worst, the scenario of the 2022 windafll tax in Italy resulted in a much lower revenues for government than anticipated. This serves as a precedent that the effect of windfall taxes has not changed in contemporary times. If President Biden is serious about decarbonization, energy security, and lowering energy prices, he should resist the calls for a windfall tax.