Tuesday, August 5, 2008

The Windfall Profits Tax on Oil Companies is a Good Idea

I'm generally pretty skeptical of policies whose justification requires one to believe they'll never be used again, and for that reason I've been opposed to Obama's windfall profits tax on oil companies, which he would use to finance a $500 per-person tax rebate. But yesterday I realized that I was wrong. Let me elaborate.

The standard argument in favor of a windfall anything tax is two-pronged. First, regarding fairness, the argument is that the taxee's wealth resulted from luck, not foresight, and so it's not unfair to tax more than usual; this is no doubt part of why Obama's people think his proposal's a political winner.

I want to focus on the second argument, which regards efficiency. The argument is that taxes based on past events don't distort future incentives, so unlike, say, a tax on ongoing oil consumption, a windfall profits tax won't reduce future production/consumption. The problem with this argument is that it's difficult to believe that windfall profits taxes will stay windfall: if the political winds support taxing oil companies' profits now, they'll probably support taxing them in the future as well. And if the one-time aspect of the tax isn't credible, then oil companies will respond by reducing future investment in oil production (more on this below). Since most economists believe this sort of credibility problem is difficult to overcome in practice, we tend to view "windfall taxes" as "taxes", with the implication that future incentives are affected, after all.

So why do I think this is a good idea nonetheless? Let's consider the two possible results of the windfall profit tax:

  1. Oil companies view the tax as truly a one-time deal. In this case, their incentives for future production are unaffected. The only effect of the tax is to transfer wealth from the average oil-company shareholder to the average taxpayer. On balance, such a redistribution is likely to be progressive, so I'm happy to support it. (Here we get into morals, and others certainly are entitled to subscribe to different ones from mine.)

  2. Oil companies view the tax as likely to continue. In this case, future oil production, and thus oil consumption, is likely to fall, since gas prices will rise. Unlike, say, carrots, oil involves massive negative externalities. Even many anti-interventionists (like, say, Greg Mankiw) support dealing with these externalities via taxes or cap-and-trade plans, with the goal of reducing long-run production and consumption of oil.

    A while back, I suggested that the right policy is to increase gas taxes while coupling the proposal with a rebate to help people deal with the higher cost of gas (I actually suggested waiting out the current economic situation for the tax, but that's an unimportant detail of the proposal I suggested). So, on reflection, I've realized that the "worst case" scenario of the windfall profits tax is a less transparent version of the policy I support in the first place. As second-best results go, this is one I could live with.

I note that Robert Waldman has made related arguments over at AngryBear (HT: Mark Thoma). His discussion is worth a read.


Anonymous said...

And why are we simply going to have a windfall profits tax on Big Oil? Shouldn't we have windfall profits tax on every industry that did better than we believe they should have? Is there any consistency or are we only going after the "bad" companies? Is there any method to this madness?

It's really quite arbitrary--who we should tax, how much we should tax, how often we should tax, etc. That an economist is even willing to go on record advocating such nonsense is rather telling of how strong the Obama delusion is. How long did it take you to convince yourself of your arguments?

Darrell Balmer said...

The windfall profits tax is a great example of economic illiteracy. Corporations are legal fictions. They do not consume anything. Everything they buy is ultimately passed through as a product or service to human beings. If you increase taxes even one time humans pay the tax. It is some combination of stockholders, creditors, employees including executives, or customers. If one or more of those groups did something wrong it should be targeted and quit pretending it was the corporation. In the case of oil companies, the primary thing they did wrong was to be a visibly big target. No one has said that the industry has to high a return on assets or return on sales. Any economist that defends the windfall profit tax is doing a great disservice to the country.

Dean Moriarty said...

"Shouldn't we have windfall profits tax on every industry that did better than we believe they should have? "
I don't think it so capricious, bud. The reason for targeting the oil companies is the enormous increase in prices that accompany the increase in profits. That, and the problems of fossil fuel emissions put oil companies in a negative light. Or so I guess.

Nothing really arbitrary about it: much of tax policy is based on the notions that those most able to pay, and those reaping the biggest rewards from our free economy, should perhaps be those that shoulder the burden more than others.

Darrell, people use the term "corporation" I think in reference to the executives and big shareholders that are reaping most of the rewards. People look at "doing wrong" in terms of price gouging, pollution, and manipulation of legislation to secure loans, breaks, and other economic rent-seeking behavior.

It isn't outrageous to make the claims the author is making. With all due respect, neither of you point to any solid data or make any cogent moral argument about the soundness of this idea. Personally, I'm not sure how I feel about it, but your arguments don't do as much to undermine it as you seem to think.

donpedro said...

Although it's debated, most studies find that the incidence of corporate taxes falls mostly on shareholders, who are chiefly--but of course not entirely--the wealthy.

No one is arguing that the stockholders, etc. of oil companies did anything wrong.

If it makes you feel better, you could think of it this way: the windfall profits tax on oil company will temporarily raise taxes on the small number of Americans who are benefiting from the surge in oil prices, in order to benefit everyone else and move the country away from oil dependency.

All the tax policy questions you mention--who, how much, how often--are "arbitrary," so saying that a windfall profits tax is "arbitrary" is not an argument against the policy.

It's true that most economists who have thought about the matter would argue that if we were to design a tax system from scratch, a simpler system would be preferable. But we're in a very much second best world, where many particular industries are subject to a variety of subsidies and tax exceptions. As Rumsfeld might have said, we face the energy crisis with the tax system we have, not the tax system we would like to have. Considering all those distortions--and all the subsidies which have benefited Big Oil--the windfall profits tax is a reasonable temporary measure. In the long run, I agree we would be better off with a simpler program, say, a carbon tax (or tradable permits) combined with reducing corporate tax loopholes, which is exactly the policy Obama favors.

Anonymous said...

Don Pedro: Your response to darrell's questions misses a key point that any economist should understand: the current value of the company reflects the discounted present value of future after-tax profits. Therefore, if you reduce those, the stock falls and the person who holds the stock at the time of the announcement of the tax is the person who is hurt.

And that person (stockholder) may not even be the one who held the stock during the run-up in prices. Is that fair?

Anonymous said...

Certainly, the windfall profits tax will not be seen as a one time thing. It will be seen as something that politicians do when it is politically expedient for them to do so. So the oil companies will 1) figure out how to pass those costs on to the consumer and/or 2) domestic oil production will fall just as it did in the 80s.

If those politicians are really serious about taking money from the oil companies without adversely affecting the consumer, then they'll eventually have to micromanage the company to ensure that cost is not being passed on to the consumer. Bad idea.

A decrease in domestic oil production does not necessarily mean that global production will fall. In other words, oil will be produced in some other place in the world where there are less stringent environmental regulations. Oops, there goes the planet.

As a realist, I believe that our country will need oil for a long time yet; so I want to enable us to have some meaningful control of supply. As an environmentalist, I feel that it is much better for us to drill in the US than to create any more incentive for other countries with less stringent environmental regulations to continue to destroy the planet.

We need a comprehensive energy policy that moves us away from oil while acknowledging that we will still need oil for some time so we should position ourselves to leverage some level of control over supply.

Thomas said...

When do the windfall profits taxes on big agriculture come in? Haven't they been profiting at the expense of everyone's misery just like big oil has? Where do we draw the line here?