TCS Daily

Is a Windfall Profits Tax a Good Idea?

By David R. Henderson - November 15, 2005 12:00 AM

Many people are surprised that oil company profits in recent months have been so high. Some politicians, including even some Republicans, have threatened to impose windfall profits taxes on oil companies to take some of these profits for the government. Yet the higher profits oil companies have made in recent months are a totally predictable result of the standard workings of supply and demand, and allowing supply and demand to function has some very desirable results. Moreover, not only would the windfall profits taxes have bad results, but they also are unjust.  

The high profits that oil companies have earned in recent months are the result of two factors -- a reduction in supply combined with an inelastic demand for oil. Demand is inelastic when a large-percentage increase in price leads to only a small reduction in the amount demanded. So when the supply of oil and gasoline fell after Hurricane Katrina, the only way to avoid a shortage was for the price to rise substantially to reduce the quantity demanded to where it equaled the smaller quantity supplied. With oil companies supplying a few percent less product and with prices rising by a much greater percent, revenues ballooned. The result: large profits.  

Had prices been kept low, oil companies would have made lower profits, but consumers would have demanded more. This greater amount demanded, coupled with the smaller supply, would have resulted in the kind of shortages and line-ups we experienced in the 1970s due to President Nixon's price controls on oil and gasoline. One very valuable function of free-market prices is that they allow the available supply to go to those who value it most, where value is measured by the amount they're willing to pay. One might think that this means the product goes to only the rich, but this is false. The rich person who wants to use it in his Rolls might well be outbid by the poor person who values it more in his Honda Civic. What matters is willingness to pay, which, although it is correlated with wealth, is not perfectly correlated.  

The only other way the oil companies would have made no extra profits would have been if they had not had inventory on which to earn those profits. That would have occurred only if the oil companies had been completely unprepared. Preventing windfalls, then, would amount to penalizing good planning. Do we really want the government to reward unpreparedness rather than good planning?  

Some of my fellow economists who argue against a special windfall profits tax point out that these profits can be used to finance further exploration and production of oil. That is correct. But even if the companies gave every last penny of their windfall in dividends to stockholders, the profits would still serve as an incentive to find and produce more oil. The reason is that oil companies will see the government's action on this issue as a signal of future government actions. If the government taxes or otherwise discourages windfall profits by, for example, muscling them to donate some of these windfalls to charity, as Senator McCain has proposed, oil companies will anticipate similar government actions in the future. Knowing that they will be taxed or face intense pressure to give some of their wealth away, they will see a reduced revenue stream from producing and finding oil. Result: less oil than otherwise.  

Most people think that we should not bail out the oil companies if the price of oil suddenly falls, as it did in the early 1980s and then again in the early 1990s, and as it will do again. What I'm advocating is symmetric treatment: let them bear the losses of price drops and be rewarded with the gains of price increases. And not just fairness is at stake here. If oil companies reap the rewards of their good decisions and suffer the consequences of their bad ones, they will make more good decisions and fewer bad ones. In particular, the more they get to keep, the more creative they will be at producing oil. And they will do more of this when consumers find it most valuable for them to do so -- when prices are high.  

Moreover, people who are upset that oil companies are making lots of money are angry with the wrong people. The oil companies are precisely the people producing oil. The high prices are not due to their actions but are due, instead, to the effects of hurricanes combined with the fact that there aren't more people in the business. It would make more sense, though only slightly more, if politicians got mad at people who are not in the oil business. If they were in the oil business, we would have more oil and prices would be lower.  

Seriously, though, there is someone we should be angry with: various governments that make it difficult or impossible for companies to build more refineries in the United States and for oil companies to produce more oil and natural gas. The Not-in-My-Back-Yard mentality has led federal, state, and local governments to put huge costly barriers in the way of oil companies that want to produce more oil and natural gas and that want to build refineries. The politicians blame the oil companies for not using their revenues to build more refineries, but if they want to know whom to blame, they need only look in the mirror and at many of their constituents.  

Last, but by no means least, a windfall profits tax is incredibly unjust. Most people would think that a tax on their windfall profits from selling their house would be unjust. And they are right. Similarly, those who invest in oil deserve to reap the rewards. The rewards, from owning houses and from producing oil, are higher because of government restrictions on new building and on new oil production. But the just response is to reduce or eliminate the restrictions, not to tax those who took risks on the assumption that their property rights would be respected.  

David R. Henderson is a research fellow with the Hoover Institution and co-author of Making Great Decisions in Business and Life (Chicago Park Press.) He was previously the senior economist for energy policy with President Reagan's Council of Economic Advisers.

TCS Daily Archives