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Windfall tax not good for US energy

No idea of ​​politics ever really died out.

As oil prices soared, Sen. Sheldon Whitehouse (D-RI) and Rep. Ro Khanna (D-CA) introduced a bill targeting oil company profits. Although billed as a Tax on windfall profits, the proposal is actually an excise tax. The United States already implemented such a tax, in 1980, and it led to a drop in domestic production and greater dependence on imports. Punishing domestic production is the last thing we would want to do in the current crisis.

The bill would impose a 50% tax on the difference between the current sale price of a barrel of oil and the average price of a barrel of oil from 2015 to 2019, which was around $66 a barrel. It would apply to sales of companies that produce or import at least 300,000 barrels of oil per day (or did so in 2019).

To show the problems with this tax, consider the most basic issues of investing: risk and reward. For an investor to make a risky investment, he needs a higher expected reward. And energy is a high-risk sector. Even before the pandemic, energy was the most volatile sector of the stock market in the 2010s. And when the pandemic arrived, more than 100 oil companies went bankrupt and major producers drastically reduced their operations.

This kind of shock, in addition to the 2014 shale crash and regulatory uncertainty, has made oil companies more hesitant on large capital expenditures. The balance of these high risks is the potential for high rewards, with some years yielding big profits. If there is a tax to levy these alleged excess profits, there is no reason to accept all the risks associated with the investment and new production in the first place. The arbitrary choice of 2015 to 2019 to calculate the “normal” oil price only highlights the design problems of this tax.

This proposition is also not an untested idea – we have seen this policy tried before and seen the negative consequences. The tax is similar to the Tax on windfall profits introduced by Jimmy Carter in 1980. This established an excise tax of 70% on the value of petroleum sales exceeding $12.81 (in 1980 dollars).

Several analyzes of the windfall tax of 1980 have found that it reduced domestic production and increased dependence on imports. A Congressional Research Service paper found that the tax reduced domestic oil production by 1.2–8.0% and increased dependence on foreign oil by 3–13% between 1980 and 1988 (when the tax was finally repealed). A 2018 paper in Economic policy found that the tax reduced domestic production, largely by reducing total production from wells already in operation. The paper noted that such a tax could not be modeled as a simple tax capturing rents (in simple terms, excess profits) from oil producers, but would instead reduce incentives to produce at the margin.

Going back further, during the two First World War and The Second World War, the United States has adopted so-called “excess profit taxes” at all levels, not just on oil. While these taxes were in fact taxes on corporate profits, rather than the excise tax now referred to as a windfall tax, they had no consistent way of differentiating between normal profits and “excess” profits. As such they have created many same distortions as regular corporate income taxeswhile further complicating the tax system.

Ultimately, politicians might view oil company profits as a well to be drilled for money. But it’s a high-risk industry, and high returns in some years offset huge losses in other years. Punishing high returns (with high risks still in place) would be a huge mistake as energy has become a central concern for the United States and its allies in global affairs.