Windfall profits tax: an act of criminal recklessness

If a government wants people to have less of something, it increases the tax on that something. Trevor Manuel, for example, takes great delight during his annual budget speeches, in announcing what he calls ‘sin taxes’ which are increased taxes on things like liquor and tobacco.

The declared objective of increasing the taxes is to induce people to smoke and drink less – not more. If consumers buy less because of the higher prices, producers have no option but to produce less than they otherwise would have done. The principle is straightforward and universally applicable. That is where the catch lies for politicians and their advisors who wish to levy higher taxes on critically important products.

Higher taxes reduce production of the things politicians and their supporters don’t like, giving them the result they want. However, economic consequences don’t suddenly alter and allow them to levy higher taxes on something they do like, or want suppliers to produce more of, without the higher taxes reducing production. The consequences are inexorable, tax it and you will get less of it. Whether you like or dislike the product has no effect on the outcome.

In 1980 president Jimmy Carter approved the imposition of what was called the Crude Oil Windfall Profits Tax (WPT) at the same time as price control on petroleum products was removed. The regulated price received by U.S. oil producers was as low as $6 per barrel compared to $30 per barrel outside the U.S. The idea of the WPT was to prevent the U.S. producers from reaping huge profits as a result of the abolition of the price controls.

The stated objective of removing the price controls on oil products was to encourage oil companies to produce more fuel. The price controls had reduced American production and made the U.S. more dependent on foreign oil supplies. However, the WPT again sent the producers the opposite signal: produce less fuel. The Congressional Research Service found that the WPT decreased production by 3 per cent to 6 per cent and increased American dependence on foreign oil supplies by 8 per cent to 16 per cent.

But then politicians have a habit of enacting legislation that has the opposite effect to what they intend. Throughout history governments have introduced price controls intended to provide consumers with desirable goods at lower prices. In Roman times, the merchants fled from Rome, taking their goods with them into the countryside. Roman consumers ended up with no goods. Naturally the emperor, Diocletian, blamed the merchants for the distressing situation.

SA governments have had a habit of levying excessive taxes on the things they supposedly wanted producers to produce more of, such as precious minerals. The current SA government is no exception. All governments of countries with resources seem to do the same thing. The counter-productive effects have come to be known as the ‘curse of resources’ when the real description should be ‘the curse of bad government policies.’ A rapid price increase means that supply is inadequate to meet demand. A higher price encourages increased production and lower consumption. Without government intervention, prices will eventually become relatively stable again at a different level of supply and demand.

Sudden rapid price rises, such as the increase in the price of oil and fuel, can result from a reduction in supply as happened when Hurricane Katrina shut down a substantial part of U.S. oil production and refining. Although price rises have the effect of reducing demand, oil is said to be ‘price inelastic’, which means that a price rise results in a relatively small decline in demand.

The high price will spur oil producers to increase production but that does not happen overnight and if they believe that their extra effort will bring inadequate gains, such as having the profit on that effort eroded by WPT, they will not invest in the necessary productive capacity. Even the threats of a WPT emanating from members of the U.S. Congress will have slowed down the corrective process. Oil producers will be holding back on some planned investments, awaiting a decision on the WPT.

If politicians seriously wish to see oil production increase rapidly and prices of fuel fall at the pumps, they should give oil producers an absolute assurance that they will drop the WPT notion. After all, governments everywhere are already receiving massive amounts of additional tax from oil producers and consumers and there have been no reports of governments cutting back on these taxes for the benefit of consumers.

Fuel sales are so heavily taxed in most countries that governments receive more in taxes than the oil companies receive in profits. Oil companies are taxed on their profits, in the same way as all other companies. There is consequently no justification for imposing higher rates of taxation on them merely because they are suppliers of a desperately needed product that consumers are prepared to pay high prices for in order to ensure that they have a continuous supply. Imposing a windfall profits tax on oil producers at this time would be a disservice to consumers and an act of criminal recklessness by any government doing so.

Author: Eustace Davie is a director of the Free Market Foundation. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author’s and are not necessarily shared by the members of the Free Market Foundation.

FMF Feature Article/ 02 May 2006 - Policy Bulletin / 03 November 2009