Windfall profits tax discourages production

Experience with windfall taxes has not been positive, say H. Sterling Burnett and Christa Bieker of the National Center for Policy Analysis in the U.S. In April 1980, Jimmy Carter signed the "Crude Oil Windfall Profits Tax" to replace failed oil price controls. This was the largest tax ever imposed on an American industry and was designed to recover a portion of money politicians believed was unfairly received by oil companies. The money was earmarked to develop renewable energy, thus reducing U.S. dependence on foreign oil, and to fund low-income energy assistance programmes. But the tax failed to deliver either and the Reagan administration led its repeal in 1988.

According to the Congressional Research Service:

The windfall profits tax raised a total of $40 billion, instead of the $227 billion initially projected, and generated no revenue after 1986, because oil prices fell and domestic production was lower than expected.

The tax reduced domestic oil production 3 per cent to 6 per cent because it increased investment risk.

Imports increased 8 per cent to 16 per cent because of the competitive advantage the tax gave to foreign oil companies.

It is not surprising that a windfall profits tax fails to either increase domestic production or reduce prices. When profits are penalised, there are fewer incentives to increase capacity. Oil production is risky and requires heavy initial investment in infrastructure. Meanwhile, oil prices can fluctuate. New oil may or may not be discovered. Because of these uncertainties, investment in oil production requires the ability to forecast likely outcomes. A windfall tax complicates this task. When a company is unsure what the price of oil will be at a certain point in the future and consequently unsure whether it will be penalised by the government for making a profit that year, investment risk increases, explain Burnett and Bieker.

Source: H. Sterling Burnett and Christa Bieker, Taxing Profits, Draining Energy, National Center for Policy Analysis, Brief Analysis No. 549, March 30, 2006.

For text: http://www.ncpa.org/pub/ba/ba549/

For more on Energy: http://eteam.ncpa.org/issues/?c=national-energy-policy

FMF Policy Bulletin/ 04 April 2006