Commentary: Windfall Profits Tax a Loser for Citizens and the Economy

Published June 1, 2006

Egged on by the red-faced anger served up by rant-and-rave TV populists, Wisconsin Gov. Jim Doyle (D) on May 1 launched an online petition calling for Congress to put a cap on oil profits and subject oil companies to special new “windfall” profits taxes. The recent spike in gasoline prices has set off a stampede of such politicos demanding aggressive action against “Big Oil.”

Congress may prove unable to resist passing a windfall profits tax before voters go to the polls this fall. If so, we’ll experience the full meaning of H.L. Mencken’s adage that democracy is that form of government in which the people get exactly what they want, good and hard.

No Windfall Profits

What they won’t get, however, is nearly as much money out of such a tax as they probably think. A windfall profits tax targeted at earnings far beyond the U.S. industrial average would return zero revenue to the Treasury because windfall profits in the oil sector are figments of the imagination.

While the raw earnings figures sound big, they are unexceptional when we take into account the size of those companies. Divide profits by sales, for instance, and you’ll find that in the fourth quarter of 2005 (the last quarter for which data are available), profit margins were 6.8 percent at British Petroleum, 7 percent at ConocoPhilips, 7.1 percent at Shell, 7.7 percent at Chevron, and 10.7 percent at ExxonMobil. The 20 largest investor-owned oil companies earned a collective 8.8 cents on every dollar of sales for that quarter.

Infotech, Banks Do Better

Now, it’s not a stretch to note that the lady who sells us hot dogs on the street probably earns a better profit margin than that. But more to the point, the nation’s most prominent critic of “oil profiteering”–Fox News personality Bill O’Reilly–works for a company (News Corp.) that reported a 10.2 percent profit during the fourth quarter of 2005. If you’re after really big earners, however, check out Yahoo (a 45.5 percent profit margin), Citigroup (33.4 percent), Intel (24 percent), and Apple (22.7 percent).

Returns on invested capital over a longer time frame are even more telling. Analysts at Goldman Sachs report returns on investment capital in the oil and gas sector from 1970 to 2003 were less than the U.S. industrial average over that same period.

Although few believe it, the oil industry would have to earn record profits for a long time before it could produce above-average returns for its long-term investors.

Tax a Mistake

Even if oil industry profits were extraordinary, a special tax would be a mistake. Windfall profits taxes threaten to institutionalize a form of one-way capitalism in which investors are allowed losses or meager profits but average or better returns are disallowed. Who would want to invest money in an industry like that?

Consumers have a stake in the answer to that question. If investors are discouraged from putting their money into the oil sector, there will be less oil and gas on the market and, thus, higher prices than would have otherwise been the case.

Moreover, the United States already has a corporate income tax in place to harvest “windfall profits” regardless of which sector produces them. Taxing profits differently depending upon which sector of the economy coughs them up gets the government in the business of allocating capital across the economy as a whole. This would introduce politics into places where politics simply should not go.

This is not simply idle ideological speculation. We’ve actually been down this road before, in the form of the Crude Oil Windfall Profit Tax of 1980. According to a study published by the Congressional Research Service, the tax discouraged investment in the domestic oil industry to such a degree that domestic oil production was 3 percent to 6 percent less as a result of that tax during the eight years of its existence, from 1980 to 1988, and foreign oil imports grew accordingly–by 8 percent to 16 percent during that time. There isn’t a single credentialed oil economist in the country who would argue that windfall profits taxes are good for consumers.

High Costs Driving Prices

The truth is that gasoline prices are high because world crude oil prices are high. They are exacerbated at the moment by the seasonal switchover from wintertime gasoline to more environmentally friendly summertime gasoline.

That transition has been longer and more costly than usual because of the elimination of MTBE from the gasoline market (a fuel additive that has been found to contaminate groundwater), the fact that a great deal of refining capacity is still shut down as a consequence of Hurricane Katrina, and the extensive spring maintenance that has been required to keep the refineries that have been operating flat-out all winter from falling apart.

In time, however, today’s high prices will set off an economic chain reaction that will produce lower prices. High prices beget fatter profit margins, which in turn induce greater investment in new supply. High prices also encourage conservation and fuel economy, which in time will significantly reduce demand. More supply and less demand equals lower prices.

But it won’t happen as quickly as it might if Congress loses its collective head and passes a heavy tax on “windfall” oil profits that don’t really exist.

Jerry Taylor ([email protected]) and Peter Van Doren ([email protected]) are senior fellows at the Cato Institute. Van Doren is editor of Regulation magazine. This article initially appeareed on the Cato Institute Web site at Reprinted with permission.