Why Windfall-Profit Tax on Oil Companies Is Just Hot Air

Published November 8, 2005

Oil companies have always been easy targets for politicians.

Energy company profits rise at the same time political pressure to fight higher energy prices grows. Exxon Mobil Corp.’s announced $6.6 billion in profits during the third quarter set off a cascade of complaints.

Demands for congressional hearings became more vocal as the entire oil industry reported some $96 billion in profits during the third quarter.

U.S. Senators Byron Dorgan (D-ND) and Chris Dodd (D-CT) have called for the passage of a windfall-profits tax on oil companies. They hope to put such a proposal–a 50 percent tax on the sale of oil over $40 a barrel–into a tax bill later this month. The revenue would be given to consumers in the form of an income tax rebate.

The industry’s third-quarter profits “come as a windfall, falling into the laps of the big oil companies with little or no additional effort or expense,” Dorgan argued.

Top executives of three major oil companies–Exxon Mobil Corp., ConocoPhillips, and Royal Dutch Shell–have been summoned to Washington to justify their record profits in a Senate hearing later this week. While the hearings might give politicians a chance to beat up the oil industry, a windfall-profits tax is a very bad idea in several ways.

Despite record profits, oil company profit margins are not excessive. They remain below those of other industries.

Exxon Mobil’s profit margin in the third quarter was 9.8 percent. In 2004, Citigroup’s margin was 15.7 percent, while Merck’s was 25.3 percent. But even this line of argument misses the most important point.

These companies risk billions to locate, recover, refine, and distribute petroleum products. Raising their taxes will lead to less exploration and less investment in refining capacity.

Capital will flow to industries where after-tax returns are greater. This will push up energy prices in the long run as supply is constrained.

A profits tax will do nothing to lower the price of gasoline for consumers. In fact, excise taxes on gasoline at the federal, state, and local level push up the price at the pump. These taxes are often calculated as a percentage of the retail price. As a result, they are hurting consumers at the same time they provide a windfall of revenue to the government–the exact same problem politicians have with oil companies that make more money (but not greater margins) when oil prices rise.

While higher oil prices increase profits, they also increase the cost and risk of holding inventories. To spend billions today to find or store more oil that could fall in price tomorrow is a risky endeavor.

At the same time, government regulation has increased energy industry costs.

The way to help consumers in the short run is to cut excise taxes. In the long run, more domestic drilling and refining capacity should be allowed.

Taxing windfall profits hurts consumers and entrepreneurs; but it benefits government.

That’s bad policy.

Brian W. Wesbury is a senior fellow of The Heartland Institute and senior managing director of Claymore Securities, Inc.