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Wheres the windfall profit for a tax?
July, 16th 2008

The nuclear fission in national politics is letting loose generous doses of radiation on a daily basis. One such lethal dose came last week from the Samajwadi Partys Amar Singh who seems to be a loyal friend indeed for his most important friend in need. In what should rank as one of the most unsubtle episodes of political bargaining ever seen in this country, Singh wants a windfall profit tax imposed on oil companies and a fee to be charged from telecom companies using extra spectrum as a quid pro quo for voting with the government in Parliament.

Such talk can be good politics but is it good economics? Do those now propounding a windfall profit tax know what exactly such a tax is and its history?

The answer to both questions is a resounding no. A windfall profit tax on oil companies now would be illogical and an unwise economic measure; those arguing in favour should look at the experience of other countries that have imposed such a tax in the past, specifically the US, where it did more harm than good to their economy.

What is a windfall profit?

According to Wikipedia, the term 'windfall profit' was first used in the colonial era. Subjects were prohibited from using lumber that was more than a foot in width except where due to an act of God, such as a storm, trees fell down in their own property. In such a case, they could use the wood or sell it. Needless to say, there were several such instances of acts of God and subjects reaped windfall profits by selling such wood. So, a windfall profit presupposes an act of God. It is profit earned through other than the ordinary course of business. Does this definition fit our oil companies? It appears not.

Unflattering history

The US experimented with a windfall profit tax on oil companies in the 1980s and the experience was anything but worthwhile. President Jimmy Carter imposed such a tax in April 1980 after dismantling price controls on the oil industry. The freeing of controls caused oil prices to rise from $14 to $24 a barrel raising demands from lawmakers for a tax on the windfall earnings of oil companies. Unlike what its name signifies, the windfall profit tax imposed by the Carter administration was actually an excise tax in that it was calculated on the difference between the market price of oil and a base price set by the administration. Higher the market price, higher was the tax burden.

However, the tax failed to serve its purpose and, worse, worked against the interests of the government. It failed to generate the projected revenues, increased the reliance of the US on oil imports and turned tax administration into a nightmare for the Internal Revenue Service.

According to a study by the US Congressional Research Service called The Crude Oil Windfall Profit Tax of the 1980s, Implications for Current Energy Policy by Salvatore Lazzari, a specialist in public finance, released in March 2006, the tax generated just $80 billion in revenue between 1980 and 1988 compared to a projection of $383 billion. The net revenue was even lower at $38 billion as the tax could be set off against income tax liability.

Lazzaris study estimates that the tax reduced domestic oil production from anywhere between 1.2 and 8 per cent and dependence on imported oil grew from 3 to 13 per cent. The tax was finally repealed by the Reagan administration in 1988 as it failed to generate projected revenues, increased dependence on imported oil and turned into an administrative burden for the Internal Revenue Service.

Wheres the windfall profit?

Now, it is doubtful if those calling for a windfall profit tax in India are aware of the unpleasant experience that the US had with the tax. It is even more doubtful if they have studied the financial statements of the domestic oil companies Oil and Natural Gas Corporation (ONGC), Indian Oil, Bharat Petroleum and Hindustan Petroleum. If they did, they would not be demanding such a tax now.

The financial statements reveal how these companies are reeling under the burden of subsidy; they show how these once cash-rich companies are now borrowing heavily to finance their working capital and are heading for losses this fiscal. So, where are the 'windfall profits' to be taxed?

The only oil company that stands to gain from the rising global crude oil prices is ONGC. But ONGC is already suffering a windfall profit tax though not by name. Just consider this. The company contributed Rs 22,000 crore as its share of the subsidy burden in 2007-08 (through discounts to the downstream refining companies). This reduced its turnover to Rs 59,848 crore in 2007-08, 27 per cent lower than what it ought to have been.

The impact was bigger on the post-tax earnings. ONGC parted with almost half its profits to fill the subsidy hole. Its post-tax earnings at Rs 16,701 crore were lower by Rs 13,241 crore thanks to the subsidy burden. Why was ONGC asked to bear such a large share of the burden? It was because it stood to gain the most from the rise in global oil prices. If this subsidy-sharing is not a form of windfall profit tax, what is it? Remember, ONGC pays a 33 per cent corporate tax in addition to this subsidy.

The downstream refining and marketing companies such as Indian Oil, Bharat Petroleum and Hindustan Petroleum also share about 10 per cent of the subsidy burden of the government. It is really illogical to think of a windfall profit tax on them when they are already reeling from the subsidy burden and heading for losses.

So, if it is not ONGC and the downstream refining companies, who is the windfall profit tax aimed at then? Reliance Industries and Essar Oil are the only other oil companies in the net apart from Cairn India, which is anyway a marginal player in the present scenario. If at all Cairn were to earn a 'windfall profit' it would be when its Rajasthan fields go on stream in 2009 while Essar Oil has yet to stabilise and become a profitable refining company.

That leaves us with Reliance Industries whose profits surged by 62 per cent in 2007-08. But, then again, it is debatable if this can be construed as a 'windfall profit'. The company runs an efficient refining operation and has been intelligent in its crude oil sourcing. That its refinery can process heavy and sour crude that is priced at a discount to the premium Brent is also a factor in its better profitability. This is more a case of efficiency driving profits rather than an act of God.

So, what is all this talk of a windfall profit tax then? Such a tax is certainly not going to help bring down pump prices of petrol or diesel. What it will do though is cause immense damage to the already faltering oil companies and lead the government into complex litigation. The rationale for such a tax is completely suspect and can be challenged in the Courts. This is territory not traversed by the government before and could lead to needless complications in an election year.

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