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Windfall tax doesnt work
July, 23rd 2008
The Samajwadi Partys Amar Singh recently proposed instituting a windfall profits tax on energy industry firms. The Prime Ministers Office has forwarded the proposal to the finance ministry. With wisdom, the ministry will resist the idea. There is a rich history of windfall profit taxes, and the lessons are clear that it is rarely a good idea. In the US, for example, windfall, or excess profits, taxes were instituted during World Wars I and II and the Korean War. These were designed to meet short-term financial needs. Whatever the publics legitimate concerns over rising energy prices, the present price inflation hardly rises to the level of existential, wartime emergency. What about such a tax in peacetime? After all, many energy companies are recording enviable profits and consumers are paying more at the gas pump. So, the argument goes, a redistributive tax is needed on fairness grounds, anyway. The US tried such a non-emergency tax in the 1980s, after a similar period of energy price spikes. Indeed, then president Jimmy Carter faced his own personal political crisis as he was responding to concerns about gas shortages and gas lines at filling stations. The results of that tax were not pretty. The non-partisan and highly respected Congressional Research Service studied its effects. For starters, the levy did not raise the money its supporters believed it would. Initial projections had the tax bringing in a quarter of a trillion dollars. In reality, it brought in $40 billion. The researchers also found that the tax slashed domestic oil production by as much as 6% and increased oil imports by as much as 15%. Its easy to see why the tax would have such ill effects, and why it would fail to realize the revenues claimed. Energy exploration, development, refining and distribution is a risky and capital-intensive industry. If the institutional framework of doing business, including the tax structure, changes significantly, firms will change their behaviour as well. The response of energy firms to the 1980s tax in the US was sensible. They cut back. The energy sector is among the most capital-intensive on the planet. As such, energy firms assume enormous risks when they invest the substantial sums of capital in projects, and they should be entitled to the returns. If the market changes and oil prices plummet, no one should cry for them or bail them out if they suffer losses. Indeed, it is hard to remember now, but oil dropped below $10 a barrel on the world market less than a decade ago. Many energy firms took significant hits. But no one was calling to rebate their losses. Markets can be frustrating institutions in that their beneficent effects can, at times, take longer to be realized than politically convenient. The current high oil prices, for example, have triggered a wave of new investment in oil exploration as well as interest in renewable and alternative energy sources. By bringing new supply online or by prompting changes in consumer behaviour that drive down demand markets work to bring products to those who need them and provide incentives for innovations to meet growing needs. But the distorting effects of taxes based on emotion instead of economic logic will cause long-term harm that overwhelms short-term good. Indeed, the present crisis highlights the long-term harm that has been caused by Indias system of energy subsidies. This assistance has badly distorted the market for energy products in the worlds largest democracy. Markets can only function properly when the price mechanism sends useful signals throughout the economy. Subsidies sever that vital link. In the case of a market as massive as Indias, the distortions are particularly pernicious. Whatever the motivation for a windfall profits tax be it sibling rivalry or populist rhetoric the historical and economic record is unambiguous.
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