Déjà-vu on Windfall Profits Tax on Oil Industry

Outraged over current oil prices (crude oil is averaging $60 per barrel and retail gasoline $2.38 per gallon), some members of Congress want to impose windfall profits taxes on U.S. oil producers. Many policymakers seem to have forgotten that hurricanes Katrina and Rita are still impacting U.S. energy output in the Gulf Coast region and full production may not be restored for months.

It’s natural to feel frustrated by the sharp rise in energy prices faced by U.S. households and industry, but will “punishing” the oil industry with higher taxes do anything to make prices fall? Most experts believe that is not likely, for the following reasons.

First, U.S. oil producing firms are “price takers,” not “price makers” in a global market. They are not members of the price-fixing body, OPEC, whose oil production decisions are made, at least in part, collectively, and heavily influence the world market supply. The price of a barrel of oil, like most commodities, is set on the international markets by traders making sales between willing buyers and willing sellers.

Second, the United States tried a windfall profits tax (WPT) from 1980 to 1988; a report by the non-partisan Congressional Research Service concluded that the WPT reduced domestic oil production by 3 to 6 percent and increased oil imports in the range of 8 to 16 percent over the 1980-86 period. Hence, history has shown that a windfall profits tax increased U.S. dependence on foreign oil and would do so again if repeated.

Third, U.S. Department of Energy (DOE) data from 1986 to 2003 show that capital expenditures by the oil industry tend to strongly correlate with the price of crude oil.

In 2003, the trend in oil prices and capital expenditures diverged and DOE’s Financial Reporting System suggests that the harsh and unreliable investment climate in 2003 in countries like Indonesia, Venezuela, and Libya caused a cutback in capital expenditures by US oil firms for that year. In fact, Indonesia, which may well have 7 or more billion barrels of oil yet to be discovered (or enough oil to fuel all of the US’s transport needs for about 16 months) has “an investment climate that has been described as one of world’s worst” according to DOE.

Rising oil prices encourage companies to invest more in finding new reserves and to increase production from existing fields. Increasing taxes on oil company revenues will only reduce the desire and ability of firms to find and produce more oil. One of the axioms of public finance scholars is that if you tax something, you get less of it.

Hence, a windfall profits tax, by reducing capital available for investment in future energy production, will mean lower future energy production and hence lower government revenues into the foreseeable future.

Reinstituting the windfall profits tax on oil companies, changing the LIFO (last in-first out) inventory rules or limiting the foreign tax credit that companies can use to reduce the double taxation of foreign source earnings will only reduce the amount of money companies can plow back into finding more oil and reduce the return to shareholders. U.S. public and private pension funds hold approximately $267 billion in oil company stocks (or about 41 percent of the market value of these stocks).

According to a new report by former Clinton official Robert J. Shapiro, U.S. workers contributing to these pension funds and current retirees would bear 41 percent of the shareholders’ costs of a WPT.

A more useful approach for bringing down high energy prices would consist of several steps. Make more locations (both offshore and onshore) available for domestic exploration and development to help increase supply. Revise the U.S. federal tax code to increase the speed of capital cost recovery for new investment. Reduce the corporate tax rate to give companies more funds for capital expenditures. Fund the provisions in the 2005 Energy Policy Act aimed at increasing energy supplies, encouraging conservation, and promoting renewable energy sources.

Finally, work with developing and emerging economies to promote economic freedom, the rule of law, and the sanctity of contracts. In the long run, these steps would gradually enhance energy supplies, reduce demand for energy, and relieve the global pressure on energy prices.