What’s dumb about a windfall profits tax?

The always smart Kevin Drum writes

The windfall profits tax is a dumb idea, and I wish Obama didn’t support it, but I guess politics is politics. It’s not the biggest deal in the world.

I asked in comments what’s so dumb about a windfall profits tax. I haven’t checked how many commenters responded to me, but some which I’ve found are after the jump.

My thoughts on a windfall profits tax on Oil companies (I consider an additional rebate a separate issue).

I start with the simplest assumptions so it is assumed that the tax won’t affect incentives, because it refers to the past and it is assumed to be a one off move (starting simple). Also assume the very old theory of the firm which acts in shareholders interest and is not liquidity constrained. In that case, the tax is a tax on oil company shareholders who are (including people with 401(k)’s) relatively rich. So I like it.

It seems, see below, that oil companies are passing their profits to shareholders through share buybacks. I think this helps support the old theory of the firm assumption. However, if they insistend on reinvesting profits, I would consider that an additional reason for the windfall profits tax. Last time they had a windfall (the second oil shock due to the Iranian revolution and the Iran-Iraq war) they decided to diversify and made some of the least productive investments in US history. Have you ever heard of Exxon office systems ? Big investment in smart typewriters which were like pc’s but dumber and ten times as expensive. Oil companies handle oil. They are not suited to act as investment bankers and, still less, as venture capitalists. generally high profits are a sign of skillful management which maybe can improve firms they take over. In this case, it was dumb luck. I’d say stock buybacks are the lesser waste, but reducing the deficit would be much nicer.

Now what if they assume that this is the first in a series. Often confiscation now and never again would be good policy if the promise were credible. The belief that there will be more windfall profit taxes in the future seems to me to be desireable. It means that Oil companies don’t gain as much when the price of oil goes up. Since they are imperfectly competetive, it seems to me that this would drive their actions twoards the social optimum. For example, if they aren’t helped with oil prices go up, they won’t oppose a carbon tax so fiercely. Also actual investment in alternative fuels now has the cost that production of alternative fuels causes the price of oil to decline. The threat (or promise) of further windfall profits taxes would increase their incentives to invest in alternative fuels. If designed rationally (see below) it would also increase their incentive to look for oil (which isn’t so key if there really isn’t so much left to be found).

I’d propose making a forecast for Oil holdings (inventories including proven reserves underground, crude in tankers and tanks and unsold petroleum products) and tax alpha times the price times this quantity from oil companies (with alpha positive but less than one). If the forecasts were exact, this would make the oil companies act as if they were perfectly competative. They won’t be, but so long as they are not so optimistic as to drive a company bankrupt, the costs of forecast errors will be a transfer plus something second order in the forecast errors. No such policy is like making a forecast of zero which is worse even than my forecasts.

OK at least one flame war from Drum’s site

The problem with a windfall profits tax is that it is the kind of ad hoc solution that Obama criticized when it took the form of a gas tax holiday. It may be a more effective gimmick, but it’s still a gimmick: pure pander.
Posted by: lampwick on August 4, 2008 at 12:21 PM | PERMALINK

Huh ? more like the opposite. Given that Oil refining and pumping are close to capacity, a gas tax holiday is similar to a windfall profits subsidy not tax. Both are ad hoc, but they have opposite effects. I would consider an argument that there is something wrong with a windfall profits tax to be an argument that something bad will happen if one is imposed.

Big Oil’s profits by percentage are far less than Google’s, for example. Google’s profit is around 25%. Now there’s a windfall. Why aren’t we taxing them extra heavy? No way they should be making that much money when there are starving people out there.

Posted by: SJRSM on August 4, 2008 at 12:23 PM | PERMALINK

This is interesting. First many of my arguments apply to an increase in price and not to increase in production (searches for google I guess). Second the windfall was a windfall (the behavior of inventories suggest that Oil company executives didn’t even see it coming as, say, Kevin Drum did). The google guys have demonstrated an ability to create wealth. I really like the idea of google venture capital. They got money by being very smart. I suspect that they will do smart things with it and won’t capture all of they wealth they create.

The only thing I could support was a windfall profits tax where the companies get to deduct from their payment every dollar they spend on renewables.

But as a general rule, resentment and vengeance are not good foundations for tax policy.

Posted by: lampwick on August 4, 2008 at 12:41 PM | PERMALINK

I’m not sure I want oil companies working on renewables. Why do we think they are better suited to manage that than other firms (I love what Shell is doing by the way) ? I am more pro market than lampwick so I think incentives to invest in renewables should be those implied by a carbon tax and not directed at any particular firms.

Remember the last time we based tax policy on resentment (hint did a plurality of Americans tell a Clinton pollster that they supported increased taxes on the rich to fund waste fraud and abuse). I’d say that the record of US tax policy based on resentment is, as a general rule, excellent.

There already is a tax on that “windfall.” It’s called the corporate income tax, and Big Oil is currently paying Uncle Sam to the tune of billions as their profits skyrocket. The proposal to effectively increase the corporate tax rate on a specific industry is unwise because consumers will pay for the tax increase in the form of higher fuel bills (as energy companies reduce exploration and development budgets). They’ll also “pay” to the extent that energy stocks are found in their portfolios.

Posted by: Jasper on August 4, 2008 at 12:47 PM | PERMALINK

a windfall profits tax isn’t just an increased tax on profits. It depends on the price times inventories not production minus costs. My proposal would, if anything, increase the incentives to oil companies to explore and develope oil fields. Someone in a thred below pointed out that average != marginal. I think Jasper really doesn’t understand that, but it could be that he assumes that the windfall part will be a fraud and will be perceived to be a fraud.

Yes, the windfall tax is a bad idea, and the energy rebate is even worse. We’re at a sad state when we count on stipends from the government to help spur the economy. What we need are policy changes that will impact how people buy and use energy in the long-term, not a panacea fix.

Posted by: MeLoseBrain? on August 4, 2008 at 2:16 PM | PERMALINK

Yes we must make the best the enemy of the good. Plus Keynesianism unbuilds character.

Someone notes that Becker and or Posner claim that the windfall profits tax was not good policy. Support for their assertion is missing. But the great part is this

.. “I was careful with my reference not to use a right wing source for the argument. Unless Becker-Posner is a right wing source.”

The scary thing is that I don’t think the commenter was joking.

I’m not done with the thread but I’m sure I’ve exhausted your patience.