"Big Oil Tax" Proposals: Analysis of Windfall Profits Taxes

Military action around the Strait of Hormuz has increased global oil prices. In response, policymakers around the world have put forward proposals targeting oil and gas producers who are seeing profits increase in the short run from the spike in prices.

The proposals run into three problems: we already have a taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. that captures windfall profits, a temporary policy can still change investment decisions, and so-called windfall profits taxes often continue past the supposed emergency.

Current Proposals

Congressional policymakers have put forward multiple proposals for windfall profits taxes focused on energy. The Big Oil Windfall Profits Tax Act, introduced by Sen. Sheldon Whitehouse (D-RI) and Rep. Ro Khanna (D-CA), would tax sales of crude oil at 50 percent of the gap between the average price of crude oil in the calendar quarter and the average crude oil price in 2025. Notably, this policy would be permanent. It would fall on companies producing or importing an average of 300,000 barrels per day.

Congressman Brad Sherman (D-CA), meanwhile, has proposed a 100 percent tax on crude oil sales in excess of $75 per barrel, which would be in effect until three conditions are met: the end of hostilities with Iran, the reopening of the Strait of Hormuz, and the price of oil returning to $75 per barrel.

We Already Tax “Windfall Profits”

In the United States, we have a corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax.. The corporate income tax falls on profits, which are revenues minus costs. In years when high oil prices mean higher oil company profits, oil companies already pay higher amounts of taxes because the corporate income tax is proportional.

The Big Picture: In Commodities Markets, Expect the Unexpected

Part of the reason one invests in oil extraction, or any volatile commodity business for that matter, is the potential upside of high-price years offsetting the potential downside of low-price years. An investor might not expect, say, US strikes on Iran leading to the closing of the Strait of Hormuz (shrinking oil supply and pushing prices up) or a global pandemic (reducing oil demand and lowering prices), but they know these kinds of things happen, and the downside risk to their investment from low-price scenarios is offset by the potential upside of high-price scenarios.

On paper, if a windfall profits taxA windfall profits tax is a one-time surtax levied on a company or industry when economic conditions result in large and unexpected profits. Historically, such taxes have targeted oil and energy companies when costs have risen, especially from war or other crises. is truly temporary and short-term enough to not disincentivize new supply being brought online, then it might not have distortive effects. But even ostensibly temporary policies shape expectations. If investors expect that governments will claim a disproportionate share of profits in years with high oil prices, the expected returns of investing in new oil production capacity will fall.

Past Bad Experiences: European and American

In the wake of the last global oil price spike in 2022, several European countries imposed windfall profits taxes. Aside from not raising much revenue, they also spelled bad news for investment in the energy sector. Spain’s windfall profits tax, which was based on energy company operational revenue, ended up hitting clean energy investment, as many large energy companies are involved in both fossil fuel and renewable energy.

The United Kingdom still has its supposedly temporary windfall profits tax in place and is scheduled to keep it on the books until 2030, following several expansions and extensions. While the United Kingdom’s North Sea oil production had begun declining before the introduction of the windfall profits tax, the tax has compounded issues there.

The United States also has a history with windfall profits taxes targeting oil, albeit not one as recent as Europe. In 1980, the Crude Oil Windfall Profits Tax Act imposed an excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. of up to 70 percent of the difference between the quarterly crude oil price and a base price.

Several analyses of the 1980 Windfall Profits Tax have found it reduced domestic production and increased reliance on imports. A Congressional Research Service paper found that the tax reduced domestic oil production by between 1.2 and 8.0 percent, and increased reliance on foreign oil by between 3 percent and 13 percent between 1980 and 1988 (when the tax was eventually repealed).

A 2018 paper in Economic Policy found that the tax reduced domestic production, largely by reducing the total output of wells already in operation. The paper noted that such a tax could not be modeled as simply a tax capturing the rents (in layman’s terms, excess profits) of oil producers but rather would reduce incentives to produce at the margin.

The Smarter Alternative

As mentioned earlier, windfall profits are already subject to the corporate income tax. Instead of creating another way to tax windfall profits that penalizes new investment in the process, the best option for policymakers is to make the entire base of the corporate income tax windfall or other “supernormal” profits.

This can be achieved by allowing full deductibility of capital investment, effectively exempting the “normal” return to capital. Under current law, investment in short-lived assets like equipment and machinery, along with research and development, can be deducted immediately. However, deductions for investment in long-lived assets like commercial and residential buildings must be spread over long time periods (39 and 27.5 years, respectively), with the exception of certain manufacturing structures. Stopping short of full and immediate expensing creates a tax penalty for new investment; removing it would concentrate the corporate income tax on supernormal profits.