Wednesday, November 09, 2005

A windfall profits tax for oil companies?

With oil companies' profits way up, reflecting what has happened to gasoline at the pump, Democrats are naturally pushing the windfall profits tax issue. At times like this, the tax becomes a great talking point for them, just as Republicans use power blackouts as an excuse to push totally unrelated giveaways to oil and coal companies.

Is there any decent intellectual defense for a windfall profits tax on oil companies? The standard economics-inflected answer would be no, for the same reason that one might want to let price gougers charge what they like for water in a drought disaster area. The argument is that the high returns encourage them to anticipate and fill demand, bidding the price back down and causing the market to respond to demand shocks much faster than it would otherwise. Thus, in the oil company case, the standard argument would be that windfall profits attract apparently needed extra capacity into the industry.

Nonetheless, a couple of reasonable arguments could be made, in present circumstances, for a windfall profits tax on oil companies. The first is worth considering though probably in the end wrong; the second has more clout. The first argument is that oil companies have a huge risk position in energy prices, which may not be economically desirable for them. Presumably they are in the energy supply business, and would want to hedge price risk rather than placing huge side bets on energy price uncertainties that are resolved once they have made a bunch of investment decisions. A windfall profits tax amounts to a government supplied hedge, in that they pay higher tax rates if they win the bets they have perhaps inadvertently made on energy prices than if they lose. The problem with this argument, however, is that it presupposes that they can't or won't properly hedge on their own. (This is mainly a company-level issue about default risk and the like, since shareholders can presumably diversify their stockholdings even if particular companies aren't diversified.) One would really need a missing financial market for hedging oil price risks to make this argument fly, and with derivatives and the like this is a hard argument to make. Flawed managerial incentives probably don't do the trick either, since the standard view is that managers are too risk-averse, relative to the interests of diversified shareholders, due to their firm-specific economic interests.

A variant of this argument would be that, for companies we might be likely to bail out if things get really bad (e.g., automobile companies and the airlines), having a windfall profits tax on the upside would make things more neutral overall. But it may not be the case that we would be bailing out the oil companies on the downside, which would be needed for the implication that a windfall profits tax on the upside makes things more symmetric with respect to extreme outcomes.

This brings us to the better argument, which is a political second-best. Even before the Bush-Cheney administration, oil companies had a tendency to win huge concessions, tax and otherwise, from the federal government, due to their immense political clout and insider connections. So we probably have a background situation in which oil companies are inefficiently favored by government policy. A windfall profits tax is one of the politically more feasible correctives, although it probably is not the response one would choose in the absence of political constraints.

So let's hear it, albeit tentatively, for a windfall profits tax on oil companies, on the view that it might (however imperfectly) reduce the overall bias of government policy in favor of this line of business as opposed to others.

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