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Commentary

“Windfall” Profits Tax on Oil Would Slow Flow


     
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It is far more fashionable these days to condemn oil industry profits than to consider the possibility that there might be something good about them. This is especially so when, weeks after Hurricane Katrina devastated the Gulf Coast, gasoline prices remain high and approaching cold weather triggers nightmares in the Northeast about budget-busting heating oil bills.

Reports that the profits of the major oil companies surged during the third quarter seemingly added insult to the injuries of drivers still reeling from sticker shock at the pump. Proving once again that politics makes strange bedfellows, Senate Majority Leader Bill Frist, R-Tenn., has joined a growing number of colleagues and commentators from the left and the right in denouncing the oil industry’s supposed price-gouging and profiteering in Katrina’s wake.

Under the pretense of protecting consumers from greedy Big Oil, some of the industry’s congressional critics have raised the possibility of reinstating a tax on “windfall” profits. But the attack dogs might do well to consider the consequences of such a punitive measure. A tax on profits would do more harm than good—a lesson we learned a quarter-century ago.

In 1980, President Carter signed into law the Crude Oil Windfall Profit Tax Act, which established excise taxes as high as 70 percent on the difference between the market-determined price of oil and a (lower) price set by law. The tax was dropped in 1987, but according to the Congressional Research Service, almost $80 billion was drained from the industry’s income statements while it was in effect.

Money that could have been invested in new oil and gas production and to expand refining capacity was instead diverted to Washington. It should come as no surprise that oil production fell. In fact, 1.6 billion fewer barrels of crude oil were produced in the United States from 1980 to 1987 than would have been produced otherwise. American dependence on foreign oil rose apace.

However tempting it may be for populist politicians to meddle in energy markets, almost anything Congress does will only make a bad situation worse. Oil and gas production is a risky business, as Katrina and Rita demonstrated so vividly.

Despite the industry’s above-average risk exposure, Big Oil is not extraordinarily profitable. According to Business Week and Oil Daily, average industry earnings were 7.7 cents per dollar of sales in the second quarter of 2005, also a time of relatively high gas prices. During that same quarter, by comparison, banks earned 19.6 cents; pharmaceuticals 18.6; software and related services 17; semiconductors 14.6; household and personal products 11.3; insurance 10.7; telecommunications 9.6; food, beverage and tobacco 9.4; and real estate 8.9. The corresponding figure for U.S. industry as a whole was 7.9 cents per dollar of sales.

Oil company revenues may be running at record levels, but so is the cost of the industry’s most important input, crude oil, selling on global commodity markets nowadays for about $60 a barrel. Only a few years ago, during Asia’s economic crisis, it was going for $9.40 a barrel.

The good news is that markets are working. They—not the oil companies—determine the prices of crude oil, gasoline and heating oil. When world supplies are stretched tight, as they have been over the past five years, prices predictably rise and become more volatile. Supply disruptions explain why prices rose dramatically after Katrina wreaked havoc on the refineries and oil production facilities in the Gulf.

Because of the recent price spike, gasoline use is down. Consumer interest in hybrid vehicles and alternative fuels is at an all-time high. But even at today’s prices, the production of alternative fuels remains at a significant cost disadvantage relative to fossil fuels. For the foreseeable future, then, America’s energy security will continue to depend on a reliable supply of crude oil and the capacity to refine it.

The National Petroleum Council estimates that, to meet expected demand, producers will have to invest almost $1.2 trillion through 2025 to fund oil and gas exploration and production in North America. Raising capital of that magnitude requires investor confidence in the industry’s long-term fiscal stability. There has to be an incentive for oil and gas development. Profits provide that incentive. Take away industry profits, and drilling will stop.

Congress should consider measures that will increase oil supply, not reduce it. Vast regions of the United States remain off-limits to oil and gas production. Owing to overly restrictive government regulations, the construction of refineries and liquefied natural gas (LNG) terminals has become extremely difficult. The United States has less refining capacity now than in the 1970s. Action is needed in Congress to open up new areas to energy development, both onshore and off, and to provide an environment conducive to expanding refinery capacity and adding more LNG facilities.

The worst thing that could be done is to revive the windfall profits tax from the 1980s. Such an ill-conceived policy would short-circuit the market forces that must operate for the oil industry—and the national economy—to recover from Mother Nature’s wrath.


William F. Shughart II is a Research Director and Senior Fellow at The Independent Institute, J. Fish Smith Professor in Public Choice in the Jon M. Huntsman School of Business at Utah State University, and editor of the Independent Institute book, Taxing Choice: The Predatory Politics of Fiscal Discrimination.


  From William F. Shughart II
TAXING CHOICE: The Predatory Politics of Fiscal Discrimination
So-called “sin taxes”—the taxing of certain products, like alcohol and tobacco, that are deemed to be “politically incorrect”—have long been a favorite way for politicians to fund programs benefiting special interest groups. But this concept has been applied to such “sinful” products as soft drinks, margarine, telephone calls, airline tickets, and even fishing gear. What is the true record of this selective, often punitive, approach to taxation?






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