May 8, 2008

May 8, 2008 | Commentary on Regulation

Don't fall for a "windfall" profits tax

"Excess profits." That's what oil companies are earning, Barack Obama says -- and he's not alone. Recent earnings reports from these companies have set off such a wave of anti-profit proposals that it seems our politicians are reading Mao's Little Red Book. The book they should be consulting is The Little Red Hen.

The record and near-record profits reported by Shell, Exxon and Chevron come from two factors: 1) The price of petroleum is at record and near-record levels, and 2) these companies produce petroleum.

Of course, they refine and distribute the petroleum products as well, but that's not where the record profits arise. Indeed, the companies that focus on refining and distribution don't generate much envy. Marathon, for instance, reported first-quarter profits that inched up only 2 percent.

In the popular profits-cause-high-prices theory of economics, there are no risks, and petroleum reserves magically find their way into corporate portfolios. In this world, profits can be confiscated -- ahem, taxed -- with no adverse effect because profits serve only to inflate costs.

In the real world, the firms that bought, developed and held on to petroleum reserves when petroleum prices were low employed better foresight than those firms that did not. They also put their wealth at risk. Oil field investments in 1981, when prices were last at record levels, didn't pay off early, if at all. So it was a brave decision to invest in oil resources back in the 1990s when oil prices were low and getting lower.

Since reality is no fun when it comes to taking other people's money, it's often ignored. But reality cannot be avoided.

We can tax oil profits now with little impact on current prices, since the wells and refiners that bring us today's fuel are already in place. However, targeting the return on any investment necessarily cuts the incentive to continue making that investment. So, a "windfall" profits tax now will lead to less exploration, less drilling and less oil in the future. When we swing the sledgehammer at oil company profits, we hit future heating oil and gasoline consumers.

Those arguing that investors don't need such high profits to continue investing miss a critical point. Investors never know for sure how much they are going to earn. There is always a distribution of possible payoffs -- from large losses to large gains. Chopping off the upper tail, as a "windfall" profits tax will, pushes the expected return closer to zero and, therefore, reduces exploration, drilling and development.

In fact, investment can be harmed by just the threat of diminished returns. One study shows that proposed healthcare regulations in 1993, for example, reduced research and development in the pharmaceutical industry by $7 billion, even though the profit-limiting legislation ultimately didn't pass.

In a world already awash in unintended consequences, a "windfall" profits tax would add yet another: By reducing America's share of petroleum reserves, it necessarily puts a greater share in the hands of foreign ownership. Think Venezuelan President Hugo Chavez and Iranian President Mahmoud Ahmadinejad.

Though The Little Red Hen: The Sequel hasn't been written, we could imagine that the duck, the goose and the pig helped with the planting, harvesting and baking the following year. If Washington reads the right story, leaves oil profits alone, and unlocks areas closed to oil drilling, we could see a thousand derricks bloom.

David W. Kreutzer is senior policy analyst at The Heritage Foundation.

About the Author

David W. Kreutzer, Ph.D. Senior Research Fellow, Energy Economics and Climate Change
Center for Data Analysis

Distributed nationally on the McClatchy Tribune Wire