March 1, 2006 | WebMemo on Energy and Environment
Many in Congress are looking to provide Americans with relief at the gas pump, but raising taxes on the oil industry is not the way to do it. The track record for punitive measures like the windfall profits tax shows that they usually harm consumers along with the targeted industry. Thus far, Congress has wisely resisted calls to impose a windfall profits tax directly. However, the Senate is trying to sneak such a measure into the tax reconciliation bill (The Tax Relief Act of 2005, H.R. 4297) by changing rules on the way oil inventories are valued. According to the Joint Committee on Taxation, the proposed change would raise taxes by $4.33 billion. For the sake of the driving public, Congress should reject this approach.
A Bad Idea
Continued high gasoline prices-despite drops in recent weeks, they are still well above $2.00 per gallon-along with announcements of record high quarterly profits by most major oil companies have led to some strange logic in Washington. If high oil industry profits coincide with high pump prices, the logic goes, then reducing those profits via confiscatory taxes will somehow lower prices at the pump. Based on this reasoning, Sen. Byron Dorgan-sponsor of The Windfall Profits Rebate Act of 2005, S. 1631-and others have tried to resurrect the windfall profits tax, which would sharply raise taxes on oil.
The windfall profits tax is a tax levied on oil producers when the price of oil exceeds some predetermined level. Dorgan's S. 1631 would impose a 50 percent tax on the price of oil above $40 per barrel. Thus, at the current market price of about $60 per barrel, each barrel an oil company sells or refines would be taxed an additional 50 percent on the $20 "windfall" above $40, or $10. This tax would be imposed on top of the 35 percent federal corporate income tax and other taxes on the industry. Under the bill, the government would rebate the proceeds of the windfall tax to the public.
There is considerable populist appeal in raising taxes on "big oil" at a time when the industry can most easily afford it and then giving the proceeds to taxpayers. But the last time it was tried, the windfall profits tax backfired badly. It discouraged the expansion of domestic energy supplies and led to increased oil imports. According to a 1990 Congressional Research Service study, the windfall profits tax in place from 1980 to 1988 "reduced domestic oil production from between 3 and 6 percent, and increased oil imports from between 8 and 16 percent." In effect, putting domestic oil producers at a disadvantage had the unintended effect of strengthening OPEC's hand. In the end, the tax hurt consumers more through higher energy prices than it helped them through higher tax revenues, which turned out to be far lower than originally predicted because the tax discouraged production.
These unintended consequences were among the reasons why the windfall profits tax was repealed in 1988. Its effects, however, still linger; it likely slowed exploration and drilling of sources that would be producing today.
If the windfall profits tax were re-imposed, the impact on domestic production would be just as great as or greater than it was in the 1980s. Since then, the expense of oil exploration and drilling has increased. These projects cost billions of dollars and take decades, over which time the price of oil will fluctuate. Indeed, the price of oil was well under $20 per barrel for most of the 1990s, reaching a low near $10 per barrel as recently as 1998. Needless to say, oil industry profits were modest at the time. Many oil wells operated at a loss, and some shut down for good. If American oil companies have to endure periods of low oil prices but must forfeit extra proceeds to the government during times of high prices, they would undertake much less exploration and drilling. Furthermore, OPEC and foreign oil companies would again enjoy a comparative advantage relative to U.S. based firms.
Given the tightness in current supplies and predictions of strong future growth in demand for energy, anything that discourages additional oil production will inevitably hurt the energy-using public.
Still a Bad Idea
While S. 1631 and other attempts to directly impose a windfall profits tax have faltered, the Senate is now trying to do so indirectly in H.R. 4297, the tax reconciliation bill. The Senate's version of this bill includes a provision that amounts to a backdoor windfall profits tax. It would change the manner in which oil companies value their inventories so as to capture an additional $4.33 billion in tax revenues over the next two years. Though ostensibly a minor accounting change, the purpose of this after-the-fact tax code revision is the same as that of the windfall profits tax: to make oil companies pay much more in taxes during times of high prices.
The House and Senate are beginning the process of reconciling their respective versions of the tax reconciliation bill. Fortunately, the House has thus far shown no interest in joining the Senate in its backdoor windfall profits tax. And Secretary of the Treasury John Snow, in a letter to House and Senate conferees, reiterated the President's opposition to this tax change.
As it is, the tax rates faced by the oil industry are already quite high; indeed, they are higher than those faced by other American firms and most competitors. Raising taxes further is unlikely to lower gas price and, over the long term, may discourage the domestic energy sector from expanding supplies. For these reasons, this provision should be left out of the final version of the tax reconciliation bill.
Lawmakers should not penalize-or subsidize-different industries through the tax code. Rather than make the tax code more complex, politicians should junk the existing system and replace it with a simple cash-flow tax that logically defines taxable income as the difference between total revenues and total costs. This is the "flat tax" approach and it would eliminate the corrupting influence of special-interest tax provisions while making American companies more competitive in the global economy.
Ben Lieberman is Senior Policy Analyst in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.
 Joint Committee On Taxation, "Estimated Revenue Effects of H.R. 4297 , The 'Tax Relief Act Of 2005,' As Amended By The Senate On February 2, 2006," February 8, 2006.
 Salvatore Lazzari, "The Windfall Profit Tax On Crude Oil: Overview Of The Issues," Congressional Research Service, Sept. 12, 1990.
 Scott Hodge, "Large Oil Industry Tax Payments Undercut Case for Windfall Profits Tax," The Tax Foundation, January 31, 2006.