Taxing Profits, Draining Energy

Brief Analyses | Energy and Natural Resources

No. 549
Thursday, March 30, 2006
by H. Sterling Burnett and Christa Bieker

Gasoline prices last year never reached the inflation-adjusted peak of the 1980s, but due to a variety of factors they were much higher than Americans have become accustomed to recently. These included strong demand in the United States and several developing nations, production and refining decisions by the Organization of Petroleum Exporting Countries (OPEC) and political instability in a number of oil exporting countries. Prices spiked - topping $3.00 per gallon in some areas - after Atlantic hurricanes damaged off-shore oil platforms and Gulf Coast ports, refineries, roads and pipelines. The spike in gasoline prices alarmed and angered many Americans who, polls showed, were suspicious that oil companies were conspiring to keep prices artificially high.

The record profits posted by all major oil companies in 2005 only added to the public's feeling of victimization.

In response to constituents' demands to "do something" about energy prices, congressmen proposed various versions of a Windfall Profits Tax. One such tax, proposed by Senators Byron Dorgan (D-N.D.) and Christopher Dodd (D-Conn.) would have placed a 50 percent excise tax on some oil when the price of a barrel is over $40. Other senators proposed using windfall tax revenues to increase funding for low-income energy assistance programs.

Fortunately, no windfall tax proposal has gained traction yet. Contrary to the claims of tax proponents, oil industry profits are not unusual relative to other industries and a new tax is more likely to increase the United States' dependence on foreign oil rather than reduce it - while doing nothing to raise production or lower prices.

Effects of the 1980 Windfall Profits Tax

The Oil Industry Doesn't Make Windfall Profits. Despite a number of government studies and congressional hearings, no evidence has been presented showing that the oil industry has colluded to keep retail gasoline prices high. For instance, the Energy Information Agency (EIA) in the U.S. Department of Energy found that approximately 85 percent of the changes in gasoline prices in the aftermath of Hurricane Katrina were due to changes in the market price of crude oil.

Global energy markets determine the price at which oil is bought and sold by even the largest oil corporations. For instance, ExxonMobil, the world's largest private oil company, accounts for only 3 percent of the market and the prices it pays for crude oil are set by trading on commodities exchanges in London , Hong Kong and Chicago .

While oil companies have recently enjoyed record profits, their profit margins have historically been below the market average. Between 1970 and 2003, the return on oil companies' investments averaged less than the rest of the economy. Even with recent increases in profits, they are still near the national average, according to data compiled by Standard and Poor's Compustat. For instance, oil and gas industry profits were 8.2 percent of sales in the third quarter of 2005, 21 percent higher than the national average of 6.8 percent. By contrast:

  • The food, beverage and tobacco sectors, with an average profit margin of 8.5 percent, and household and personal-product industries, with an 11.4 percent profit, were 25 percent and 68 percent, respectively, above the national average.
  • Profits in the semiconductor industry (14.1 percent), banking (18 percent) and pharmaceutical industry (18.5 percent) were 107 percent, 165 percent and 172 percent above the average, respectively.
  • Furthermore, oil and refining company profits per gallon of gasoline sold were lower than the 23 percent average federal and state tax per gallon.

Windfall Profits Tax Discourages Production. Past experience with windfall taxes has not been positive. In April 1980, Jimmy Carter signed the "Crude Oil Windfall Profits Tax" to replace failed oil price controls. This was the largest tax ever imposed on an American industry and was designed to recover a portion of money politicians believed was unfairly received by oil companies. The money was earmarked to develop renewable energy, thus reducing U.S. dependence on foreign oil, and to fund low-income energy assistance programs. But the tax failed to deliver either and the Reagan administration led its repeal in 1988. According to the Congressional Research Service:

  • The windfall profits tax raised a total of $40 billion, instead of the $227 billion initially projected, and generated no revenue after 1986, because oil prices fell and domestic production was lower than expected.
  • The tax reduced domestic oil production 3 percent to 6 percent because it increased investment risk.
  • Imports increased 8 percent to 16 percent because of the competitive advantage the tax gave to foreign oil companies. [See the figure.]

Windfall Profits Tax Discourages Investment. It is not surprising that a windfall profits tax fails to either increase domestic production or reduce prices. When profits are penalized, there are fewer incentives to increase capacity. Oil production is risky and requires heavy initial investment in infrastructure. Meanwhile, oil prices can fluctuate. New oil may or may not be discovered. Because of these uncertainties, investment in oil production requires the ability to forecast likely outcomes. A windfall tax complicates this task. When a company is unsure what the price of oil will be at a certain point in the future and consequently unsure whether it will be penalized by the government for making a profit that year, investment risk increases.

The tax would put U.S. oil and gas companies at a competitive disadvantage in the global energy marketplace. Oil companies in Venezuela, the European Union, Russia and Mexico would receive relatively higher profits than U.S. firms, whose stock prices would fall. Potential investors could direct their dollars overseas or to other industries. And profits siphoned off by taxing domestic oil companies will not be available for investment in new production and refining capacity.

Many analysts also believe that increasing America 's dependence on foreign oil poses a grave national security threat. The EIA reports that the United States already relies on foreign countries such as Canada, Nigeria, Mexico, Saudi Arabia and Venezuela for over half of its crude oil supply. Increasing this reliance will only give these countries more leverage over American foreign and defense policies and the domestic economy.

Alternatives to Windfall Profits Tax. Before casting aspersions on the oil and gas industry for profiting from the recent rise in prices, Congress should note their own contributions to the current high prices of gasoline and natural gas. Tens of billions of barrels of oil are locked-up on public lands in Alaska, including the Arctic National Wildlife Refuge, the Western United States and the outer-continental shelf. Yet, Congress has repeatedly chosen not to open ANWR to oil production. In addition, there has been a moratorium on new development and production off the coasts of California, the East Coast and much of Florida since 1990, and Congress has refused to lift it.

The market is already responding to high energy prices: sales of large SUVs have fallen, more people are purchasing energy-efficient appliances and more oil and gas production is coming on line. As a result, though 17 percent of Gulf of Mexico oil production and 4 percent of natural gas output is still off-line in the aftermath of the 2005 hurricane season, prices for both oil and gas have fallen dramatically. From a high of more than $70 per barrel in August 2005, oil prices have fallen 14 percent to hover around $60 per barrel. And natural gas futures prices have fallen from more than $15 per million British Thermal Units (BTUs) to just over $6 per million BTUs. Congress should let markets work, rather than making the situation worse by imposing new taxes.

H. Sterling Burnett is a senior fellow and Christa Bieker is an intern with the National Center for Policy Analysis.

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