A windfall profits tax idea that could actually work
Some administration officials have an idea that deserves more attention
Democrats’ private polling, from what I’ve heard, tells a pretty clear and consistent story: the only thing voters really care about right now is inflation Republican ads and paid messages are all focused on inflation, and there is no “message” from the incumbent party that works very well in the face of prices that are objectively rising faster than incomes.
In other words, it’s much more a problem of substance than of message.
And yet, if you’re in politics, you do need to say things. And of the various messages that Democrats could deliver, the ones that resonate most with the public are the ones that emphasize the huge profit-taking opportunities that inflation is presenting for many companies. Unfortunately for Democrats, one consequence of education polarization is that all the people who care what fussy highbrow journalists think are now on their side, so when they say things about economics that aren’t true and then Catherine Rampell complains, those complaints hurt them. And in being an annoying complainer, she has in fact strengthened the hand of the more rigor-inclined members of the administration who are now able to argue that even well-testing messages could backfire via media effects.
I am less fussy, and I am a believer in the idea that you can’t take the politics out of politics. The current inflation really has created profit windfalls for certain companies, and it is fine to feel and express annoyance about this. My big concern with greedflation is that it’s important for policymakers not to get high on their own supply. Oil companies are currently enjoying huge profit margins, but if they cut prices to reduce margins it would generate shortages, and Biden would be even worse off in a universe with gas lines and rationing. So what Bharat Ramamurti says here is a fine observation about the cosmic injustice of life, but I’m not sure it’s a basis for policy.
Before Ramamurti worked in the White House, he worked for Elizabeth Warren, who believes that we should slap oil companies with a windfall profits tax. That’s the kind of thing that economists mostly hate because it wouldn’t actually do anything to reduce prices and could backfire by reducing supply.
But I have heard one idea kicking around at lower levels of the Biden administration that I haven’t seen reported elsewhere, possibly because nobody at a sufficiently senior level or on Capitol Hill is embracing it. I happen to think it’s a pretty good idea, though, so I’m going to explain it here in hopes of elevating it in the discussion. The idea is to try to levy a windfall profits tax on oil companies that is inframarginal — profit increases really have been very large, so some of the windfall profit is taxed, but because the tax is capped, there is zero marginal tax on windfall profits.
This gives expression to populist outrage without changing forward-looking incentives.
Indeed, it even brings in revenue that the government could use to create incentives to boost production, taking the advice of yesterday’s post to abandon the push for a shadow carbon tax and embrace energy abundance.
A windfall profits tax with $0 marginal rate
The problem with taxing windfall profits, of course, is that the profits constitute an incentive to invest in new production. Right now, a barrel of oil is very, very expensive. This means that it is worthwhile to pump one out even though labor and other inputs are expensive. Indeed, to a large extent our current frustration is that investors are erring on the side of demanding dividends, debt repayment, and other forms of cashing out rather than incremental investments. So you1 don’t want to adopt a policy that disincentivizes investment.
But note this is a question of the marginal tax rate, not the average one.
What’s the difference? The federal government has a bunch of tax brackets, creating the following rate structure:
If my taxes were raised by increasing the top rate from 37% to 39%, that would cost me some money but also reduce my financial incentive to grow Slow Boring membership and deal a potentially devastating blow to the takes industry. But if raising the 24% rate to 30% would also cost me a bunch of money without raising my marginal rate at all. A lot of people would face a marginal rate increase in that example, but I wouldn’t.
In the business sector, we don’t normally apply a graduated tax — companies just pay a flat rate. But we could! And in particular we could respond to the current weird situation by creating a weird rate structure. Let’s say every single oil company in America has more than doubled its profits this year. Well, the government could declare every dollar of profit above last year’s level to be a “windfall” profit and levy a special tax on it right up until you reach double last year’s profits, at which point the tax goes away.
So the extra tax — levied on profits that are greater than 100% of last year’s profits but less than 200% of last year’s profits — exists, but there is no marginal tax on further increases in profit.
Making policy this way is normally a bad idea because it’s pretty gimmicky, and the industry would presumably respond in kind with a lot of gimmicky corporate restructurings. But in response to a one-off, the amount of avoidance would probably be reasonably low.
Your inframarginal tax would thus raise revenue without clobbering incentives. It’s a policy that expresses populist sentiments while still, I think, passing the Rampell Test.
What do you do with the money?
So what is the point of this?
On some level, reducing the deficit is anti-inflationary in this economic climate and that’s the point. But it seems more reasonable to try to use the money to accomplish something. One idea is that the revenue could offset a federal gas tax holiday, which is appealing politically because it directly connects to pain at the pump.
As policy, though, this is bad. Subsidizing additional gasoline consumption worsens the underlying situation.
In California, Gavin Newsom’s version of a gimmicky gas price mitigation program was to send households flat rebate checks on a per-car basis, which is better. Detaching it from car ownership — basically doing another version of the pandemic stimmie checks — would be even better than that. But all of these are demand-increasing policy ideas, which really isn’t ideal.
The boldest and I think most correct approach would be to directly subsidize domestic oil production. Joe Manchin has been asking the Biden administration to invoke Defense Production Act powers to boost domestic fossil fuel output, and I’m for doing anything to make Manchin happy in order to get a deal done on a reconciliation bill. But I also think the reality is that DPA invocations (which used to be very rare) have become a bit of an empty way of signaling a desire to do something rather than actually doing anything. Because the reality is that the DPA doesn’t create money out of thin air, so unless it’s backed up by financial resources, it doesn’t let you do that much.
But the revenue from a windfall profits tax could be applied to try to help frackers obtain the sand they need to increase output or address other specific input gaps.
A powerful statement
On the merits, I don’t think a windfall profits tax to subsidize domestic production would necessarily be a huge game-changer for domestic oil and gas output.
And in general, I think Republicans are overestimating the impact that the Biden administration's actions — like making it easier for states to veto pipeline construction or canceling offshore oil leasing — are having on the supply situation. Letting those projects go forward would not have any direct, short-term impact.
But I do think the Biden administration’s policies, including the failed effort to put Sarah Bloom Raskin on the Fed Board of Governors, have generally signaled a desire to deter investment in U.S. oil and gas production. Biden’s foreign policy, which is largely led by a different group of more politically moderate people, has consistently pushed OPEC+ for more output while at least dangling the prospect of more Iranian and Venezuelan output as a possible result of various diplomatic processes. And I do think it would be helpful to integrate Biden’s domestic and foreign approaches and say that in the context of the Russia-Ukraine War, the administration is seeking to increase the output of non-Russian oil, including oil from the United States of America.
Optimistically, moving to directly subsidize domestic production along with reversing prior efforts to squelch domestic output would lead to meaningful economic changes. It’s true that these changes would take time to filter through.
But that’s no reason to delay. Energy prices were a visible problem back in the fall of 2021, and the administration didn’t really want to do much because it wasn’t clear they had tools that were effective in the short term. Given the outbreak of the war and the timing of the State of the Union, I anticipated a big pivot in Biden’s speech, but it didn’t happen. Actions taken back then would have taken a while to pay off but maybe could have borne some fruit by the midterms. Now it may be too late for that, but it’s definitely not too soon to worry about the home heating situation that we’ll be facing in November and December. Wrapping it all up with a windfall tax proposal is a nice way of differentiating a prudent concern for the geopolitical and economic issues from simple industry shilling. And maybe it would help Biden bring some progressives along with him.
At least I don’t. I do think some Democrats in Congress really do want to constrain domestic fossil fuel production as much as possible without saying clearly that’s what they are doing.
"...a potentially devastating blow to the takes industry."
The difference, though, is that a takes-prophet can profit from takes without profit-taking.
However you slice the extra tax, the profit from oil production goes down. That will factor into calculations on whether to drill new wells or use the money in another way. And the introduction of any tax will chill drilling since these are multi-year projects and there will be justifiable fear that any WFP tax will be the first, not the last.