Jerry Taylor and Peter Van Doren
08/01/06
Political calls to levy windfall profits taxes on the oil industry are counterproductive for two reasons. First, they threaten to institutionalize a form of one-way capitalism in which investors are allowed meager profits but more robust earnings are punished. Who would want to park their money in an industry like that? If investors are discouraged from putting their money into the oil sector, where is the capital going to come from to put more oil and gas into a resource-starved market?
Second, the United States already has a corporate income tax in place to harvest a share of those “windfall profits,” regardless of which sector produces them. Any policy that subjects income from particular industrial sectors to more onerous taxation because they are the villain du jour is bad public policy. In essence, it gets the government in the business of allocating capital to different sectors of the economy and sets up incentives for rent-seeking behavior on the part of corporations and their political patrons.
Yet angry calls for taxing the “obscene” profits of Big Oil continue. The truth is, however, that oil company profits are not that impressive when compared to the size of the companies in question. Consider ExxonMobil, for example, the largest and most profitable public oil company in the world. Its most recent quarterly earnings statement reports a staggering $10.3 billion in total quarterly profits. But if you divide ExxonMobil’s net income by sales, we discover that the company reported a 10.7 percent profit margin in the fourth quarter of 2005. That is probably a bit above the U.S. industrial average, but it is hardly remarkable. For example, the nation’s most prominent critic of “oil profiteering,” Fox News personality Bill O’Reilly, works for a company (News Corp.) that reported a 10.2 percent profit margin during that same quarter. If you are after big earners, check out Yahoo (a 45.5 percent profit margin), Citigroup (33.4 percent), Intel (24 percent) or Apple (22.7 percent).
Returns on invested capital over a longer time frame are even more telling. Analysts at Goldman Sachs found that returns on investment capital in the oil and gas sector from 1970 to 2003 were less than the U.S. industrial average over that same period of time.
Nevertheless, advocates for a windfall profits tax contend that gasoline markets are not competitive, that fat profit margins induce little more supply than might otherwise be induced by “reasonable” profit margins, and that such huge profits are largely unanticipated and unearned. Windfall profits taxes, they maintain, would simply redistribute wealth from producers to consumers without any significant effect on supply.
That is exactly what we were told 26 years ago when Congress passed the Crude Oil Windfall Profit Tax in April 1980. It turned out, however, that economic incentives did indeed matter. Because the windfall profits tax made investment in domestic production less attractive than it otherwise would have been, empirical analysis by economists at the Congressional Research Service found that the tax reduced domestic oil production by 3 to 6 percent and increased foreign oil imports by 8 to 16 percent.
The charge that market concentration has allowed oil companies to gouge consumers is laughable to anyone even passingly familiar with the industry. Corporate oil executives do not plot in back rooms what to charge at the pump. Instead, they tie wholesale fuel prices to prices in the nearest spot market plus transportation costs. After they sell their gasoline to retailers based on those contracts, your local service station owner decides what prices to post.
Analysts have produced a mountain of studies investigating the impact of recent mergers and acquisitions in the oil sector and gasoline prices—all save two find no evidence that the former has had any impact on the latter. The two that found to the contrary (published by the U.S. Government Accountability Office and two economists from the University of Texas) report that gasoline is only a penny or two more expensive per gallon than it would have been absent industry consolidation.
Entertaining the idea of a windfall profits tax is akin to a 3-year-old entertaining the idea of once again putting his hand on a hot stove. The difference, however, is that a 3-year-old apparently learns his lessons quicker than your average politician or consumer advocate.
 | Jerry Taylor and Peter Van Doren are senior fellows at the Cato Institute. |