The article below was published on Project Syndicate (see here for the original) and is reproduced here with their kind permission. Project Syndicate is a non-profit organisation that produces commentaries by prominent political leaders, policymakers, scholars, business leaders, and civic activists from around the world, providing analysis and insight to over 500 media outlets worldwide, often for free or at subsidised rates.
By Daniel Litvin (Founder and Senior Partner) and others (see below)
While many households wonder whether they will be able to afford to heat their homes this winter, energy companies are raking in record profits, and governments in a growing number of economies, from the United Kingdom to the European Union, want a cut. Is this an obvious way to appease a public reeling from inflation and help replenish state coffers, or is it market-distorting populism at work?
In this Big Question, we ask Daniel Litvin, Yanis Varoufakis, John H. Cochrane and Isabella M. Weber whether the benefits of a one-off tax on the energy sector’s war-fueled windfall would outweigh the costs.
Yes, if done carefully and in a balanced way. But for governments, this is like trying to walk a tightrope in high winds.
The high winds are the fraught politics of taxes on extraordinary profits – the angry arguments and counter-arguments that typically accompany moves to levy them. On one side, voters fume over apparent profiteering by the companies. On the other, companies cry foul over what they see as arbitrary grabs for their cash and complain that their incentive to invest will be undermined. Amid these political gales, devising a well-balanced strategy is no easy feat, but that is what policymakers must do.
The case for windfall taxes in Europe is strong. The war in Ukraine has caused energy prices to rise far beyond what energy companies anticipated when they made their original investments. Moreover, given the need to combat climate change, reducing fossil-fuel companies’ incentive to make long-term investments is not a bad thing.
Too crude a windfall tax, however, risks deterring investment that is needed in the short term. Europe needs alternatives to Russian gas to keep the lights on and homes warm over the next few years. Renewable energy and nuclear power will be able to make up for only some of the immediate losses. The EU is now also proposing windfall taxes on electricity-generating companies, including those using renewable energy sources. Moves that deter investment in clean energy would be counterproductive in both the short and the long term.
There are ways to craft windfall taxes that reduce these risks. To safeguard investor confidence, such taxes need to be widely understood to be a one-off response to an extraordinary situation. And they should apply only to the share of a company’s profits that represents a genuine windfall. But all this is easier said than done. In the past, governments have taken either an excessively light-touch approach to natural-resource taxation, essentially allowing companies to print money, or an overly heavy-handed approach that discouraged investment. European governments may get closer to striking the right balance now. The tightrope awaits.
Windfall taxes are utterly defensible as levies on unexpected pure rents that recipients did nothing to deserve and that they receive only by virtue of enjoying a position of market power within an economy. The usual criticisms of taxation as market-distorting, price-signal-jamming, investment-deterring state intervention do not hold. No one can argue convincingly against a windfall tax being imposed on an electricity-generating company that uses solar, wind, or hydro power, but suddenly is flooded with cash because the price of natural gas has skyrocketed.
But while windfall taxes are undoubtedly justified, their efficacy is suspect. We know that electricity companies belong to multinational corporations skilled in the dark arts of obscuring their profits through complex intra-organizational (fake) trades. We also know that, unwilling to be content with profits from electricity, they indulge themselves in derivative trades that can wipe out – or seem to wipe out – much of their windfall profits during times like this.
For these reasons, windfall taxes are necessary but insufficient. Governments should aim to prevent the windfall profits from reaching these companies in the first place, by imposing wholesale price caps on non-gas-using electricity producers, which reflect their average cost plus a reasonable net return.
JOHN H. COCHRANE
The one-time “windfall” tax is a recurrent temptation; governments have talked about them every time energy prices have spiked since the 1970s. The tax appears to raise money without discouraging investment, because the investment has already been made. But such a tax is like one drink to an alcoholic: passing this one will cement expectations for the next one.
The message to investors and energy companies is clear. Put up money today. If prices go down, tough. If prices go up, we’ll tax away your “windfall.” Hmm. Maybe you should do something else with your money.
The proposed European taxes are even more hilarious, because they fall on “green” technologies like solar panels and windmills. Perhaps there is poetic justice in the beneficiaries of immense subsidies seeing some of their profits removed, but poetry does not provide good incentives, and good incentives are vital if these are ever to be self-sustaining industries. The United States is on the verge of destroying new drug development with the same bad ideas. It will be a long winter, so let’s carve up that golden goose. Too bad about those eggs next Easter.
ISABELLA M. WEBER
It used to be heresy to connect price growth to profits. Those of us who have been pointing since last year to windfall profits as an important driver of inflation were mocked for being ignorant of the basic laws of economics. By now, however, the idea that profits can fuel inflation has become a respectable view among central bankers like US Federal Reserve Vice Chair Lael Brainard and Isabel Schnabel, an executive board member of the European Central Bank. Nobel laurate economists like Paul Krugman have also acknowledged the link.
As this view has taken hold, so has support for a one-off tax on windfall profits. The British government has already implemented one for oil and gas producers, and the German government is planning to tax “coincidental profits” in the electricity market. And if it were up to United Nations Secretary-General António Guterres, more economies would follow suit: “I am calling on all developed economies,” he recently told the General Assembly, “to tax the windfall profits of fossil-fuel companies.”
This is a welcome change. It opens up the possibility of an understanding of inflation that transcends a purely monetary or macroeconomic perspective. When windfall-profit taxes are used to fight inflation, the implication is that price surges in specific important sectors – rather than overly expansive fiscal and monetary policy – are driving broader price increases.
Excess profits in an inflationary crisis are typically triggered by bottlenecks. If they occur in essential sectors, such as oil and gas, higher prices reverberate throughout the economy. Other sectors then try to cover their increased costs by raising prices; some might even raise prices beyond what is needed, using higher costs as a pretext to bolster their profits. Wage adjustments eventually follow. The cascading effects of upstream price explosions radically destabilize a once-stable system.
As I explained in my recent testimony before a US congressional committee, large windfall profits in essential sectors like oil and gas also have serious distributional consequences. Oil companies, asset managers, financial intermediaries, and ultimately the wealthiest households (which hold the largest shares in fossil-fuel assets) are on the winning side. Poor households, which spend the largest share of their incomes on energy, are the main victims. Windfall-profit taxes can act as a corrective.
Yet windfall taxes are a rather indirect policy tool: firms first acquire the excess profits, then the state must chase them down, collect the tax, and channel the proceeds toward those who have been harmed by the price explosions. Nevertheless, the expectation of effective windfall taxation can also lead to an adjustment in pricing behavior on the part of firms, so that windfalls are reduced. But price caps can often do the same job more directly, because they prevent firms from reaping windfall profits in the first place. This is particularly relevant when the profits are booked by foreign providers, as is the case with oil and gas in many countries. States cannot tax foreign windfall profits.
Price caps could also have positive distributional effects across countries. Guterres rightly calls for rich countries to use the money collected from windfall taxes to help poor countries. But even if governments do impose such taxes, they are more likely to use the revenues to compensate voters for inflation-induced income losses. Internationally coordinated price caps would not rely in the same way on charitable transfers from richer to poorer countries. But even if windfall-profit taxes can be a second-best option, they are still an important policy tool in tackling the current inflation crisis.
Copyright: Project Syndicate, 2022
Please see here for the original article.
Daniel Litvin is Senior Adviser to the executive committee of ERM, the global sustainability consultancy, and a visiting senior fellow at the London School of Economics’ Grantham Research Institute. He is also the founder of Critical Resource, which advises energy and resource companies on sustainability and geopolitical risk, and the author of Empires of Profit: Commerce, Conquest, and Corporate Responsibility
Yanis Varoufakis, a former finance minister of Greece, is leader of the MeRA25 party and Professor of Economics at the University of Athens.
Isabella M. Weber, Assistant Professor of Economics at the University of Massachusetts Amherst, is the author of How China Escaped Shock Therapy: The Market Reform Debate (Routledge, 2021)
John H. Cochrane is a senior fellow at the Hoover Institution.