O'SULLIVAN John headshot

John O’Sullivan is author of The President, the Pope, and the Prime Minister, Adviser to Lady Thatcher, National Review’s Editor at Large, and Commander of the British Empire

In 1979 President Jimmy Carter proposed a windfall profits tax on oil companies as part of his overall “strategy” for dealing with the energy crisis. I was then editing Policy Review magazine in Washington and in January 1980 we published a critique of the proposal by the former U.S. Treasury Secretary William E. Simon. In fact the article was written by me, with some help from my deputy Phil Lawler. Bill Simon liked the piece and made no changes in it at all. He was happy to be associated with the arguments we had made; Phil and I were happy because a piece by a big name would attract greater attention to our magazine – which it did. Everyone was content.

Carter never got his tax through. Later in 1980 Ronald Reagan was elected, and he immediately launched a policy based on freeing up energy prices that was the precise opposite of Carter’s but that followed quite closely the logic of our article. It produced a fall in oil and energy prices that led inter alia to a boom in the world economy that lasted a quarter of a century (with two short and shallow recessions.) The idea of a windfall tax on energy prices sank beneath the waves of cheap oil.
But you can’t keep a bad idea down. Emerging in the role of the Jimmy Carter of 2013 (quite plausibly in my book), Sir John Major has come out fighting for a windfall tax on energy companies. When I looked back on my old Policy Review article, I was surprised by the degree to which Sir John has made it topical again. So, with only the most minor of editing changes, here it is:
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Tilting at Windmills
“There are ten thousand stout fellows in the streets of London ready to fight to the death against Popery,” observed Dr. Johnson, “Though they know not whether it be a man or a horse.” A similar state of affairs reigns in Washington, D.C. There are ten thousand stout fellows in the Carter Administration ready to do and dare against windfall profiteering in the oil industry – though they know not whether it be a man, a horse or, as I will argue here, a dragon (which is to say, a mythical beast).
Look first at the economic history of the notion. According to Arthur Seldon, the author of that indispensable little guide, the Everyman Dictionary of Economics, it was Keynes who invented the term “windfall profits” to describe those entirely unforeseeable economic gains which accrue to people as a result of inflation. Here is a Keynesian argument which contains a good deal of truth. Inflation is a mixed curse. Not only economically and socially disruptive in general, inflation also inflicts disproportionately severe hardships on some groups and confers actual economic advantages on others. It does so, moreover, in an arbitrary, capricious and unforeseeable fashion.
Debtors, for instance, benefit from inflation, which reduces the real cost of repaying debts. So do owners of those forms of property which rise in value as investors desperately seek a hedge to shelter them from the inflationary whirlwind. Houses and objets d’art are usually safe investments against inflation – but not invariably. Hence, they too have an arbitrary windfall element in their gains. On the other hand, creditors lose by being paid back in a devalued currency. In effect, they have been paying the debtor for the privilege of lending him their money. Savers of all kinds also suffer, especially holders of fixed-income securities. And those entering the housing market for the first time find that house prices have risen so steeply that their down-payments are just about adequate for purchasing a converted tool shed.
Inflation, then, rewards some with windfall profits and burdens others with windfall losses. If a government were seriously intent on correcting these inflationary inequities created by its own monetary incontinence, it would have to introduce a complex indexed network of differential subsidies and taxes to compensate some and punish others in proportion to their ever-changing financial gains and losses. This is clearly an administrative impossibility.
Yet, even if it were a simple book-keeping transaction, politicians would steer well clear of it for the obvious reason that the government is the biggest windfall profiteer of all from inflation.
The trick is worked thus. Taxpayers, whose incomes rise in line with inflation, are no better off in real terms. But their rising paper incomes push them into higher tax brackets so that they pay in tax a larger percentage of the same real income. Corporations too – including the oil companies – find that inflation has reduced the real value of allowable depreciation provisions. Add together all of the taxes which have been silently increased by inflation in recent years and you will find that the total figure amounts to a substantial extra sum in government revenue. Milton Friedman estimated that the government’s total revenue from inflation amounted to more than $25 billion in 1973 alone! And other studies have suggested that inflation-induced tax increases could add $50 billion to its citizens’ tax bill by 1980. So a tax on the government’s own windfall profits (i.e. a tax reduction) would restore large sums to all classes of taxpayers (again, not excluding the oil companies).
The Element Of Chance
So much for the windfalls of inflation. In a wider, more colloquial sense, however, the term has come to mean any undeserved and unexpected surplus of income over costs. But how are respectable profits distinguished from the windfall  sort?
Let us look at two hypothetical and contrasting success stories. Suppose that you wake up tomorrow morning with a vision: the accurate blueprint for a revolutionary new automobile engine that multiplies gasoline mileages several fold. Your invention is quickly put into production, enabling hundreds of thousands of drivers to enjoy Cadillac comfort at Pinto prices. Naturally, your line of cars sells as fast as your assembly line can produce them. As the inventor holding  the patent, you become fabulously rich. What shall we call the riches you acquire? Quite obviously, they are the profits of ingenuity, application, hard work and enterprise.
Now, take a slightly different case. Suppose that you are working in your garden, planting tulip bulbs, when suddenly your trowel strikes a massive oil deposit – a real gusher. Again, in short order, you become rich.
What is the difference between the two cases? In each case you would reap fantastic profits over a short period of time. In each case you would reduce American dependence on imported oil, thereby easing our balance of payments worries. Whether by making more gasoline available or by reducing motorists’ consumption of fuel, you would be aiding the consumer. Society would benefit equally from both contributions. But in one case, your rewards would come as the fruit of your own ingenuity; while, in the other case, they would apparently be the result of pure, blind, dumb, senseless luck!
In all probability, your neighbors would be proud of you in the first instance, resentful in the second. If the public approves of the manner in which you acquire your riches (as it smiles upon the fabulous incomes of athletes and movie starlets), then the money you earn is regarded as rightfully your own. If the public frowns on your business or doubts your moral claim to deserve the level of rewards, then your income is disparaged as “windfall profits.”
Yet this distinction is based upon a fundamental confusion. As the egalitarians themselves argue when it suits them, we are simply unable to identify and separate the distinctive contributions of luck and merit to economic success. Both play a part – but a different part in each individual case.
Luck, for instance, covers more than merely discovering oil wells with a trowel. It is responsible for much that is most personal and individual about us. There is no merit in being born with the kind of figure that wins the Miss Universe contest or the kind of brain that picks up Nobel prizes. From the moral standpoint it is merely a matter of chance. Of course, merit enters at some stage. Some put advantages to good use; others allow striking figures to run to fat or waste high intelligence searching for an infallible system to break the bank at Monte Carlo.
Nor is meritorious endeavor enough on its own. There are decent people who work hard all their lives but never prosper because God endowed them with average or inferior abilities. Even in what seem the clearest cases of poor-boy-makes-good, therefore, we have no way of disentangling, let alone measuring, the relative importance of personal effort, inherited ability, the helpful or damaging influence of other people, or any of the innumerable factors that might just determine success or failure in the individual life.
The concept of windfall profits is weakened even further if the element of foresight is introduced. Some people profit from their acute business savvy, their ability to predict fortuitous market conditions. Now, conscious accurate prediction surely reduces the purely chance windfall element in their reward. But does the mere exercise of intelligent speculation, which may profit from price changes without affecting them, make a man as deserving as our gasoline engine inventor? Does it make him more deserving than our lucky gardener? Indeed, would the gardener’s profits be less of a windfall if he had chosen his house partly because of rumors that the surrounding land was oil-rich? Suppose, too, that he had paid more for the land because of these rumors. Would not his windfall profits then be the reward of risk capital, namely the extra element of the house price? And if so, would they not be more “deserving” and justifiable – though bringing no greater benefit to society? On the other hand, would the speculator be more deserving of a high income if his speculation happened to improve the workings of the market by smoothing out price fluctuations?
Who can answer these questions at all satisfactorily? Only God has the comprehensive information required for making judgements of that order.
A capitalist economy makes no attempt to pursue such distinctions. Income is not taxed on a scale according to the abstract, unknowable merits of the earner. Instead, anyone who generates wealth is entitled to keep his fair share after paying the level of tax levied on everyone else. The prospect of reward stirs people to take initiatives – and the prospect of unusual reward prompts daring people to take unusual initiatives.
Our present prosperity is based upon those incentives
We cannot therefore pass judgement on the windfall element in individual success. But can we perhaps ascertain whether certain economic activities as such inevitably lead to undeserved windfall gains? There is a school of thought which has long argued that possession of a scarce and valuable resource can yield windfall profits if its supply cannot be increased in response to price changes. An opera singer’s voice and rising land values are the textbook examples.  As Mark Twain put it, “Buy land, my boy, they’re not making any more of it.”
In this context, the phrase “windfall profits” means any profit that cannot be justified socially as bringing supply and demand into balance. Yet, taking these textbook examples, it can be shown that there are no goods – not even land itself – in fixed supply. If the price is right, land can be manufactured. Is not much of Holland land reclaimed from the sea? And until environmentalists stymied the plan on behalf of rare geese, the British Government was proposing to build the third London airport at Maplin, at present a sandy sea marsh. Nor is land as such even in short supply. There is enough jungle, desert, arctic waste and malarial swamp in the world to house all humanity, allowing ample elbow-room several times over. What people mean when they lament the shortage of land is that land of a certain kind or usage is in short supply in a particular locality. But this problem can be solved easily enough by changing the existing land use. Agricultural land can both be reclaimed from the desert by irrigation and rezoned for building development.
To illustrate this point, let us again take a hypothetical case. A leafy suburb, far from the madding crowd and so inhabited by Friends of Humanity with Volkswagen beetles and a taste for granola, is surrounded by land zoned for agricultural purposes only. Because people wish to move into this desirable but artificially restricted neighborhood, the price of both land and houses soars to windfall levels. Eventually, permission is sought and obtained for nearby land to be zoned for building. At once the land values in the suburb fall sharply as more land comes onto the market and reduces the artificial scarcity. Meanwhile, the rezoned farmer’s land increases rapidly in price as restrictions are lifted which, until now, have held its value artificially low.
What has actually happened in this example? The farmer has been suffering a windfall loss for years – and only now is he able to obtain the true market value for his property. But that is not how the matter appears to the Friends of Humanity. Perhaps irritated by the fall in value of their principal capital asset, they rage that the farmer has been granted an ill-gotten windfall profit, namely the rise in land value “created” by the “community” when it rezoned his land—i.e., when it finally gave him the right to use his own land for his own purposes). Land is therefore not in fixed supply. And any windfall profits which seem to accrue from its possession are really the result of government restrictions on land use.
But before we leave this topic, what of the popular opera singer’s voice? Well, if the price for her kind of sound were set high enough, she could sing more, multiply her performances greatly by the use of films and recordings, and encourage the production of near-substitutes by training pupils to sing as nearly as possible in her distinctive style. Her profits would now be much greater than before – but they would not be windfall profits in the sense described above because they would have elicited a cataract of arias to the delight of opera lovers and the irritation of their neighbors.
Whose Windfall? Whose Profit?
We are thus led to a series of agnostic, commonsense conclusions. The first is that all profits and all losses contain a windfall element – the windfall usually being an unanticipated consequence of government action. Thus, Chrysler would not be in such dire straits if the government had not added to its costs by imposing extravagant safety and environmental standards for automobiles. Secondly, it would be extremely rare for any profits or loss to be attributable wholly to windfalls. Certainly, Chrysler cannot make this claim since American Motors, a company of similar size, actually achieved an economic recovery during the same period of regulationitis. Finally, we have no way of knowing precisely how big the windfall element is in any particular gain or loss.

The conclusion that all profits of their nature contain a windfall element would be supported by textbook economists on slightly different grounds. For they agree that all profits reflect an element of risk which itself reflects the element we call uncertainty, the unexpected, or chance. Were that not so and a very high profit on, say, offshore oil could be absolutely guaranteed, then investors would flock to put their money into it. In so doing, they would greatly increase demand for underwater equipment, oil drilling platforms, divers, skilled geologists and all the factors needed to move the oil from under the sea to the gasoline station. The price of all these goods and services would therefore rise – the process only stopping at the point where the cost of additional investment capital equalled the return expected on the investment. Therefore, in the absence of uncertainty and windfall chance, there would be little or no profit at all after a brief interval.

All in all, the case for singling out certain profits as unjustifiable windfalls and consequently subjecting them to disproportionately heavy taxation is thin to the point of invisibility. Insofar as it has any substance at all, it implies that the government has a duty to compensate people for windfall losses, notably those resulting from its own misguided interventions, and to restore to the community the windfall gains it has itself made from inflation with taxation.

As for the specific argument for a windfall profits tax levied solely on the oil industry, that is simply a hole in the air. It has no substance whatever. If windfall profits exist throughout the economy either in undiluted form or, as I have argued, as an element in almost all incomes, what possible justification is there for singling out a particular class of taxpayer and exacting a levy from them alone? This is discriminatory and unjust—no different in principle from an sdministration deciding to levy a higher rate of income tax on labor union members on the grounds that their union-negotiated wages contain a windfall element based on excluding non-union members from the factory. Indeed, for the analogy to be absolutely precise, the extra tax would have to be limited to members of a particular union, selected merely because of its temporary political unpopularity. Even in such circumstances, a tax of that character would produce an outburst of protest. But because businessmen shrink from political conflict and controversy, there is little concern publicly expressed at this manifest instance of injustice directed at the oil companies.

And what is the likely consequence of this discriminatory tax? At a time when investment in all forms of energy is imperative, potential investors have been warned to stay away from the oil industry. The proposed tax is a declaration that profits from oil will be treated not more favorably, but more harshly, than profits from all other industries and services. Since other industries use more energy than they produce, this amounts to a policy of investment incentives directed to creating and maintaining our energy shortage!

Much of the political momentum behind the proposed tax, of course, comes from the feeling that it is somehow immoral for the oil companies to make large. profits as a direct result of damaging actions by foreign governments and OPEC. Hence the demand that the companies should not “rip off the American people’’ and so on. We are here in the presence of great rhetorical and logical confusion.

 First, a congressman denounces the oil companies for their wickedness in making vast windfall profits and threatens them with the punishment of nationalization. It soon becomes clear even to him, however, that it is absurd to blame a company for the windfall accident of seeing its profits rise because foreign governments increase world oil prices. After all, what is a virtuous oil company to do in these circumstances? Is it supposed to pay a voluntary tax over and above the regular and corporate taxes? And if so, would not all citizens be equally obliged to pay voluntary taxes if they enjoyed some windfall gains – say, at the races? But a congressman at once sees the difficulty of explaining this at election time and so moves on to a new tack.

So, second, he denounces the oil companies for deliberate collusion with OPEC and each other in raising prices. Little hard evidence has been produced to support these dark suspicions. And that is not surprising since the oil industry’s profits are not out of line with other industrial profits in the U.S. Over the period 1968-78, fully half of which includes the period since OPEC quintupled oil prices in 1973, the oil companies show a rate of return on capital of 13.7 percent compared to a manufacturing average of 13.5 percent. Those industries which have enjoyed much larger profits include broadcasting, publishing, soft drinks and cosmetics. And, if there were incontrovertible evidence that the oil giants were colluding with OPEC and each other, the government could take advantage of the laws in existence which prohibit such commercial arrangements. That it does not take this obvious step is surely an eloquent comment on the truth of its rhetorical accusations.

For a windfall profits tax is the worst possible response to a cartel. It amounts to accepting the cartel as a permanent economic fixture and tolerating the “rip-off” it enjoys from artificially high prices on the condition that the government gets a share of the swag.

Frustrating Market Forces

Of course, in the short term, oil profits do rise when OPEC increases its prices. But an increase in profits for the suppliers (and potential suppliers) of a suddenly scarce commodity should be welcomed. Only when profits rise can companies be sure of raising the immense amounts of capital necessary for new exploration and devolopment. Only then will outsiders be given the incentive to undertake the substantial costs of entering the oil business. So, the faster profits rise, the faster new oil will come into the market and the faster OPEC’s stranglehold will be removed. A tax will hinder this beneficial process, either slowing down energy independence or making the consumer pay more for it. In other words, it is Big Government which is ripping us off, not Big Qil.

There is another fundamental problem with the windfall oil profits tax—how is it to be calculated? Presumably it must be based on some estimate of the windfall element in oil profits (which, as we have already seen, is impossible to calculate). Sophisticated defenders of the notion and President Carter argue that it will be a levy on that part of the profits from deregulated oil prices that can be ascribed to OPEC’s cartel activities. It will, so to speak, be a levy on the difference between the actual deregulated market price and the Platonic ideal of the market price as if OPEC had never been invented.

But that can be no more than a guesstimate, an arbitrary figure plucked from the air, a gleam in President Carter’s eye. So, in practice as compared to sophisticated theory, the tax will simply be a levy (of 50 percent in President Carter’s proposal, 60 percent as passed by the House and goodness knows what in the end) on any rise in oil prices since President Carter spoke (without any fussy inquiries into whether the rise is due to cartel activity or market conditions.)

In Forty Centuries of Wage and Price Controls, Robert Schuettinger and Eamonn Butler have surely exploded the myth that government enjoys a superior wisdom that enables it to second-guess the market successfully. The first results of this policy are shortages, queues and a flourishing black market.

In this instance, the first result of holding down oil profits while prices are rising would be to cut the automatic link between higher prices and increases in supply. It would reduce the profits available for exploration and discourage entrepreneurs from embarking on the risky business of discovering new oil fields. New oil would be less profitable and so less likely to come into the market.

The second result would be to make existing known oil fields, which are on the margin of profitability, simply not worth exploiting. In recent years, the British have discovered that OPEC’s raising of world oil prices has transformed just such marginal oil fields into handsome investments. By introducing a windfall profits tax on such fields, however, the U.S. Government would achieve exactly the reverse. However high oil prices soared, the level of profits would be held down with the result that many oil fields worth developing at the then reigning price would be left pleasantly undisturbed. Thus, “old” oil would also be less likely to come into the market.

Who would benefit from this? Environmentalists would be pleased, of course, and those environmentalists living in warm climates would be pleased long-term. So would OPEC, since alternative oil, now theoretically profitable at prevailing world prices, would not actually come into the market and reduce the world oil price by increasing supplies. But the American consumer would be actually worse off. He would be paying higher prices but still sitting in the gas lines which higher prices are usually allowed to banish. Demagogues, however, would flourish – denouncing oil companies for the shortages, caused by misguided government intervention, and demanding more government intervention to cure them.

Then, no doubt, we would have inflicted on us the secondary consequences of intervention in the market – namely, a growing bureaucracy, controls that extend to more and more features of economic life, increasingly severe penalties to enforce them, and, finally, the seizing up of the economic system – at which point the whole apparatus would be removed and economic life could begin again.
Ironically, President Carter’s oil strategy contains some of these disasters built-in from the start – notably new bureaucracies in the form of the Energy Mobilization Corporation, with powers to override the objections of lesser bureaucracies and to disburse vast sums of public money on bright ideas about synthetic fuels and new sources of energy. The more one examines President Carter’s notion of using oil windfall profits to finance a new energy independence, the more illusory, nonsensical and self-destructive it appears.

Of course, to advance the argument that two plus two equals four in the vicinity of the White House today is to risk being denounced as a tool of the big oil corporations. But the new McCarthyism of the anti-business culture should not prevent public men from declaring that nonsense is nonsense is nonsense. Nor should the present political unpopularity of the oil companies—an unpopularity often based on economic illiteracy and scare-mongering—allow us to treat them with manifest injustice. We should remember Chief Justice Jay’s dictum: “Justice must always be the same, whether it is due from one man to a million men or from a million to one man.”

41 comments for: John O’Sullivan: Windfall taxes. A bad idea then. And a bad idea now.

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