Windfall Profits Tax Redux

Senators Elizabeth Warren (D-MA) and Sheldon Whitehouse (D-RI) are pushing for a new windfall profits tax on petroleum. This will essentially reinstate the Carter-era legislation enacted in response to the second oil shock in 1980. Since Congress is considering and will be debating a policy which was actually implemented in the past, the first question to ask is how well it worked the first time. The answer is not well at all. Not just bad, but God-awfully bad.

The energy crisis started in 1973, when some Arab OPEC members wanted to punish the US and our allies for supporting Israel in the Yom Kippur War. Although over the longer term, this war’s major geopolitical results were Egypt’s leaving the Soviet orbit and regaining the Sinai Peninsula, ultimately resulting in peace and normal relations between Egypt and Israel. In the early days of the conflict, an oil embargo seemed the one thing Arab oil producers could do to show solidarity with Egypt and Syria. The embargo directly affected Europe and Japan, which imported most of their oil from the Middle East, impacting the US less directly. Then as now, the US produced most of its oil domestically. By cutting off most of our allies’ traditional and cheapest oil supplies, the embargo shifted European and Japanese demand to the rest of the world supply, including US oil, driving up the world price.

Loose monetary policy under the Johnson and Nixon administrations had already resulted in high inflation, and President Nixon had imposed his infamous wage and price controls. Though price controls caused product and commodity shortages across the country, they were initially  highly popular and contributed to Nixon’s landslide reelection in 1972. The 1973 embargo caused the world price of oil to rise from $3.00 per barrel to $12.00. In the US, the retail price of gas rose about 30 percent, peaking above $0.50 per gallon, though it would have gone higher without price controls. After Nixon was reelected, price controls for most goods were allowed to lapse, but they were kept on retail gasoline.

Although $0.55 per gallon for gas sounds cheap to us today, not only was this a punishing price increase at the time, in the seventies most cars also had very poor fuel economy by today’s standards. Few full-size cars could get even 20 miles per gallon, and many luxury cars still got less than 10 mpg. The resulting gas shortages were widespread, and Nixon’s price controls made them worse. A number of states implemented odd-even rationing, where cars with even-numbered license plates were only permitted to buy gas on even-numbered days, etc. This caused motorists to waste 150,000 barrels of scarce oil daily while waiting in line to buy gas.

Then in 1979 the Iranian Revolution overthrew the Shah and disrupted Iran’s oil production, starting the second oil shock. To make matters worse, Iraq invaded Iran in 1980, also cutting off much of Iraq’s oil production. The world price of oil reached nearly $40 per barrel, with retail gas prices in the US often exceeding an unprecedented $1.00 per gallon. Gas prices continued to rise steadily until 1983. President Carter was trying to push energy deregulation legislation through Congress, but the rapidly increasing gas prices of the second oil shock made that more difficult politically. The compromise was to deregulate prices in stages, but in exchange he had to support the Crude Oil Windfall Profit Tax Act of 1980. The exceptionally convoluted tax applied to the difference between the actual sale price of US crude oil and a somewhat arbitrary removal price—the 1979 base price of crude oil adjusted for inflation and state taxes.

Since the government would capture between 15-70 percent of any oil revenue above the adjusted 1979 price, imported oil was significantly cheaper than domestic, which shifted much of US demand from domestic to foreign sources. Moderately higher market prices for crude oil would have given producers an incentive to drill new wells and reopen wells that had been capped when prices were still low. The windfall profits tax prevented any real expansion of US domestic production, and because the tax artificially limited domestic supply, oil prices rose farther and faster—and stayed higher longer—than they would have without this extraordinarily ill-considered tax. Lots of domestic oil that could have been pumped from existing wells was simply left in the ground, effectively saving it for later, and very few new wells could be drilled given the unfavorable tax treatment, because the tax ensured that any oil new wells produced could not be sold at anything like a competitive price.

Even the name “windfall profits tax” is a misnomer. It is not a tax on profits, or even on the increase in profits due to an increase in the market price. Instead it is an excise tax on each unit sold, computed as a percentage of the change in the selling price above an arbitrary reference price. If the price increase results in lower revenues for the seller, that’s just too bad for them, but it will also cause a decrease in production. The rationale was simply to penalize oil producers, who were seen as benefiting from the energy crisis, almost like war profiteers. The tax did nothing to increase the supply—instead it reduced both the supply of domestic oil and tax revenues. Price increases in retail gas were borne by consumers, with the poorest consumers hardest hit.

Because the windfall profits tax shifted demand to foreign producers while limiting domestic oil output, it provided a true windfall to our OPEC trading partners, not just at the expense of US consumers, but motorists and consumers throughout the world. American producers who could have helped satisfy some of our oil demand were prevented from doing so by the ruinous excise tax, which foreign producers did not have to pay. We might just as well have raised US taxes to finance foreign aid, though in this case the benefits went to some of the least needy beneficiaries imaginable.

The price of petroleum has a broad and major impact on the economy, because oil, and electricity generated from oil, are needed to produce a wide variety of products. Most modern plastics are petroleum-based. Modern steel mills are generally oil-fired, and though the most advanced arc and magnetic induction furnaces may not use oil directly, in many cases the massive amounts of electricity they use are generated from burning oil. The same holds for turning bauxite into aluminum, a process which also requires lots of electricity.

Furthermore, even when the manufacturing process is not oil intensive itself, the finished products still have to be transported to the final user, on trucks, trains, or ships, all of which burn petroleum products. Even a relatively minor increase in the price of oil can trigger a recession, something we saw in 1973-1975, 1980-1982, and 1990-1991. Allowing markets to function, and permitting producers and consumers to substitute cheaper goods and technologies for more expensive ones can alleviate or prevent a recession, but mandating wage and price controls, and penalizing the producers of badly needed goods, keeps them from meeting market needs, and can only worsen and prolong a recession.

Supply and demand for oil are not very responsive to price changes in the short run. Once you buy a gas-guzzling vehicle, in the words of playwright Arthur Miller, “It’s furniture and you’re married to it,” at least for a few years. Your choice of how much to drive is the only margin on which you can make adjustments in the face of higher gas prices. Producers can drill more wells and uncap old ones that were too costly to pump from when the price was lower, but they can’t do this right away. As time passes, producers can make adjustments to increase supply, such as drilling new wells and reopening closed ones, or employing new extraction technologies like hydraulic fracturing.

Similarly, given enough time, consumers can make adjustments to decrease demand by buying more fuel-efficient vehicles. Together these natural market adjustments help moderate extreme price increases, though they take some time to work. Government intervention like windfall profits taxes keeps market participants, both producers and consumers, from acting to moderate extreme price changes on either the supply or the demand sides. It’s a proven strategy for making a bad situation worse.

Originally published by the American Institute for Economic Research. Republished with permission under a Creative Commons Attribution 4.0 International License.