Some in Congress are calling for a so-called "windfall profits tax" on oil companies in a misguided belief that they are “gouging consumers” during the most recent rise in global oil prices. The premise that a higher tax on oil companies would reduce gasoline prices for American consumers, however, defies the laws of economics and history.
In reality, higher taxes on oil companies would have no near-term effect on prices at the pump and would actually raise gasoline prices in the long term because it would lead to reduced oil and natural gas production.
And to be clear, experience demonstrates that windfall profits taxes are a bad idea when applied to any industry as they have been shown to hurt American consumers and workers while failing to meet the objectives of their proponents.
Windfall profits tax failed before
In 1980, President Carter enacted a windfall profits tax on the majority of oil produced in the U.S. The non-partisan Congressional Research Service found that this punitive tax led to domestic oil production declining by as much as 8% and imports increasing by a whopping 13%. By making production more expensive at home, the country turned to cheaper imports, undermining efforts to make the country more energy secure following the Arab oil embargoes and resulting oil crises of the 1970s. This tax left the U.S. much more vulnerable to the whims of rising petrostates like Russia and was repealed in 1988. It was a bad idea then, and it’s a bad idea now.
Oil is a cyclical industry
Global markets set the price of crude oil, and those markets are influenced by many factors. Basic supply and demand is the most important one. When global demand for gasoline goes up, the price of oil rises. When demand falls prices also fall. Supply matters as well. When more supply comes online, prices decline. When supply is constrained, they rise.
The nature of the oil industry is one of cycles. As with any commodity, when market forces drive prices up and supply is slow to respond, producers benefit through higher profits – for a time. Conversely, when those same forces work to drive prices down at other times, producers suffer as fixed costs remain constant, and for oil companies those fixed costs are immense. The fact that the oil industry can be subject to rapid changes in fortune is well-understood by the businesses and their investors. They accept the risk of lean times for the benefit of those periods when prices are higher. So it is unreasonable to ignore that the pendulum swings both ways. A windfall profits tax would not change the demand for oil, but it could prevent producers from recovering the costs of new production.
Market dynamics would be much simpler if supply and demand were the only determinants of price. However, global events also play a major role because they can dictate major changes in both supply and demand. When geopolitical affairs are unsettled, as we are seeing with Russia’s invasion of Ukraine, prices tend to rise based on the uncertainty and risk created. In addition, policy choices can artificially constrain energy production, such as halting needed pipelines, failing to hold lease sales, or pressuring banks not to finance oil and gas projects.
Oil companies must respond to swings of the market in the near term and plan accordingly to maintain an average profitability for shareholders over the long term. Like all commodities, the oil business can be risky. With so many unknown and uncontrollable inputs, it is extremely difficult to forecast the price of oil. If oil companies’ forecasts are off too much, the entire business could be at risk. But risk is usually paired with reward. It is the potential for reward that allows oil companies and their shareholders to assume the risk of bust periods.
Prices would not go down, but production would
The current rise in oil prices, which drove increases in gasoline prices, is caused in part by surging demand as the world recovers from the COVID-19 pandemic during a time of tight global oil supplies. The tight supply was driven in part by how far oil prices fell during COVID and the fear that a resurgence of the virus could lead to a similar falloff in demand. Supply chain disruptions and workforce shortages have also hampered industry’s ability to increase production more quickly.
Geopolitical instability is the other major factor driving prices higher. The Russian invasion of Ukraine is driving prices higher because Russia is a major producer and exporter of oil, providing roughly 10% of global supplies before the invasion, and sanctions and bans have removed a significant portion of those exports from the market.
While prices can be expected to recede when these factors improve, some are predictably seeking to punish oil companies by taxing the higher profits they are earning in the misguided belief that such a tax would lower gas prices. It would be the first time in history higher taxes lead to lower prices.
In the long term, a windfall profits tax would raise prices because it would reduce production of oil and constrain supply. It would do so by reducing the reward investors could hope to earn. A windfall profits tax would reduce the returns because it would do nothing to lessen the significant risks investors would take, meaning less investment would flow to the oil industry. Less investment would mean less exploration and less supply coming in the future. It is as straightforward as that.
Profit cyclicality is not exclusive to the oil industry. Other industries experience it too, whether because they are tied to commodities, or because of breakthroughs that cause profits to rise, or other factors. Investors weigh these ups and downs for these industries similarly to the way they do with oil companies. A windfall profits tax is terrible precedent that would have a similar negative impact on investment in the targeted industries. American consumers and workers would miss out on important new products and breakthroughs that would enhance their lives because of reduced investment.
The right approach
U.S. producers have led the world in innovation and environmental protections, which has made the us the largest oil and natural gas producer in the world while having one of the lowest carbon intensities from oil and gas production. To encourage more production at home, the administration should immediately end its ban on leasing and permitting on federal lands and finalize a new offshore energy development program. Additionally, new critical energy infrastructure is necessary to transport the abundant sources of oil and natural gas U.S. reserves around the nation, and to our global allies.
About the authors
Curtis Dubay
Curtis Dubay is Chief Economist, Economic Policy Division at the U.S. Chamber of Commerce. He heads the Chamber’s research on the U.S. and global economies.
