California could impose new ‘windfall’ tax on oil companies. Here’s what it might look like

The windfall tax probably won’t raise or lower gas prices, says Severin Borenstein, an energy economist at UC Berkeley, but it would be “very difficult to actually implement.”

Policymakers must decide exactly how much profit constitutes a windfall. “Beyond what level do we say, ‘This is too much profit and we’re going to tax it?'” he said. The United States temporarily adopted excessive taxes on profits during World War I, World War II, and the Korean War, with mixed results. When the US government massively increased spending during World War I, some companies saw their profit margins increase. So the government began taxing the profits of all industries above a certain return on investment, which eventually yielded about 40% of the tax revenue collected for the war.

But because taxes were complicated, well-paid lawyers at big firms could use “creative play” to lower their employers’ taxes, while small firms without a phalanx of lawyers bore more of the burden, said Joe Thorndike, the office’s director. Tax history project at Tax Analysts.

“These taxes, more than most, really depend on a moral argument, a moral justification, to exist, and when that starts to break down with these failures of justice, that’s really a problem,” Thorndike said.

The idea was revived in 1980 when the federal government was about to loosen price controls on US-produced oil. That year, Congress passed a windfall tax aimed at oil industry profits. Thorndike said the idea was that companies would profit massively when oil rose to market price, and the process would be expensive and painful for consumers. However, this tax was not a tax on profits, but rather a system of excise taxes on petroleum, according to a report by the Congressional Research Service (PDF).

It wasn’t a smashing success. During the eight years it was in effect, it brought in $80 billion — far less than the $393 billion Congressional researchers estimated it would generate. Because the tax applied only to U.S.-produced oil, it likely reduced domestic production while increasing the country’s dependence on foreign oil, congressional researchers found. It was also difficult for the Internal Revenue Service to administer and difficult for the oil industry to comply with. It was therefore abolished in 1988.

Europe takes an unexpected toll

As energy prices have soared in Europe and the UK, local leaders have also opted for windfall taxes. Greece, Hungary, Italy, Romania, Spain and the United Kingdom have introduced their own, and six other countries have indicated their intention to introduce similar taxes, according to a September analysis by The Tax Foundation. At the end of September, the European Union agreed on an unexpected tax on oil and gas profits.

Different countries have taken different approaches. For example, Hungary taxes a wide range of industries, from oil producers to renewable energy companies to pharmaceutical companies, while the UK taxes the country’s oil and gas companies. Italy saw much lower revenue than expected, apparently due to tax non-compliance by Italian energy companies.

Because these taxes in Europe are so recent — and because they’re temporary — it’s hard to say what impact they will have, said Sean Bray, an EU tax policy analyst at The Tax Foundation.

Here in California, Borenstein, an energy economist from Berkeley, hopes the Legislature will use the special session to discuss what he sees as the Golden State’s “fundamental problem” when it comes to gas: figuring out how to maintain sufficient supplies as long as the state. it uses a cleaner mixture of it and tries to phase out the use of fossil fuels.

“We’re completely ignoring this issue until there’s a big price increase,” Borenstein said. “And then everyone runs around screaming how outrageous it is, instead of actually having a serious political discussion about what the right way to deal with it is.”

So how would it work?

Details are reserved at this time. But the basic idea is that companies that mine, produce and refine oil would pay a higher tax rate each year on their earnings above a set amount, a spokesman for the governor said. Money raised by the tax would be sent through refunds to “California taxpayers affected by high gas prices,” a spokesman for the governor said in an email.

The logic behind windfall taxes is to tax a company at a higher rate when they make huge profits – “windfalls” – for some reason not their own doing.

There’s also often a moral dimension to the thinking, said Kirk Stark, a tax law professor at UCLA. In theory, taxing extremely high profits at an extra high rate should make it less likely that companies will take advantage of circumstances such as war and natural disasters to raise prices—like a businessman raising the price of bottled water from $2 to $40 after a hurricane. “There’s almost a moral judgment that in some situations market prices can be immoral,” Stark said.

Getting the incentives right is tricky, Borenstein said, as is preventing companies from evading taxes. For example, if the state were to tax profits at California refineries, those refineries—owned by companies including Chevron and Valero—could begin buying oil from another division of their parent companies at higher prices.

This could reduce their profit. And if they are no longer making large profits, their tax expenditure would be reduced.

“The devil is in the details,” Borenstein said.


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