Windfall Tax Woes

In response to large profits posted by BP and Shell, the UK government is considering a so-called “windfall” tax on oil and gas companies. The aim of this measure is to redistribute, to consumers, the proceeds from those profits so as to ease the burden of the spiralling retail cost of fuel and heating.

In a free market, a sudden rise in price in response to an influx of demand – usually due to an equally sudden change in circumstances, such as a natural disaster – can, indeed, furnish handsome profits to companies which happened to purchase their inputs while prices were still low. Ordinarily, this would serve as a signal to entrepreneurs that there is a grave shortage of capacity in that particular industry, relative to the height of demand. Such entrepreneurs would then rush to expand their investment in the industry, increasing production of the heavily demanded commodity so that its price could be brought down again. Indeed, it is likely that the initial, extraordinary profits – rather than being distributed to shareholders to be spent on mansions and yachts – will be the first source of that fresh investment. Such profits are, therefore, of a benefit to the consumer, but it is also worth noting that they are just as temporary as high, consumer prices. Increased investment in the industry will have the effect of raising the cost of inputs while lowering that of outputs, shrinking profits back to relatively “normal” levels.

A windfall tax, however, would completely destroy this important incentive mechanism. By robbing the companies of those profits, the opposite signal is sent to entrepreneurs and investors: stay away from this industry or your returns will be confiscated! With no fresh investment forthcoming, that industry then struggles to cope with meeting the increased demand through its existing capacity, the only consequence of which can be scarcity and permanently high prices. The proceeds of the tax itself can, at best, provide only temporary relief - and that is assuming that the government doesn’t find some way of wasting the money completely.

Further, in the case of oil and gas, the reason why large profits cannot be used to expand capacity as efficiently as they otherwise could be is because of green-centric government policies that make it difficult to do so. In fact, for the past generation or so, the strategy of governments towards so-called “climate change” has generally consisted of running down the existing fossil fuel infrastructure while throwing subsidies at inferior alternatives such as wind farms. We are now feeling the squeeze as the dilapidated capacity that remains is struggling to cope.

Another destructive mechanism that governments often resort to in these situations is price fixing, although price ceilings are normally applied directly to consumer goods rather than to capital goods. The initial effect here is to stop any kind of extraordinary profits from being made in the first place. The long term consequence, however, will be the same: desperately needed investment in a vital industry stays away.

The only solution to the rising cost of energy is to get governments out of the business of energy entirely, so that companies are able to deploy resources freely to where they are most demanded. In tandem, governments will need to cease all of their activities which are causing the inflationary pressure in the first place, namely: the incessant printing of money, and their geopolitical adventurism that has wrecked supply chains still reeling from the insane COVID lockdowns.