Over the last few months, consumers have been squeezed by high energy prices while energy companies have brought in more cash than they’ve seen in a decade.
To some, this is a problem—one with an obvious solution: tax the additional profits of energy companies to generate revenue that can be used to alleviate the strain on households.
Unfortunately, a “windfall tax” would do very little to solve the problem. In fact, it would make things worse:
- scaring off investors,
- deterring climate action, and
- making the next energy shortage worse.
Here’s why.
First, what is a windfall tax?
It is a temporary, additional tax imposed on companies that have seen a flood of profits—a “windfall”.
Generally speaking, the rationale for such a tax is that: 1) companies benefited from something that was not the result of their own investment, ingenuity, or effort; and 2) that benefit came at the expense of society, so redistribution is an appropriate corrective approach.
Governments can redirect the tax revenue to those hurt most by the sudden change or fund government services more broadly.
The UK offers a real-life example. In May, it announced a 25% windfall tax on oil and gas companies, and the revenue will be used to cut a one-time cheque of up to £650 to the lowest-income households.
Given the current situation, with prices at the pump 50% higher than before the pandemic, it’s easy to see why such a tax might, on face value, seem appealing to Canadians.
So, what’s the problem?
Windfall taxes are arbitrary and subjective…
Several highly subjective judgement calls go into the who, what, and when of a windfall tax.
The first of these is deciding when such a tax is even warranted: when are profits normal, when are they “excessive,” and who decides which is which?
The second is determining on whom a windfall tax should be imposed. Many businesses benefited handsomely from the pandemic, for instance. The case for a windfall tax could easily be made for banks, social media companies, and grocery stores during the height of COVID. So why energy companies but not these?
Finally, if governments get used to such taxes, it’s easy to imagine the bar for imposing one lowering with time.
They ignore business cycles…
The energy sector is characterized by wide swings in economic fortunes as business cycles and profits are notoriously volatile. This makes it impossible to determine a “normal” level of annual profit. And it’s especially a challenge for an industry just coming out of over five extremely lean years (see chart).
Moreover, windfall taxes make for inconsistent policy. High profits are taxed away in good years, but losses aren’t similarly buffered in bad years. Investors end up absorbing the full extent of the downside of the business cycle but lose the opportunity to fully benefit when things go their way.
…which can scare off investors…
This creates another major problem: windfall taxes change the risk profile for investors. Suppose unusually high profits are subject to arbitrary extra tax but investors are left to absorb losses on their own. That would reduce expectations for long-term return, deterring investment and making it inherently riskier.
…deterring climate action…
Windfall taxes on energy companies will hamper Canada’s climate objectives. First, industry profits allow companies to invest in carbon capture and other emissions-reducing technologies. Taking some of that money away leaves less to invest, at precisely the moment governments are asking these companies to invest the most.
Second, raising the risk profile of investing will drive capital and innovation away from the sector more broadly. It will be more difficult to sell shares and raise funds—at a time when decarbonization efforts require significant ingenuity and investment.
…making the next energy shortage worse…
Furthermore, a large part of why gas prices have been so high recently is because of undersupply, stemming from too little capital investment in global production. Policies like windfall taxes will only worsen that problem—deterring investment in new production and driving future prices even higher (or preventing them from returning to more affordable levels).
…and ultimately making Canadians poorer.
At the end of the day, it’s consumers that end up worse off under a windfall tax. Underinvestment in supply will drive prices higher, and consumers will again struggle to fill their tanks and heat their homes. Reduced investment will lead to less production, fewer jobs, and slower economic growth. And shareholders—including private and public pension plans—will see lower returns, making it harder to build a retirement fund.
Conclusion
Some people undoubtedly like the idea of windfall taxes because they see large companies enormously benefiting from external circumstances while consumers are worse off. But there will be a price to pay eventually. Windfall taxes will only further constrain supply growth and end up hurting the very people they were intended to help.
Mike Holden, Vice President of Policy & Chief Economist
Alicia Planincic, Economist & Manager of Policy