There’s a strong case to levy windfall taxes

Earlier this week, Britain announced a windfall tax on oil and gas producers that would last two years and is expected to net £5 billion. The idea is to generate financing for the £15 billion worth of relief the government proposes for citizens struck by extra-high energy prices, thanks to a shortage of gas and the war in Ukraine. India should also skim off some of the unearned income generated by hydrocarbon companies — the tax should be levied on revenue, rather than on profits, and pegged at something like 20%.

Conceptually, a windfall is easy to understand, but empirically, it is not easy to identify. British oil major BP is a major beneficiary of the surge in oil and gas prices in the wake of the war in Ukraine, but has reported losses in its latest quarterly numbers, because of divestment of its Russian operations at non-commercial prices, in order to be on the right side of western sanctions.

A windfall is a profit gain that accrues to a company for reasons unrelated to any effort by the company. Take a company like Saudi Aramco, which has some of the lowest cost of extracting oil in the world. Assume it is $15 a barrel — it might actually be lower, or higher, it does not matter — and the company makes a particular level of profits from its operations when oil prices move within a range. When war results in a spike in the price to well over $100 a barrel, its revenue shoots up. There is little reason for its costs to go up in tandem, and so its profits also shoot up. Why should the company have exclusive entitlement to the superlative profits generated essentially by the Russian occupation of Ukraine, forcing consumers around the world to pay a higher price for the oil they buy? So, the case is fairly strong for levying a tax on windfall profits.

However, identifying windfall profits could be a challenge, and for reasons unrelated to the ability of high-grossing accountants to dress up a company’s profits in size-zero attire. It is important to distinguish windfalls from cyclical upturns. Take a refining business. When petroleum product prices are rising steadily, a refinery would sell its refined products at a price significantly higher than the prices associated with the price of the crude when it acquired that inventory. What goes up, later goes down, too. As the cycle turns, the company would be forced to sell refined products at prices lower than the ones associated with the price of crude at the time of acquiring that inventory. Gains on the upswing would be offset by losses on the downswing. It would not be fair to count the profits on the upswing as a legitimate target of a windfall tax, without allowing for the losses on the downswing.

Therefore, care must be taken to identify what is taxed. Statistical evidence must be used to identify the upper bound of a cyclical upswing in prices. Only the price above that should be deemed to generate windfall profits.

Then again, profits are a matter of opinion. If the company chooses to book higher depreciation in a year of potentially high profits, it can make those surplus profits disappear. The company might pre-pay a loan, purely to reduce reported profits. It is safer to target revenues, rather than profits, in order to tax windfall gains.

Upstream hydrocarbon companies and refineries are legitimate targets of windfall profits. So are coal miners. It would make more sense for the government to let steel be exported without curbs, instead of levying a tax on steel exports, let steelmakers take the benefit of elevated international prices and gain from the resultant increase in taxable profits, even if these are not windfall profits.

In India, refiners are likely to come up with under-recoveries in their retail sales, thanks to state-owned oil marketing companies holding prices down, in the face of proximate assembly elections, even as crude prices climbed steadily, as an argument against windfall taxes. If the companies are taking a hit on retail sales, why penalize them further with a windfall tax?

Refiners do not sell their entire produce in the domestic market at a loss. Some of them are major exporters of petroleum products. These fetch global prices that are unnaturally elevated, thanks to the Ukraine war.

The government needs revenues – not just for the normal business of governance but to meet the additional expenditure forced on the country by a global rise in defence spending. As countries like Germany begin to spend 2% on defence and Nato becomes more powerful than before, countries such as Russia and China would feel compelled to increase their defence expenditure as well, to maintain the status-quo on offensive and defensive capability. As China spends more on defence, it would make sense for India, too, to spend more on defence. Windfall taxes would come in handy.