Why Sunak is (still) right to reject a windfall tax on energy companies

The Labour Party and LibDems are continuing to push hard for a ‘one-off’ windfall tax on the profits of North Sea oil and gas companies. These businesses are indeed likely to make more money than even they had expected, thanks to the surge in global energy prices.

The European Commission has also supported the idea of a temporary increase in taxes on profits from electricity generation. Some EU members, notably Spain and Italy, have already taken this up.

Here in the UK, Chancellor Rishi Sunak is still resisting. This may not be popular, but I think he has got this one right.

There are some good arguments on both sides. It does seem unfair that any company could make bumper profits, even indirectly, from a tragedy such as the war in Ukraine, or from Covid.

Truly ‘one-off’ windfall taxes can also be a relatively efficient way of raising more revenue, without distorting behaviour in the future. This is mainly because they are effectively an additional tax on past investment rather than on the profits from decisions yet to be taken.

In addition, windfall taxes still leave some room for price signals to work properly. The alternative of clumsy price caps can create extra distortions, because they reduce the incentive for consumers to use energy more efficiently. Those that can afford to pay higher prices, or who can save energy, should be expected to do so.

Bringing these first two points together to make a third, a windfall tax on North Sea oil and gas companies could be a fair and efficient way to find more money to support low-income households struggling with the cost of living.

Labour has suggested that the additional revenues from raising North Sea corporation tax by 10 percentage points, for one year, could fund a £600 reduction in energy bills for the most vulnerable.

So, what’s not to like?

Taking each of these three points in turn, the ‘fairness’ argument is overplayed. What is or is not ‘fair’ is inevitably subjective. The language used by supporters of a windfall tax is often emotive and not helpful when trying to design a rational and simple tax system.

It seems just as reasonable to argue that it is ‘fair’ for a company to benefit from higher prices when the goods or services that it supplies is in high demand. Even if you accept that an increase in profits caused by the fallout from a war should be treated differently from an increase caused by any other shock, how do you decide how much of the increase is due to the war and how much would have happened anyway?

What’s more, if profits do rise, North Sea companies will already be paying more in corporation tax (at a relatively high rate of 40pc), even without any increase in their tax rates. The Office for Budget Responsibility has estimated that North Sea receipts could jump from £3.1 billion in 2021-22 to £7.8 billion in 2022-23, if oil and gas prices remain near their post-invasion highs.

Profit numbers are often tossed around with little understanding of their meaning or context. For example, supporters of a windfall tax often point out that company A has made profits of £1 billion (or whatever), which is a 50% increase on the previous year, and say ‘isn’t that a disgrace?’.

But these are often big, global companies, for whom profits of even a multiple of £1 billion are not unusual (the figures are pretty meaningless unless compared to turnover, or capital employed). And the 50% increase is misleading when the base for comparison is the abnormally low level of profits (often losses) made during the Covid recession.

It can also be misleading to focus solely on profits. Some big players have had to write off large investments in Russia. This may not impact their profits for corporation tax purposes, but it may not leave shareholder much better off either.

Lastly on this point, many are now arguing that it is somehow ‘fairer’ to avoid taxing individuals by raising taxes on companies instead. However, companies are only legal entities and cannot bear the economic burden of taxes themselves. This burden is always passed on to real people, not all of whom will be wealthy shareholders.

The efficiency advantages of windfall taxes are overplayed, too. In reality, these sorts of ad hoc, arbitrary and retrospective tax changes are likely to add to business uncertainty and undermine investment.

Supporters of a windfall tax argue that the extra profits were ‘unexpected’ and therefore that investment plans cannot have depended on them. The fact that some energy companies are buying back shares also suggests that they have more than enough cash for the investment opportunities available to them.

Nonetheless, the objections to windfall taxes are broader than this. Profits normally ebb and flow over the business cycle, and the precise amounts are usually ‘unexpected’ to some degree. The losses in 2020 were presumably ‘unexpected’ too.

Luck works both ways. However, if companies come to believe that profits might be taxed at a higher rate in better years, their projected returns from investment will be lower, and so there will be less of it.

This risk might be minimised if firms can be persuaded that a windfall tax is indeed just a ‘one-off’. But many advocates of a windfall tax have undermined their own case here, by citing precedents or by suggesting that these additional taxes should become a permanent feature of the tax system.

Some have even suggested that the idea should be extended to other businesses, such as online retailers, which happen to have done well during the pandemic.

The ‘slippery slope’ argument is often overused, and yet it surely applies in this case. Why should any company go the extra mile during a crisis if they fear they might be whacked with a punitive tax? Or why should any internationally mobile company chose to invest in a country where the tax regime is so fickle?

In the meantime, windfall taxes might allow price signals to work on the demand side, but they will still reduce the incentive to increase supply. And if the additional tax is indeed temporary, it might actually encourage some firms to delay production (or at least find some other way to defer paying tax) until it has been removed.

Finally, the argument that the revenues from a windfall tax could be used to cut energy bills is a red herring. The case for additional spending and exactly how this is financed should be seen as separate issues. While I agree there is a strong case for providing more support to particular households, this could be financed in many other (and better) ways.

It rarely makes sense to link any type of spending to one particular source of revenue (‘hypothecation’). This surely applies to the energy market now too, where prices are so volatile and the tax base is uncertain. But if politicians really want to go down this route, why not just say that they will cut bills using the additional revenues that North Sea oil and gas companies will already be paying?

In short, I get why many people are uncomfortable with the suggestion that anyone could profit, even indirectly, from the suffering in Ukraine, or from struggling families in the UK. Nonetheless, windfall taxes are both unnecessary and likely to backfire.

This is an extended version of a piece which was first published in the Daily Telegraph on 14 April 2022

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