How a Windfall Oil Profits Tax Would Hurt You

We are witnessing a fresh round of stiff-necked fulminations over the need for a new windfall tax on oil profits from elected officials who appear to understand little about the economic impact their legislation has on US taxpayers.

A growing number of Congressmen want to enact a windfall profits tax to punish what they say are greedy gougers in the oil industry. Though the Senate just rejected a proposed windfall tax of 25% on "unreasonable" profits of the five big oil majors, Exxon Mobil Corp. (XOM), Chevron Corp. (CVX), ConocoPhilips (COP), Dutch-based Royal Dutch Shell (RDS-B) and British-based BP, (BP), it's not off the table. 

Democratic presidential candidate Barack Obama is now exploiting anxiety over high gas prices by pledging to enact a windfall profits tax on U.S. oil companies if elected.

If you hear a false note from this proposal clanging in your ear, listen to it, because short-sighted thinking, cant and pretense is coming fast and thick here, thicker than the oil Venezuela produces.

Yes, several energy chief executives are too richly compensated, earning them the ignominious title of fat cat CEOs.

Yes, the oil majors could do a better job of digging out new sources of energy to ease the dependence not just on oil but foreign governments hostile to the US.

And, yes, oil companies have been reckless with numerous tanker spills, ruining pristine environments around the world.

But that’s not the end of the story.

Oil companies don’t arbitrarily set their prices sky-high. Market forces determine oil prices. OPEC has a huge hand in setting prices.

Also, half of the world’s population is sheltered from fuel prices by subsidies, which has boosted demand and kept oil prices high.

Drivers can get gas for cents on the dollar in Venezuela, China and Iran. Indonesia, Taiwan and Sri Lanka are now cutting subsidies. China is considering doing so, too. At the same time, China is reportedly stockpiling oil, gas and diesel so as not to endure any embarrassing shortages during this summer's Beijing Olympics. Its earthquake increased demand, too.

And the truth is, a stronger dollar would lower oil prices. Actions by the Federal Reserve to strengthen the dollar will help. The Fed has weakened the dollar which has helped cause oil prices to spike, as oil is priced in dollars.

Oil prices really started to soar just around the same time the Fed started opening the spigots last August to pump liquidity into the markets to save the financial sector, our sister publication, the Wall Street Journal, notes.

The last time the price of oil in dollars and in euros was at parity, exactly the same, was at 25 in 2002, says David King, former head of the New York Federal Reserve's Industrial Economies division. Since then oil in euros has tripled in price--but it has quintupled in dollars since then, notes King. What does that tell you about tighter monetary management at the European central bank and the US Federal Reserve?

As the Fed cut rates, the treasury bonds that are usually the preferred investment vehicle of choice for pension funds and endowments no longer could keep pace with inflation so investors plowed into oil. Paper barrels in the form of speculators grew due to this phenomenon.

But if speculators were solely to blame for high oil prices, you might see a sizable increase in oil inventories, or at least levels suitable for world demand, as one analysis notes. There is no evidence of that. The stampede into commodities index funds, after the crash and burn of financials, has those indices now at $225bn, but that's still far less than the tens of trillions of dollars worth of transactions in oil markets each year.

Finally, just the mere tough talk of a stronger dollar from the Treasury Secretary and Fed chair Ben Bernanke has helped ease oil prices.

That helps, because already on an annualized basis, if you math out the oil spike since the beginning of the year, the extra $135 bn cost to the U.S. economy from higher oil prices has vaporized the fiscal stimulus checks the government approved.

To be sure, the higher oil hit won’t come all at once, but it’s a slow bleed that will sap the economic growth the federal government had hoped would come from the checks.

Congress, the media and presidential contenders also don’t know how to read a profit and loss statement as they zoom in on the oil majors’ revenue line item alone, ignoring the other important moving parts in the financials.

For instance, the oil majors get drilled for hauling in rich sales, but Congress and presidential contenders focus only on that line. They should focus on the costs to bring in those sales, reflected in profit margins.

To get a profit margin, you divide net profits (which includes costs) by the amount of revenue the company took in. The average net profit margin for the S&P Energy sector, according to figures from Thomson, is 9.7%, one report shows.

The average for the S&P 500 is about 8.5%. Not much of a difference. Johnson and Johnson has routinely showed profit margins of about 20%, same for the financials before they got socked due to their bad bets in the housing and credit crisis.

But here’s an important economic point. Companies don’t pay taxes. Instead, they pass tax costs along to workers, consumers and shareholders. Or they pull stakes and move operations out of the country. Why do you think the US accounting firms have been steadily growing their operations overseas? It’s because of the US’s onerous tax and regulatory structure.

Besides, who reaps the windfall from a windfall profits tax? The government, whose elected officials then use that money to buy more votes with pork. I can assure you, despite the lip service paid to cutting the deficit, cutting the deficit would be last on the list once the revenues from a windfall profit tax comes in, because there will always be talk of more taxes, more spending, more pork to be found to preserve power, more regulation to control our lives.

More, more, more to keep our teetering, Supersize-me government going.

Yes, the oil majors get a lot in the way of tax subsidies. So do plenty of other sectors in the US economy, notably the ethanol and drug industries.

And oil companies pay a lot of money in taxes to the government.

Over the last three years, Exxon Mobil has paid an average of $27 bn annually in taxes, says Mark J. Perry. a professor of economics and finance at the University of Michigan. That’s as much in taxes annually as the entire bottom 50% of individual taxpayers paid in 2004 (most recent year available), which is 65,000,000 people, Perry notes.

Exxon’s effective tax rate in some years is at around 40%, bouncing down to a still steep 35% in other periods.

The combined top federal, state, and local corporate tax rate in the United States is 39.3%, the second highest (after Japan) among the 30 countries of the Organization for Economic Cooperation.

Even the socialist, welfare-state-loving Scandinavian countries--Sweden, Denmark, and Norway--have a combined average corporate income tax rate that is more than 11 percentage points below the U.S. corporate tax rate.

So what the government giveth in subsidies, it quickly takes away with taxes.

Also, the Tax Foundation’s Scott Hodge and Jonathan Williams noted say that in recent decades federal, state and local governments “have collected far more revenue from gasoline taxes [from consumers] than the largest U.S. oil companies have collectively earned in domestic profits.”

The Congress has threatened a windfall profits tax since 2005. Back then, more than 250 economists sent their concerns to Congress in an open letter, with signers including two Nobel Laureates in economics, as well as professors from the University of Chicago to Princeton University and Harvard Business School.

They cited a Congressional Research Service report about the results of a windfall profits tax imposed in the 1980s, which noted a windfall profits tax would mean less gasoline available to Americans. The CRS found that the previous tax led to decreased domestic oil production and increased reliance on foreign sources–-the opposite of widely accepted goals for U.S. energy policy.

And a 22-country study from the conservative American Enterprise Institute found that higher corporate tax rates lead to lower wages, with a 1% increase in corporate tax rates associated with a 0.7 to 0.9% drop in wage rates.

"Lower corporate taxes will lead to higher wages over time," says Kevin Hassett, a coauthor of the study.

The oil boom is creating jobs that could be lost overseas if a windfall profit tax is enacted. One analysis I just read says that according to annual reports for the largest 25 energy companies in the S&P 500, 20 oil firms had more employees at the end of last year than they did at the end of 2006.

Average weekly wages for non-supervisory workers in the natural resources and mining industry (which includes oil and gas extraction workers) were nearly 70% higher than the national average, this analysis says.

Is anyone in Congress listening? And is Senator Obama listening too?