Taxing 'windfall profits'

By Mark J. Perry

Sunday, October 23, 2005

Many Democrats, in response to spikes in oil and gasoline prices, are calling for price controls on gasoline in response to complaints of "gouging." Some even are suggesting a revival of the oil "windfall profits" tax.

Have they forgotten the mess previously created when these same energy policies were imposed?

Price controls in the 1970s led to gasoline shortages and long lines at the pump. That was followed by a tax on "windfall" oil profits. That scared away investors from the energy sector and put a stop to new oil development.

If we don't understand the economic reasons that gasoline prices change, we run the risk of repeating past political mistakes by imposing energy policies that are counterproductive. Simply put, U.S. oil companies don't set prices for crude oil or gasoline and they were not responsible for the recent price spikes.

Prices are determined by the global forces of supply and demand in the world marketplace for oil -- and rapidly expanding economies like China and India now are part of the picture. If the price of crude oil or gasoline rises, it happens for one of two reasons: an increase in world demand for oil or declining supply.

The recent record-high gas prices were exacerbated by the loss of oil and gas production facilities in the hurricane-damaged Gulf region. Because oil supplies were reduced by 2 million barrels per day, gas prices naturally soared.

Rising gas prices accomplish something very important that price controls can't -- conservation. As gas prices rise, many people start to use less and consumption falls. The result: Prices then start to drop in response to falling demand, which, pre-Hurricane Wilma, was reflected in the drop in crude oil prices to two-month lows.

It might seem absurd to talk about oil development amid all the turmoil over volatile gas prices, but not really. Those who talk about imposing taxes on the so-called "windfall" profits of oil companies ought to keep in mind that the industry needs those profits to invest in new technology, new products and, most importantly, increased oil and natural gas production.

The last "windfall" profits taxes led to an annual reduction in domestic oil production of almost 6 percent; it put upward pressure on the price of oil and natural gas.

Furthermore, the tax was largely responsible for an increase in our nation's dependence on foreign oil that ranged between 8 percent and 16 percent annually, according to the Congressional Research Service.

The United States should allow oil and natural gas production on federal lands and offshore areas that have been off-limits or subject to restrictive permitting. Combined, federal lands and offshore areas contain an estimated 102 billion barrels of oil that could be recovered with today's technology -- more than the proven reserves of most OPEC countries.

Developing oil and gas resources in the United States, modernizing existing infrastructure and improving efficiency calls for massive investments. The oil companies and the global financial system have the capacity to fund these investments. But they will not do so unless conditions are right.

Investments of this magnitude require long-term fiscal stability in the oil industry, and significantly increasing the tax burden on oil companies during a time of energy instability does not make economic sense.

What is needed now is less government interference in the energy markets, not more of the same command-and-control energy policies that failed so miserably in the past.

Mark J. Perry is an associate professor of finance and economics at the University of Michigan-Flint.