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Windfall Profit Taxes and Windmills

DQWindmill

Gas prices are going up. Believe me, my wallet is well aware of this as I not only live in the Bay Area, but my weekly commute is over 200 miles.

Not surprisingly, there has been a lot of steam generated by politicians about taxing the so-called “windfall profits” of oil companies. While I can’t argue with advocating for the development of alternative energy sources, the entire notion that one can point at Exxon’s $40.6 billion net income and declare that oil companies make “too much money” is to me about as ridiculous as Don Quixote’s battle against windmills.

There are three reasons as to why you can’t just point at the amount of money Exxon makes (or for that matter, a pharmaceutical company or a telecommunications company or any company) and immediately jump to the conclusion that profits are too high and hence must be taxed:

  1. Large profit doesn’t necessarily mean a high profit margin
  2. A high profit margin doesn’t necessarily mean the company is doing well
  3. Taxation on profits is not going to reduce prices

The first reason is basically stating the question how much is too much profit? Is $1 million too much? How about $1 billion? Or $10 billion? Or how about Exxon’s $40.6 billion? The reason why this is a trick question with no answer, is because the sheer amount of profit a company makes is no indication of how much it is profiting from every sale. For example, if two poker players end the night having won $50, but the first player started with $10 and the second player started with $100, who would you say is the better poker player? Probably the former, because he had less to work with. On a similar level, you can’t just point at $40.6 billion and immediately say that profits are excessive. They certainly aren’t excessive if Exxon had to sell $1 trillion worth of gas to make that profit, as that would mean Exxon was only making 4 cents on every dollar — and what would be the point of regulating/taxing that?

But, let’s say you’re smarter than the average politician/bear, and you point out that Exxon has a profit margin of 10% (Exxon’s sales in 2007 were $405 billion), and that is simply too high when people around the country are struggling to pay their energy bills. This then takes us to the second reason, which is basically questioning how difficult is it to make that profit? Let’s say there are two poker players who both started with $100, and both ended the night having won $50 — in this case, both players have the same “profit margin” (50%). However, let’s say one player played at a table full of children who don’t know how to play, and the other played at a table full of World Series of Poker champions. Now, given this setup, it should be obvious who the better player is. You are likely to say that the player who made a 50% margin playing the table full of WSOP champions is the better player and that his profit margin was very difficult-to-get and probably not excessive. On the other hand, we would be ashamed of the player who basically stole candy from babies and would think that money was not well-deserved.

Translating this back to the world of windfall profits, the takeaway message is that the profit margin that a business earns is no indication of “windfall” profits because the profit margin does not reflect how “difficult” it was to earn the profit (and so doesn’t reflect the profits necessary for an industry to continue to invest in it). The pharmaceutical industry is a perfect example of this, and a perennial whipping boy of politicians who seem to not comprehend that it is not only extremely unlikely for a particular investment to make it from the lab to a patient, it takes a very long time and is also extremely expensive. Companies in the oil industry are in a similar boat in that significant upfront investments (e.g. Exxon needs to hire workers and buy equipment before it starts drilling) with no guarantee of success (e.g. what if Exxon drills where there is no oil?). Now, to be clear, this argument doesn’t mean that it’s impossible to earn “windfall profits”, but it does mean that different industries have different standards of profitability to determine how well a company is doing.

And lastly, even if we find an example of a company that is making excessive profits by an industry-specific definition, people should understand that a tax on profits is unlikely to result in a cut in prices. The reason is pretty basic — there are three levers a company can use to raise profits — it can raise prices, it can try to sell more things, or it can try to lower costs. If we assume that companies usually aim to maximize profits, which is typically a decent assumption, then a tax on profits will simply encourage the company to either:

  1. raise prices
  2. sell more things
  3. lower its cost structure (maybe by firing some workers or outsourcing more stuff)
  4. some combination of the above

#1 is especially likely if the item being sold is something which is a necessity to the buyer or something which the buyer would buy the same amount of with little regard for price (which allows the seller to “get away” with charging more). Typical examples of this are things like food, oil, and healthcare — typical targets of movements to tax windfall profits. What this means is even if the tax were 100% efficient (no overhead costs for collecting it and overseeing it, no impact on the quantity of product provided) and it was completely refunded back to the consumer, at best you are saving the consumer a few percent of the original price, as they are forced to bear the brunt of the tax in price hikes.

Of course, hoping the politicians will listen is much the same as telling Don Quixote not to bother attacking windmills.

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