Source: Matt Telegraph

The term windfall tax has been in the economic news almost as much as the word inflation in recent weeks. So what does it mean and does a windfall tax make economic sense?

A windfall is an unexpected gain received by a firm or individual due to changes in external circumstances, reflecting no particular action of their own. The term relates to the ‘windfall’ that happens when, say, a person living next to an orchard gets a nice supply of ripe apples landing in their garden when an unexpected wind causes their neighbour’s fruit to fall down. In the case of the energy supply companies, the unexpected windfall has been the surge in profits due the rise in gas and oil prices which have happened for a range of factors external to them — such as the surge in demand for energy as the world emerged from lockdown and the effects of the Ukraine war on Russian gas supplies. The energy companies have thus gotten much richer due to no action of their own. They have benefited from a windfall. The profits of BP, for example, have risen 50% from £4 billion to £6 billion in the first three months of 2022 compared to the last three months of 2021. Given firms like BP have just got lucky, surely there is a case for taxing some of this luck and sharing it with consumers who have got ‘unlucky’ in having to pay more for their heating or petrol?

The key economic rationale for such a tax is the concept of Economic Rent. Economic Rent is the payment to a factor of production over and above what is required to induce its supply. One can see how the increased earnings of the energy companies constitute economic rent. Let’s face it: in the last three months of 2021 BP was happy to provide oil and gas at profits of £4 billion; now they are making £6 billion. The extra £2 billion is clearly economic rent — they are being paid more to provide what they were prepared to provide anyway. On this basis, one could tax away the extra £2 billion and BP would still be making a tidy £4 billion profit and the supply of oil and gas would not change. This is the key argument in favour of a windfall or lump-sum profits tax — it leaves the world unchanged but governments now have more money to make things better in other parts of the economy by, for example, offsetting taxes on fuel to cut the cost of living.

We can illustrate these points by a standard monopoly diagram for a firm. The below diagram, courtesy of tutor2u, shows a monopoly firm like BP or Shell initially facing the demand curve AR, to which corresponds the marginal revenue curve, MR. As a profit maximising firm it will produce where MC=MR, and this is the output Q1, leading to a price of P1. At output Q1, the Average Cost per unit is C1 and the price or Average Revenue per unit is P1, leading to a Super Normal profit equal to the inner yellow shaded box

(Since at Q1 the Total Revenue of the firm is P1 x Q1, and the Total Cost is C1 x Q1. So TR>TC and TR-TC = Super Normal Profit. Remember Normal Profit, the profit the firm must receive to induce it to undertake operations, is considered a cost to the firm and is included in Average Cost).

Now of course Super Normal Profits, being a level of Profit above the Normal Profit, are already a form of Economic Rent since this profit is not necessary to ensure the firm produces at Q1. But let’s leave that to one side. Now assume that demand shifts out for the oil produced by the firm — as world demand surges. On the diagram this leads the demand and average revenue curve to shift to AR2, to which there will now be a new MR curve MR2. Again the firm sets MC=MR, so it increases output to Q2, selling this output at the price P2.

The crucial thing for us to note is the increase in Super Normal Profits, which have now expanded out to the larger box OQ2 x OP2. The INCREASE in Super Normal Profits is shown by the light brown addition to the firm’s profits. It is this increase in Super Normal Profits that is the windfall gain to the producer and is pure Economic Rent — payment over and above what the firm like BP requires to produce the output Q2.

Let’s imagine now that the government taxes this entire extra profit by a lump some windfall tax. What will happen on this diagram? The answer is: ABSOLUTELY NOTHING. The output decision of the firm depends upon MC and MR. Have either of these changed due to the tax? No. The tax on profits does not affect the firm’s costs of production — the costs of extracting oil or gas. So MC and AC don’t change. And neither does MR and AR — the demand for gas or oil won’t change directly because of the tax. So with MC and MR not changing, the profit maximising output won’t change. The firm will still supply Q2. It just won’t make so much profit. Its profits will still be at the old pre-windfall levels — say £4 billion compared to £6 billion. But while the industry has not been affected, at least in the short run, the government has £2 billion of money for good causes. This is the basic argument FOR a windfall lump sum tax on profits.

Of course this analysis suggests that there is little opportunity cost in taking this action. And we know that in economics this can rarely be the case.

The main objection to such a windfall tax is that it will impact the incentives of firms over time. If they know that large, supernormal profits will be more highly taxed, they might be disincentivised to raise productivity in the future since any gains may be taxed again. This uncertainty over taxation can itself deter future investment. And this future investment is very much needed particularly if new greener technology is to be made cost effective.

However this argument is not especially strong since in the UK and the USA to date, windfall taxes have indeed been rare and imposed on very few occasions. And there is little evidence to say that previous windfall taxes have deterred investment. Against the moral argument of the poorest suffering significantly higher energy bills, also through no fault or action on their part, the argument is weaker still.

Perhaps a more significant argument is that such a tax is asymmetrical — when prices fall on world markets and revenues and profits fall, the government does not come to the rescue of oil companies with subsidies.

Boris Johnson appeared very much against the tax when he argued last week that it will deter investment. Perhaps the Chancellor will design a tax that is only imposed if large oil, gas and electricity companies fail to invest — but this requires policing and will begin to impact efficiency as companies devote resources to deciding how best to minimise their tax bills.

In The Wealth of Nations (1776), Adam Smith argued that taxation should follow the four principles of fairness, certainty, convenience and efficiency. Whilst there is some uncertainty created by the prospect of a windfall tax, it does seem to meet the other criteria. So we really should be expecting such a tax any time soon.

Update: 2 days after publishing this post, the Chancellor did indeed announce a significant windfall tax.

Further reading with examples of previous windfall taxes:

  1. Should the UK impose a windfall tax on energy companies’ profits? — Economics Observatory.
  2. https://www.sonecon.com/wp-content/uploads/2022/01/windfall_1105.pdf