[Economy] Explained – What is Windfall Tax?

The story so far: 

Finance Minister Nirmala Sitharaman on Monday, September 2, defended the windfall tax imposed by the Centre on domestic crude oil producers, saying that it was not an ad hoc move but was done after full consultation with the industry.

The Central government on July 1, introduced a windfall profit tax of ₹23,250 per tonne on domestic crude oil production, which was subsequently revised fortnightly four times so far. The latest revision was on August 31, when it was hiked to ₹13,300 per tonne from ₹13,000. Ms. Sithraman explained the introduction of the windfall tax as a way to rein in the “phenomenal profits” made by some oil refiners who chose to export fuel to reap the benefits of skyrocketing global prices while affecting domestic supplies.

Besides India, a wave of countries including the United Kingdom, Italy, and Germany have either already imposed a windfall profit tax on super normal profits of energy companies or are contemplating doing so.

What is a windfall tax?

Windfall taxes are designed to tax the profits a company derives from an external, sometimes unprecedented event— for instance, the energy price-rise as a result of the Russia-Ukraine conflict.

These are profits that cannot be attributed to something the firm actively did, like an investment strategy or an expansion of business. The United States Congressional Research Service (CRS) defines a windfall as an “unearned, unanticipated gain in income through no additional effort or expense”.

Governments typically levy a one-off tax retrospectively over and above the normal rates of tax on such profits, called windfall tax. One area where such taxes have routinely been discussed is oil markets, where price fluctuation leads to volatile or erratic profits for the industry.

There have been varying rationales for governments worldwide to introduce windfall taxes, from redistribution of unexpected gains when high prices benefit producers at the expense of consumers, to funding social welfare schemes, and as a supplementary revenue stream for the government.

For instance, in 1980, then United States President Jimmy Carter introduced a crude oil windfall profit tax on the country’s oil industry. This was because the U.S. government between 1979 and 1981 started releasing controls on oil prices and anticipated that this decontrol would lead to oil companies making huge profits. This meant that prices, capped till then by the government, would rise to world market levels; the U.S. government’s Joint Committee on Taxation had estimated that the decontrol would increase profits for the oil industry by over $400 billion.

So, to recoup much of the revenue that would have otherwise gone to the oil industry as a result of the decontrol, the government imposed the windfall tax.

Why are countries levying windfall taxes now?

Prices of oil, gas, and coal have seen sharp increases since late last year and in the first two quarters of the current year, although having reduced recently. “The increase stems from a combination of factors, including a mismatch between energy demand and supply during the economic recovery from COVID-19, further amplified by the Russian war in Ukraine,” noted an August paper by the International Monetary Fund (IMF). Pandemic recovery and supply issues resulting from the Russia-Ukraine conflict shore up energy demands, in turn driving up global prices.

The rising prices meant huge and record profits for energy companies while resulting in hefty gas and electricity bills for household bills in major and smaller economies. Since the gains stemmed partly from external change, multiple analysts have called them windfall profits.

In early August, Antonio Guterres, the United Nations Secretary-General, sharply criticised the “grotesque greed” of big oil and gas companies for making record profits from the global energy crisis on the back of the world’s poorest people. He said it was “immoral” that the largest energy companies in the first quarter of the year made combined profits of close to $100 billion.

The second quarter profits of big oil companies surpassed those in the previous one- Exxon Mobil posted its biggest quarterly profit in history at $17.9 billion in Q2 2022, BP announced its second-quarter profit at $8.45 billion (highest in 14 years), and Saudi Aramco’s quarterly profit almost doubled from $25.5 billion last year to $48.39 bill this time.

The U.N. chief urged all governments to tax these excessive profits “and use the funds to support the most vulnerable people through these difficult times.”

The calls to introduce windfall taxes also found support in organisations like the IMF, which released an advice note as to how such a tax should be levied. The chief of the Organisation for Economic Co-operation and Development (OECD), Mathias Cormann also recommended in March that given the windfall gains, European governments levy windfall taxes on the energy company profits to help fund support programmes for those most affected by inflation.

In July, India announced a windfall tax on domestic crude oil producers who it believed were reaping the benefits of the high oil prices. It also imposed an additional excise levy on diesel, petrol and air turbine fuel (ATF) exports.

India’s case was different from Europe’s, as it was still importing discounted Russian oil.  Analysts also saw the windfall tax as a way for the Centre to narrow the country’s widened trade deficit.

In Germany, most parties in the ruling coalition, except that of the finance minister, were keen on the idea of imposing a windfall tax on “excessive” profits of energy companies. Chancellor Olaf Scholz announced over the weekend that the country had decided to levy a windfall tax or “coincidence tax” on electricity companies in order to partly fund a 65-billion-euro ($64.7 billion) package to shield its citizens from soaring inflation.

The IMF noted that Italy has already imposed a one-time 25% tax on energy companies, while Spain announced a temporary windfall tax for extraordinary profits earned in 2022 and 2023 by electricity utility companies. Romania too introduced an 80 % windfall profits tax on additional revenue earned by electricity producers.

What are the issues with imposing such taxes?

Analysts say that companies are confident in investing in a sector if there is certainty and stability in a tax regime. Since windfall taxes are imposed retrospectively and are often influenced by unexpected events, they can brew uncertainty in the market about future taxes.

The IMF advice note also said that taxes in response to price surges may suffer from design problems—given their expedited and political nature. It added that “introducing a temporary windfall profit tax reduces future investment because prospective investors will internalize the likelihood of potential taxes when making investment decisions”.

There is another argument about what exactly constitutes true windfall profits and how can it be determined what level of profit is normal or excessive. A CRS report, for instance, argues that if rapid increases in prices lead to higher profits, in one sense it can be called true windfalls as they are unforeseeable but, on the other hand, companies may argue that it is the profit they earned as a reward for the industry’s risk-taking to provide the end user with the petroleum product.

Another issue is who should be taxed- only the big companies responsible for the bulk of high-priced sales or smaller companies as well— raising the question of whether producers with revenues or profits below a certain threshold should be exempt.

Besides, the windfall tax imposed by Italy has already met with a roadblock; Reuters reported that many Italian power, oil, and gas companies had not paid their 40% instalment of windfall taxes by the prescribed June date, leaving the government with a revenue shortfall of nearly $9 billion.

Notably, even when a similar tax was introduced by the U.S in the 1980s on domestic oil companies, the revenue it generated for the government was significantly lower than what it had projected, while the tax also reduced domestic oil production and increased imports.