Windfall taxes are no free lunch

Philip Booth, Professor of Finance, Public Policy and Ethics, St. Mary’s University, Twickenham; Senior Academic Fellow, Institute of Economic Affairs discusses windfall taxes with us.

It is no wonder the electorate supports a windfall tax to try to deal with the costs of the pandemic. After all, a windfall is something you get for free. The electorate at large perceive that others have had some good fortune. A windfall tax would allow us to pay off some of the debt whilst putting our hand in somebody else’s pocket. What is the problem with that?

A windfall tax is targeted at a particular industry which has in some way made higher profits as a result of an event that is beyond its control. They were used at least twice in the first Thatcher government. In 1981, Geoffrey Howe levied a tax on banks which were thought to have benefited from high interest rates whilst not sharing in the pain suffered by other parts of industry and commerce. The following year, there were additional taxes imposed on the profits from North Sea oil. As Chancellor, Gordon Brown then imposed windfall taxes on the privatised utilities in 1997 which, over a number of years, raised £5bn. He justified his decision on the grounds that they had monopoly power which had led them to make excess profits.

In the wake of the pandemic, it has been argued that supermarkets and companies that rely on online markets have gained because of the extraordinary circumstances and that they should be punished, just as the privatised utilities, banks and oil companies had been in the past. Some have even argued that those working at home gain from lower costs and they should pay extra taxes too.

As it happens, the Howe and Brown examples do have a stronger justification than the use of windfall taxes post-pandemic. At least in the case of the North Sea oil and the utilities tax it could be argued that the profits arose as a result of the failure of government policy. In the case of oil, the government grants monopoly rights to drill and profits were boosted by the OPEC cartel. In the case of the privatised utilities, it could be argued that not enough was done to expose them to competition. Indeed, the banking sector, back in 1981, was so protected by government that it could be argued that excess profits were made by the banks.

However, even in these circumstances, windfall taxes were a bad idea. 

Firstly, reduced post-tax profits lead to reduced returns on pension savings (which in the case of the tax on privatised utilities contributed to the collapse of pension saving from the late 1990s). Windfall taxes raise the required return on capital, not just by the cost of the additional taxes, but also through higher risk premiums that are necessary because investors come to perceive the tax regime as being unstable. A higher cost of capital means that, ultimately, the owners of companies are compensated at least to some extent. However, customers have to pay more for goods and services as companies have to provide higher gross returns to shareholders. If the economy becomes less capital intensive because of the arbitrary tax regime, this will reduce workers’ wages as productivity declines.

A second round effect of windfall taxes is that they reduce competition. Incumbents, at least in the short term, have to put up with the tax regime. However, potential new entrants into an industry can choose to use their capital in some other way and not to enter the industry that is subject to an unstable tax policy.

And it is this point which is crucial when it comes to the question of post-pandemic windfall taxes. The pandemic is likely to see a considerable shake-up in business models. It is important that resources move away from models that are in decline and respond to new patterns of demand. At least to some extent, Zoom will replace business travel and online shopping will replace high street stores. The profits made by the businesses that have thrived in the pandemic are the spur to more competition in these areas. A windfall tax would have the three-fold effect of raising costs to consumers, preventing the adjustment to new business model and thus the creation of thousands of new jobs, and discouraging new entrants from coming into the market to compete with the first movers.

If we are going to levy a one-off tax to help pay for the costs of COVID, it should be a broad-based addition to income tax or VAT paid by all taxpayers. Windfall taxes are popular because they are narrowly based, arbitrary and extremely opaque. These are dreadful principles on which to base a tax system. To put it simply, a windfall tax would be a shot in the foot for an economy that needs a shot in the arm.

Phillip Booth is a Professor of Finance, Public Policy and Ethics.