Tax excess margins

With prices of commodities like oil soaring, there have been calls for a so-called “windfall-profits tax” from people like Sheldon Whitehouse and Elizabeth Warren. Matt Yglesias brings up the usual objection: If prices are soaring, it’s because producers aren’t producing enough to satisfy demand. Further taxing profits, the story goes, would only blunt incentives to produce, and so would be counterproductive. Yglesias suggests imposing a tax designed to be “inframarginal”, that would tax profits at levels beneath those producers are pretty sure to generate, but leave higher levels of profit untouched to preserve incentives to produce. I agree with Josh Barro that for a variety of reasons, this proposal is “too clever by half”. It would be hard to get right, especially considering how the precedent it sets would be perceived over a longer timeframe.

Nevertheless, it is good that Yglesias moves beyond the neoliberal reflex to assume taxes must always reduce incentives to produce. In theory, a reliably inframarginal tax wouldn’t affect those incentives at all. But we can do even better than that! We can design a profit tax that actually improves incentives to produce!

Holding the cost of goods sold constant, firms have two broad strategies to increase profits: They can increase the quantity of goods that they sell, or they can increase the price. Shareholders may be pleased either way, but the rest of us have a preference for the first strategy. We would like firms to seek profits by increasing production at moderate prices, rather than imposing scarcity and charging high prices. If markets were subject to textbook competition, firms could never choose the second strategy. One firm’s scarce production at high prices would become other firms’ opportunity to expand quantity and market share. But in concentrated industries, or say, an industry dominated by an international cartel and a few large producers, firms may tacitly coordinate to choose the second strategy. Call it “capital discipline”.

When competition does not prevent firms from resorting to scarcity and pricing power, a tax can. The key is not to tax profits per se, but profit margins. Then firms are free to be as profitable as they want to be, if they increase the quantity they produce and sell at customary margins. But if they try to shirk producing and just raise prices, the gravy gets taken away.

You wouldn’t want to tax accounting-derived profit margins. Firms would just raise prices anyway, and find ways to pad costs to keep margins low. But for commodities like oil, we know how expensive oil has to be for even high-cost producers, like US-based frackers, to turn a decent profit on each barrel of oil sold. So all we have to do to penalize the scarcity strategy is tax revenue collected at a fair margin above that price. Suppose the all-in cost to frackers per barrel produced is $80/barrel. We simply impose a tax on revenue above $100/barrel. Once the price of oil rises to this level, it does no good for producers if the price jumps even higher, to $120 or $140. The state takes the extra $20 or $40 away. The only way, then, to increase profits is to sell more barrels, or produce them more efficiently. And that is the incentive structure we want. Rather than blunting incentives to produce, taxing excess margin restores the incentives that, in a textbook economy, competition would provide. The same approach could be applied to refiners’ “crack spreads”. (See David Dayen.)

Not all of our politicians are idiots. If you read the details of the Whitehouse/Warren proposal, it is structured largely this way. It would tax 50% of the difference between current prices and prices known to be profitable for producers during an earlier period. It’s designed to hold producers harmless, if they increase quantities, but reduce the benefit they receive from a higher price. It even exempts smaller producers, to encourage competition to do the work and obviate the tax.

There’s no reason to get too clever by half. Sure, as you’d expect from Elizabeth Warren, a so-called “windfall-profit tax” (that is really an excess margins tax) has a populist stick-it-to-the-price-gougers vibe. But it is also a well designed levy from a technocratic perspective that would enhance incentives to produce when competition is insufficient to discourage industries from seeking scarcity rents. If such taxes are imposed regularly, the threat of them would reduce the incentives for industries to consolidate in the first place. Taxing persistent excess margins is in the sweet spot where good politics and good policy intersect. We should do more of it.


Postscript regarding climate change: I am terrified of climate change. It feels perverse to be writing about fossil fuels as an ordinary commodity whose quantity of production at lowest possible cost we should seek to maximize. Over as short a term as possible, we would like fossil fuels not to be produced at all, to be left in the ground. But I broadly agree with Matt Yglesias that, as a practical, political matter, kneecapping supply is a bad approach to this end. The material pain that unusually high energy prices produce, unless mitigated by some sweetener (like a carbon dividend), provokes backlash that undermines political coalitions serious about climate. High fossil fuel prices not due to an overt tax make the people who work to sabotage climate solutions richer and more powerful. These political circumstances may change, perhaps very soon unfortunately, as each summer is deadlier and more frightening than the last. But for the moment, high fossil fuel prices provoke political reaction more effectively than they promote desirable efficiencies. As long as this remains true, the key to weaning ourselves must be to render fossil fuels expensive relative to carbon-neutral alternatives, rather than in absolute terms. That is, we need to drive down the perceived cost of substituting efficiencies or alternative energy sources so that reduced use of fossil fuels is not painful. This is a political rather than ethical claim. From an ethical perspective, we ought to be willing to tolerate large standard-of-living sacrifices (and the redistributions that would be necessary not to starve people) in order to preserve a habitable planet. Politically, however, we are not there yet, so we must invent spoonfuls of sugar to help the medicine go down.

 
 

5 Responses to “Tax excess margins”

  1. Brett writes:

    Profit Margin tax seems like it would specifically punish innovation. If you try something new in the hopes of getting a bigger profit margin from it in an existing industry, it will just be taxed away.

  2. Somebody writes:

    This doesn’t work even for the example of oil. One of the main ways to increase production is to tap sources that are more expensive to exploit. If you set the default price based on the Saudi cost to produce a barrel ($30) nobody can ever exploit the Canadian tar sands ($85).

    I’m opposed to exploiting the tar sands for other reasons, but the analogy holds for lots of other scenarios. The easy way to increase production at a factory is to pay for overtime, etc.

  3. Effem writes:

    You haven’t spent enough time studying cyclical industries. Often years or decades of negative economic profits (below cost-of-capital) will be made up for in a single up-cycle where supply/demand gets very tight and excess profits are large. Cutting off that right tail would absolutely reduce new investment. Still not ideal, but it’d make more sense to do something along the lines of: “tax profits well in excess of cost-of-capital on a 10-year cumulative basis” – but you’d find we rarely (if ever) end up taxing commodity producers under such a scheme.

    If we want something resembling price controls (which is what a profits tax is); we should tax profits or cap prices of goods with very low marginal cost of production such that there is limited impact on supply. Internet advertising comes to mind.

  4. benign brodwicz writes:

    steve,

    you still don’t get it. force distribution of excess profits (say 10%) to employees so that it reenters the spending stream and boosts demand and output. keep the money out of the hands of government, which will only waste it!

    cheers,
    benign

  5. Noumenon72 writes:

    Not seeing how this differs from a price cap.