It should not be difficult to understand that if a firm is prevented from realizing excess profits when the price of its product rises unexpectedly, while it will have to support excess losses when the price drops below expectations, its owners will not incur costs to make sure it has enough productive capacity to profit from a possible future emergency. So why is the government of the European Union imposing an excess-profit tax on European energy producers following the Russian supply cuts? (See “Exxon Sues EU Over Windfall Profit Levy,” Wall Street Journal, December 28, 2022; “Exxon Sues EU in Move to Block New Windfall Tax on Oil Companies,” Financial Times, December 28, 2022.)
Is it because politicians, bureaucrats, and voters are so cognitively impaired that they cannot understand this simple case of incentives? It would be a too simple and ad hoc hypothesis.
The reason instead is that political processes and especially democratic processes are myopic, biased toward the short term and often the very short term. The typical politician may not be in power when the detrimental consequences may be recognized years from now—while, on the other hand, they are strongly pressured to do something now, anything, and especially with somebody else’s money. Government bureaucrats are sure to get their salaries and pensions whatever happens, short of widespread destruction of capital or a revolution. The typical voter has no incentive to spend time and other resources on getting and analyzing information on public policy since his individual vote will not change anything in a collective choice; and even if he made inordinate efforts to understand, he would have to cast his single vote on bundles of complex measures whose intricate and interrelated consequences are typically impossible to forecast.
In the current climate of public opinion, moreover, government rulers don’t really care if oil supply from private companies drops because their incentives have been undermined. The rulers know (or think) that they will be able to recreate new incentives through subsidies or tax preferences, or just boss the companies around through fear of further regulation or expropriation. In fact, the rulers will normally benefit from enhanced state powers and many of them would anyway prefer private companies to be gradually replaced by state corporations.
READER COMMENTS
steve
Dec 29 2022 at 11:02am
If you are correct shouldn’t energy companies be going out of business? Which companies have failed?
Steve
Jon Murphy
Dec 29 2022 at 11:07am
Jon Murphy
Dec 29 2022 at 11:07am
Why?
steve
Dec 29 2022 at 1:02pm
“its owners will not incur costs to make sure it has enough productive capacity to profit from a possible future emergency.”
Look at Venezuela? How about Norway? Saudi Arabia for that matter. I think by now almost everyone agrees that businesses completely dominated by a socialist system are more likely to fail, but that is not what is currently happening. There have been a number of windfall tax events and as far as I cant tell it didnt harm productive capacity for future emergencies in any measurable way. Companies arent failing/havent failed. It looks like when companies think they can make more money they pump more oil and if they dont they do less .he current events with prices being driven up by the war Russia started seem much more akin to prices being driven up by the Enron folks creating shortages.
Steve
Jon Murphy
Dec 29 2022 at 1:19pm
I’m still having trouble understanding your point. It doesn’t logically follow that regulation X will cause firms to fail if it makes expanding capacity more difficult. Applying the breaks will slow your speed but not necessarily cause the car to stop entirely.
The current state of affairs in the oil world is actually strong evidence to Pierre’s point. Oil prices have risen over the past few years and yet production has not. Oil and gas companies are having difficulty getting capital (because of regulations and ESG nonsense). A windfall tax is further hindering their ability to expand production.
What that translates to is not firms failing left and right, but rather a very inelastic supply curve with the burden of the tax falling on consumers.
steve
Dec 29 2022 at 4:18pm
I think oil companies have made it pretty clear that since the shortage could disappear quickly they have been hesitant about drilling. If Ukraine and Russia come to terms how many of us really expect Germany to not go back to using Russian gas? Lets look at Saudi Arabia. They could fairly easily increase production but they arent. Is that somehow due to ESG and regs? Oil companies got burned a bit with the pandemic slowdown and pretty happy with making a lot of money w/o a lot of new investment. Note that current profits even after windfall taxes will still be as high or higher than they were when they were willing to keep expanding production so its fear of lack of future demand affecting production not lack of extra large profits right now.
Steve
Jon Murphy
Dec 29 2022 at 5:35pm
First, there is no shortage
Second, the data I cite predates the war
Pierre Lemieux
Dec 29 2022 at 11:16am
Steve: The way producers don’t go out of business in similar cases is that they respond to the new government-distorted incentives: they reduce investment (or quantity supplied in the short run if government intervention increases short-run marginal cost–not the case with an excess-profit tax). Ultimately, Atlas shrugs. Look at Venezuela. Argentina was once among the richest companies in the world. And so forth.
vince
Dec 29 2022 at 3:52pm
It’s an excess profits tax. There’s still profits. Instead of shutting the business down, the tax would reduce investment and also reduce the stock price.
Mactoul
Dec 29 2022 at 6:42pm
With so much socialism and ever increasing regulations, the world continues to grow ever richer.
This is what everyone has witnessed in their entire lives.
When was the hayday of free markets and no regulation? Compare then and us. Who is richer?
This is what governments are banking upon and can they be blamed?
Indeed, the precisely the same logic applies to McCloskey theme –contrary to McCloskey, it isn’t changed attitudes that are responsible for present prosperity but simply technological growth.
Pierre Lemieux
Dec 30 2022 at 11:55am
Mactoul: You must ask yourself the same questions that Deirde McCloskey and also Joel Mokyr asked: Why did 19th-century technological innovations grew at an accelerating rate and lead to an unprecedented explosion in the general standard of living? Remember that there had been important technological innovations before in the story of mankind before. Why didn’t they lead to the Great Enrichment? Look at the chart on p. 59 of my review of Mokyr linked to above and also at my EconLog post “Individualism and Western Civilization.” Technology does not explain much if one cannot also explain why it develops and why it why it generates economic growth.
MarkW
Dec 30 2022 at 10:00am
Why Are Governments So Myopic?
Because politicians believe a majority of voters are similarly myopic. Actually the politicians may not be myopic themselves, but that doesn’t matter. If they (probably correctly) believe they can win votes via demagoguery against oil companies, that’s what they’ll do. The job of pundits really isn’t to convince politicians, it’s to convince the general public.
Jim Glass
Dec 30 2022 at 12:37pm
“Why Are Governments So Myopic?”
Because politicians believe a majority of voters are similarly myopic.
And believe so correctly. (Voters also are profoundly ignorant in all dimensions, easily manipulated emotionally, place loyalty to tribe above reason … but I digress.)
Actually the politicians may not be myopic themselves, but that doesn’t matter.
Exactly. My favorite, most clear cut, large scale example of this is the creation of Social Security.
FDR believed it very important that SS be fully self-funded on an actuarially sound basis with no transfers between generations. He was so set on this that when he read the original text of the 1935 SS Act and found it included some general revenue support in the 1960s(!), he threw a famous tantrum and had the bill withdrawn from Congress and re-written. (Try to find a politician today so dedicated to fiscal responsibility.)
So his SS Act of 1935 was as he wanted it, funded with a payroll tax rising to 6% in the 1940s while not paying full benefits for 20+ years, the resulting tax surplus being saved in federal bonds. And he proudly proclaimed SS to be “actuarially sound and out of the Treasury forever.”
That lasted until 1939. See the problem? All that tax cash coming in and not being spent. Left-side politicians said, “it is immoral for the payroll tax on workers to be used for the sake of rich bond owners, we must spend it on socialist projects” (socialist projects then being a lot more socialist than they are now). The Right-siders said “The left is just going to squander the money on socialist pork spending for themselves, we must slash the tax.” The two sides compromised by cuttung the tax to 2% and spending all the revenue from it right away on faster, bigger benefits.
FDR was quite upset and his head of SS, Arthur Altmeyer, protested to Congress…
Altmeyer said the Congressional leaders told him, “Yes, but that will be somebody else’s problem.” FDR vetoed the change – it was his only veto to be over-ridden. Social Security went bust in 1981, taxes were then raised and benefits cuts — increasingly so into the future. Last I looked those born after 1953 will get back ~$30 trillion less from SS than they put in, that amount being transferred to those born before 1953.
*Everybody* in 1939 knew the SS law change would be very bad in the future, “gross financial mismanagement”. They couldn’t stop themselves. Just like Congress today can’t make Medicare pay for big money nursing home care, and can’t stop it from paying for routine out-of-pocket expenses. They dang well know better but they have no choice.
The voters want what they want, and Congress critters who don’t give it to them get removed from the political gene pool. Many politicians pose as being stupider than they are in order to survive.
“The best argument against Democracy is a five-minute conversation with the average voter.” — Churchill
[See The Real Deal: The History and Future of Social Security, by former SSA Trustee Sylvester Schieber, and SSA.gov’s excellent history resources.]
robc
Dec 30 2022 at 2:50pm
My interpretation: FDR asked congress to be unprincipled constitutionally, then was surprised when they were also unprincipled financially.
Pierre Lemieux
Dec 31 2022 at 1:18pm
Jim: An interesting example that confirms everything in my post!
Jim Glass
Jan 2 2023 at 7:19pm
Yes. we sure agree on this, I just looked up the current unfunded liability…
Note that this is just for current participants. And the Medicare liability dwarfs this.
Mactoul
Dec 30 2022 at 7:02pm
Sometimes government hyperopia is a problem. Witness all the hoopla with climate change and what sea level would be a century later.
Pierre Lemieux
Dec 31 2022 at 1:27pm
Mactoul: I don’t think so. Governments satisfy important and noisy electoral clienteles, whatever the immediate cost. QED.
Recall Anthony de Jasay:
David
Dec 30 2022 at 10:08pm
Maybe they’re not myopic or stupid; maybe they are just malevolent.
Pierre Lemieux
Dec 31 2022 at 1:33pm
David: There is a danger with this hypothesis, though. The danger is to explain everything good by benevolent spirits, and everything bad by malevolent spirits. The explanation assumes the explanandum.
Thomas Lee Hutcheson
Dec 31 2022 at 8:28pm
Which tax has a lower dead weight loss?
Pierre Lemieux
Jan 1 2023 at 4:44pm
Thomas: A head tax. QED?
robc
Jan 2 2023 at 1:22am
Single Land Tax.
Pierre Lemieux
Jan 2 2023 at 11:06am
robc: That’s a good example too, which we alas tend to forget.
Jim Glass
Jan 2 2023 at 7:43pm
“lower dead weight loss?” “Single Land Tax.”
In theory, not in practice. Transaction costs for a single land tax are huge. That’s a deadweight loss, and why it doesn’t exist anywhere after going extinct everywhere it used to be. (Last gasp: Pittsburgh).
We can remember how Coase used to complain so much about how transaction costs never appear in the nifty supply-demand curves analysis so often relies upon. Perfect example.
Pierre Lemieux
Jan 2 2023 at 7:54pm
Jim: Remember three things: (1) If a land tax is only on unimproved land, then the supply curve is vertical and there cannot be any deadweight loss. That’s the form of a theory: if … then. (2) A deadweight loss is a cost, but not all costs are deadweight losses. (3) A theory is necessarily different from reality because it is meant to explain many cases (different from other points of view).
Jim Glass
Jan 3 2023 at 4:58pm
You’re not taking any guff from Coase, eh? But his ghost may have a question for you.
First, let’s start with the supply-demand curve for land tax, as seen on the Land Tax page at Wikipedia and many other places. It’s so simple and elegant and waste free! Enough to mesmerize many simple folk into thinking the tax itself is simple and elegant and waste free. No deadweight loss at all!
Then let’s look at the real tax. It inherently, unavoidably relies on property valuation by appraisal — which is by far the worst, most inefficient form of assessment. At the state level the great majority of all tax litigation is over appraised property values, in spite of all the other taxes states impose (income, business, sales, etc.) In the federal system, litigation over property valuations dwarfs all other tax litigation relative to tax dollars involved. And this is when appraisals are honest!
NYC had a billion dollar property assessor corruption scandal that ran on for years. (Have you ever heard of a “billion dollar income tax auditor” scandal?) And that’s just with a single level of valuation. Imagine the fun the assessors would’ve had with a compound valuation — first valuing the entirety of every property in NYC, then also valuing just the improvements on each and every one, to subtract them to get the “land alone” value.
Pittsburgh tried this in 2000. In that one year 140,000 tax appraisals went to litigation and the entire system collapsed. The tax was immediately repealed, though cleaning up the litigation took years more. OK…
NOW, let’s consider Coase and that nifty, original supply-demand curve. He was exactly right! Somehow, the huge transaction costs that make the tax literally impossible don’t appear in the supply-demand curve that makes it look so efficient and attractive! Go figure. Sorry, but nobody can argue with Coase about that. He’s spot on there.
As to “deadweight loss”, I know full well how those nifty lines work, yet Google also provides definitions such as “deficiency caused by an inefficient allocation of resources”. To me, a tax system that so massively drives inefficient allocation of resources as to literally destroy itself looks like it meets the definition of creating that pretty dang well. But if your preferred definition is “supply of land remains unchanged in spite of the tax system destroying itself”, so the self-destruction of the Pittsburgh tax system caused no deadweight loss, then maybe not?
So the Ghost of Coase asks — being that the very substantial cost of the appraisal mechanism is inherent and unavoidable in land tax — should the supply-demand curves for land tax be…
1) Adjusted to include the inherent transaction cost of the appraisal mechanism within them, to provide a realistic picture of the tax’s true inefficiency and cost impact? Or…
2) Left alone as is, in the purist manner, leading Matty Yglesias and robc, etc., to be so impressed by its simplicity and theoretical efficiency as to lobby hard for its adoption because in theory it is the most efficient of all taxes — in the spirit of Homer Simpson’s “In theory Communism worked, in theory.”
You decide!
Really, I can’t think of a better example of such “blackboard economics” than Land Value tax. Can you?
Pierre Lemieux
Jan 4 2023 at 11:10am
Jim: A few technical points:
1) I agree that evaluation of land value–and even more of unimproved land value, which is what we are talking about–is difficult. But so is the evaluation of “income,” and even more real income. (One of the multitude of related problems: Is the cost of a business suit you buy only to wear in the office a production cost?)
2) Costs cannot shift a vertical supply curve. The ultimate reason is that they don’t affect behavior. (They would however appear in the government’s budget.)
3) Whatever Wikipedia says, a deadweight loss is the value lost when the (marginal) cost of something produced is higher than its consumer (marginal) benefits (too much produced), or when consumer (marginal) benefits are higher that the (marginal) cost of production (to little produced).
4) Coase’s critique of “blackboard economics” is well known and not, I think, his strongest point (see my obituary of Coase). If you cannot, even in theory, draw a demand and supply curve, you have a big analytical problem. (But then, see Buchanan’s Cost and Choice, which is very Coasian.)
robc
Jan 2 2023 at 9:20pm
Why would transaction costs for a single land tax be any wirse than for property tax? It should be less, as calculating land value is easier than land+improvements+property value.
Also, Pittsburgh had a land value tax, not a single land tax. They were still paying income tax, for example.
David Seltzer
Jan 1 2023 at 4:30pm
My conjecture as to why individual politicians are myopic. I suspect it’s because they are limited by an aversion to the risks of innovation. It may be a property or characteristic of their nature. In a system of democratic majority and regulatory capture, it easier for politicians to pick winners for their meaningful constituents than risk the failure of the entrepreneur who dares greatly and fails. Innovators like Jobs, Musk, J. K. Rowling, Branson Bezos, et al, are less risk averse and more robust in self-confidence in a competitive world of producers and consumers. The John Galt’s and Howard Roark’s of the world are not fearful humans.
Jim Glass
Jan 2 2023 at 7:31pm
Jobs, Musk, Rowling, Branson, Bezos, Galt and Roark didn’t have to worry about getting voted out of their jobs every two years by mobs of ignorant short-sighted voters moved by tides of Twittiots.
Politicians act as they do for a reason.
David Seltzer
Jan 3 2023 at 2:20pm
Jim, I thought about your comment. Some would be ousted in in two years. The longest serving members of congress have acquired considerable power. Biden served in the Senate for 36 years. Said he would tax those making over 400k to make them pay their fair share. Tax foundation says “The top 1 percent paid a greater share of individual income taxes (38.5 percent) than the bottom 90 percent combined (29.9 percent).” Chuck Schumer has been in Congress for 41 years. McConnell for 37 years. Warren, 10 years. Warren wants to tax “windfall profits” of oil companies. Strom Thurmond, staunch segregationist, 47 years Ted Kennedy, 46 years. Obama, 8 years. “You didn’t build that!” “If you like your plan…” Their modus operandi; you build it, we’ll tax it, regulate it and tell you how to use resources. In this woke environment, we will censor your speech and tell you how to think. The dominion of shareholders is diminished with large dead weight loss. Bezos, et al, are the exceptions for exceeding two years of not being “voted” out of business by market forces. 90% of new startups fail in the first two years of existence. Less than 50% of business’s get to the 5th year. 30% make it to 10 years. It seems these intrepid entrepreneurs probably worry about being voted out of their livelihoods in two years and still dare greatly.
Anders Jönsson
Jan 16 2023 at 5:31am
I agree that some might be cognitively impaired, but I doubt that is the reason. After all, they would all have large offices with professional economists as advisors.
It is more the visuals. Over half of citizens believe that we are heading for disaster because of fossil fuels. In that context, it simply does not look that good that oil companies (or even more so, resource exporting countries) make such enormous windfall profits from the fact that people do not want to freeze to death.
Of course, these oil companies already know that demand will increase in the medium term, whatever that may mean (but in our lifetime). As a result, they barely invest in exploration – driving up the prices and the windfall profits even more. Meanwhile, the risks are so high for exploration or innovation in the only obvious alternative, nuclear, that massive subsidies are needed: a system of profits without loss, in other words.
We all know this. But politics is not about thinking things through, but about optics. And the optics are about as atrocious as bailing out risk-taking bankers gone wild. The windfall tax will not hold up legally as it falls foul of basic investor protection clauses in the treaties – in other words primary legislation. I only hope that in the ensuing public debate the underlying problem might become more salient and push governments towards investing in innovation and sustainable solutions rather than massive subsidies into wind mills.
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