Windfall Tax

Syllabus: General Studies Paper 3

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.

• 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 influenced by unexpected events, they can brew uncertainty in the market.

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 U.S. Congressional Research Service (CRS) defines a windfall as an “unearned, unanticipated gain in income through no additional effort or expense”.
• Governments typically levy this as a one-off tax retrospectively over and above the normal rates of 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.

Why are countries levying windfall taxes now?

• Prices of oil, gas, and coal have seen sharp increases since last year and in the first two quarters of the current year, although they have reduced recently. 
• Pandemic recovery and supply issues resulting from the Russia-Ukraine conflict shored up energy demands, which in turn have driven up global prices. 
• The rising prices meant huge and record profits for energy companies while resulting in hefty gas and electricity bills for households in major and smaller economies. 
• 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. 

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. 
• Difficulty in constituting true windfall profits; their determination and level of normalisation of profit. 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 risk-taking to provide the end user with the petroleum product.

The International Monetary Fund (IMF), which released an advice note on how windfall taxes need to be levied also said that taxes in response to price surges may suffer from design problems—given their expedient and political nature. 

• It added that “introducing a temporary windfall profit tax reduces future investment because prospective investors will internalise the likelihood of potential taxes when making investment decisions”.
• The tax should be imposed on a share of economic rents (meaning excess profits).