Explained | What is windfall tax and why are countries imposing it on the energy sector right now?

Source: The post is based on the article “Explained | What is windfall tax and why are countries imposing it on the energy sector right now?” published in The Hindu on 14th September 2022.

What is the News?

The Finance Minister has defended the windfall tax imposed by the Government on domestic crude oil producers by saying that it was not an ad hoc move but was done after full consultation with the industry.

What is the 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.

Note: The United States Congressional Research Service defines a windfall as an unearned, unanticipated gain in income through no additional effort or expense.

What is the rationale behind imposing a windfall tax?

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 imposing Windfall Tax now?

Prices of oil, gas and coal have seen sharp increases since late 2021. This 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.

These 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.

What are the issues with the windfall tax?

Firstly, 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.

Secondly, there is another argument about what exactly constitutes true windfall profits and how can it be determined. For instance, 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 petroleum products.

Thirdly, there is an issue of 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.