The economics of windfall taxes

The imposition of a windfall tax on energy companies is supported by a majority of the public and many politicians. Revenues would be used to support low-income households struggling to pay gas and electricity bills following a series of steep price rises.

Yet consideration of the economic impacts of such a measure should lead to its outright rejection. Firstly, the arbitrary imposition of an extra payment would increase the risks to businesses of investing: as a result, they will demand higher returns on their investments or choose not to invest at all. Secondly, the tax would reduce the dividends paid out to energy company shareholders. These companies are not owned by “fat cats” but by us all through pension funds and insurance companies. Finally, it would reduce the funds available for investment in new sources of supply, thereby increasing energy costs in the long term.

Given the above effects, a windfall tax could harm many of the people it was designed to help and actually reduce long-term tax revenues. More generally, harsh though it may seem, it is a very slippery slope trying to protect parts of the population from particular price increases – especially in the energy sector. That is the way to stop people adjusting to a new environment of greater scarcity and is precisely the best way to induce shortages of supply in the future.

9 September 2008, IEA Blog

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