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

In News:

• Finance Minister Nirmala Sitharaman defended the windfall tax imposed by the Centre on domestic crude oil producers.
• She said the introduction of the windfall tax as a way to rein in the phenomenal profits made by some oil refiners.
  • These refiners chose to export fuel to reap the benefits of skyrocketing global prices while affecting domestic supplies.

Background

• The Central government on July 1, introduced a windfall profit tax of ₹23,250 per tonne on domestic crude oil production.
• This was subsequently revised fortnightly four times so far.
• Analysts believe that the windfall tax in India was targeted mainly at Reliance Industries Ltd and Russian oil major Rosneft-backed Nayara Energy.
  • As per the government, these companies were making a killing on exporting large volumes of fuel made from discounted Russian oil at the cost of the domestic market.
    • Keeping the national interest in mind, India started to import cheap Russia oil after the Ukraine war.

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.
• The United States Congressional Research Service defines a windfall as an unearned, unanticipated gain in income through no additional effort or expense.
• These are profits that cannot be attributed to something the firm actively did, like an investment strategy or an expansion of business.
• Governments typically levy a one-off tax retrospectively over and above the normal rates of tax on such profits, called windfall tax.

Rationale behind imposing windfall taxes

• Redistribution of unexpected gains when high prices benefit producers at the expense of consumers,
• To fund social welfare schemes,
• As a supplementary revenue stream for the government,
• As a way for the Centre to narrow the country’s widened trade deficit.

Why are countries levying windfall taxes now?

• Prices of oil, gas, and coal have seen sharp increases since late last year and in the first two quarters of the current year, although having reduced recently.
• The 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.
• The 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.
  • Eg., the combined profits of Shell, Exxon Mobil, Total Energies, BP, Chevron Corp and Saudi Aramco went from $45.09 billion in Q2 2021 to $107.64billion in Q2 2022.
• Since the gains stemmed partly from external change, multiple analysts have called them windfall profits.

Multilateral institutions supporting windfall tax

• The calls to introduce windfall taxes found support in organisations like the IMF, UN, and Organisation for Economic Co-operation and Development (OECD).
• Recently, the U.N. chief urged all governments to tax these excessive profits and use the funds to support the most vulnerable people through these difficult times.
  • He said it was immoral that the largest energy companies in the first quarter of the year made combined profits of close to $100 billion.

Issues with imposing such taxes

• Brings uncertainty in the market
  • Since windfall taxes are imposed retrospectively and are often influenced by unexpected events, they can brew uncertainty in the market about future taxes.
  • This may affect the future investment in the related sectors.
• Populist in nature
  • Many analysts believe that such taxes are populist and politically opportune in the short term.
  • The IMF advice note also said that taxes in response to price surges may suffer from design problems—given their expedited (quick) and political nature.
• Profits earned in such instances are reward for the risk taken
  • Companies argue that it is the profit they earned as a reward for the industry’s risk-taking to provide the end user with the petroleum product.
• Who should be taxed is another issue
  • Another issue is who should be taxed- only the big companies responsible for the bulk of high-priced sales or smaller companies as well.
  • This raises the question of whether producers with revenues or profits below a certain threshold should be exempt.