What Would a Windfall Profits Tax Mean for California?

Governor Newsom proposed a “windfall tax” or “price gouging penalty” in fall 2022 to capture a share of the extraordinary recent profits of oil companies operating in the state and return it to Californians impacted by high gas prices. The governor has said that he will call a special session of the Legislature to take up this proposal. This Q&A discusses the concept of a windfall profits tax, why Governor Newsom is calling for such a tax on oil companies, and how it could impact Californians.

What is a windfall profits tax?

In general, a “windfall profits tax” or “excess profits tax” is intended to tax the portion of a corporation’s profits that exceed some specified “normal” level. Excess profits might represent advantages a corporation has due to market concentration and lack of competition or due to an external event like a war, natural disaster, or a pandemic — or a combination of these factors.

For example, during WWI, WWII, and the Korean War, the US put in place excess profits taxes that were intended to discourage some corporations, such as weapons manufacturers, from receiving outsized benefits due to war.

In the 1980s, the US instituted a “Crude Oil Windfall Profits Tax,” but it was not a true tax on excess profits. Instead, it was an excise tax on domestic oil production applied to the difference between the market price of a barrel of oil and a base price.

There have also been proposals by some academics, advocacy groups, and federal policymakers for windfall profits taxes on corporations that have seen record profits during COVID-19 while many Americans have suffered the health and economic consequences of the pandemic.

What is the difference between a windfall profits tax and a corporate income tax?

There are several ways to structure a windfall profits tax. But the main difference between a windfall profits tax and a corporate income tax is:

• A regular corporate income tax takes a percentage of a corporation’s total profits (revenues minus costs and other deductions allowed for tax purposes).
• A windfall or excess profits tax is designed to get at those profits above a normal rate of return on investment or above the average profits during a baseline period.

And while a corporate income tax is levied on corporations’ profits every year, a windfall profits tax is generally a temporary tax in place for a specified period of time such as during a war or a period of high oil prices.

However, an excess profits tax could be implemented on a permanent basis if designed to tax profits above a specific rate of return or profit margin. In this case, the intent would be to capture some of the extraordinary profit a business receives by virtue of having a high degree of market power, control of some natural resource, or some other advantage, rather than just capturing the windfall profits received due to some external event like a war, pandemic, or natural disaster. In fact, a permanent tax may be a more effective policy since it is less likely to discourage investment as it is more stable and predictable.

Why is Governor Newsom proposing a windfall profits tax now?

Governor Newsom has drawn attention to the fact that oil companies have seen record profits recently while many Californians are struggling with high gas prices. He has suggested that oil companies are using their market power to price-gouge Californians. To the extent that this is true, it may be sensible for policymakers to recapture some of the undue profits oil companies have made and return them to Californians.

If policymakers do enact a windfall profits tax, California would likely be the first state to do so. However, some European countries have recently enacted various versions of temporary windfall taxes targeted at energy companies in response to rising prices in that sector.

Should California policymakers adopt a windfall profits tax on oil companies?

In general, it’s reasonable to tax excessive profits a corporation receives due to monopoly power or taking advantage of a crisis. Corporate profit margins have been at or near long-time highs, and not just for the energy sector. And corporate profits have accounted for a significantly larger share of price increases over the past few years compared to the average over the previous four decades, while many corporate executives have recently discussed on investor calls how they have benefited from keeping prices high.

However, if policymakers choose to move forward with this proposal, they should be prudent when designing it to minimize unintended consequences that could harm Californians, such as reductions in supply leading to even higher prices. The “Crude Oil Windfall Profits Tax” that was in place in the US from 1980 to 1988 — which was actually a tax based on the price of a barrel of oil instead of oil company profits — was not very successful, raising significantly less revenue than projected and contributing to a reduction in domestic oil production and an increased reliance on foreign imports.

Policymakers have many options for ensuring that corporations making excessive profits — including but not limited to oil companies — are paying their fair share in state taxes. Since the early 1980s, the share of corporations’ California income that they pay in state taxes has fallen by about half. This significant drop is a result of factors including reductions in the official corporate tax rate in the 1980s and 1990s as well as the enactment of multiple corporate tax breaks which disproportionately advantage large and multinational corporations, have uncertain economic effects, and cost the state billions in revenues each year.

Policymakers can eliminate or limit some of these costly tax breaks and increase the corporate income tax rate on the most profitable corporations. State leaders could also explore adopting a permanent tax on oil and gas extraction — known as a “severance tax” — as many other states already have. The additional revenue raised from these measures could then be used to help ensure all Californians can thrive in their communities.

How should California use the revenues from a windfall profits tax or other corporate tax increases?

Californians have been hit by rising costs of almost everything this year — from gas to groceries to rent and more. These price increases are especially harmful to Californians with low incomes, who struggle to afford the basics even in times when inflation is low. About 2 in 3 California households with incomes below $35,000 reported having trouble paying for their usual expenses in September and October 2022, as did nearly half of those with incomes between $35,000 and $75,000.

People with low incomes are hit hardest by inflation because they need to spend larger shares of their income to meet their basic needs like food, housing, and transportation, which have been subject to large increases. They also have less ability to change their spending patterns to reduce the impact of inflation on their budgets, such as by switching to lower-cost versions of products, since they are likely already purchasing the lowest-cost versions. Black and Latinx households may also be disproportionately harmed by inflation as they are more likely to be renters than homeowners and rental inflation is generally higher than overall inflation.

Policymakers should keep these facts in mind when deciding how to distribute the revenue from a windfall tax — which likely would be much smaller than recent rounds of tax rebates for Californians — or other strategies to improve the taxation of profitable corporations. Additionally, as state leaders work to craft the state’s 2023-24 budget, they should avoid giving away tax breaks to corporations and prioritize the pressing needs of Californians who are struggling the most with the costs of living, such as by protecting and strengthening cash assistance and other supports to help families with the costs of child care, health care, and housing.