The Windfall Tax

2 June 2022

The Windfall Tax

Raising money.

By John Watson

Photo of John Watson

So now we have the answer. The energy package is to be backed by a windfall tax which will raise £5bn, a substantial proportion of the money needed to help the public to deal with the economic spill-over of war in the Ukraine. The decision, though, has required much soul-searching.

Windfall tax, in this case a new Energy Profit Levy of 25% on oil and gas profits, will push the effective rate on those profits from 40% to 65%; that rate will drop back to its previous levels as the international price of energy normalises with a built-in drop-dead date at the end of 2025. That reflects the fact that current market conditions allow energy companies to make much higher profits than normal and is designed to ensure that a high proportion of these profits go to the government to help it finance its relief package. Labour have been calling for a windfall tax for some time. The industry seems able to live with it. The profits on which the tax is suffered are fortuitous in that they result from unusual market circumstances rather than on any commercial innovation by the taxpayer. What is not to like? Yet the Prime Minister, a man not averse to populist low-hanging fruit, is known to have resisted the move as being non-Conservative. What exactly was the problem?

High tax rates on fortuitous profits are no novelty to the UK tax system. For years the taxation of land development profits was dominated by attempts to capture that part of a developer’s gains which reflected the “unearned” value of planning permission. Development gains tax, development land tax, the obligation to carry out public works in return for planning permission, all were inspired by the idea that the opportunity to develop was provided by the state and that the state should share correspondingly in the profits. Then there is the residential property market with profits driven beyond inflation by inexorable pressure and owner-occupiers exempt from capital gains. Clearly another sort of windfall here so, the direct taxation of owner-occupiers being electorally impossible, the state took its share through stamp duty land tax and a higher rate of corporation tax on residential developers. And of course there is the energy sector itself where the corporation tax rate was already at 40% and the state participated in North Sea profits through a special regime. There of course there were no voters involved so the question was purely a technical one. How could the Treasury maximise its yield without killing the golden goose?

Yet for all this precedent, windfall taxes are worrying because of the uncertainty which they introduce into the system. Imagine yourself an energy company deciding whether to invest in new infrastructure. The planned expenditure has to be compared with spending the money in other ways, in other countries perhaps. To make the decision you will run hundreds of cash flows and each of those cash flows will be built on a series of assumptions as to interest rates, tax rates, the energy market and all the rest of it. A change in the tax rules, or indeed a change in the regulatory regime, can by reducing possible upside throw those careful calculations out of the window and, worse still, can do so when you are already committed to the project. The real possibility of this happening as a result of a windfall tax is therefore a turnoff from an investor’s point of view.

Of course the Treasury know this and their proposals for a windfall tax are offset by a new generous system of allowances for those who invest in UK energy infrastructure. Fair enough, I suppose, but it is only realistic to think that one of the reason allowances need to be so generous is because of the uncertainty which the windfall tax causes.

One of the concerns which the Prime Minister had with the proposals was that they might be inflationary and he consulted four eminent economists (including Lord King, erstwhile governor of the Bank of England) for comfort that that would not be the case. One of them suggested a wealth tax as an alternative and as that idea is likely to be the subject of debate if Labour wins the next election, it is worth saying something about it now. From a fairness point of view a wealth tax has much to say for itself. Whereas income taxes only touch assets in productive use and capital gains tax discourages the reallocation of assets, a wealth tax is spread over a broader base and, subject to the exceptions and reliefs which would no doubt find their way in, gives little reasons to prefer one asset class to another. The problem of course is a practical one. Broadly speaking income tax and capital gains tax simply give the state a proportion of cash receipts, out of which the tax can be paid, whereas a wealth tax can mean selling capital assets and, most politically explosive of all, homes. It is therefore seen as far more disruptive and its collection an offence against the golden rule set by Louis XIV’s finance minister Jean-Baptiste Colbert:

“The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.”

And yet all the other tax raising techniques have their downsides too. Income tax is a turnoff for endeavour, capital gains tax – as mentioned above – impedes the efficient reallocation of assets, expanding inheritance tax to cover lifetime gifts would increase the financial dominance of the older generation. There is no easy answer to this but, in the context of last week’s package, one thought strikes you. Why did the Government not restrict its assistance with fuel bills to those who need it through some form of means test? Money saved and money raised through taxation are broadly equivalent. Had the payments been restricted to those who really need them, the balance could have been usefully applied to boosting the support given to hardship cases.

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