By Jerry Taylor and Peter Van Doren,Cato Institute

The recent spike in gasoline prices has set off a stampede of politicos demanding that hammer and tong be applied to that all-purpose bogeyman, “Big Oil.” Egged on by the red-faced anger served up by rant-and-rave TV populists, Congress may prove unable to resist passing a windfall profit tax before voters go to the polls this fall. If so, we’ll experience the full meaning of H.L. Menken’s adage that democracy is that form of government in which the people get exactly what they want – good and hard.

What they won’t get, however, is nearly as much money out of such a tax as they probably think. A windfall profit tax targeted at earnings far beyond the U.S. industrial average would return zero revenue to the Treasury because windfall profits in the oil sector are figments of the imagination.

While the raw earnings figures sound big, in proportion to the size of those companies, they are unexceptional. Divide profits by sales, for instance, and you’ll find that in the fourth quarter of 2005 (the last quarter for which we have data available), profit margins were 6.8 percent at British Petroleum, 7 percent at ConocoPhilips, 7.1 percent at Shell, 7.7 percent at Chevron, and 10.7 percent at ExxonMobil. The 20 largest investor-owned oil companies earned a collective 8.8 cents on every dollar of sales for that quarter.

Now, it’s not a stretch to note that the lady who sells us hot dogs on the street probably earns a better profit margin than that. But more to the point, the nation’s most prominent critic of “oil profiteering” – Fox News personality Bill O’Reilly – works for a company (News Corp.) that reported a 10.2 percent profit during the fourth quarter of 2005. If you’re after really big earners, however, check out Yahoo (a 45.5 percent profit margin), Citigroup (33.4 percent), Intel (24 percent) or Apple (22.7 percent).

Returns on invested capital over a longer time frame are even more telling. Analysts at Goldman Sachs report that returns on investment capital in the oil and gas sector from 1970 to 2003 were less than the U.S. industrial average over that same period. Although few believe it, the oil industry would have to earn record profits for a long time before it would produce above average returns for its long-term investors.

Even were profits more extraordinary than they are, a special tax would be a mistake. Windfall profit taxes threaten to institutionalize a form of one-way capitalism in which investors are allowed losses or meager profits but average or better returns are disallowed. Who would want to invest money in an industry like that?

Consumers have a stake in the answer to that question. If investors are discouraged from putting their money into the oil sector, there will be less oil and gas on the market and, thus, higher prices than would have otherwise been the case.

Regardless, the United States already has a corporate income tax in place to harvest “windfall profits” regardless of which sector produces them. Taxing profits differently depending upon which sector of the economy coughs them up gets the government in the business of allocating capital across the economy as a whole. This would introduce politics into places where politics simply should not go.

This is not simply idle ideological speculation. We’ve actually been down this road before in the form of the Crude Oil Windfall Profit Tax of 1980. According to a study published by the Congressional Research Service, the tax discouraged investment in the domestic oil industry to such a degree that domestic oil production was 3 percent to 6 percent less as result of that tax and foreign oil imports grew accordingly by 8 percent to 16 percent. There isn’t a single credentialed oil economist in the country who would argue that windfall profit taxes are good for consumers.

The truth is that gasoline prices are high because world crude oil prices are high. They are exacerbated at the moment by the seasonal switchover from wintertime gasoline to more environmentally friendly summertime gasoline. That transition has been longer and more costly than usual because of the elimination of MTBE from the gasoline market (a fuel additive that has been found to contaminate groundwater), the fact that a great deal of refining capacity is still shut-down as a consequence of Hurricane Katrina, and the extensive spring maintenance that has been required to keep the refineries that have been operating flat-out all winter from falling apart.

In time however, today’s high prices will set off an economic chain reaction that will produce lower prices. High prices beget fatter profit margins, which in turn induce greater investment in new supply. High prices also encourage conservation and fuel economy, which in time will significantly reduce demand. More supply and less demand equals lower prices.

But it won’t happen as quickly as it might if Congress loses its collective head and passes a heavy tax on “windfall” oil profits that don’t really exist.

Jerry Taylor and Peter Van Doren are senior fellows at the Cato Institute. Peter Van Doren is also editor of Regulation magazine.

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