Senior Fellow Kevin A. Hassett

Director of economic policy studies Kevin A. Hassett discusses the absurdity of the windfall-profits tax in the recently proposed Consumer First Energy Act. The tax would stifle future investment, as potential investors would fear their profits will be seized by a government hungry for greater tax revenue. And the provisions meant to encourage investments in alternative energy would induce oil companies to undertake investments for which they are unprepared. All in all, the lack of understanding of basic economics shown by this proposal highlights the potential for any number of dangerous future market interventions under Democratic leadership.

With President George W. Bush's popularity fluctuating between that of a mosquito and a root canal, some Democrats inside the Beltway are beginning to express extreme optimism. Democratic victories in November, so the story goes, may be so large that sweeping policy changes will be possible in 2009.

A look at the latest Senate energy bill suggests how fundamentally perilous such an outcome would be for the U.S.

The centerpiece of the "Consumers First Energy Act" is a 25 percent windfall-profits tax on oil companies. According to a May 7 press release from the Democrats, the measure would "force big oil to pay their fair share."

Given how large oil company profits are right now, and how expensive gasoline has become, it is easy to be jealous and resentful. But those emotions don't provide sound policy justifications. In life, when you act while your emotions are hot, you inevitably regret it.

The same is true in policy. Still, that the Democrats would even propose such a thing as a windfall-profits tax is fundamentally unnerving. The proposal raises big red flags.

The first is that it undermines the rule of law and discourages future investment by all entrepreneurs, not just oilmen. This problem is well-known in economic circles.

Politicians always have a temptation to promise companies that tax rates will be modest, and then switch these rules once the companies start to make money. Since the switch occurs after the firms set up their factory or oil well, then one might think it will do no harm. After all, the companies aren't going to stop operating.

Dishonest Partner

But the double-cross will signal to all would-be new investors that they are playing with a dishonest government partner. If their business becomes highly profitable, every businessman's dream, then the government is going to change the rules. This year it is oilmen; last year it was private-equity firms. Next year, it could be you.

The second red flag is raised by a special condition applied to the windfall-profits tax. Quoting again from the Democratic press release: "This provision would not apply to the profits those companies reinvested in clean, affordable, domestically produced renewable fuels, expanding refinery capacity and utilization, or renewable electricity production."

In other words, if oil companies invest in alternative energy, then those investments will shield their profits from the tax.

Government Hubris

This type of micromanagement of corporate activity smacks of hubris. To the extent that oil companies aren't investing to the Democrats' satisfaction in alternative fuels, they are doing so because they have either decided that such investments aren't economically promising, or because they don't feel they have a sufficient comparative advantage over other types of firms (chemical companies, for example) that might better make those investments.

If this policy achieves its desired objectives, then it will induce firms to take on activities that haven't passed a market test. That can't be a good idea.

The micromanagement also reflects a logical inconsistency. Lifting windfall-tax rates with bait-and-switch tax policy can only be defended as a revenue raiser if firms don't respond rationally to incentives.

Yet the special provision exempting profits invested in pursuit of alternative fuels only works if firms respond to incentives. Both measures taken together only make sense if firms respond to the provisions Democrats want them to respond to, but don't respond to the provisions Democrats don't want them to respond to.

Economic Illiterates

Goodness. Can anyone really be that naive to think the companies won't respond to the windfall-profits tax but will respond to the alternative-fuel incentives?

The scariest part of all of this is the thumbnail sketch that emerges of any politician who would propose such madness. He would have to be an economic illiterate, unable or unwilling to think through complexities, or to accept the notion that policies can have unintended consequences. He must also be a panglossian optimist about the effectiveness of government intervention.

Such a person would be capable of proposing just about anything without surprising us much.

Consider the Possibilities

He could increase marginal tax rates on everyone, since he would reason that work incentives don't affect labor supply. He could lift the minimum wage by $5 or $10, because he wouldn't expect employers to respond by cutting jobs. He could raise corporate tax rates, because he wouldn't think companies will choose to locate their manufacturing in lower-tax countries. He might even propose strict limits on hamburger consumption, because he knows better than you do what your diet should be.

Perhaps it is true that nobody could be that crazy, and that any administration will eventually allow economists into the policy-making process. Maybe so, but I would feel a lot better if those economists could have an influence during the election cycle.

Kevin A. Hassett is a senior fellow and director of economic policy studies at AEI.