Windfall profits should be left to markets, not snuffled up by states

During his long reign as chancellor, Gordon Brown came up with so many bad ideas that it was hard for even his most industrious critics to keep up. But amid all the fiddly changes to tax rates, the raids on pension funds, and the incomprehensible benefits system, one of the very worst was the windfall tax. This week, we found out why.

There are reports that the government is planning to reverse levies imposed on North Sea oil. That's a good decision. The oil price is plunging, investment is drying up and companies drilling for oil off the coast of Scotland need help to stay in business. But wouldn't it have been better if the tax had never been imposed in the first place?

The windfall tax made its insidious way into British life in Brown's first budget in 1997. It was introduced on the so-called excessive profits of the privatised utilities, and used to fund the New Deal to get young people back to work (which didn't work very well, since most of the young people who found jobs on Brown's watch were Czech or Polish).

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The idea has been tried again and again in the form ofone-off or extra levies on specific industries. The Treasury imposed a tax on banking bonuses. And Brown, in 2005, doubled the rate of tax on North Sea oil firms, due to the windfall profits being made from high energy prices.

If it's profitable, tax it

Now there are constant calls for new windfall taxes on any sector that happens to be making a lot of money. Ed Miliband, who rarely sees an economically illiterate idea without immediately seizing on it, has proposed a windfall tax on tobacco companies to fund the NHS.

One Tory MP Nigel Evans has called for a tax on petrol retailers who fail to pass on falling oil prices to motorists. Don't be surprised to see a call for a windfall tax on Aldi and Lidl for doing so well at the moment;or on the Candy Crush people; or on Spurs for making so much money from selling Gareth Bale to Real Madrid. It seems to be the default mode for politicians right now. If someone makes a lot of money, slap a special tax on them.

Yet the government is also now looking at ways to help the North Sea. Chancellor George Osborne said at the weekend that the Treasurywas examining waysof cutting the levy on oil producers.

And with good reason. The plunging oil price is playing havoc with their finances. Investment is drying up. Even existing wells may struggle to stay in business with an oil price of $40 a barrel.

While it may be amusing to watch the Scottish Nationalists explain how a bankrupt industry can fund an independent country with a lavish welfare state, it is also deeply damaging. Companies shouldn't be driven out of business because they can't pay their tax bills.

This is how free markets work

More importantly, it tells you that specific taxes for certain industries are a terrible idea. In a free-market economy, prices constantly move around all over the place. They are called price signals it's how the market works.

If an industry is making windfall profits, because prices are high for a while, then people will very quickly notice that, and go after those profits. Supply will rise, prices will fall and very soon, companies in that sector will be making windfall losses.

That is what has happened in oil. A few years ago, the price was sky high. That encouraged a lot more production. Supply rose and the profits promptly vanished. So now the government will have to reduce those taxes. The same disastrous pattern has been seen elsewhere.

The last Labour government in Australia imposed a windfall tax on its mining industry at a time when booming Chinese demand meant it was raking in huge sums. Then the market crashed. What happened?The government had to reverse the tax.

Two big problems with a windfall tax

There are two big problems with this. Firstly, it stops companies from planning sensibly for the medium-term. They should be building reserves in the good times, so that they have a cushion to fall back on in the inevitable downturn.

Brown may have thought he'd abolished "boom'n'bust", but most corporate managers know that the business cycle always comes back. When times are good, they will save some money, and perhaps cut back on investment a bit, so they don't get stuck with too much capacity when the downturn comes.

But if the government takes most of the profits in the good times, there is nothing left for the bad and the industry has no choice but to beg the government for its cash back. How can an industry be run sensibly in those circumstances?

Secondly, it assumes that the government somehow knows what the right level of profits is. But of course it doesn't. What looks like a windfall one year looks like necessary cash for investment in another. If the state really thinks it knows how to run an industry that well, perhaps it should just nationalise it at least it would be more honest.

Windfall taxes are a quick fix for cash-strapped governments. But North Sea oil is an important industry, and it deserved better than this cavalier treatment. So do all the industries threatened with one-off levies. They may raise some cash but they do long-term damage.