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Should oil companies pay higher taxes? Prof Ho explains the economics of optimal taxation

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By: Professor Ben Ho

The public debate over Obama’s proposals to increases taxes paid by oil companies has been a missed opportunity. Testimony and arguments in both congressional hearings and in the public at large have largely ignored the very well established findings in public finance economics on how taxes should optimally be set. The standard ­­frameworks economists use and largely agree upon go a long way in helping to frame the debate.

On the surface, both Democrats and oil companies are correct about the likely effects of the proposals. Oil companies argue that increasing taxes on the investments domestic oil companies make will make their investments less profitable, shift oil production overseas, reduce the supply of oil, and reduce the number of domestic jobs in the oil industry. Democrats acknowledge these consequences exist, but argue that the tax increases that they propose are so small relative to industry profits that these negative impacts will be small relative to the billions raised to reduce the federal deficit.

However, this debate is missing the larger point. Senate finance chair, Max Baucus, actually asked the right question at a hearing last year, but the question was largely ignored. The question posed: since we are agreed that the government needs to reduce the federal deficit, what is best way to do so? This question is answered by the economics of optimal taxes.

Basic Principle – Spreading the burden as widely as possible; or reducing distortions as much as possible

A fundamental principle of optimal tax economics is that taxes should be spread across as broad a tax base as possible, both in terms of the number of sectors but also in terms of number of companies. The reason is that the first dollar of tax revenue raised from taxing a particular sector has almost no cost to the economy (in terms lost consumption and lost production, or in the terms politics cares about, less money in pocketbooks and fewer jobs). However, the cost to the economy increases with each dollar of tax revenue extracted. Therefore, taxing a sector that is already heavily taxed is more costly to the economy than taxing a sector that is not taxed at all.

This principle of equal treatment is behind the oil companies arguments that the tax is fundamentally unfair because it targets domestic producers without affecting foreign producers, and because it targets the oil industry even though the oil industry pay more taxes as a percent of profits than most other major US industries. The distortion to the economy becomes larger when taxing more heavily taxed sectors.

Exception #1 – The Ramsey Principle: Some sectors are more susceptible to distortion than others

However, there are several important exceptions to the rule that all companies should be taxed the same. The first is the Ramsey principle of optimal taxation notes that certain sectors are more susceptible to the distortions taxes cause than other sectors. Sectors like oil where demand and supply are inelastic, meaning that quantity demanded and quantity supplied do not change very much in response to price, are good places for government to raise revenue since the taxes have less of a distortionary effect on the economy.

Exception #2 – Pigouvian taxes: When a product causes harm to society that are not accounted for in its price

Another exception is when a sector causes negative externalities, when a product causes harms to a society that are not accounted for in its price. A tax (known as a Pigouvian tax) would be justified if it reduced consumption of that good, reducing the negative externalities to society. However, if reducing externalities is the motivation, Obama’s proposals are particularly poorly targeted. The externalities from oil come from all oil producers, not just domestic producers. By targeting, only domestic producers, the proposed taxes will have minimal effect on prices, and thus minimal impact on reducing consumption of oil. In fact, by shifting production to foreign producers, Obama’s tax proposals could make these externalities worse.

Exception #3 – Taxes should be focused on consumption, instead of savings or investment

Finally, a final exception to the idea of spreading out taxes evenly, is that economists are largely agreed that taxes should be focused on consumption rather than on investment/savings. Part of the reason the US saves so little, is because the US has among the highest taxes on investment/savings (like the corporate income tax) in the developed world. The tax subsidies the Democrats would like to eliminate are subsidies offered to all industries and were intended to remedy this imbalance in order to encourage investment.

Taken together, this suggests that neither Democrats nor Oil Companies are entirely right. There is broad agreement that the federal deficit should be reduced, and there are sound economic reasons for why oil companies should be paying to achieve that reduction. Ideally, such tax increases should come with comprehensive tax reform, and should be applied broadly and evenly, and targeted on consumption not investment. In a non-ideal world, such comprehensive reforms may not be possible, but still these are the discussions that are crucial for understanding the debate.

For a more detailed discussion on taxes, Professor Ho offers a short primer.
To find the tax rates paid by the S&P 500, check out NerdWallet’s Corporate Tax Tool