The Tired Tale of Bad Incentives

Hi,

Here’s a great way oil companies could lower their “obscene profits”: give all of their employees massive raises. Or, they could go on a wild spending spree on unprofitable investments. Or, they could take all of their cash and place a massive wager on the betting markets that the Democrats will win big in the midterms.

In other words, they could boost their costs, bad investments, or losses so their profits shrink or even disappear.

Obviously—or, I should say, “It should be obvious that”—there are some big problems with this approach. First, it would be very stupid. But there’s no law against being stupid with your money, right?

No, there’s not. But corporate executives aren’t spending their own money, they’re spending their shareholders’ money. While you are free to blow as much of your own shmundo on pet rocks, meme stocks, or a “seeing eye cat” business, there are laws against blowing other peoples’ money on stupid stuff.

If ExxonMobil or Chevron dropped billions on unprofitable white elephants, dropping benjamins like a pimp with a week to live, shareholders could sue because the company has a fiduciary obligation to spend investors’ money responsibly. And for a corporation, spending money on anything other than maximizing profit in a responsible manner—i.e., good business practice—is actually not allowed. The officers of the company would—rightly—open themselves to a lawsuit from shareholders if they didn’t do this.

But of course, if Congress passes a law that taxes “excessive” profits, the equation changes. It might actually be good business to make less-than-ideal investments. After all, spending money on iffy prospects would still hold open the possibility of returns. But just handing cash to the government has no potential upside for investors or the bottom line.

Think of it this way: If Uncle Sam declared he was going to take any of the money left in your bank account on December 31, spending that money before New Year’s Eve (on just about anything: lottery tickets, dog toys, a truckload of Godzilla vs. Mothra VHS tapes) would suddenly make more sense to you.

But here’s the thing. Blowing all of your savings on stuff you don’t really need is a bad idea absent the imposition of bad incentives from above. In other words, doing dumb stuff with your money only makes sense in a policy environment where dumb decisions are incentivized.

Indeed, it’s worth noting that despite all of the politicians who shriek that big corporations don’t pay their “fair share” in taxes, corporations are doing what politicians effectively told them to do. Tax “loopholes” to encourage investment on certain things and corporate responsibility on others mostly exist to incentivize companies to do what Washington deems important or valuable. By all means get rid of most of them, but don’t denounce the greed of corporations doing what the writers of the tax code said they should do.

I bring this up to make a very simple point. The Democrats proposing a windfall profit tax on oil companies are trying to force corporations to make bad decisions. Obviously, Democrats don’t see it that way. They always think the government can spend money better than you or any greedy corporation. Indeed, they also think that oil company profits are the product of greed, and outsized profits are the result of outsized greed. As (the deeply flawed but brilliant) Joseph Sobran once said, “‘Need’ now means wanting someone else’s money. ‘Greed’ means wanting to keep your own. ‘Compassion’ is when a politician arranges the transfer.”

Joe Biden said the other day that ExxonMobil “made more money than God this year.” While I would love to spend the next four or five paragraphs exploring the theological claim that God is a member of the 1 percent, I’ll stay on point. It’s true that ExxonMobil is enjoying what some call “unconscionable profits.” But as I noted recently, during the pandemic, ExxonMobil suffered from what no one—save perhaps its shareholders—called unconscionable losses. They ate $22 billion in 2020 alone. I don’t recall many proposals to make those shareholders whole for their excessively generous losses.

And let’s just note that those shareholders include millions of teachers, cops, and pretty much anyone who gets a pension from funds invested in ExxonMobil. The three largest pension funds—the California State Teachers’ Retirement System, the California Public Employees’ Retirement System, and the New York State Common Retirement Fund—are all investors in ExxonMobil. Add in the Georgia Division of Investment Services and those four pension funds alone hold more than 30 million shares in ExxonMobil. And even the big, mean “capitalist” investment firms that invest in energy companies are funded by many of the same pension funds.

One of Biden’s proposals to “fight inflation” is to tax stock buybacks—a backdoor way of saying that the government should tax retirement investments. He also says, “You want to bring down inflation? Let’s make sure the wealthiest corporations pay their fair share.” (Warning: His press secretary’s explanation of this claim is apt to cause nosebleeds.)  This is just a convoluted way of saying, “Let’s tax the profits of the companies retirees rely on.”

It’s like every time reality presents a new problem, the Biden administration insists its remedy for the old problem is the ticket for fixing the new one. When oil and gas prices were low, Democrats wanted to tax energy companies to help transition to a “green economy.” This is why they kiboshed the Keystone XL Pipeline, restricted drilling on federal lands, reversed Trump’s methane rules, etc. The idea was to make fossil fuels more expensive and encourage investment in wind and solar energy. Now that oil and gas prices are high, the solution is to—wait for it—make oil and gas more expensive. Sen. Ron Wyden, who wants a massive surtax on oil companies’ profits, has been remarkably consistent on the urgent need—regardless of the price of gas or the inflation rate—to increase taxes on oil companies. Inflation is just the latest crisis he doesn’t want to go to waste. He’s like the bear in that old joke: “This isn’t about the hunting anymore, is it?”

While Biden yells at the oil companies to produce more oil and gas like Grampa Simpson yelling at clouds, no one has managed to explain how raising taxes on those companies will accomplish that. But that’s not the point of his yelling. He needs someone to blame for inflation, and blaming Vladimir Putin didn’t work.

The Federal Trade Commission has investigated whether U.S. oil companies set the price of oil a zillion times (give or take a kabillion). They don’t, in part because they make up a relatively small share of the global oil industry. ExxonMobil is a behemoth but only accounts for about 3 percent of global oil production and 2 percent of global energy production overall. ExxonMobil could go non-profit tomorrow and global commodity markets would still do what global commodity markets do.

Moreover, we’ve tried this before. Jimmy Carter implemented a windfall profits tax and it didn’t achieve any of its desired goals. From the Tax Foundation’s Alex Muresianu: 

Several analyses of the 1980 Windfall Profits Tax have found it reduced domestic production and increased reliance on imports. A Congressional Research Service paper found that the tax reduced domestic oil production by between 1.2 and 8.0 percent, and increased reliance on foreign oil by between 3 percent and 13 percent between 1980 and 1988 (when the tax was eventually repealed). A 2018 paper in Economic Policy found that the tax reduced domestic production, largely by reducing total output of wells already in operation. The paper noted that such a tax could not be modeled as simply a tax capturing the rents (in layman’s terms, excess profits) of oil producers, but rather would reduce incentives to produce at the margin. 

As Muresianu notes, all of these schemes rest on some notion that politicians know what the correct price of oil should be. But that’s not how this works. 

Prices are signals that summarize and consolidate vast amounts of crowdsourced information that no market participant can individually possess, never mind control. If ExxonMobil knows how to set prices for oil, why did it lose $22 billion in 2020? Why did more than 100 oil companies go bankrupt during the pandemic? Why not just declare, like Michael Scott declaring bankruptcy, that the price will be what they want it to be? And if ExxonMobil—where even the janitors and truck drivers probably know more about the oil industry than most senators—can’t tell you what the price will be, why do we think Ron Wyden or Elizabeth Warren can?

Investors make educated bets—for want of a better word—on what will happen in the future. The greater the risk, the greater the anticipated reward has to be to warrant the investment. A windfall profits tax—by whatever name it goes by—increases the risk by threatening or eliminating the potential for reward. It’s fine to dislike this system, lots of people do. But if you think Wyden and Warren can run a better one, I’d like to hear the argument for that. And if you think it makes perfect sense to privatize corporate losses but socialize corporate profits, just come out and admit you want to nationalize the energy sector, or the economy entirely.

Biden openly says he thinks oil companies are making too much money because they are refusing to sell more of their products. There’s no evidence for this. But there is evidence that he very much wanted to make oil more expensive. In a 2020 primary debate he was outraged by the suggestion his climate plan wasn’t ambitious enough. “Number one, no more subsidies for the fossil fuel industry,” he told Jake Tapper, “no more drilling on federal lands, no more drilling, including offshore, no ability for the oil industry to continue to drill, period, ends, number one.”

It seems to me that the very definition of childishness is to demand credit for your virtuous ideas but reject any responsibility for the consequences of them being implemented.