Windfall tax – Concept and effects on fuel prices

Recently, the Ministry of Finance has justified the imposition of a windfall tax on domestic crude oil producers in July 2022. Windfall taxes are designed to tax the profits a company derives from an external, sometimes unprecedented event—for instance, the energy price rise as a result of the Russia-Ukraine conflict. A windfall is defined as an “unearned, unanticipated gain in income through no additional effort or expense”. The idea is to target firms that were lucky enough to benefit from something they were not responsible for – in other words, a windfall. There have been varying rationales for governments worldwide to introduce windfall taxes, from redistribution of unexpected gains when high prices benefit producers at the expense of consumers, to funding social welfare schemes, and as a supplementary revenue stream for the government.

How may windfall tax affect market?

• Uncertainty in the Market: Companies are confident in investing in a sector if there is certainty and stability in a tax regime. Since windfall taxes are imposed retrospectively and are often influenced by unexpected events, they can brew uncertainty in the market about future taxes.
• Populist in Nature: It is believed that such taxes are populist and politically opportune in the short term.
• Reduces Future Investment: Introducing a temporary windfall profit tax reduces future investment because prospective investors will internalise the likelihood of potential taxes when making investment decisions.
• No precise definition: It is not precisely defined what exactly constitutes true windfall profits and how it can be determined what level of profit is normal or excessive. If rapid increases in prices lead to higher profits, in one sense they can be called true windfalls as they are unforeseeable, but it can be argued that it is the profit the companies earn as a reward for the industry’s risk-taking to provide the final product to the end user. It is not defined who should be taxed—only the big companies responsible for the bulk of high-priced sales or smaller companies as well—raising the question of whether producers with revenues or profits below a certain threshold should be exempt.

Windfall tax on domestic oil producers

International crude prices have surged in the last few months. Domestic crude producers sell crude to domestic refineries at international parity prices. Domestic oil producers and refiners in India made additional revenue as crude oil was selling at a record $120 per barrel in the international market recently.

Besides, Indian refiners were also making profits by importing discounted crude oil from Russia and selling it outside the country. Domestic refiners were earning far more by selling their oil overseas, where it fetched better prices. The government imposed an export tax to check this practice.

Windfall tax: Benefits to the government

The windfall tax adds to the government’s earnings. The government had in May announced an excise duty cut of Rs 8 and Rs 6 per litre on petrol and diesel, respectively, to cool down inflation. Finance Minister Nirmala Sitharaman has said this will have revenue implications of around Rs 1 lakh crore a year for the government. As per a Press Trust of India report, the windfall tax on crude production alone was estimated to generate revenue of Rs 65,600 crore and the tax on export products another Rs 52,700 crore if they were to be continued for the full year. Thus, the revenue from windfall taxes can help the government make up for the losses.

India: Not the only country to impose windfall tax

India is not alone. There are several other countries that impose windfall taxes on companies. India introduced windfall taxes for the first time on July 1, 2012, joining a growing list of countries that tax energy firms’ above-average earnings. However, worldwide oil prices have recently fallen, hurting profit margins for both producers and refiners. On July 1, 2022, export tariffs of Rs 6 per litre ($12 per barrel) were imposed on petrol and aviation turbine fuel, as well as a Rs 13 per litre tax on diesel exports ($26 per barrel). A windfall tax of Rs 23,250 per tonne on local crude output (about $40 per barrel) was also imposed.

In May 2022, the then United Kingdom Finance Minister, Rishi Sunak, imposed a windfall tax on oil and gas majors by stating that the oil and gas sector is making extraordinary profits not as the result of recent changes to risk-taking, innovation, or efficiency but as the result of surging global commodity prices, driven in part by Russia’s war.

Italy also levied a windfall tax recently. Early in May 2022, Italy announced it would tax the profits of energy companies at 25 per cent to help fund a support package for consumers and businesses that have been hard-hit by soaring energy costs. The new tax is a hike from the existing 10 per cent windfall tax imposed in March on the profits of energy companies.