Backdoor Oil Tax Is Unconstitutional
Mallory Factor and Phil Kerpen of the Free Enterprise Fund (Forbes.com, 3/9/06)

http://www.forbes.com/business/2006/03/08/windfall-profits-oil-tax-cx_mf_0309oiltax.html

Washington, D.C. -

In this city, some bad ideas never die--they don't even fade away. Condemned by economists across the political spectrum, the windfall profits tax on oil companies went down on a ringing 64-35 Senate defeat in November.

But rather than let a bad idea die, some of our esteemed U.S. senators came up with an even nuttier, and probably illegal, version of that bad idea and slipped it into an important, must-pass piece of legislation, the tax reconciliation bill. That measure is an unconstitutional, $4.3 billion asset seizure, ex post facto. Above all, it is a backdoor windfall profits tax accomplished by arbitrarily forcing oil companies to revalue their 2005 inventories.

The windfall profits tax proposal was a knee-jerk reaction to oil company profits and public outrage over high prices at the pumps. The tax, under the amendment sponsored by Sen. Byron Dorgan, D-N.D., would have confiscated 50% of profits when oil is above the arbitrary price of $40 a barrel. It would have applied only to large, integrated U.S. energy companies.

The oil industry is highly cyclical, and just as energy companies are racking up big profits now at a price peak, they were bleeding red ink when barrel prices were around $10 less than a decade ago. The massive fixed costs in developing energy resources are simply unaffordable if the upside of boom years is cut off by high taxes. And if new technology breakthroughs are going to come to create a paradigm shift away from Middle Eastern oil, they will almost certainly come from the integrated energy companies who pour billions and billions of dollars of profits into research and development.

This tax has been tried and failed. Then President Jimmy Carter imposed a very similarly structured tax in 1980, and the result was huge compliance costs, minimal federal revenue and a steep decline in domestic oil production. The Congressional Research Service estimated that the impact of the tax was an annual decline in domestic oil production of between 3% and 6%.

The appeal of the windfall profits tax comes from the argument that government should get a piece of the action when an industry is doing well. But the government is already getting way more than its pound of flesh from oil companies. A recent Tax Foundation study found that from 1977 to 2004, tax collections from major U.S. energy companies totaled a staggering $2.2 trillion, more than triple corporate profits over that same period of only around $630 billion.

When this battle was heating up last year, hundreds of economists wrote to Congress and told them not to enact a windfall profits tax. The near unanimity of qualified opinion on the issue was ultimately more powerful than the easy demagoguery of knee-jerk populism, leading to the strong Senate no vote on Dorgan's amendment.

Yet, U.S. senators of both parties are just unable to resist large pools of private wealth, so they set out on an even more clever way to raise taxes on this already highly taxed industry. Here's how their unconstitutional, backdoor windfall profits tax works:

Large integrated energy companies would be forced to revalue their 2005 ending inventories by the wholly arbitrary amount of $18.75 per barrel. They would also be prohibited from using the last-in, first-out accounting method of valuing their inventory, a well-accepted method under the Internal Revenue Code since the 1930s. LIFO accounting is not a loophole, but rather the best way to track the cost of petroleum products.

There is a principle at stake here that's far more significant even than the billions of dollars the federal government is trying to grab from oil companies. It is outrageous for government to retroactively prohibit a business practice that is consistent with proper accounting principles and has been perfectly legal for 70 years. Moves like this risk undermining the foundation of our economic system--a well-established system of laws that create a predictable, level playing field.

This ex post facto tax risks a broad chilling effect on other industries, which could legitimately fear that Congress will retroactively seize their profits too if they achieve too much success. The tax reconciliation conferees should strip the unconstitutional backdoor oil tax from the reconciliation bill and let the old, failed idea of a windfall profits tax die.

Factor is chairman of the Free Enterprise Fund, and Kerpen is policy director for the Free Enterprise Fund.