Why windfall taxes come at a great cost

There is no such thing as free money. This was learned the hard way last month, when investors made clear after Liz Truss’s mini-Budget that the era of cheap money was over. Mass borrowing for day-to-day spending was going to have a big premium attached: a bill so large that no government would want to pay. Rishi Sunak understood this delicate dynamic, and said so many times over the summer. His willingness to admit the truth – that the government’s many promises can’t be delivered for free – is what, eventually, landed him in No. 10.

But now in power, Sunak and his chancellor Jeremy Hunt risk making another ‘easy money’ assumption, albeit a very different one. The massive profits of the energy companies have, once again, caught Sunak’s eye. It’s not hard to see why. The headline figures are rather staggering. Shell doubled its profits from the year before between July and September, reaching £8.2 billion, its second-highest profit record. BP reported profits of more than £7 billion over the same three months. As costs surge to the point where the government has to step in, the profits of energy companies are soaring as well.

While calls for a windfall tax for energy companies originated with the Labour party, it was Sunak as chancellor who brought one in, adding an additional 25 per cent levy on oil and gas profits until the end of 2025 – a far bigger tax than Labour had been calling for. Now that Sunak and Hunt are under pressure to find up to £50 billion to plug the growing hole in the public finances, these ‘windfall’ profits are an obvious place to look.

The state of the public finances deteriorated quickly over the summer. By the end of Sunak’s stint in No. 11, he was no longer costing every bit of every handout. Still, there was an attempt to do some costing, and unpopular tax rises were announced to make up for higher spending. Upon his arrival as Prime Minister, Sunak is reported to have asked the Treasury where the £30 billion surplus – the amount by which tax receipts had exceeded the Office for Budget Responsibility’s October 2021 forecast – had disappeared to. Sunak thought of this as an emergency fund when he was chancellor, adamant it could be needed for occasions such as this. 

With the money gone within a matter of weeks, and Hunt having to find tens of billions of pounds, it has been made clear that both tax rises (for everyone) and spending cuts are on the way. But in a bid to sweeten the pill on taxpayers, the Treasury is considering extending the current windfall tax. It could keep the Truss government’s plans to implement a windfall tax on renewable companies. 

With no pain-free options on the table, it is understandable that No. 10 and the Treasury might consider these kinds of windfall taxes the most politically tolerable of all the choices. But they are by no means cost-free. Sunak’s first windfall tax hiked the tax rate for oil and gas firms in the North Sea to 65 per cent – so high it led BP to announce it would review its UK investment plans.

This investment point is an important one: especially to Sunak, who has made clear on multiple occasions (including in his Mais lecture) that one of the primary solutions to the UK’s productivity problem, in his opinion, is increasing private business investment. This explains why, while raising corporation tax, he also brought in super deductions for businesses that choose to reinvest their profits. It also explains why his windfall tax has a loophole that gives a 91p tax break on the pound if companies use their ‘windfall’ money to invest back into the business instead.

In the case of Shell, that has been used to the max, enabling the company to avoid the windfall tax so far by major investment. Much is being made of Shell avoiding the tax. The tax was deliberately designed this way – investment is what Sunak wants to see – but it creates a problem with the ‘fiscal black hole’ narrative. If the windfall tax does work to increase investment, it is not bringing major money into the Treasury (Sunak estimated his spring windfall tax would bring in £5 billion a year – though that number has been heavily contested as too high by some who think corporate behaviour is bound to change). 

Windfall taxes are not a pro-business policy, even with Sunak’s investment loophole. But any changes that takes money to the Treasury rather than back into the business becomes explicitly anti-growth. It’s a cost that the UK can ill afford: medium-term growth forecasts for the economy are virtually stagnant, and are expected to be downgraded further when the OBR releases its latest predictions later this month.

These longer-term costs must be weighed against the short-term ones. The government breaking trust with the business community, implementing repeated tax grabs, will eventually take its toll on future investment decisions. Using a windfall tax to cover day-to-day spending will only delay inevitable spending cuts. Penalising energy companies for ramping up their oil and gas production during an international shortage sends a dangerous signal to other businesses and sectors: that rising to the occasion can prove costly.

Expanding and creating windfall taxes will perhaps buy the government a bit more time to sort out its spending plans. But even a temporary attitude towards windfall taxes comes at the great cost of enabling this kind of tax raid; one Labour would not be hesitant to use in power. With never-ending borrowing off the table, company profits are slowly being painted as the new magic money trees. This is just another convenient illusion that will sooner or later come crashing down.