Friday, 2 September 2022

Inflation and profits

Stuff's Daniel Smith asked me for comment on profits and inflation, and the case for a windfall tax. I'll copy below what I'd sent through as there wasn't room for all of it in the story. 

A temporary boost to profits is a consequence of high inflation, rather than a cause of it. High inflation, caused by the combination of global and local monetary responses to the pandemic, supply shocks, and high levels of government spending, pushed up consumer prices first. A lot more money was chasing a reduced quantity of goods. Firms responded to that increase in demand by raising their prices and hiring more workers. Consumer prices were bid up first. During that interval, firms earned higher profits in part because real wages had fallen: wages moved up more slowly than the prices of goods and services. Now, firms competing for workers are bidding wages up. As real wages return to normal levels, company profits will return to normal levels. 

It makes no more sense to claim that high profits cause inflation than to claim that low profits cause recessions. They’re linked, but not in that way.

A windfall tax on company profits is an exceptionally bad idea. It is not an appropriate response to high inflation. It would not help consumers. And it would further erode stability in expectations around the policy environment. 

A windfall profits tax winds up hitting exactly the firms that should be expanding. Remember that high current profits, driven in part by continued fiscal and monetary stimulus, will not be uniformly distributed. Companies seeing smaller increases in demand for their goods and services will not be seeing those higher profits. High profits in some sectors give those sectors incentive and ability to expand. They do this, in part, by bidding workers and materials away from other sectors where demand is lower. Their doing so is a good thing – it shifts workers and materials over to areas where their services are far more valuable. The profits provide the signal about where greater output is needed, and the incentive to provide it. A windfall tax blunts that signal while reducing those firms’ ability to bid workers away from areas where their services are less valuable. 

Perhaps more importantly, a surprise windfall tax on company profits would undermine institutional stability and credibility. Companies invest based on expectations about how policy works. Tax policy in particular tries to provide stability by sticking to a principled approach, with any changes being very well signalled through the Generic Tax Policy Process. Whenever that process is undermined, we wind up with bad tax policy and an erosion in institutional stability. If companies expect tax changes at random if they invest here, and particularly expect to be hammered simply for having had higher profits than expected, the burden does not just fall on those companies. It falls on all of us. New Zealand becomes a risker place to do business, so investors will demand a higher return to reflect that higher risk. Capital becomes even more scarce in a capital-poor country, which hits long-term productivity and wages. 

It is a terrible idea.

There is one area where government could and should consider redistribution of excess profits, however. 

For years, the New Zealand Initiative has advocated for a Carbon Dividend, following Canada’s example. There, the vast majority of government revenues from its carbon tax are sent back to Canadian households as a carbon dividend, to help them to make their own adjustments to a higher carbon-price world. The Initiative has advocate that the government similarly direct all of the revenues that the government earns when it auctions ETS credits into a carbon dividend. The government is likely to earn on the order of $1.7 billion dollars this year when it auctions carbon credits. Sent back to households as a carbon dividend, it could provide a family of four with about $1300. We have also recommended that, whenever the government earns higher than normal profits from its 51% stake in the power companies, for example if higher ETS prices wind up feeding through into higher electricity prices overall, those excess dividends should also be put into the pot to provide a higher carbon dividend.

I suppose that I should also have noted that companies already pay higher company taxes when profits are high, that it's particularly odd to look at for New Zealand's oil and gas sectors. Sure, anyone pulling oil out of Taranaki is now getting higher prices for it. But that all falls under a royalty regime. You could argue that that regime should have provision in it for different royalty rates depending on what happens with prices, but that ought to be set out before companies put in their bids for exploration permits. Not ex post. 

Oh - the $1.7b is just the current ETS price multiplied by the number of units to be auctioned this year. It's a thumb-suck and will vary with what happens at the next auctions. 

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