IEA Blog

Countries trade on their reputations. It is not just the number of eager, materialistic consumers that causes businesses to invest in one country as opposed to another. The hospitality of the host nation – and especially its government – is also of huge significance.

Two of the most the attractive features investors will consider are private property rights and the rule of law. The reasons are obvious. Without protection of private property, investors cannot guarantee that they will get to keep the proceeds of their investment (or even the initial stake). Whether it is petrochemical firms being bullied out of half their shares in Siberian oil and gas fields, or banks having their profits taxed heavily, the effect is the same: the investor will look elsewhere in the future. The same follows for the rule of law: if politicians can use the tax authorities to attack those that are both successful and unpopular, investors will steer clear.

Of course, one might argue that no investor will be deterred by the decisions of Gordon Brown and Alistair Darling. In six months time they will be nothing more than economic bogey-men; names that bankers use to scare their children. Their ability to do harm will have ended at the ballot box. So how much harm can a windfall tax on bank bonuses really do?

Firstly, the election may change nothing. George Osborne wouldn’t rule out a windfall tax on bank bonuses either, while Vince Cable wants to tax bank profits to create an insurance fund for the sector.

But more importantly, in the minds of investors, even a one-off windfall tax conveys the message that British politicians view high profits or incomes like bandits view a passing caravan.

There is a real issue regarding taxpayer liabilities: the banks owe vast sums to the exchequer, so Vince Cable may be right to say that “a special tax on the banks’ profits” should last as long as the “banks continue to depend on taxpayer guarantees”. The banks certainly should pay their debt off as quickly as possible – though it would only delay repayment if taxes damaged the banks’ ability to generate the profits from which the debt must be paid.

But it is entirely different to say that banks profits should be taxed more heavily than those of other businesses even after the debt is paid off, or that individual bankers (who are needed to generate the profits from which the debt will be paid, and who will only do so if they have incentives to do so) should be the targets of a special tax regime. Hitting those who generate wealth with high taxes may indeed drive talented people and successful institutions abroad. More importantly, applying different laws to different groups undermines a free society and damages the fundamentals of the economy. That’s no way to end a recession.

The imposition of a windfall tax on energy companies is supported by a majority of the public and many politicians. Revenues would be used to support low-income households struggling to pay gas and electricity bills following a series of steep price rises.

 
Yet consideration of the economic impacts of such a measure should lead to its outright rejection. Firstly, the arbitrary imposition of an extra payment would increase the risks to businesses of investing: as a result, they will demand higher returns on their investments or choose not to invest at all. Secondly, the tax would reduce the dividends paid out to energy company shareholders. These companies are not owned by “fat cats” but by us all through pension funds and insurance companies. Finally, it would reduce the funds available for investment in new sources of supply, thereby increasing energy costs in the long term.

 
Given the above effects, a windfall tax could harm many of the people it was designed to help and actually reduce long-term tax revenues. More generally, harsh though it may seem, it is a very slippery slope trying to protect parts of the population from particular price increases – especially in the energy sector. That is the way to stop people adjusting to a new environment of greater scarcity and is precisely the best way to induce shortages of supply in the future.