What is a Windfall?

A couple months ago when the politicos began talking, again, about a windfall profits tax on oil companies, we compared the profit margins of various companies and industries… and even the Harvard endowment.  Alas some people still don’t want to confront the facts, and the WSJ took them to task in an editorial last Monday.  I couldn’t agree more.

The "windfall profits" tax is back, with Barack Obama stumping again to apply it to a handful of big oil companies. Which raises a few questions: What is a "windfall" profit anyway? How does it differ from your everyday, run of the mill profit? Is it some absolute number, a matter of return on equity or sales — or does it merely depend on who earns it?  Enquiring entrepreneurs want to know.

Mr. Obama didn’t bother to define "reasonable [profit]," and neither did Dick Durbin, the second-ranking Senate Democrat, when he recently declared that "The oil companies need to know that there is a limit on how much profit they can take in this economy." Really? This extraordinary redefinition of free-market success could use some parsing.

So let’s follow their chain of thought as they pick it apart.  First, companies with big profits (by pure dollars…) pay big taxes.

Take Exxon Mobil, which on Thursday reported the highest quarterly profit ever and is the main target of any "windfall" tax surcharge. Yet if its profits are at record highs, its tax bills are already at record highs too. Between 2003 and 2007, Exxon paid $64.7 billion in U.S. taxes, exceeding its after-tax U.S. earnings by more than $19 billion. That sounds like a government windfall to us, but perhaps we’re missing some Obama-Durbin business subtlety.

So if the government "takes" some of that supposedly excess profit, presumably the company would pay less in taxes… so what would that accomplish?  But how about profit margin instead of pure dollars?

Maybe they have in mind profit margins as a percentage of sales. Yet by that standard Exxon’s profits don’t seem so large. Exxon’s profit margin stood at 10% for 2007, which is hardly out of line with the oil and gas industry average of 8.3%, or the 8.9% for U.S. manufacturing.

If that’s what constitutes windfall profits, most of corporate America would qualify. Take aerospace or machinery — both 8.2% in 2007. Chemicals had an average margin of 12.7%. Computers: 13.7%. Electronics and appliances: 14.5%. Pharmaceuticals (18.4%) and beverages and tobacco (19.1%) round out the Census Bureau’s industry rankings.

Ok, that doesn’t work either.  How about "growth in profits"…?

In a tax bill on oil earlier this summer, no fewer than 51 Senators voted to impose a 25% windfall tax on a U.S.-based oil company whose profits grew by more than 10% in a single year and wasn’t investing enough in "renewable" energy. This suggests that a windfall is defined by profits growing too fast. No one knows where that 10% came from, besides political convenience. But if 10% is the new standard, the entire tech industry is going to have to rethink its growth arc. So will LG, the electronics company, which saw its profits grow by 505% in 2007. Abbott Laboratories hit 110%.

Many of those companies are in risky industries with crazy markets creating wide variations from year to year; so what happens if profit falls or even goes negative the following year, which often happens?  So much for the business continuity funding that large profit margins are designed to protect, which could lead to lost jobs… hmmm… oh well.  We brought up the Harvard endowment in an earlier post, but how about individuals?

The fun part about this game is anyone can play. Jim Johnson, formerly of Fannie Mae and formerly a political fixer for Mr. Obama, reaped a windfall before Fannie’s multibillion-dollar accounting scandal. Bill Clinton took down as much as $15 million working as a rainmaker for billionaire financier Ron Burkle’s Yucaipa Companies. This may be the very definition of "windfall."

And as with any government attempt at regulating a free market, there will be unintended consequences.  Here’s just one possibility:

General Electric profits by investing in the alternative energy technology that Mr. Obama says Congress should subsidize even more heavily than it already does. GE’s profit margin in 2007 was 10.3%, about the same as profiteering Exxon’s. Private-equity shops like Khosla Ventures and Kleiner Perkins, which recently hired Al Gore, also invest in alternative energy start-ups, though they keep their margins to themselves. We can safely assume their profits are lofty, much like those of George Soros’s investment funds.

Ok, I give up.  When is a windfall a windfall?  Or is it defined purely by polls and political expediency?  It wouldn’t be the first time.