What Is a Windfall Tax?

A windfall tax is a tax levied by governments against certain industries when economic conditions allow those industries to experience significantly above-average profits. Windfall taxes are primarily levied on companies in the targeted industry that have benefited the most from the economic windfall, most often commodity-based businesses.

How Windfall Taxes Work

Oil and gas companies are common targets of windfall taxes. The massive net income increase for oil and natural gas producers—the International Energy Agency estimates they will double from 2021 to 2022, hitting an unprecedented $2 trillion—is the current trigger for the discussion and recent imposition of windfall taxes.

For example, on September 30, 2022, the Council of the European Union agreed to impose a "temporary solidarity contribution" on businesses in the crude petroleum, natural gas, coal and refinery sectors on profits that are "above a 20% increase of of the average yearly taxable profits since 2018." This is on top of whatever taxes they already owe in their individual countries. In each member state, proceeds are to help households and companies, and to ease the effects of high electricity prices.

And in October 2022, President Biden threatened that he would seek a windfall profits tax on oil and gas companies, which have reported very high profits and continue to charge high prices. He told them to use their "outrageous" bonanza—the effect of the Ukraine war—to expand oil supplies or reduce consumer prices.

The Windfall Tax Debate

As with all tax initiatives instituted by governments, there is always a divide between those who are for and those who are against the tax. The benefits of a windfall tax include proceeds being directly used by governments to bolster funding for social programs. Those against windfall taxes claim that they reduce companies' initiatives to seek out profits. They also believe that profits should be reinvested by companies to promote innovation that will, in turn, benefit society as a whole.

Then there is the question of whether windfall taxes actually raise the amounts that are predicted. Consider the most recent example in the U.S., the Crude Oil Windfall Profit Tax of 1980, imposed by Congress during President Jimmy Carter's administration.

According to a 2006 report from the Congressional Research Service, the windfall profits tax (WPT) generated $80 billion in gross revenues between 1980 and 1988, "significantly less than the $393 billion projected. Due to the deductibility of the WPT against the income tax, cumulative net WPT revenues were about $38 billion, significantly less than the $175 billion projected." In a more current example, The Washington Post reports that the windfall tax in Italy had "(as of September [2022]) yielded only about one-fifth the income the government had hoped for." On the other hand, the taxes do yield revenue that would not otherwise be available to offset the societal costs of high prices.

Critics point to other possible negative consequences. While windfall profits are taxed to encourage the taxed entities to lower their prices for the benefit of consumers, the tax could end up reducing investment because the new tax could make the after-tax profit not be worth the effort. This happened with the 1980 tax, according to the Congressional Research Service report. It notes that, from "1980 to 1988, the WPT may have reduced domestic oil production anywhere from 1.2% to 8.0% (320 to 1,269 million barrels). Dependence on imported oil grew from between 3% and 13%." The tax was repealed in 1988.

Windfall Taxes on Individuals

Windfall taxes may also apply to individuals who gain sudden riches from receiving a significant sum of money through a gift, inheritance, or through game-show, gambling or lottery winnings. In many cases, inheritances, gifts from family members or friends, and life insurance payouts are tax-free to the recipient.

However, federal, state, or local taxes may be owed by the giver or by the estate from which the inheritance is received. Any wealth gained from playing the lottery or gambling is considered taxable income. These winnings are fully taxable and must be reported to the Internal Revenue Service (IRS) by filing the individual tax return.

An individual who is awarded a sizeable monetary settlement after winning a lawsuit is likely to owe federal tax on the amount received. While certain settlements, such as damages for personal physical injuries or physical sickness, are considered non-taxable by the IRS, most other types of damages are taxed as ordinary income.

The Bottom Line

Windfall taxes will always be a contentious issue debated between the shareholders of profitable companies and the rest of society. The massive net income increase oil and natural gas producers—the International Energy Agency estimates they will double from 2021 to 2022, hitting an unprecedented $2 trillion—is the current trigger for the discussion. Currently, it is Exxon's shareholders who have benefited; they received a higher dividend, raised after the company announced a nearly $20 billion profit just for July to September.

Windfall taxes can be imposed on companies in certain segments of the economy, such as oil and gas, that benefit from situations such as commodity shortages that greatly increase the prices of their products at the expense of consumers. Individuals may also owe tax on a windfall, depending on its source and the tax laws of the federal government or their state or locality.