Taxing unearned profits

The following article is from the “Tax and Monopoly” October 2022 issue of the Tax Justice Focus, an online magazine that explores boundary-pushing ideas in tax justice and revolutionary solutions to the most pressing challenges of our time. Each edition features articles from prominent experts and academics from around the world. The “Tax and monopoly” issue is co-published with the Balanced Economy Project and Roosevelt Institute.

For too long policymakers have failed to distinguish between productive profits and rents derived from market concentration and the control of scarce resources. A revived anti-monopoly movement must make full use of this difference to ensure that taxes encourage investment while eliminating rent-extraction as a business model.

Open and competitive markets are good for the economy, for business, and for consumers. To compete, companies must invest, innovate, be productive, and offer lower-cost, better quality products to customers. Fear that a competitor will bring out a newer or cheaper product keeps companies on their toes.

The most successful companies enjoy modest profits because the rest are competed away. Or so says the orthodoxy.

The problem

This idealised world does not exist outside economics textbooks, however. To the extent that real markets resemble the ideal, they do so as a result of state intervention. Left to themselves, market forces will often tend towards monopoly and the capture of value through the extraction of what economists call ‘rents’ – or unearned profits. The task of policymakers is to protect the level playing field while confronting corporate power when it seeks to escape from competitive forces. Economist Adam Smith recognised this very problem, observing that a truly free market would require an active government to guard against anti-competitive behaviour. Firms can earn productive profits (e.g., due to past investment, risk-taking or innovation,) and they can also receive rents, the fruits of uncompetitive behaviour. Distinguishing these two is critical.

All markets suffer concentration or monopolisation, to a lesser or greater degree. In some areas, called natural monopolies, competition is all but impossible. Take, for example, a railway between two cities: it makes no sense for a competitor to build a duplicate railway next to it, before they can compete. But monopolisation happens in less obvious areas: for example, the ‘network effects ’enjoyed by tech giants like Google; control over scarce resources like oil; or where companies lobby to create high ‘barriers to entry’ to competitors. The negative effects of such market power can include higher prices, sluggish innovation, and as economists such as Jan Eeckhout have shown, economy-wide lowering of wages.
The critical distinction, when looking at corporations, is therefore between profits that are generated by firms in exchange for the goods they sell and the services they provide (‘productive profits’), and the profits they generate simply because of their size or their market power. Economists tend to call the latter ‘rents’.

One of the best ways to understand market concentration is to look at rates of profit. In an open and competitive market, profits should tend towards zero as firms undercut each other. As sectors move away from perfect competition, firms can use their market power to charge higher prices, and profits (or ‘mark-ups’) tend to rise. There are some exceptions to this, for example what may appear as unearned profits may in fact be the return on past investment, competition, risk-taking or innovation – so called Schumpeterian rents.

Brett Christophers argues that rent-seeking is particularly stark in 21st century Britain: ‘the leading corporations are largely rentiers, and the biggest sectors of the economy are largely characterised by rentier dynamics’. Today, for instance, six energy companies hare 83% of the retail gas market, four broadband companies supply over 85% of broadband customers, and four banks have 64% of retail bank accounts. The UK Competition and Markets Authority (CMA) also observe ‘a marked increase in concentration [and profitability] in the years after the 2008 financial crisis’. This may help explain the UK’s chronic underinvestment in capital compared to other OECD countries. The pandemic has made matters worse: just six US tech firms added over $4 trillion to their market value since the pandemic began. For UK-listed firms since the pandemic, profits were up 34% at the end of 2021, with 90% of this increase accounted for by only 25 companies that largely operate in concentrated sectors.

Solutions

So, what can we do? And what is the specific role of taxation?

There are no magic bullets: to confront monopoly or market power needs policymakers and regulators to act in coordination and use a range of tools, as the Biden administration recognised last year with a new cross-government antitrust agenda.

The most powerful tool to re-shape the economy, potentially, is re-invigorated competition policy (or, to use the US term, antitrust). But the tax system can be exceptionally powerful tool both as a shaper of the economy – by applying different tax rates to extractive versus productive activities to re-balance economic activity – and as a redistributor of unearned rents. It’s on this that we focus in what follows.

Corporate tax

The past decade has seen a race to the bottom on headline corporate tax rates, across developed economies and beyond. In the UK, the headline rate has fallen from 30% to 19% today. Politicians have claimed that this boosts investment – a laudable aim, but tax cuts have not achieved it. Slashing rates by over a third has not remedied the UK’s low investment problem. We argue that other factors are driving the UK’s low investment — potentially including widespread rentierism. Many economists argue that the optimal rate of corporate tax is likely to be much higher than the current average global rate. Corporation tax rate is not the only, or even the principal, factor in firms’ decisions about where to locate, even where they are relatively mobile. Rather, firms invest when they can see future growth and profit opportunities. This is better addressed through broad industrial policy. IPPR has previously called for UK corporation tax rates to rise to 25–30%.

Recent agreements at the G7 and OECD on a global minimum corporation tax rate at 15%, and tools to recoup tax revenues internationally if tax havens cut their headline rates below this level, will potentially end this race to the bottom. Far better than a race to the bottom is ‘upwards competition’ on broader policies that make the UK an attractive investment destination: to create sound infrastructure, a well-trained and skilled workforce, thriving research and development, and rising productivity.

Headline corporation tax is levied on all profits, so does not distinguish between ‘productive profits’ and rents from market power. It is possible, however, to alter the effective rate that different firms pay, via a system of allowances or tax exemptions that benefit productive firms over rentiers.

The design of tax reliefs or exemptions matters as deductions that are set too high, or are too complex, will erode the tax base without countervailing positive economic effects. Badly designed tax reliefs can be less effective – and less transparent – than public spending of equivalent cost. Yet there can be good economic arguments for well designed reliefs and exemptions as part of an economy-shaping tax system to steer corporate behaviour towards desirable outcomes. Investment allowances, for example, are widely supported to encourage companies to invest their profits. The UK recently created a temporary investment deduction at a generous 130%.

Windfall taxes and beyond: excess profits tax

Separate from the headline rates of corporation tax levied on all profits, a country can also directly tax windfall profits (which we define as profits reaped from sudden, extreme price changes in products or commodities outside firms’ control). For example, global gas prices have spiked following the Russian invasion of Ukraine, massively increasing the profits of fossil-fuel firms. These firms have distributed these enormous windfalls to their share holders via record-breaking dividends and share buybacks. The UK, Italy and other countries have responded by levying a windfall tax on energy producers/fossil-fuel extractors, and redistributing these to support struggling consumers. This is legitimate redistribution, and it also curbs these profits by firms with market power that can monopolise windfall returns. It is no coincidence that, more broadly, windfall returns tend to be made in highly concentrated sectors: oil and gas extraction, tobacco, and mining and mineral extraction

Yet, as discussed above, returns to firms with significant market power are not just in monopolising windfalls. Without competition, firms can reap excess profits on an ongoing basis. These profits are clearly unearned, at the expense of the wider economy and consumers, so excess profits that are not just windfall profits should be taxed, to disincentivise rentier activity and redistribute its unearned gains.

To make this happen, policymakers must first establish a toolkit to determine which firms operate in environments of significant market power, and to quantify the magnitude of the returns on that power. An emerging community of economists on both sides of the Atlantic is now studying this problem and developing novel solutions.

The final way of taxing economic rents is to focus on the ways in which they return to, and further enrich, (already wealthy) shareholders, widening economic inequality. Share buy-backs, for instance, are anathema to a productive and competitive market: they are symptomatic of firms that can identify no further investment opportunities beyond artificially boosting their own stock market price. Companies like BP and Shell, for example, have paid out record sums to shareholders at the expense of under-investing in clean, renewable energy technologies. The Biden administration’s landmark Inflation Reduction Act includes provisions to tax share buy-backs at 1%, an initiative that should be replicated internationally, and – in time – at an increased rate.

Other economists have proposed novel methods of taxing firms’ market capitalisation as an easily-implemented proxy for wealth taxation which should be considered by policymakers.15 These approaches are attempting to achieve the same objectives as an excess profits tax but levied on a different tax base, and so to some extent are substitutes for each other.

Corporate Power and Competition Policy

Taxes alone can never fully resolve market concentration and monopoly. It is simply not enough to bemoan low investment and innovation across modern economies – we must recognise that there are firms and sectors that benefit and profit from stagnation. Their power must be confronted directly. There will always be a role for pro-active competition or antitrust policy, which will need to change over time as new technologies open markets that may be particularly prone to market concentration. This is particularly important during periods of high inflation when monopolistic firms may take advantage of broad price rises to increase their markups.

We have proposed that the UK’s CMA should launch pre-emptive investigations into the potential for excess profits in the most concentrated sectors of the economy. In Germany, the government has already suggested ways to tighten competition enforcement in sectors perceived to be unfairly profiting from the current situation.

In the US, the Biden administration is embarking on an ambitious programme of anti-trust policy that combines a broader conception of competition with more rigorous enforcement. Similarly, the UK’s CMA should broaden its conception of market power which is currently focussed too narrowly on prices. IPPR has previously called for the CMA to consider the interests of consumers, suppliers, entrepreneurs, taxpayers, workers and the broader value of innovation in order to promote and protect the public interest.17 A review of the CMA’s powers and decision-making principles could determine whether market share thresholds for regulatory action should be set, whether regulatory tools to address vertical integration and price discrimination should be strengthened, and whether competition policy should have an a priori objective to limit market power by limiting market concentration.

If we truly want to shape our economies for the better, it is high time that we concentrate on the division in our economy between productive profits and rent extraction that costs us all. This has been neglected for too long, but the effects of the pandemic and the current global inflationary crisis highlight this. Taxation is both a way to confront rent extraction and an important tool to redistribute rents.

George Dibb is head of the Centre for Economic Justice at the Institute for Public Policy Research (IPPR), the UK’s leading progressive thinktank. George leads IPPR’s work on economic policy and is based in Westminster. With a background in science and innovation, George’s interests include economy-shaping industrial strategy, research and development, sustainability, and climate change.