The option of a punitive tax on Russian oil

The current dynamics of supply and demand mean that a punitive tax on Russian oil would be onerous for Russia and profitable for the rest of the world, something more credible and sustainable than an embargo. The idea deserves more attention than it has received.

CAMBRIDGE – As I write, Russia’s military has entered the Ukrainian capital, Kiev. It is now clear that the threat of sanctions did not deter Russian President Vladimir Putin from launching his invasion. But making good on the threat can still play two other roles: sanctions can limit Russia’s ability to project power by weakening its economy, and they can create a precedent that could influence Putin’s future behavior vis-à-vis other countries like Georgia, Moldova, and Russia. and the Baltic states.

One of the reasons the threat of sanctions might not have prevented the war is that Russia did not find them credible. If imposing a sanction is costly, the political will to do so may be weak or evaporate over time. For example, Western consumers are already upset about high energy costs. An embargo on Russian oil will reduce global energy supply and push prices higher still, potentially triggering a backlash against the policy.

That may be the reason why Western countries have not imposed it, but have opted for financial sanctions that, so far, do not seem sufficient. After all, arguably the biggest sanction to date, the suspension of the Nord Stream 2 pipeline, which would have delivered Russian natural gas directly to Germany, will put pressure on Europe’s already tight natural gas market.

Sanctions are more effective and credible if they impose large costs on the intended target but imply small costs or even benefits for those who impose them. Finding such sanctions is easier said than done, as the Nord Stream 2 project shows. So what tools does the West have in its arsenal?

One that has received surprisingly little attention is punitive taxes on Russian oil and gas. At first glance, imposing a tax on a good should increase its price, making energy even more expensive for Western consumers. Right? Incorrect!

This is something called tax incidence analysis, which is taught in basic microeconomics courses. A tax on a good, such as Russian oil, will affect both supply and demand, changing the price of the good. How much the price changes and who bears the cost of the tax depends on how sensitive both supply and demand are to the tax, or what economists call elasticity. The more elastic demand is, the more the producer bears the cost of the tax because consumers have more choices. The more inelastic the offer, the more the producer bears -again- the tax, because he has fewer options.

Fortunately, this is precisely the situation facing the West now. Demand for Russian oil is very elastic, because consumers don’t really care whether the oil they use comes from Russia, the Gulf, or somewhere else. They are not willing to pay more for Russian oil if other oil with similar properties is available. Therefore, the after-tax price of Russian oil is determined by the market price of all other oils.

At the same time, Russian oil supply is highly inelastic, meaning that large changes in the producer price do not induce changes in supply. Here, the numbers are staggering. According to the financial statements of the Russian energy group Rosneft for 2021, the company’s upstream operating costs are $2.70 per barrel. Likewise, Rystad Energy, a business intelligence firm, estimates the total variable cost of production of Russian oil (excluding taxes and capital costs) at $5.67 per barrel.

Put another way, even if the price of oil fell to $6 a barrel (it is now above $100), it would still be in Rosneft’s interest to keep pumping: supply is really inelastic in the short run. Obviously, under those conditions, it would not be profitable to invest in maintaining or expanding production capacity, and oil production would gradually decline, as it always does due to depletion and loss of reservoir pressure. But this will take time, and by then others may seize Russia’s market share.

In other words, given a very high elasticity of demand and a very low elasticity of short-run supply, a tax on Russian oil would essentially be paid by Russia. Instead of being costly to the world, imposing such a tax would actually be profitable. A punitive global tax on Russian oil, at a rate of, say, 90% or $90 a barrel, could extract and transfer to the world some $300 billion a year from Putin’s war chest, or about 20% of GDP. Russia in 2021. And it would be infinitely more convenient than an embargo on Russian oil, which would enrich other producers and impoverish consumers.

This logic also applies to Nord Stream 2. A tax equal to 90% of the European Union natural gas price, currently around €90 ($101) per megawatt-hour, would keep Russian gas on the market but expropriate the rent.

But how feasible would a 90% global tax on Russian oil be? In 2019, 55% of Russian exports of mineral fuels (including oil, natural gas and coal) went to the European Union, while another 13% went to Japan, South Korea, Singapore and Turkey. China got only 18%. If all these countries except China agreed to tax Russian oil at 90%, Russia would try to sell all of its oil to China. But this would put China in a strong negotiating position. In such a scenario, it would be in China’s interest to impose the tax, because such an instrument would extract rent that it would otherwise have to pay to Russia.

In short, a punitive tax on Russian oil would significantly weaken Russia and benefit consuming countries, making it more credible and sustainable than an embargo. The idea deserves much more attention than it has received.

The author

Former planning minister of Venezuela and former chief economist of the Inter-American Development Bank, he is a professor at Harvard University’s John F. Kennedy School of Government and director of the Harvard Growth Laboratory.

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