Excess Profits Tax: Definition & Meaning
When income exceeds what is generally considered to be normal profit levels, it could be subject to an excess profits tax.
But what is an excess profits tax?
Read on as we find out more about this special form of taxation.
Table of Contents
KEY TAKEAWAYS
- An excess profits tax is an extra tax that is imposed on business or corporate profits or a certain level of high income.
- The tax can either be permanent or temporary.
- It is usually put in place to offset income inequality. This is especially true for windfall profits.
- In the United States, excess profits taxes have been used by the federal government during times of crisis (World War I and World War II).
What Is an Excess Profits Tax?
An excess profits tax is a special form of tax. It is assessed upon individual or corporate income tax beyond a specific amount of return on invested capital. This is usually in excess of what is generally deemed to be a normal amount of income. Excess profits taxes are designed to tax the portion of profits generated from some external circumstances not of company’s making, such as profits resulting from the war (for example, defense contractors).
An excess profits tax can be used with the intention of reducing income inequality. Or generating emergency revenue for the government. This is as well as redistributing windfall gains that can result from specific government policies or other special circumstances.
Any excess profits taxes can be a permanent feature of a tax system or simply temporary measures.
Purpose of Excess Profits Taxes
An excess profits tax is an extra tax that is levied on the profits of a business or income above a specified rate of profit. Any self-employed individuals or companies that earn above this specified level have to pay an additional tax on income deemed to be above the ‘normal’ level.
An excess profits tax is assessed in addition to any corporate income or individual income tax that is already in place. So an excess profits tax basically represents an increase in marginal tax rates. This is on profits that fit into the higher tax brackets.
Because of this, an excess profits tax will represent an increase in the progressivity of the tax system. This is through taxing higher-income individuals and high-income businesses. The tax rate is imposed at an even higher rate than is normal.
When it comes to income inequality in society, some policymakers and economists advocate for excess profits taxes. This is as a way to slow or reduce the wealth gap.
This type of tax isn’t popular among people who feel that it discourages productivity by reducing the motivation to make sure businesses profit.
Calculation of Excess Profits Taxes
You can calculate your excess profits that will be subject to the excess profits tax by using the following formula:
History of Excess Profits Taxes
In 1917, congress enacted the first excess profits tax in America. The rates ranged from 20% to 60% on the profits of every business that is in excess of peacetime earnings. A law came in that limited the tax to corporations and increased the rates in 1918. By 1921, the tax was repealed. This was despite powerful attempts to make the excess profits tax permanent.
In 1933 and 1935, congress passed two mild excess profits taxes. This was as a supplement to a capital stock tax.
During the Second World War, Congress passed four excess profits statutes. This was between the years 1940 and 1943. The rates ranged from 25% to 50%. During the Korean War, they also put in place an excess profits tax. This was effective from 1950 through to 1953. The tax rate during this time was sitting at 30% of excess profits. With top corporate tax rates going to 47%, up from the previous 45%.
Some of the Congress members attempted to pass an excess profits tax of 40% in 1991. This was meant to be put on large oil companies as part of an energy policy. But this effort was unsuccessful.
There are some who advocate for a peacetime use of the excess profits tax. Most of these proposals face a strong amount of resistance from businesses as well as a number of economists and politicians. Their argument is that it would create a disincentive to capital investment.
Recent Excess Profit Tax Proposals
When the coronavirus pandemic broke out in 2020, economists Gabriel Zucman and Emmanuel Saez put forward an idea. This was an excess profits tax that was to be put on businesses that benefited from the effects of the pandemic. As well as the government enforcement of related public health restrictions.
When the global epidemic brought about quarantines, shelter-in-place orders, business closures, and social distancing measures, many businesses were harmed. However, many businesses also benefited during this time. These businesses tended to offer online or remote services.
Businesses that benefited the most were any kind that had anything to do with:
- Online shopping
- Remote business applications
- Cloud computing
- Streaming services
- Social media
These businesses saw a major increase in traffic and business volume. This was because more and more people were working, socializing, and shopping from home via the internet instead of going out.
During this time, the federal government dramatically increased spending by passing a stimulus package to offset the damage caused by the virus to the economy, as well as the public health response to it.
Zucman and Saez proposed that the excess profits tax help pay for the rise in emergency spending. As well as to help ensure that the windfall profits of the businesses that have benefited from the coronavirus pandemic are shared around with those that suffered most.
Summary
An excess profits tax is a tax that is levied on profits that are in excess of what is generally considered to be normal. Every iteration of this form of tax tends to be slightly different. However, the most common way to figure it out is the average income from a pre-war period.
It is a tax that is meant to slow the wealth gap for high income earners, but it is a controversial tax for many.
FAQS on Excess Profits Taxes
Excess profits are profits that are above the level needed for an entrepreneur to retain their current line of business operations. Essentially any increase in profit that leads to huge profits being made – far past the normal profit margins.
The other name for having excess business profit is experiencing a windfall.
A windfall tax is a one-off tax on businesses that have an unexpected high-profit income period. This is normally due to exceptionally favorable conditions in the competitive market.
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