What Is an Excess Profits Tax and When Is It Used?

An excess profits tax is a levy imposed on business earnings that surpass a predetermined threshold meant to represent a “normal” level of profit. Any income above this amount is considered “excess” and is taxed in addition to standard corporate income taxes, increasing the marginal tax rate on those higher-end earnings. The tax is designed to capture profits considered above what a company would earn through its regular operations.

The purpose of this tax is to address situations where companies experience high profits from external circumstances, such as large-scale events that create sudden economic shifts, rather than their own innovation. The tax can be a temporary measure to generate revenue during a crisis or a more permanent feature of a tax system. It targets the portion of profit not attributable to the company’s direct efforts.

Historical Implementation in the United States

The United States has turned to an excess profits tax during several major conflicts to fund military expenditures and address public sentiment against war profiteering. The first application occurred during World War I. With the nation’s entry into the war in 1917, Congress enacted a tax to capture the extraordinary earnings of companies benefiting from government defense contracts and economic mobilization.

This tax framework was expanded with the Revenue Act of 1918. It established a dual system for calculating the tax baseline, allowing companies flexibility. The tax rates were progressive, reaching as high as 80% on the highest brackets of excess profits. This measure generated substantial revenue for the war effort while curbing corporate enrichment from the war.

The concept was revived on a larger scale during World War II. The U.S. government passed the Second Revenue Act of 1940, which included a new excess profits tax in response to the massive increase in industrial production and government spending. Policymakers were determined to prevent a repeat of the perceived profiteering that occurred during the previous war.

The World War II tax was structured with a flat rate of 90% on all profits deemed excessive, a rate later increased to 95% by the Revenue Act of 1943. To provide a measure of relief, the law included a post-war credit, refunding 10% of the tax paid. This tax proved to be an enormous source of revenue, funding a significant portion of the war’s cost.

A third excess profits tax was enacted during the Korean War with the Excess Profits Tax Act of 1950. The economic context was similar to the previous world wars, with a rapid increase in military spending creating windfall gains for many corporations. The tax was intended to finance the conflict and ensure companies supplying the war effort did not reap disproportionate rewards.

This iteration set the rate at 30% of excess profits, levied on top of the regular corporate income tax, bringing the combined top rate for corporations to nearly 70%. The law allowed companies to choose between two methods for calculating their normal profit baseline. The tax remained in effect until its scheduled expiration at the end of 1953, the last time the U.S. has implemented a broad-based excess profits tax.

Determining the Normal Profit Baseline

An element of any excess profits tax is the method used to establish the “normal” profit level, as only earnings above this line are subject to the levy. Historically, two primary methods have been employed in the United States. The choice of method provides flexibility, allowing a corporation to select the baseline that is most favorable to its financial situation, ensuring the tax targets genuinely excessive profits.

The first approach is the “average earnings” method. Under this model, a company’s normal profit is calculated based on its average net income over a specified historical period, such as the years immediately preceding the event that triggered the tax. For instance, the World War II tax used the period of 1936-1939 as the base period, and a company’s average profit from those years became its normal profit baseline.

To illustrate, if a corporation had average profits of $1.15 million during the base period and later earned $3 million in a war year, the excess profit subject to the tax would be $1.85 million. This method directly links the concept of excess profit to a company’s own established earning power under normal economic conditions.

The second approach is the “invested capital” method. This method defines normal profit as a specified rate of return on the company’s capital and was an alternative for companies with low profits or an unrepresentative earnings history. The law would specify an allowable rate of return, for example, 8% on the first $5 million of invested capital and a lower percentage for capital above that.

For example, a company with $10 million in invested capital might have a normal profit credit of $650,000 based on specified rates of return. If the company earned $2 million in profit, its excess profit would be $1.35 million. This method bases normal profit on a standardized return relative to the amount of capital at risk in the business.

Taxation of Windfall Profits

Distinct from a broad excess profits tax is a windfall profits tax, which targets unexpected gains in a specific industry resulting from external events rather than corporate strategy. These taxes are not based on a company’s overall profitability but are triggered by a sudden surge in revenue tied to a particular commodity or market condition. The tax is designed to capture earnings seen as unearned from a market anomaly.

A prominent example in the United States was the Crude Oil Windfall Profit Tax of 1980. This was an excise tax levied on the production of domestic crude oil, not a tax on profit in the traditional accounting sense. It was enacted in response to the decontrol of oil prices, which, combined with high global prices, was expected to generate massive revenues for oil producers.

The tax mechanism was tied to the selling price of oil. It established a “base price” for different categories of oil and taxed a portion of the difference between the actual sale price and this base price. Tax rates varied depending on the type of oil and the producer’s size, with major oil companies paying higher rates than small independent producers.

The tax was complex in its administration due to different tiers and exemptions. It was repealed in 1988 as oil prices declined and the administrative burden became more pronounced. The Crude Oil Windfall Profit Tax is an example of how a government can target specific, event-driven gains within a single industry.

Modern Proposals and Global Context

In recent years, discussions around new excess or windfall profits taxes have re-emerged globally, driven by economic disruptions that produced record profits for certain sectors. The COVID-19 pandemic, for instance, led to extraordinary earnings for pharmaceutical companies and large online retailers. This prompted calls in the United States and other nations for a temporary tax to capture these gains.

These proposals often mirror the historical logic of wartime taxes, suggesting that companies benefiting from a collective crisis should contribute a larger share to the public good. For example, some proposals in the U.S. Congress have suggested levying a tax on the profits of large corporations that exceed their average profits from the years preceding the pandemic.

The global energy crisis that intensified in 2022 also sparked a wave of windfall tax implementations, particularly in Europe. As energy prices soared, major oil and gas companies reported unprecedented profits. In response, the European Union endorsed a temporary “solidarity contribution” from fossil fuel companies on their surplus profits.

Similarly, individual countries like the United Kingdom introduced their own version of an energy profits levy. These taxes are structured to be temporary and are directly linked to the high commodity prices driving the windfall gains. The revenue raised is often earmarked to help consumers and businesses cope with high energy bills.