hausmann102_Dmitry FeoktistovTASS via Getty Images_russiagasoil Dmitry Feoktistov/TASS via Getty Images

The Case for a Punitive Tax on Russian Oil

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

CAMBRIDGE – As I write, Russia’s army has entered Ukraine’s capital, Kyiv. It is clear now that the threat of sanctions did not dissuade 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 capacity to project power by weakening its economy, and they can create a precedent that might influence Putin’s future behavior vis-à-vis other countries such as Georgia, Moldova, and the Baltic states.

One reason why the threat of sanctions might not have prevented war is that Russia did not regard them as 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 at the high energy costs. An embargo on Russian oil will reduce the global energy supply and send prices even higher, potentially triggering a backlash against the policy.

That may be why Western countries have not imposed it, opting instead for financial sanctions that have, so far, been underwhelming. After all, arguably the most significant sanction to date – the suspension of the Nord Stream 2 pipeline that would have delivered Russian natural gas directly to Germany – will strain Europe’s already tight natural gas market.

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

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

At issue 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 good’s price. 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 the demand, the more the producer bears the cost of the tax because consumers have more options. The more inelastic the supply, the more the producer – again – bears the tax, because it has fewer options.

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Fortunately, this is precisely the situation the West now confronts. Demand for Russian oil is highly elastic, because consumers do not really care if the oil they use comes from Russia, the Gulf, or somewhere else. They are unwilling to pay more for Russian oil if other oil with similar properties is available. Hence, the price of Russian oil after tax is pinned down by the market price of all other oil.

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

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

In other words, given very high demand elasticity and very low short-term supply elasticity, a tax on Russian oil would be paid essentially by Russia. Instead of being costly for 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 per barrel – could extract and transfer to the world some $300 billion per year from Putin’s war chest, or about 20% of Russia’s 2021 GDP. 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’s natural gas price, which is currently around €90 ($101) per megawatt-hour, would keep Russian gas in the market but expropriate the rent.

But how feasible would a 90% world tax on Russian oil be? In 2019, 55% of Russia’s exports of mineral fuels (including oil, natural gas, and coal) went to the EU, while a further 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 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 the rent that it would otherwise have to pay to Russia.

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