Windfall profits as a problem of transition to markets
Introduction: Switching to markets can mean giving existing licensees more rights, and an opportunity to make a windfall profit they have not earned by reselling their licences. This may enhance efficiency, but if it is seen as unfair, it may discredit the whole auction process.
Spectrum trading represents a means of improving economic efficiency in terms of how the radio spectrum is used. Nevertheless, the mechanism used does have implications with regard to the incentives for spectrum trading and the possibility of making windfall profits. If it is assumed that auctions result in an efficient assignment of spectrum, then there shall initially be no incentive for a trade. However, in the case of other assignment mechanisms that do not depend directly on the amount users are willing to pay, there may be an immediate incentive to trade which could give rise to certain problems.
Windfall profits accrue to owners of specific property rights without any effort or economic activity on their part. The basic premise holds that a distribution of scarce resources gives the recipients an opportunity to make a profit. If they do so as a result of commercial activity, associated with the roll out of a network infrastructure, then there are no grounds for censure. On the contrary, there would only ever be cause for concern if it were possible for the user to make excessive profits without taking on correspondingly higher risks. Also if profits could be made simply by trading, without engaging in any productive activity or if spectrum had been obtained by means of a non-market based mechanism.
From a purely economic standpoint, windfall profits do not constitute an argument against spectrum trading. If, however, they are regarded as problematic for other reasons, there are various means of limiting such gains in the context of spectrum trading. First of all, usage rights should initially be assigned in an auction. Other options include a spectrum charge, effective market regulation, a windfall tax (much like a tax on capital gains) or a trading duty whereby the state recoups a proportion of the net gain when a trade takes place. Nor should it be forgotten that even windfall profits which accrue solely to the seller can also boost government finances. This is most immediately apparent if the seller in question is a state-run or state-funded institution which has purchased its spectrum rights via a market mechanism. If, for example, the armed forces had acquired some spectrum in a market and were to sell off surplus spectrum, the additional funds this would bring would generally mean that less funding would be needed from other sources.
Furthermore, the more efficient use of spectrum that is expected to result from trading also implies that the new users will make higher profits (assuming that the user is a for-profit entity). This in turn will result in increased tax revenues for the state (from income and capital gains tax and, if revenue also increases, from value-added tax). Once all factors have been taken into account, the issue of windfall profits, if suitable care is taken, therefore presents far less of a problem than is often portrayed.