In an effort to show voters that they’re “doing something” about high gas prices and the deficit, the Obama Administration has been touting its proposed 2013 budget plan as a way to close “tax breaks for Big Oil.” Yet in reality, the proposals amount to unfair soaking of deep pockets, and would actually lead to higher gasoline prices. If the Administration wants to bring in more revenue from the energy sector, while delivering relief to motorists, it would expedite the leasing of oil located on federal lands.
Nonsensical Administration Claims
In his recent remarks at the Rose Garden, President Obama said:
It’s like hitting the American people twice. You’re already paying a premium at the pump right now. And on top of that, Congress, up until this point, has thought it was a good idea to send billions of dollars more in tax dollars to the oil industry.
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The oil industry is doing just fine. With record profits and rising production, I’m not worried about the big oil companies. With high oil prices around the world, they’ve got more than enough incentive to produce even more oil.
And there you have it —in a few sentences the president has apparently repealed basic economics. He is claiming that imposing a tax hike on the oil sector won’t affect its output. We will have to file this claim away, the next time the president or his allies suggest that a carbon tax would provide an incentive for industry to shift out of fossil fuels and into alternative energy sources.
Actually, we don’t have to wait long for the opportunity. The White House’s own official analysis of its 2013 budget proposal states:
Oil and gas subsidies are costly to the American taxpayer and do little to incentivize production or reduce energy prices…Removing these lower-priority subsidies would reduce greenhouse gas emissions and generate $38.6 billion of additional revenue over the next 10 years…[Bold added.]
President Obama’s speech in the Rose Garden is directly contradicted by the White House’s budget, while the budget document contradicts itself too. On the one hand, the Administration is claiming that extracting billions more in taxes from the oil industry wouldn’t affect its incentives to produce oil. On the other hand, the budget document claims that the reducing “subsidies” would result in lower greenhouse gas emissions that only occur if less oil is produced. Regardless of one’s views on the tax code, these statements can’t both be true at the same time.
Raising Taxes Reduces Output
Putting the rhetoric aside, the basic economic fact is that when you tax something, you get less of it. That’s why government officials like the idea of taxing liquor and cigarettes, after all: to get people to drink and smoke less. It’s why environmentalists favor carbon taxes: to get people to use less carbon-intensive goods.
Regardless of other considerations, the simple reality is that raising taxes on the oil industry will lead to less oil brought to market, than would otherwise be the case. That means higher oil prices, which in turn mean higher gasoline prices for motorists.
In his remarks, the president tried to mute the relevance of this Econ 101 lesson—that supply curves are upward sloping (i.e. that the amount supplied of something increases as the price increases)—by saying oil prices are currently high. Yet even if we accepted that argument, is President Obama proposing merely a temporary suspension of these tax provisions, which will go back into effect once oil prices fall below, say, $80 per barrel?
Of course not. The White House budget [.pdf] projects the revenue increase from these measures over the next ten years (see page 222). There are no asterisks or footnotes discussing the movement of oil prices; it is assumed that these changes to the tax code will remain in effect. The president’s talk of “I’m not worried about the big oil companies” is a smokescreen. The current public frustration over high gasoline prices has given a political opportunity to slap a huge tax hike on an unpopular target; there has been no careful consideration of the economic fallout from reducing the incentives for oil production.
These Aren’t “Tax Giveaways”
Beyond the dubious economic analysis of the impact on gasoline prices, the Administration’s rhetoric is also wrong for suggesting that these are “giveaways” or special “loopholes” enjoyed by “Big Oil.” We’ll analyze three of the biggest proposed changes: The repeal of the domestic manufacturing deduction for oil and gas companies (which would bring in an estimated $11.6bn over 10 years), the repeal of percentage depletion allowances for oil and natural gas wells ($11.5bn), and the repeal of expensing of “intangible drilling costs” ($13.9bn), as detailed on pages 221-222 and 236 of the proposal.
Domestic Manufacturing Deduction: The rhetoric concerning the domestic manufacturing deduction is particularly silly. Back in 2004 Congress changed the tax code to encourage companies to keep their production activities within the United States. This was not a feature unique to fossil fuel companies, but as Wikipedia explains:
Every business in the manufacturing sector, whether small or large, should consider the manufacturing deduction under IRC § 199. While section 199 comes with a complex set of rules, it nonetheless represents a valuable tax break for businesses that perform domestic manufacturing and certain other production activities.
In the interest of tax simplification, it might make sense to eliminate the Section 199 domestic manufacturing deduction altogether, ideally coupled with a reduction in marginal tax rates across the board. But what does not make sense—and what would only make the tax code even more convoluted—would be to leave the Section 199 domestic manufacturing deduction in place for every other qualifying industry, but to amend it so that oil and gas activities no longer qualify. In other words, the Administration is carving out an exception to an existing loophole so that oil companies pay more taxes than other manufacturers. This is what the Administration is proposing, and describing as “closing loopholes for Big Oil.”
Percentage Depletion Allowance: Far from being a “loophole,” the percentage depletion allowance is simply an acknowledgement of economic and accounting reality—and a lukewarm one at that. For example, consider a firm that takes in $1 million in revenues over the course of a year, while paying out $700,000 in wages and other out-of-pocket expenses. Sounds like the firm made a profit, or net income, of $300,000, right?
Not so fast. What if you further learn that the firm’s production activities use a $1 million machine that has to replaced every 5 years? Now we have to worry about depreciation. Disregarding the time-value of money, the firm’s accountants have to set aside $200,000 each year to reflect the using up, or wearing out, of the machine. So what appeared to be $300,000 in net income is actually more like $100,000.
Something similar happens with firms that sell depletable natural resources, such as oil and gas deposits. To a first approximation, if a company takes a barrel of oil out of the ground and sells it to a customer, the revenue it receives isn’t income but instead is just a transformation on the balance sheet from one asset to another. The firm is taking its wealth in the form of crude oil in “inventory” and turning it into dollars on deposit at the bank. It would grossly overstate the net income of the firm to consider only its out-of-pocket expenses incurred when bringing that oil to the surface, and neglecting the loss in the asset value of the remaining oil in the ground.
Because of these types of considerations, the tax code historically has allowed oil and gas companies to deduct a certain percentage of the value of their sales in the form of a depletion allowance. The true irony here is that this particular provision was originally put in place in 1926, and in 1975 was removed for the integrated oil companies. In other words, today the percentage depletion allowance can only be claimed by the independent producers and royalty owners. One can argue the merits of the rule, and claim that the percentage (currently 15% but with limitations) is too high or too low, but it is simply false to claim that the Administration is seeking to close loopholes on “Big Oil” by eliminating this provision.
Intangible Drilling Costs: The treatment of so-called intangible drilling costs (which allows the deduction of other expenses related to the exploration and discovery of new wells) is also preferential for the independents. These provisions allow the independent oil and gas producers to fully deduct their “intangible drilling costs” in the year that they are incurred, rather than only being able to deduct one-third of such expenses, and having to spread them out over five years, as the major producers must do.
So here again, we see that the Administration’s rhetoric is the opposite of reality. Far from sticking it to “Big Oil,” the proposed changes would primarily impact the independent producers. Furthermore, allowing for full expensing in the first year is hardly a “loophole” unique to energy companies: The Obama Administration implemented 100% expensing on a wide range of qualifying business investments from September 2010 through the end of 2011, in an effort to jumpstart the economy. To repeat, one can argue the pros and cons of such provisions, but it is dishonest to portray them as special privileges for fossil fuels.
Conclusion
Generally speaking, the most efficient tax code has low marginal rates across the board, with no special treatment of any particular industry. This allows for the collection of tax receipts while minimizing the distortion caused by the political process picking winners and losers.
From this vantage point, the Obama Administration’s proposals do not simplify the tax code, for they deny general provisions to specific sectors, and they ignore accounting realities and hence penalize industries that involve depletable resources. Furthermore, the proposals constitute a net tax increase—particularly on the independent producers, not the big integrated companies—and would serve to raise gasoline prices.
If the Obama Administration really wants to achieve its stated goals of reducing the long-term budget deficit while lowering gasoline prices, the solution is obvious: It can remove impediments to the development of domestic energy supplies on federal lands.
