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Oil Subsidies 101!

September 24, 2011

It has been said that the “oil industry is the most heavily subsidized industry in the U.S. This is a rather grandiose statement, which sounds good but requires some validation. So in an attempt to dill down on the subject, no pun intended, this discussion takes a brief look at the tax codes in hopes of shedding some light on this claim.

To develop a common understanding of subsidies, a good rational is given by Gary Becker (University Professor Department of Economics and Sociology and Professor Graduate School of Business, The University of Chicago) and Richard Posner (Judge, United States Seventh Circuit Court of Appeals and Senior Lecturer, University of Chicago Law School). They state “a subsidy is defensible on economic grounds if it encourages the production of benefits that would be under-produced from an overall social-welfare standpoint were it not for subsidy.

For example, they indicate “That is the argument for allowing expenditures for research and development to be written off (deducted from taxable income) on an accelerated schedule; R&D is under-produced from an overall social-welfare standpoint because even with a patent system one firm’s R&D is quite likely to confer benefits on other firms for which the firm conducting the R&D will not be compensated; note in this connection that one requirement for a patent is that the applicant disclose the invention, and that disclosure may convey valuable information to competitors even though they cannot practice the patented invention without the patentee’s authorization.”

As a starting point, a review of the corporate income tax system gives a good indication of the relative level of taxation currently applies to capital income of the oil industry. The Congressional Budget Office Paper “Taxing Capital Income: Effective Rates and Approached to Reform” dated October 2005 shows:

• Petroleum and Natural-Gas Structures are subjected to a 9.2 % effective tax rate on capital income, the lowest of 49 categories. Computers and peripheral equipment have the highest tax rate at 36.9%

• Oil-field machinery is subjected to a 21.9% effective tax rate on capital income, ranking No 21 of the 49 categories.

These low tax rates may or may not be considered a direct subsidy. But in context to other assets types, such as educational building, which are taxed at 28.4%, the justification behind these favorable rates granted to the oil industry seems unbalanced.

Going a little bit deeper, Becker and Posner point out that the principal tax subsidies for the oil industry are:

• A “domestic manufacturing deduction” that allows oil and gas companies to deduct an extra 6 percent of their taxable income;

• A deduction for “intangible costs,” which are costs for investments in oil exploration or production that have no salvage value, such as clearing land to enable an oil well to be drilled—the oil companies are not required to amortize these costs over the entire expected life of the oil well.

• The companies are permitted to deduct royalties they pay to foreign government, on the ground that royalties paid to a government are really a tax.

They go on to say, “the aggregate value of these subsidies to the U.S. oil industry is approximately $5 billion a year, almost as much as the industry pays in federal income tax ($5.7 billion).  The industry’s total profits exceed $30 billion, so it would not be facing a crushing burden if the subsidies were to be eliminated; the Obama Administration proposes to eliminate only $2 billion of the subsidies.

Finally in a more qualitative way, David Kocieniewski article “Oil Companies Reap Billions From Subsidies,” which ran in the New York Times after the BP oil spill catastrophe suggests:

• “….. for many small and midsize oil companies, the tax on capital investments is so low that it is more than eliminated by various credits.”

• “ ….. (American producers) exploited tax laws by moving overseas to avoid paying taxes in the United States.”

• “….. many small and midsize oil companies based in the United States can claim deductions for the lost value of tapped oil fields far beyond the amount the companies actually paid for the oil rights.”

• “….. rigs, like Deepwater Horizon, are registered in Panama or in the Marshall Islands, where they are subject to lower taxes and less stringent safety and staff regulations.”

In closing, this discussion could not confirm the notion that the oil industry is the most highly subsided industry in the U.S. However, using Becker-Posner’s rationale, it is highly questionable that subsidies to the oil industry are defensible on economic grounds since it does not encourage the production of benefits that would be under-produced from an overall social-welfare standpoint were it not for subsidy. In fact the opposite is true.

Nevertheless, the discussion clearly shows a degree of disparity in favor of the oil industry from exploration to extraction. Eliminating these subsidies for the oil company and bringing their tax rates in line with other industries would bring additional revenue to the U.S. government. The real cause for concern lies in the economic impact of increased gasoline prices. How much would the price of gasoline increase to the consumer is anyone’s guess? Even a slight increase would be painful at a time of severe economic uncertainty and high unemployment. But sooner or later the oil industry must pay their fair share. You never know, relaxing subsidies may even help the bankability of renewable energy development projects.

Assuming the country does not fall into another deep recession, the net effect of the increase would be a reduction in consumption and a shift to cleaner fuels. A desired outcome if you care about the earth and our future.

4 Comments leave one →
  1. Robert Borlick permalink
    September 25, 2011 9:56 AM

    Good article. However, it raises a question that implies that eliminating tax subsidies would increase US gasoline prices. I haven’t studied that issue but my intuition tells me that the increase would not be large.

    Gasoline prices are mostly driven by the world price of crude oil, which is set in the world market and controlled by the OPEC cartel. Eliminating the subsidies for US oil companies will not change the world price of oil; it will only reduce the exhorbitant profits of the crude-rich US oil companies.

    Most likely there could be an increase in gasoline prices from eliminating the subsidies for US refiners but would be relatively small.

    The above argument suggests that the “Drill, Baby Drill” strategy advanced by the conservative right would not significantly benefit US consumers because the additional production would not change the world price by much, if at all. Again, the primary effect would be to increase the profits of the oil drillers and producers. It is true that opening up ANWR and other US tracts would raise some additional royalty revenues for the government but these would be a pittance compared to the value of the oil produced from those tracts, which are auctioned off to the oil industry a very modest prices by the Dept of Interior.

    What the US needs is a new paradigm. For example, suppose the US government was a silent partner with a 50 percent share of the oil revenues produced from the auctioned off tracts. After all, these mineral rights belong to all US citizens. Why not give them a fair share of the value instead of giving that value away to the oil companies? I think it is clear that these values are not reflected in the auction and royalty revenues. There has to be a better way.

  2. September 25, 2011 10:42 AM

    Well said.

  3. November 17, 2014 5:55 AM

    Reblogged this on BarryOnEnergy.


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