Why They Don’t Need $70 Billion from Taxpayers Amid Record Profits
SOURCE: AP/Robert F. Bukaty Route 1 traffic bisects Exxon and Mobil gas stations Thursday, April 27, 2006, in Scarborough, Maine. Exxon Mobil Corp. reported first-quarter earnings of $11 billion, nearly 70 percent higher than a year ago.
At a time when gas prices exceed $4 a gallon, these profits are coming out of ordinary people’s pockets, and not just at the pump. American families are also padding the oil companies’ enormous profits with their tax dollars. In effect, U.S. taxpayers wrote a collective $7 billion bonus check to the oil industry when they filed their taxes last month.
That’s because the tax code is stuffed with a host of subsidies for oil and gas. These subsidies are delivered through the tax code but they are essentially no different from government spending programs that provide money directly.
Some of these tax earmarks have been around for nearly a century, and the deep-pocketed industry has successfully challenged previous repeal attempts. But today’s high gas prices and inflated profits have undermined the industry’s argument that their tax breaks benefit consumers. Meanwhile, federal budget deficits have sharpened Congress’s focus on eliminating wasteful government spending—of which oil subsidies are one of the worst examples.
Even congressional Republicans—who voted unanimously to retain oil tax breaks in March—now seem to be backing off their defense of the indefensible. Both House Speaker John Boehner (R-OH) and Budget Committee Chairman Paul Ryan (R-WI) have said, albeit in vague terms, that they now support rolling back oil and gas tax subsidies. A growing number of rank-and-file Republicans have echoed these comments.
It’s time to turn these sentiments into action, and momentum is building on Capitol Hill.
Senate Majority Leader Harry Reid (D-NV) said he intends to hold a vote as early as next week on ending the oil and gas earmarks.
In the House, all 15 Democrats on the tax-writing Ways and Means Committee this week urged Chairman Dave Camp (R-MI) to schedule a session to move a tax subsidy repeal. Thirty other members of Congress, led by House Democrat Earl Blumenauer of Oregon, recently wrote Boehner urging him to allow an up-or-down vote on the “Ending Big Oil Tax Subsidies Act.” Democrats may offer amendments repealing oil subsidies to legislation on the House floor this week.
The Center for American Progress has repeatedly in the last year scrutinized the hidden world of oil and gas tax subsidies, emphasizing that they represent wasteful government spending. Here’s a summary of the major oil and gas tax breaks and their cost to taxpayers:[1]
Percentage depletion ($11.2 billion over 10 years)
Companies are generally allowed to deduct the costs of an investment over the term of that investment’s useful life. But oil companies get to use a special method for calculating their deductions called “percentage depletion.” Instead of deducting the costs of an oil or gas well as its value declines, oil companies are allowed to deduct a flat percentage of the income they derive from it. Because the deductions are based on revenues, not costs, the subsidy actually increases at times when prices are high, which of course is when oil companies enjoy their greatest profits.[2]The oil and gas industry maintains that this is not a special tax break because other companies receive similar deductions. But the percentage depletion method permitted for oil and gas is fundamentally different and more favorable. In some cases, it can eliminate all federal taxes for these companies. Moreover, percentage depletion is a poorly designed subsidy because it “doesn’t specifically target hard-to-find or difficult-to-extract oil,” as CAP’s Richard Caperton and Sima Gandhi have written.
Domestic manufacturing deduction for oil production ($18.2 billion over 10 years)[3]
Oil producers successfully lobbied for inclusion in a 2004 bill that gave the beleaguered manufacturing sector a special tax break designed to discourage outsourcing of jobs. For a number of reasons—including the capital-intensive nature of oil production, the relative mobility of investments, and of course the level of profitability—there are vast differences between the oil industry and traditional U.S. manufacturing. As Sen. Bob Corker, a Tennessee Republican, has explained: “Congress was trying to solve a manufacturing issue in this country” by enacting the deduction and included oil producers “almost inadvertently.”[4]Whatever rationale there was for allowing oil producers to claim the manufacturing deduction has evaporated in the intervening time, as oil prices have nearly tripled. Eliminating oil producers from a benefit never intended for them “will have no effect on consumer prices for gasoline and natural gas in the immediate future,” and is unlikely to have any effect over the long run, according to a recent report by Congress’s Joint Economic Committee.
Expensing of intangible drilling costs ($12.5 billion over 10 years)
Another special tax rule dating back to 1916 permits independent oil companies (and major integrated oil companies to a lesser but still significant extent) to “expense” certain costs associated with drilling oil wells. This means they can take immediate deductions for these costs rather than spreading the deductions out over the useful life of the wells, which is the normal tax code rule for other types of investments. Taking deductions immediately means the companies lower their tax bill in the first year, in effect getting an interest-free loan from the government.“Dual capacity taxpayer” rules for claiming foreign tax credits ($10.8 billion over 10 years)
Our tax system allows companies that do business abroad to reduce from their tax bill any income taxes paid to other governments. The rules are supposed to prevent oil companies from claiming credit for royalty payments to foreign governments. Royalties are not taxes; they are fees for the privilege of extracting natural resources.Notwithstanding these rules, so-called “dual capacity taxpayers,” which are overwhelmingly oil companies, have been permitted to claim credits for certain payments to foreign governments, even in countries that generally impose low or no business tax (suggesting that these payments, or levies, are in fact a form of royalty).[5] Dual capacity taxpayer rules, therefore, are a subsidy for foreign production by U.S. oil companies. President Obama and others have proposed limiting the tax credit for these companies to what it would be if they did not have the special “dual capacity taxpayer” status.
Amortization of geological and geophysical expenditures ($1.4 billion over 10 years)
Another way many oil producers get to postpone their tax liability is by writing off the costs of searching for oil over an accelerated time period of two years. The president has proposed that all oil companies write off these costs over seven years, a relatively minor tax change that would have a negligible impact on investment decisions. According to the Congressional Research Service: “If the industry were experiencing a time of stagnant oil prices that were near the cost of production, relatively small changes in tax expenses might affect investment and production activities. However, in a time of high and volatile oil prices, small changes in tax expense are overshadowed by price variations.”[6]“Last-in, first-out” accounting for oil companies (as much as $22.5 billion over 10 years)[7]
A tax accounting method known as “last in, first out,” or LIFO, provides a significant tax benefit for oil companies, especially when prices are rising. LIFO allows oil companies to calculate profits based on the cost of the oil they most recently added to their inventory. Since the most recently acquired inventory costs the most when prices are rising, this method can minimize a company’s taxable income. LIFO is available to businesses in other industries but large oil companies are perhaps the biggest beneficiaries.[8]Taken together, these oil and gas tax subsidies represent a colossal waste of taxpayer resources since they pay companies, in the form of tax breaks, to do what they do anyway—especially at a time of price-fueled record profits.
American consumers have for years been waiting for the benefits of these tax subsidies to trickle down to them in the form of lower gas prices. It hasn’t happened. In fact, these subsidies existed during the 2008 oil shock when prices hit a record $147 per barrel, yet did nothing to lower oil prices or increase production. And repealing them won’t increase prices at the pump. “Gasoline prices are a function of world oil prices and refining margins,” explains Severin Borenstein, co-director of UC-Berkeley’s Center for the Study of Energy Markets. Any incremental impact on production “will have no impact on world oil prices, and therefore no impact on gasoline prices.”
Oil tax subsidies are simply a waste of taxpayer dollars. Oil and gas companies, like all companies, make investment decisions based on the profit potential. Those decisions are driven primarily by market conditions, including the price of oil on world markets, not marginal tax incentives.
“With $55 oil we don’t need incentives to the oil and gas companies to explore,” said President George W. Bush in 2005. “There are plenty of incentives.”
Oil prices today are double what they were then. It’s time to stop giving away tax dollars to some of the world’s most profitable companies.
Seth Hanlon is Director of Fiscal Reform for CAP's Doing What Works project.
Endnotes
[1]. There are also several other special tax provisions with a smaller cost to taxpayers (or no estimated cost due to current circumstances). These include the enhanced oil recovery credit, the credit for oil and gas produced from marginal wells, the deduction for tertiary injectants, and the exception from the passive loss rules for working interests in oil and natural gas properties.[2]. Alan B. Krueger, Testimony before the Senate Committee on Finance Subcommittee on Energy, Natural Resources, and Infrastructure, September 10, 2009.
[3]. All revenue estimates are, unless otherwise noted, from: General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals (Department of the Treasury, 2011).
[4]. Chuck O’Toole, “‘Gang of 10’ Energy Compromise Would Strip Oil and Gas Deduction,” Tax Notes, August 4, 2008).
[5]. Joint Committee on Taxation, Description of Revenue Provisions Contained in the President’s Fiscal Year 2011 Budget Proposal (Government Printing Office, 2010), p. 318.
[6]. Robert Pirog, “Oil and Natural Gas Industry Tax Issues in the FY2012 Budget Proposal” (Washington: Congressional Research Service, 2011).
[7]. This is the industry estimate of the effect on oil companies of President Obama’s proposal to eliminate LIFO as a whole. See: American Petroleum Institute, “Significant Industry Tax Issues Contained in President Obama’s FY 2012 Budget” (2011), available at http://www.api.org/policy/tax/upload/FY2012_Budget-Short_Tax_Issues_Paper.pdf.
[8]. In 2005 the use of LIFO inflated the cost of goods for the five biggest oil companies by a combined $12 billion, thereby reducing their taxable income. See: David Reilly, “Big Oil’s Accounting Methods Fuel Criticism,” The Wall Street Journal, August 8, 2006.
Q&A: What's Going on With Gasoline Prices?
Q: How much has the price of gasoline increased recently?
A: Since the beginning of the year, the average price of gasoline has increased by 42 cents, from $3.36 to $3.78 per gallon. That's from the US Energy Information Administration, and it's an average of all grades, all formulations, across all regions of the country. The price has gone up more in some regions (like California) and less in others (like the Rocky Mountain states). You can see the regional variations here.
Q: How come it's gone up so much?
A: Gasoline prices are linked very tightly to crude oil prices. Stuart Staniford has the wonky graph here and the wonky explanation: "Technically, 97% of the variance of the price of gas is explained by the price of oil."
Q: So what's the relationship?
A: UC San Diego's James Hamilton, your go-to guy for the effect of oil prices on the economy, says his rule of thumb is that a $1 increase in the price of crude produces a 2½-cent increase in the price of gasoline. Lately, gasoline prices have been linked most closely to the price of Brent crude, and since the beginning of the year Brent has gone up from $107 to $123, a $16 increase. By
Hamilton's rule, this should have produced an increase of 40 cents in the price of gasoline.Q: Hey, that's almost exactly right! So there's nothing more to it than oil prices?
A: Pretty much. There are a few miscellaneous other factors, like refinery shutdowns and the change from winter to summer formulations, but they don't amount to much.
Q: Fine. But why have oil prices gone up?
A: In the long run, the answer is just supply and demand. Oil production has plateaued over the past few years because everyone in the world is pumping full out, and there's very little spare production capacity left. Meanwhile, because the global economy is recovering, demand has increased. Americans may be using less oil these days, but that doesn't make up for rising consumption in Asia, particularly China and India. So the basic reason for climbing oil prices is Econ 101: When global supply is stagnant and global demand goes up, prices increase.
In addition, there are other theories about why prices have specifically gone up just in the past couple of months. Bernie Sanders thinks it's because of oil speculators on Wall Street. Sanctions on Iran may be hurting their ability to ship crude. Additionally, some analysts think that some of the price increase is driven by fear that Iran might cut off oil shipments entirely, or else slow or close the Strait of Hormuz. In other words, some of it might be driven by panic.
But here's the main takeaway: Demand for oil is pushing up against supply limits, and that's a permanent condition. From now on, demand is always going to be bumping up against supply limits because even if supply rises a bit in the future, demand is rising even faster. And when supply and demand are that tightly constrained, every small bump in demand or disruption in supply causes a big swing in prices. Last year it was the war in Libya that caused a price spike. This year it's Iran. But it's always going to be something. It doesn't take much anymore to produce a $30 swing in oil prices.
Q: Is this bad news for President Obama? Aren't presidential elections heavily influenced by gasoline prices?
A: Nate Silver crunched the numbers on this and concluded that the effect was actually pretty small. High prices at the pump probably have a negative effect on an incumbent president, but not much of one.
Q: Whew!
A: Not so fast. You also need to factor in the fact that higher oil prices are likely to slow down the economy. Jared Bernstein provides the nickel summary: "In terms of the overall economy, what you worry about here is a) oil is an important production input to everything we do, and b) higher gas prices mean less disposable incomes for people. Those are the dynamics behind the rules of thumb—the ones that say a $10 increase in a barrel of oil translates into about a quarter more per gallon at the pump, and, if it sticks, could shave 0.2% off of GDP growth. Not good, and why oil is #2 on my list of threats to the recovery (right after fiscal drag and before Europe)."
James Hamilton has done a lot of academic work on the effect of oil prices on the economy, and the effect is very real. If prices stay high, it could put a damper on economic performance later this year, and that in turn could hurt Obama's reelection chances.
Q: Do you have any good news to share?
A: Not really. New shale oil finds in North Dakota might increase global supplies a bit, but probably not enough to make up for increasing demand from China and other emerging economies. Basically, prices are going to stay high for the foreseeable future; even small supply disruptions are likely to cause big price gyrations; and big supply disruptions are likely to cause full-blown recessions. Like it or not, this is our future. I recommend you buy a motorcycle.
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