Jenny B. Wahl
August 1996
We are not going to solve our transportation-related security, climate, pollution, and congestion problems without a serious effort to internalize the costs now generated by motor vehicle drivers.
--James MacKenzie, World Resources Institute[1]
Suppose you ran a business. You'd pay to protect your property - salaries for security guards, the cost of fences, insurance premiums, and the like. You would also expect to pay -- either through a private contract or in court --for damages you might inflict on others. If, say, the fumes from your auto-repair shop blew into the restaurant next door, you'd likely pay your neighbor something for their losses.[2] And you wouldn't expect to receive tax breaks any greater than the other businesses in the neighborhood.
None of this is true for the petroleum industry. It can count on the U.S. military to defend its interests abroad, and it depends on taxpayers to finance strategic petroleum reserves at home should overseas supplies be disrupted. Despite what oil and gas does to our health and environment, the petroleum industry bears few costs associated with these ills, either. What is more, the U.S. tax system gives out among its most handsome subsidies to oil and gas interests.[3] As a result, the prices of oil products are artificially lower than they otherwise would be.
What is the true cost of gasoline? Much more than what you pay at the pump. A gallon of regular unleaded costs about $1.30, but about 37 cents of that is state and federal taxes primarily used to pay for transportation-related expenses like road construction and maintenance. If motorists had to pay the true cost of gasoline, the pump price would be much higher.
Many experts have tried to quantify the external costs of oil. In this report, ILSR reviews dozens of existing studies and develops a range of estimates and a single best guess-number. The three key types of external costs are preferential tax treatment; the cost of protecting oil supplies; and the environmental and health costs associated with burning oil.[4] The methodology used in this report is to identify key studies, to extract from them a range of estimates of the external cost of petroleum and to translate that number into cents per gallon of gasoline. Tables 3, 4, and 5 break down the costs by category and element. Tables 1 and 2 summarize the results of these tables. Based on the studies reviewed, our best-guess estimate of the subsidies received by petroleum each year is $84 billion. or $84 billion per year. This estimate assumes a very low external environmental and health cost. This translates into about 32 cents per gallon of gasoline.[5] For Minnesota, which uses about 2.2 billion gallons of gasoline per year, this external cost represents about $704 million.
| U.S. Total Cost | ILSR Estimate | |
| Tax costs | 1.3 - 4.2 cents | 1.5 cents |
| Protection costs | 10.2 - 27.1 cents | 19.2 cents |
| Environmental and health costs | 9.8 -103.0 cents | 11.5 cents |
| TOTAL (apportioned across all sources) | 21.3 -134.3 cents | 32.2 cents |
Figure 1: The External Cost of Gasoline (cents per gallon)
| U.S. Total Cost (billion $) | U.S. ILSR Estimate (billion $) | Minnesota Cost (million $) | Minnesota Cost-ILSR Estimate (million $) | |
| Tax costs | 3.3 - 10.9 | 3.7 | 28.6 - 92.4 | 32 |
| Protection costs | 26.6 - 70.7 | 50 | 224.4 - 596.2 | 419 |
| Environmental and health costs | 25.5 - 267 | 30 | 215.6 - 2,266 | 253 |
| TOTAL | 55.4 - 348.6 | 83.7 | 468.6 -2,954 | 704 |
One comment about the applicability of these estimates to Minnesota: the figures presented in this report are national averages. Despite what Garrison Keillor says, Minnesotans in fact are average in many respects - adult population, income, federal income tax payments, number of vehicles, and gas taxes. The state boasts 1.74 percent of the population aged 18 and older, it reports 1.85 percent of income earned by individuals, it pays 1.8 percent of federal taxes.[6] Its citizens own 1.97 percent of passenger cars (about 3 million) and 1.69 percent of buses and trucks (nearly a million).[7] Minnesotans pay median federal and excise tax rates on gasoline.[8] In one key respect, however, we differ from some states - we import virtually all of our petroleum.
TAX PREFERENCES
One way that Americans subsidize the petroleum industry is through the tax code. The Treasury Department and the Joint Committee on Taxation track these sorts of subsidies but, naturally, view them in terms of losses to government corrers. Yet the two concepts are simply reverse sides of the same coin -- a lower tax due to preferential treatment is the equivalent of a subsidy.[9] Moreover, lower taxes for one set of taxpayers mean higher taxes for the rest of us.[10] One means of expressing the degree of tax preference enjoyed by an industry is to calculate its effective tax rate. Jane Gravelle of the Congressional Research Service found an effective tax rate on oil and gas extraction income of 11 percent, as compared to the statutory rate of 35 percent. Other industries have effective tax rates much closer to the statutory rate.[11]
The official term used to describe a taxpayer subsidy is a "tax expenditure." As the Joint Committee on Taxation puts it, tax expenditures are "decreases in . . . tax liabilities that result from provisions in income tax laws and regulations that have been enacted to provide economic incentives . . . or tax relief . . ."[12] The petroleum industry enjoys a variety of these provisions, despite recommendations (official and otherwise) to end them.[13] Petroleum producers are currently requesting even greater tax relief, including tax credits for oil produced from existing stripper wells and from deep water.[14]
All told, Americans will give up $3.3 billion to $10.9 billion in tax revenues in 1996 because of tax preferences enjoyed by the petroleum industry.[15] Table 3 summarizes the various annual tax subsidies that petroleum receives.
| Federal Tax Subsidies | $ Millions |
| Percentage depletion | 985 |
| Alternative fuel production | 756 |
| Expensing of exploration and development | 140-275 |
| Enhanced recovery | 97 |
| Deferral of income from controlled foreign corporations | 180-286 |
| Foreign tax credit (in contrast to deduction) | 777-3,380 |
| Accelerated depreciation | 113-4,438 |
| Research and experimentation | 114 |
| Working capital exception to passive loss limitation | 60 |
| Alaska native corporations | 0-15 |
| Exclusion of interest on municipal bonds | 0-180 |
| TOTAL | 3,222-10,586 |
| TOTAL adjusted for state taxes | 3,319-10,904 |
Percentage Depletion Method One of the largest tax subsidies enjoyed by petroleum producers is a provision that allows them to deduct a percentage of gross income to account for depletion of oil reserves.[16] Most taxpayers are entitled to deductions that correspond to the costs of doing business, but the percentage depletion deduction bears no resemblance to the costs actually incurred by oil and gas producers. In fact, producers can continue to claim percentage depletion long after all expenses incurred to acquire or develop a property have been recovered. The size of this subsidy is $985 million for 1996.
The percentage depletion method has been with us since nearly the beginning of the income tax. The allowable rate was set at 27.5 percent in 1926, finally reduced to 22 percent in 1969. The Tax Reduction Act of 1975 repealed the deduction for major oil companies, and later acts reduced the rate to 15 percent and restricted the use of the deduction. Yet recent tax law has gone the other way. Because of national security concerns, in 1989 the cap on the allowable deductible amount increased from 50 percent to 100 percent of net income. The 1990 Act expanded the use of percentage depletion to transferred property. And the Energy Policy Act of 1992 provided that excess percentage depletion deductions related to oil and gas production are not items of tax preference for purposes of the alternative minimum tax for taxable years beginning after 1992.
Alternative (nonconventional) Fuel Production Credit A second large subsidy given to petroleum producers is a tax credit of $3 per barrel-of-oil-equivalent for fuels produced by nonconventional means.[17] This credit applies, for example, to oil produced from shale and tar sands and gas produced from geopressured brine, Devonian shale, coal seams, or biomass. The petroleum industry is not the only one to benefit from this credit, but it captured 72 percent of the total in 1991 and 76 percent in 1992.[18] Texaco took enough alternative fuel production credits to reduce its tax bill by $29.3 million in 1994.[19] The overall tax subsidy to petroleum interests attributable to this preference item will be about $756 million in 1996. According to one Treasury official, this subsidy is fast becoming more important as producers look for deposits of oil in hard-to-reach places.
Expensing of Exploration and Development Costs A tenet of good tax policy is to match costs and benefits appropriately. In general, costs that yield future benefits must be capitalized and recovered over that future period for tax purposes. But oil and gas producers can instead expense certain exploration and development expenditures - that is, take an immediate tax deduction - regardless of how long these investments might be expected to generate future income.[20] In 1996, this subsidy cost us $140 million; in recent years, the subsidy has run as high as $275 million.[21] Recent Tax Court decisions have tended to favor the taxpayer - permitting larger deductions and thus greater subsidies to the petroleum industry.[22]
Enhanced Oil Recovery Credit Yet another tax benefit enjoyed by the petroleum industry is the ability to take a tax credit for the costs of certain methods designed to enhance the process of recovering oil.[23] Such methods include injecting chemicals into wells. The Treasury Department estimates this subsidy at $100 million for 1997; this amount translates to about $97 million in 1996 dollars.
Foreign Tax Provisions U.S. companies are taxed on their worldwide income but entitled to a credit for taxes paid to other governments, with some restrictions.[24] This "foreign tax credit" is intended to prevent double taxation and to harmonize domestic tax policy with the realities of multinational business operations. For the most part, the credit works reasonably well to ensure that U.S. companies pay the same (or greater) tax on income earned abroad as on income earned at home. In two major areas, however, the tax code can be manipulated: when U.S. companies establish subsidiaries overseas and can time the repatriation of dividends, and when foreign governments and U.S. multinationals conspire to call something a tax when it is not. All sorts of industries may benefit from the former; the petroleum industry may particularly gain from the latter practice.
Income earned through controlled foreign corporations is not taxed in the U.S. until it returns home as dividends.[25] Tax subsidies arising from income deferral will total $1.8 billion in 1996 for all industries. Of the largest 7,500 such corporations, between 10 and 15.9 percent were associated with oil and gas interests in 1992.[26] Estimated subsidies arising from deferral of income therefore range from $180 million to $286 million for the petroleum industry in 1996.
Tax subsidies for petroleum associated with the foreign tax credit are even larger. In 1992, petroleum companies took about $5.2 billion in foreign tax credits.[27] Because many oil-producing countries have no business tax (particularly in the Persian Gulf), some of the amounts claimed as foreign taxes were actually royalty payments in disguise, akin to the royalties and severance taxes that oil and gas companies pay to states like Alaska and Texas. As a result, a recent Senate bill proposed disallowing foreign tax credits for any oil and gas extraction income from anywhere for multinational corporations. The Administration proposed a milder version suggesting that credits be denied for income received in countries that have no effective corporate tax. Both proposals have quietly disappeared.[28] If the petroleum industry could only deduct foreign taxes instead of taking a credit for them, we could raise an additional $3.38 billion in revenue in 1996. If such a provision applied only to income from countries with no income tax, we could raise about $777 million. But the failure of the Senate and Administration proposals, coupled with major defeats for the Internal Revenue Service in the Tax Court, indicate that these subsidies are firmly entrenched.[29]
Accelerated Depreciation Allowances Most U.S. taxpayers know that they can take depreciation deductions on business assets - deductions based on asset cost that correspond to the reduction in value of the asset due to wear and tear or obsolescence. Most of us also know that we can take bigger deductions in the first years after we buy a business asset. That is, we can accelerate depreciation for tax purposes and therefore enjoy lower tax bills earlier on. By comparison with straight-line depreciation (which would entitle us to equal tax deductions each year over the life of the asset), we can keep our money longer and thus gain a tax benefit.
For all industries, the estimated tax expenditure associated with accelerated depreciation totals nearly $24 billion for 1996 and over $35 billion for 1997.[30] Yet these large numbers overestimate the true amount of tax subsidies enjoyed by asset holders. Accelerated depreciation is designed in part to counteract the effects of inflation. For good accounting reasons, people must base depreciation deductions on the purchase price of an asset. In times of inflation, however, the prices of most assets (and therefore their replacement costs) increase over time. Straight-line depreciation thus underestimates the annualized cost associated with a depreciable asset when inflation is present. But we have had relatively lower inflation in the past few years than during the period in which the tax authorities crafted the accelerated depreciation rules. Some portion of the tax expenditure currently attributable to accelerated depreciation should therefore be considered a taxpayer subsidy.
How much of the estimated tax expenditure on accelerated depreciation represents a taxpayer subsidy for petroleum? Corporate tax return data indicate that the petroleum industry accounts for about 4.7 to 4.8 percent of depreciation deductions and about 12.6 percent of depreciable assets.[31] An upper bound on the subsidy to petroleum from this tax provision could look to the 1997 tax expenditure data and include the entire (pro-rated) amount - nearly $4.5 billion. If, say, only 10 percent of the 1996 tax expenditure amount were counted, a lower bound for the figure would be about $113 million.
Expiring Provisions: Research and Experimentation, Exception from Passive Loss Limitation For Working Capital. Two features of the tax code that pertain to taxpayer subsidies to petroleum have expired, but the presence of transition rules means that subsidies in these two areas still exist for the next several years. The first feature is favorable tax treatment for research and experimentation costs, which expired in July 1995. Certain incentives will be phased out over a period of years, creating an estimated $2.4 billion in tax expenditures for 1996 and $10.9 billion for 1996-2000 across all industries. The portion attributable to the petroleum industry is approximately $114 million for 1996. A second expired provision that pertains solely to the oil and gas industry is an exception to the passive loss limitation for working capital - resulting from a complicated interaction of tax regulations. This exception was repealed in 1993 but will still cost $60 million in 1996 and $320 million over the period 1996 to 2000.
Other Relevant Federal Subsidies Two additional tax expenditure items may generate subsidies to the petroleum industry: the treatment of Alaska native corporations and the exclusion of interest on industrial development bonds. Businesses run by Alaskan natives receive favorable tax treatment to the tune of about $15 million annually. Although these companies have not necessarily been associated with petroleum, natives have recently agitated for a share of Alaska royalty oil to set up some petroleum interests. The exclusion of interest on state and local industrial development bonds for energy facilities will create a tax expenditure of about $180 million in 1996. Not all of this amount can be attributed to petroleum, but some fraction can.
To calculate subsidies to the petroleum industry generated by special tax or financial treatment, two other items deserve mention. The United States has existing or proposed tax treaties with a number of oil-producing countries, including Egypt, Indonesia, Mexico, Russia, and Kazakhstan. To the extent that treaties might reduce statutory tax rates or grant favorable treatment for certain types of income, petroleum interests may benefit beyond the confines of the existing tax code and regulations.
Besides the possibility of benefiting from tax incentives and tax treaties, oil companies are lining up with multibillion dollar projects at the doors of the Overseas Private Investment Corporation (OPIC). Essentially, those companies with OPIC status are insured with taxpayer dollars against adverse changes in the host country's political conditions. Recently, OPIC administrators approved loan guarantees and insurance worth $28 million to Texaco to establish a Russian facility. Conoco implemented a similar project at about the same time.[32] OPIC companies have been set up to foster economic development in certain regions, particularly the Soviet Union - a laudable goal, perhaps. But OPIC companies also mean that, if a company loses all or part of its investment due to unrest abroad, U.S. taxpayers will foot the bill.
Interaction of State and Federal Tax Calculations Because most states piggyback off federal tax returns to calculate state taxable income, industries that benefit from favorable federal tax deductions also benefit at the state level. (Federal tax credits do not generate similar piggyback effects.) State corporate tax rates vary widely but average about 5 percent. A conservative accounting for the interaction of state and federal taxes would augment total federal subsidies by about 3 percent.[33]
Conclusion The total tax subsidies related to petroleum are $3.3 to $10.9 billion. Per gallon of gasoline, this comes to 1.3 cents to 4.2 cents per gallon. We believe that 1.45 cents per gallon is a conservative and reasonable estimate.
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