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Eliminate Fossil Fuel Tax Preferences

The Federal Income Tax includes a number of tax preferences that encourage investment in exploration, development, and extraction of fuels from domestic oil and gas wells and coal mines.¹ The two largest tax preferences are:

• Excess of percentage over cost depletion, fuels
  Under normal income tax rules, producers of oil, gas, and coal would be able to recover the costs of their investments in wells and mines every year in proportion to the share of the resource extracted (cost depletion). But current law instead allows independent producers to deduct a percentage of gross income from production (percentage depletion), subject to certain limits. The excess of percentage of cost depletion will cost $5.1 billion between 2011 and 2015.²
• Expensing of exploration and development costs
  Under normal income tax rules, exploration and development costs for oil and gas wells and coal mines would be capitalized and recovered as resources are extracted from the property. But current law allows independent producers to deduct immediately intangible drilling costs (IDCs) for investments in domestic oil and gas wells. (Integrated producers may deduct 70 percent of IDCs and amortize the remaining 30 percent over 5 years.) Businesses may also deduct exploration and development costs of surface stripping and the construction of shafts and tunnels for other fuel minerals. Expensing of exploration and development costs will cost $4.0 billion between 2011 and 2015.

Other tax expenditures for fossil fuels listed in the budget (and their 2011-15 costs) include: 2-year amortization of geological and geophysical expenditures ($0.9 billion), capital gains treatment of royalties on coal ($0.4 billion), and an exception from the passive loss limitation for working interests in oil and gas properties ($0.1 billion). The tax code also provides subsidies for certain expenditures for more costly forms of oil extraction, including a credit for enhanced oil recovery expenditures, a deduction for tertiary injections, and a credit for oil and gas produced from marginal wells. (Some of these incentives have no projected cost because they apply only when oil prices are below a threshold level, which prices now exceed.)

In addition to these targeted tax expenditures, current law also provides a much broader subsidy for domestic US production activities: a special 9 percent deduction from taxable income. This deduction reduces the effective top tax rate on corporate income from domestic production from 35 percent to 31.9 percent and will cost $76.7 billion for all qualified domestic production between 2011 and 2015. Production from domestic oil and gas wells and domestic coal mines benefits from this deduction, but no more than any other qualified domestic production.

The Administration proposes to eliminate special tax benefits for domestic fossil fuel production. The proposals and their revenue gains between 2010 and 2020 include:

• Repeal percentage depletion for oil and natural gas wells and hard mineral fossil fuels ($11.3 billion)
• Repeal expensing of intangible drilling costs for oil and gas and expensing of exploration and development costs for coal ($8.3 billion)
• Increase amortization period for geological and geophysical amortization period for independent producers to seven years ($1.1 billion)
• Repeal capital gains treatment for coal royalties ($0.8 billion)
• Repeal the exemption to the passive loss limitation for working interests in oil and natural gas properties ($0.2 billion)
• Repeal the deduction for tertiary injectants ($0.1 billion); and
• Repeal the enhanced oil recovery credit and the credit for oil and gas produced from marginal wells (no revenue effect, based on projections of world oil prices).

The Administration also proposes to repeal the domestic manufacturing deduction for oil, gas, and coal production. This proposal would partially remove a large tax subsidy for domestic manufacturing, but would place energy industries at a disadvantage relative to other domestic manufacturing (but not relative to service industries, which do not receive the benefit). Repealing the domestic manufacturing deduction for oil and gas would raise $17.3 billion over 10 years; repealing the deduction for coal and other hard mineral fossil fuels would raise another $0.1 billion.

In general, a neutral tax system promotes an efficient allocation of investment by encouraging choices by business and households that maximize the economic productivity of assets instead of their tax benefits. Tax subsidies for selected assets and industries distort markets and cause too much output of favored goods and too much investment in favored assets or technologies. Eliminating tax subsidies for fossil fuel production would improve economic efficiency by encouraging capital to flow to assets with higher pretax returns. Eliminating these preferences would also raise prices and reduce world output of fossil fuels, thereby reducing carbon emissions and contributing to climate policy goals. But because these resources are traded on world markets, the principal effect of reducing subsidies for U.S. domestic production would be to increase U.S. imports (of oil) and reduce exports (of coal). In other words, eliminating the subsidies will mainly affect the location of production, not world prices and global energy use.

The effects on economic efficiency of eliminating the domestic production deduction for oil, gas, and coal production are less clear than the effects of eliminating targeted tax subsidies for fossil fuels. The current law deduction gives a tax advantage to domestic manufacturing relative to services. Removing the domestic production deduction for oil and gas eliminates the tax preference for that sector, but introduces a new bias favoring other manufacturing over fossil fuel production. The domestic production deduction also favors domestic over foreign activities of U.S. companies but that may partly offset other provisions in the tax law—such as the deferral of tax on income accrued within foreign affiliates—that favor investment in low-tax foreign countries over domestic investment.

Footnotes

1. The Tax Expenditure chapter in the Analytical Perspectives section of the federal budget displays the costs of these tax preferences.

2. The tax expenditure estimates reported here cover only five years—2011-2015—because estimates for the full ten-year budget window are not available.

Additional Resources
Tax Policy Briefing Book: Taxes and Energy: What tax incentives encourage energy production?
Eliminating Tax Expenditures with Adverse Environmental Effects, Eric Toder, Tax Reform, Energy, and the Environment Policy Brief, Brookings Institution, May 2007.