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Eliminate Fossil Fuel Tax Preferences

Targeted Tax Preferences for Oil and Gas Wells and Coal Mines

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. The costs of these tax preferences through 2016 are displayed in the Analytical Perspectives section of the federal budget. The two largest tax preferences are as follows:

  • 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 $6.9 billion between 2013 and 2017.
  • 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 five 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 $3.0 billion between 2012 and 2017.

Other tax expenditures for fossil fuels listed in the budget (and their 2013–17 costs) include a two-year amortization of geological and geophysical expenditures ($0.5 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.)

The Obama administration proposes to eliminate special tax benefits for domestic fossil fuel production. The proposals and their revenue gains between 2013 and 2022 include these seven:

  • Repeal percentage depletion for oil and natural gas wells and hard mineral fossil fuels ($11.5 billion)
  • Repeal expensing of intangible drilling costs for oil and gas and expensing of exploration and development costs for coal ($14.3 billion)
  • Increase amortization period for geological and geophysical amortization period for independent producers to seven years ($1.4 billion)
  • Repeal capital gains treatment for coal royalties ($0.4 billion)
  • Repeal the exemption to the passive loss limitation for working interests in oil and natural gas properties ($0.1 billion)
  • Repeal the deduction for tertiary injectants ($0.1 billion)
  • 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)

Domestic Production Activities Deduction

In addition to these targeted tax expenditures, current law provides a much broader subsidy for domestic U.S. 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 $81.1 billion for all qualified domestic production between 2013 and 2017. Production from domestic oil and gas wells and domestic coal mines benefits from this deduction, but less than other qualified domestic production because it qualifies for only a 6 percent deduction, making the effective rate on corporate income from domestic fossil fuel production equal to 32.9 percent.

The president proposes to repeal the current 6 percent domestic manufacturing deduction for oil, gas, and coal production, but would at the same time increase the deduction rate from 9 percent to approximately 18 percent for other domestic production activities, reducing the corporate rate on qualifying manufacturing to about 28.7 percent. This proposal would remove a subsidy that treats oil and gas production more favorably than service industries, which do not receive the domestic manufacturing deduction. But it would place energy industries at a larger disadvantage than currently relative to domestic manufacturing activities that receive the full deduction. The combined effect of repealing the domestic manufacturing deduction for oil, gas, and coal and expanding the deduction to other activities is approximately revenue neutral.

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, and makes it treatment more neutral compared with services, but increases the bias favoring other manufacturing over fossil fuel production. This bias is further increased by the proposal to increase the domestic manufacturing deduction for the remaining qualifying activities.