Key Findings

• The Biden administration’s budget proposals have several provisions focused on raising taxes on the U.S. fossil fuel industry.

• These proposals largely depart from neutral tax policy and intentionally target the industry.

• Internal Revenue Service data does not indicate any substantial tax preference for the fossil fuel industry, rather indicating the industry pays relatively high levels of tax.

• Raising taxes on U.S. production and ownership of fossil fuel, both domestically and abroad, mainly disadvantages U.S. companies and workers in favor of foreign suppliers.

• Taxing fossil fuel consumption, for example through user fees or more comprehensively through a carbon tax, would avoid the problem of creating preferences for foreign-owned fossil fuel.

Introduction

One prominent feature of President Biden’s agenda on the environment is to target U.S. fossil fuel (e.g., oil, gas, and coal) producers and production with about $120 billion of new taxes over 10 years through repeal of so-called “tax breaks.” While some of these changes could have a marginally beneficial impact on the environment, in practice the elimination of most of the provisions would deny the industry normal cost recovery and subject the U.S. fossil fuel industry to additional layers of tax not faced by other industries in the U.S. or abroad. By focusing on taxing U.S. producers, foreign producers of fossil fuel would benefit, causing the U.S. economy to become more heavily reliant on imports and foreign, often state-owned, producers from countries like Saudi Arabia, Russia, and China. Taxing consumption of fossil fuels, rather than domestic production, would be a more neutral approach.

What are these fossil fuel tax provisions?

In the Treasury Department’s Green Book, under the heading “eliminate fossil fuel tax preferences,” 13 current-law provisions would be repealed or replaced, raising $35 billion over 10 years.^[1] They can be split into five categories, discussed below. Additionally, the document details $86 billion of tax increases on the foreign income of U.S. oil and gas companies.

Whether these provisions should count as “subsidies” depends on one’s understanding of what the right “normal” corporate tax base is. In our view, corporations should be taxed on profits, or revenues minus costs. Those costs should include both regular expenses like wages and office supplies, as well as investment costs like acquiring new heavy machinery. And those costs should be deducted when they are incurred, preventing factors such as inflation and the time value of money from eating away at the real value of the deduction.

Category 1: Cost Recovery Provisions ($14.3 billion)

These provisions allow fossil fuel companies to deduct the costs of certain investments in a way equivalent firms in other industries would. The Biden proposals would reduce the real value of these deductions for oil and gas companies by forcing them to spread the deductions over longer time horizons. The simpler approach that would also be more neutral across industries and assets would be to let all companies fully expense their investments, i.e., immediately deduct the full cost.^[2] It’s also worth noting that the Tax Cuts and Jobs Act made 100 percent bonus depreciation available for many types of capital investment, making these provisions no different from treatment widely available across the tax code.[3]

Analysis

These provisions are conventional deductions for costs incurred, not subsidies. In the ideal tax system, all costs should be deducted the year they are incurred, whether regular recurring expenses like wages and utility bills or major capital investments in equipment, machinery, or structures.[4] Notably, many of the costs included as intangible drilling costs are wages, making full deductions the normal tax treatment even without expensing for investments in equipment and machinery.

These provisions often wrongly get classified as subsidies as some analysts rely on a different definition of a neutral tax system. Specifically, they use Haig-Simons taxation, where the cost of investment is deducted over the lifetime of the asset.[5] The problem with this system economically is that the real value of those deductions declines over time thanks to inflation and the time value of money (a dollar today is worth more than a dollar tomorrow). So companies are unable to deduct the full cost of their investments, creating a tax bias against investment. Companies respond by reducing their investment, which in turn harms workers in the form of lower productivity and lower wages.[6]

Category 2: Percentage Depletion ($10.5 billion)

Percentage depletion allows some taxpayers (specifically non-integrated producers, which also face some additional restrictions) to deduct a fixed percentage of their gross income derived from the property.[7] Meanwhile, cost depletion allows the company to deduct a portion of the cost of acquiring the reserves equal to the amount of reserves depleted in that year. Eligible companies deduct the larger of the fixed percentage of gross income or the cost of the resources depleted.

Analysis

Percentage depletion is a difficult issue, as in some circumstances it can allow companies to deduct more than the real value of the original costs they incurred, making it sometimes equivalent to a non-neutral tax break.^[8] In other cases, this system does not allow firms to deduct the full value of the original cost.[9] The ideal tax treatment of oil reserves in this regard would be to allow companies to deduct the full acquisition cost the year they purchased them.[10] It’s unclear whether shifting to expensing would on net reduce or increase tax revenue, given that the current tax treatment sometimes creates a subsidy and sometimes creates a penalty relative to expensing, but there is evidence that percentage depletion creates a negative marginal tax rate on some oil and gas investment performed by independent producers.^[11] However, if the tax code were to shift from percentage depletion and towards expensing, it would make sense to do so for all extractive industries, not just fossil fuels.

One possible effect of repealing percentage depletion (as well as several of the cost recovery provisions) is higher consolidation within the oil and gas industry. Many of these tax preferences only exist for non-integrated or independent producers. As such, eliminating those preferences would eliminate a bias favoring independent producers and thus drive companies to form into integrated operations.^[12] In fact, percentage depletion matters most significantly for the smallest oil and gas producers—often family-owned small businesses. That’s one way of saying that many of these tax increases, specifically the elimination of percentage depletion, would primarily be felt by small-scale producers and royalty owners.^[13] However, higher levels of integration in the industry might be economically efficient.

Category 3: Tax Credits ($8.3 billion)

As opposed to deductions, which reduce taxable income, tax credits reduce tax liability directly, on a dollar-for-dollar basis.^[14] The two tax credits targeted for elimination in the Biden proposal are the tax credit for marginal wells and the enhanced oil recovery credit.

Analysis

The enhanced oil recovery credit (enacted in 1991) and the marginal well tax credit (enacted in 2004) only phase in when the price of oil or natural gas falls below a certain point. The general goal of the policy is to keep partially depleted or small wells online despite price fluctuations that make them temporarily unviable. Between 2005 and 2016, both credits were unavailable.^[15] Even in 2020, when oil and gas prices declined significantly, the credit for marginal oil wells remained phased out.^[16]

Unlike the cost recovery provisions, the tax credits for marginal wells and enhanced oil recovery constitute non-neutral support for the fossil fuel industry and lead to inefficient investment in less productive (and potentially more environmentally harmful) oil drilling operations.[17] However, some argue it makes sense to support the continued operation of marginal wells to fully deplete their reserves so they do not end up getting abandoned with some reserves still underground.^[18]  In addition to the loss of domestic production from those abandoned wells, which some view as a potential problem for U.S. energy independence, state and local governments could also have had to deal with more orphan wells, if the producers themselves go bankrupt.^[19]

Category 4: Other Provisions ($2 billion)

The Green Book contains a handful of other domestic tax provisions designed to raise revenue from the fossil fuel industry.

Analysis

Taxing publicly traded fossil fuel partnerships as C corporations would subject their income to two levels of taxation: the corporate income tax at the entity level and the individual income tax on dividends and capital gains. Ideally, all income would be subject to one level of taxation.^[20] Similarly, if taxpayers could deduct savings when they first earn income, then it would make sense to tax royalties on coal as ordinary income, but the proposal as it is would not be consistent with neutral taxation. It also makes sense to allow taxpayers to deduct losses incurred in business activity, but passive loss deductions present opportunities for tax avoidance, thus creating the justification for limits.^[21]

So-called “Superfund” taxes are designed to get companies that engage in environmentally risky behavior to internalize the potential costs of those activities in case a spill occurs and needs to be cleaned up. As such, repealing the excise tax exemption for certain kinds of crude oil production makes sense.^[22] However, one concern with Superfund taxes is that they tend to carry high compliance and administrative costs without generating substantial revenue.^[23] 

Category 5: International Provisions ($86.2 billion)

In addition to those provisions related to domestic oil production, the Biden plan also includes proposals to raise tax on foreign fossil fuel production by modifying the rules regarding foreign oil and gas extraction income (FOGEI), foreign oil related income (FORI), and dual capacity taxpayers.

Analysis

It is not clear what principle is guiding these international tax changes, beyond merely raising tax on U.S. multinational oil and gas companies. GILTI is designed to tax income from assets that are intangible and highly mobile, like intellectual property, that is subject to low rates of foreign tax. Oil and gas production is the opposite: it’s tangible, unlike a patent or copyright; oil and gas reserves are stuck in the ground, as far from mobile as one gets; and, as the next section demonstrates, the oil and gas industry is subject to relatively high rates of foreign tax. As such, foreign oil and gas income should be exempt from GILTI.

Regarding dual capacity, there is no demonstrated need to tighten the rules, as current regulations require taxpayers to prove the extent to which foreign levies are in fact income taxes rather than payments in exchange for economic benefits. The proposal would artificially limit foreign tax credits claimed, which would result in double taxation (the income would be taxed first by foreign governments and then by the U.S. government).

Raising tax on the foreign income of U.S. multinational oil and gas companies would mainly serve to disadvantage U.S. companies in accessing and producing oil and gas from foreign sources, allowing foreign-based producers to fill the void since they are not subject to U.S. tax. There are several large multinational oil and gas companies based outside the U.S., mainly in the UK and Europe, Saudi Arabia, China, and Russia. To the extent these foreign-based companies have access to the same or similar technology and technical know-how as U.S. companies, raising tax on U.S. companies’ foreign income would over time result in American companies ceding control of larger and larger shares of worldwide production to those foreign competitors like Gazprom and CNOOC. Studies indicate that the reduced foreign footprint of U.S. companies, and corresponding reduced foreign investment, would entail a reduction in domestic operations for those companies, i.e., less domestic investment and employee compensation.[24]

Taxes Paid by the Industry

Because oil and gas deposits are immovable, foreign countries already tax oil and gas companies heavily.^[25] For example, in many countries the tax rate that applies to oil and gas income is above the normal corporate tax rate and above 50 percent in some cases.[26] The Tax Foundation Multinational Tax Model, based on IRS and other government data, indicates U.S. multinational companies engaged in foreign oil and gas extraction and coal mining pay the highest average foreign tax rate of any industry, at 34.6 percent—a rate that is nearly three times the average foreign tax rate across all industries (12.5 percent).[27] By subjecting foreign oil and gas income to GILTI, the Biden proposals would increase the total average tax rate on the foreign fossil fuel income of U.S. multinationals to 36.7 percent, which would put them at further disadvantage to Chinese and Russian state-owned energy companies.

The fossil fuel industry also pays relatively high rates of tax to the U.S. federal government and state and local governments. For example, the latest available data from the IRS indicates that in 2018 the oil and gas extraction industry paid $160 million in federal corporate income tax, or 19.3 percent of net income, compared to 10.6 percent on average for all industries (companies normally pay an effective tax rate that is lower than the statutory rate due to loss carryovers and other features).[28] The same IRS data indicates the oil and gas extraction industry paid $7.2 billion in state and local taxes and licenses, or 89.7 percent of net income (excluding those expenses), compared to 16.5 percent on average for all industries.

Environmental Impact

The impact of the domestic changes on oil and gas prices and consumption is expected to be quite small, partly because the tax changes are small, representing about 1 percent of industry revenues.^[29] Furthermore, oil and gas prices are determined in a world market in which U.S. production accounts for a small share—the U.S. produces about 20 to 25 percent of world oil and gas production.[30]

A study from economist Gilbert Metcalf considered the impact of repealing three major provisions: the domestic manufacturing deduction (since repealed as part of the Tax Cuts and Jobs Act), expensing for intangible drilling costs, and percentage depletion. He found this would have a negligible effect on greenhouse gas emissions and global oil markets, with global oil prices rising by less than 1 percent. Domestic markets would respond more, with domestic oil and gas production expected to fall by 4-5 percent, as domestic natural gas prices would rise between 7 and 10 percent.^[31]

As mentioned above, raising taxes on the foreign production of U.S. multinationals mainly disadvantages U.S. companies, allowing foreign companies to exploit the same foreign fossil fuel reserves. This would mean little impact on world production, prices, or consumption.

Better Alternatives

A more effective means of protecting the environment, controlling greenhouse gases, and funding infrastructure investment, that would also be less harmful to American producers relative to foreign ones, would be to tax consumption, or the demand for fossil fuels. This could be done, for instance, through an increase in the gas tax, a tax on vehicle miles traveled (VMT), or a carbon tax with a border adjustment.^[32]

As an example, British Columbia’s carbon tax reduced emissions by 5-15 percent after four years, with a negligible impact on economic performance.[33] Northern European countries such as Norway, Finland, Sweden, Denmark, and the Netherlands, some of the first places to adopt carbon taxes, saw significant declines in emissions as well.[34]

In addition, these policies would raise considerable revenue for the federal government with minimal damage to the economy. For example, we estimate increasing the federal gas tax by 35 cents per gallon and adjusting it for inflation would raise about $758 billion over 10 years for the federal government (conventionally estimated), reducing gross domestic product (GDP) by 0.1 percent over the long run and eliminating 103,000 jobs.^[35] We estimate a carbon tax of $25 per metric ton of carbon would boost federal revenue by about $1 trillion over 10 years, reducing GDP by 0.2 percent over the long run and eliminating 149,000 jobs.^[36]

Conclusion

As a general rule, policymakers should aim to treat the fossil fuel industry as fairly and as simply as possible, accounting where necessary for particular features of the industry. Full deductions for costs, such as intangible drilling costs, are non-distortionary and should remain in place. On the other hand, tax credits and other provisions that provide tax benefits beyond deductions for input costs deserve scrutiny and may be worth eliminating in exchange for a lower general tax rate for all industries. Regarding foreign income, the GILTI regime should not apply to the foreign fossil fuel income of U.S. multinationals—the income is neither intangible, nor mobile, nor low-taxed—and denial of foreign tax credits would constitute double taxation.

If the Biden administration aims to protect the environment and reduce carbon emissions, taxing consumption of fossil fuels is clearly more beneficial than taxing production, both because it is more environmentally effective and raises considerable revenue for the federal government at minimal cost to the economy. That the Biden administration has chosen to tax production instead indicates its priorities are elsewhere.

Appendix: Comparing Cost Depletion, Percentage Depletion, and Expensing

It’s useful to compare the processes for calculating cost depletion, percentage depletion, and expensing to see how they work, depending on the circumstance.

Consider a small oil producer that purchases the rights to oil reserves below a new well for $100,000. Let’s say there are 10,000 barrels of oil in total below the well, and over the next five years, they will produce 2,000 barrels of oil per year.

Under Scenario 1, the price of a barrel of crude oil rises over time, from $50 per barrel in year 1 to $100 per barrel in year 5. If the well produces the same amount every year, that means gross income rises, and the deduction values would rise.  

So in this example, excess over cost depletion allows the company to deduct more than the cost of acquiring the rights to the oil reserves. However, under a different scenario with steady prices, percentage depletion adds nothing for the company.

Under this scenario, percentage depletion never comes into play, and the company ends up being able to deduct less than the real cost of purchasing the reserves. These scenarios end up strengthening the argument for expensing as a replacement for both of these systems: matching the real value of the cost incurred to the amount deducted.

[1] United States Department of the Treasury, “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals,” May 2021, https://home.treasury.gov/system/files/131/General-Explanations-FY2022.pdf. 

[2] Tax Foundation, “Full Expensing,” TaxEDU, https://www.taxfoundation.org/tax-basics/full-expensing/.

[3] Erica York and Alex Muresianu, “The TCJA’s Expensing Provision Alleviates the Tax Code’s Bias Against Certain Investments,” Tax Foundation, Sept. 5, 2018,  https://taxfoundation.org/tcja-expensing-provision-benefits/.

[4] Stephen J. Entin, “The Tax Treatment of Capital Assets and Its Effect on Growth: Expensing, Depreciation, and the Concept of Cost Recovery in the Tax System,” Tax Foundation, Apr. 24, 2013, https://www.taxfoundation.org/tax-treatment-capital-assets-and-its-effect-growth-expensing-depreciation-and-concept-cost-recovery/.

[5] Alex Muresianu, “How the CARES Act Shifted the Composition of Tax Expenditures Towards Individuals,” Tax Foundation, Mar. 24, 2021, https://www.taxfoundation.org/federal-tax-expenditures-cares-act/.

[6] Stephen J. Entin, “The Tax Treatment of Capital Assets and Its Effect on Growth: Expensing, Depreciation, and the Concept of Cost Recovery in the Tax System.”

[7] Julia Kagan, “Percentage Depletion,” Investopedia, Jan. 17, 2021, https://www.investopedia.com/terms/p/percentage-depletion.asp.

[8] Congressional Research Service, “Tax Expenditures: Compendium of Background Materials on Individual Provisions,” December 2020, https://www.govinfo.gov/content/pkg/CPRT-116SPRT42597/pdf/CPRT-116SPRT42597.pdf.

[9] See Appendix A for more details.

[10] Garrett Watson and Erica York, “Three Reasons Why Full Cost Recovery Is Right, Even If Asset Increase in Value,” Tax Foundation, Aug. 5, 2021,  https://www.taxfoundation.org/depreciation-deductions-cash-flow-tax/.

[11] Gilbert E. Metcalf, “Taxing Energy in the United States: Which Fuels Does the Tax Code Favor,” Manhattan Institute, January 2009, https://media4.manhattan-institute.org/pdf/eper_04.pdf.

[12] Alan Krueger, “Oil and Gas Tax Provisions: A Consideration of the President’s Fiscal Year 2010 Budget Proposal,” Senate Finance Committee, Sept. 10, 2009, https://www.finance.senate.gov/imo/media/doc/654251.pdf.

[13] Energy & Industrial Advisory Partners, “The Economic Impacts of Eliminating the Percentage Depletion Allowance,” National Stripper Well Association, February 2021, http://nswa.us/wp-content/uploads/2021/06/The-Economic-Impacts-of-Eliminating-the-Percentage-Depletion-Allowance-FINAL.pdf.

[14] Tax Foundation, “Tax Credit,” TaxEDU, https://www.taxfoundation.org/tax-basics/tax-credit/.

[15] Molly F. Sherlock and Phillip Brown, “Low Oil Prices May Trigger Certain Tax Benefits, But Not Others,” Congressional Research Service, May 11, 2020, https://crsreports.congress.gov/product/pdf/IN/IN11381.

[16] KPMG, “Tax Provisions in Biden Administration’s FY22 Budget Proposals: Energy and Natural Resources,” June 18, 2021, https://assets.kpmg/content/dam/kpmg/us/pdf/2021/06/tnf-biden-fy-2022-budget-energy-june18-2021.pdf.

[17] Jacob A. Deighton, Amy Townsend-Small, Sarah J. Sturmer, Jacob Hoschouer, and Laura Heldman, “Measurements Show Marginal Wells Are a Disproportionate Source of Methane Relative to Production,” Journal of the Air and Waste Management Association 70:10 (August 2020), https://www.researchgate.net/publication/343564083_Measurements_show_that_marginal_wells_are_a_disproportionate_source_of_methane_relative_to_production.

[18] Charles T. Dillon, “Oil Industry Tax Benefits Helping the Environment,” University of Baltimore Journal of Environmental Law 7 (1999-2000),  https://heinonline.org/HOL/LandingPage?handle=hein.journals/ubenv7&div=8&id=&page=.

[19]  Sophie Quinton, “Why ‘Orphan’ Oil and Gas Wells Are a Growing Problem for States,” Stateline, Pew, July 9, 2018, https://www.pewtrusts.org/en/research-and-analysis/blogs/stateline/2018/07/09/why-orphan-oil-and-gas-wells-are-a-growing-problem-for-states.

[20] Erica York, “An Overview of Capital Gains Taxes,” Tax Foundation, Apr. 16, 2019, https://www.taxfoundation.org/capital-gains-taxes/.

[21] Alex Muresianu, “1980s Tax Reform, Cost Recovery, and the Real Estate Industry: Lessons for Today,” Tax Foundation, July 23, 2020, https://www.taxfoundation.org/1980s-tax-reform-cost-recovery-and-the-real-estate-industry-lessons-for-today/.

[22] Thomas A. Barthold, “Issues in the Design of Environmental Excise Taxes,” Journal of Economic Perspectives 8:1 (Winter 1994), https://pubs.aeaweb.org/doi/pdf/10.1257/jep.8.1.133.

[23] Don Fullerton, “Why Have Separate Environmental Taxes?” Tax Policy and the Economy 10 (January 1996), https://www.nber.org/system/files/chapters/c10898/c10898.pdf.

[24] See, for example, Mihir A. Desai, c. Fritz Foley, and James R. Hines, “Domestic Effects of the Foreign Activities of US Multinationals,” American Economic Journal: Economic Policy 1:1 (February 2009):181-203, https://www.aeaweb.org/articles?id=10.1257/pol.1.1.181.

[25] Scott A. Hodge, “Oil Industry Taxes: A Cash Cow for Government,” Tax Foundation, July 2010, https://files.taxfoundation.org/legacy/docs/sr183.pdf

[26] See, for instance, PwC, “Worldwide Tax Summaries,” https://taxsummaries.pwc.com/.

[27] Cody Kallen, “Options for Reforming the Taxation of U.S. Multinationals,” Tax Foundation, Aug. 12, 2021, https://www.taxfoundation.org/us-multinational-tax-reform-options-gilti/.

[28] IRS Statistics of Income, “Table 5.3 Returns of Active Corporations, other than Forms 1120S, 1120-REIT, and 1120-RIC,” https://www.irs.gov/statistics/soi-tax-stats-corporation-complete-report. The data include only C corporations subject to corporate income tax, as opposed to S corporations and other pass-through entities that are subject to individual income tax.

[29] Maura Allaire and Stephen Brown, “Eliminating Subsidies for Fossil Fuel Production: Implications for U.S. Oil and Natural Gas Markets,” Resources for the Future, December 2009, https://media.rff.org/documents/RFF-IB-09-10.pdf.

[30] U.S. Energy Information Administration, “What Countries Are the Top Producers and Consumers of Oil?” https://www.eia.gov/tools/faqs/faq.php?id=709&t=6; and Global Energy Statistical Yearbook 2021, “Natural Gas Production,” https://yearbook.enerdata.net/natural-gas/world-natural-gas-production-statistics.html.

[31] Gilbert E. Metcalf, “The Impact of Removing Tax Preferences for Oil and Natural Gas Production: Measuring Tax Subsidies by an Equivalent Price Impact Approach,” Journal of the Association of Environmental and Resource Economists 5:1 (January 2018), https://www.journals.uchicago.edu/doi/abs/10.1086/693367.

[32] Ulrik Boesen, “Who Will Pay for the Roads,” Tax Foundation, Aug. 25, 2020, https://www.taxfoundation.org/road-funding-vehicle-miles-traveled-tax/,

[33] Brian Murray and Nicholas Rivers, “British Columbia’s Revenue-Neutral Carbon Tax: A Review of the Latest ‘Grand Experiment’ in Environmental Policy,” Energy Policy 86 (November 2015), https://www.sciencedirect.com/science/article/abs/pii/S0301421515300550.

[34] Assaad Ghazouani, Wanjun Xia, Medhi Ben Jebli, and Umer Shahzad, “Exploring the Role of Carbon Taxation Policies on CO2 Emissions: Contextual Evidence from Tax Implementation and Non-Implementation European Countries,” Sustainability 12:20 (2020), https://econpapers.repec.org/article/gamjsusta/v_3a12_3ay_3a2020_3ai_3a20_3ap_3a8680-_3ad_3a431504.htm.

[35] Tax Foundation, “Option 48: Increase the Gas Tax by 35 Cents Per Gallon and Inflation Adjust Going Forward,” in Options for Reforming America’s Tax Code 2.0 (Washington, D.C.: Tax Foundation): April 2021, https://taxfoundation.org/tax-reform-options/?option=48.

[36] Tax Foundation, “Option 50: Institute a Carbon Tax,” in Options for Reforming America’s Tax Code 2.0 (Washington, D.C.: Tax Foundation): April 2021, https://www.taxfoundation.org/tax-reform-options/?option=50.