Heritage Foundation's position on oil subsidies shows some progress, but more is needed

This May 2011 piece (What's an Oil Subsidy?) by Nick Loris and Curtis Dubay took the issue of subsidies to the oil and gas industry head-on.  I've had discussions with Heritage over a number of years on the issue of energy subsidies, though primarily those dealing with nuclear and ethanol. I hope those discussions will continue, and broad support for eliminating expensive and damaging energy subsidies will require support across the political spectrum.

In the May piece, Loris and Dubay took some positive steps in explicitly targeting some oil and gas subsidies for removal, something I don't think Heritage would have been willing to do ten years ago.  But the authors' defense of many of the other subsidies listed was disappointing and incorrect.

1)  Section 199 Deduction to support domestic manufacturing was defended on the grounds that it goes to all manufacturing, not just energy.  Many subsidies benefit more than one industry, and the argument that it is therefore part of the "tax baseline" is always used to protect the subsidy and divert prying eyes elsewhere.  This claim should almost never be accepted outright.  Rather, more careful review to assess whether the "general" subsidy disproportionately benefits a particular industry, geographic region, or fuel is needed.  In some cases, the fine print on eligibility actually codifies far more favorable rules for some market participants than for others under what is supposedly a "baseline" subsidy.  In others, the rules may seem neutral but be of far more practical value to one industry than another.

On Section 199, I think the whole thing should be killed.  But if it remains and we are talking about oil and gas industry investments into extraction equipment or refineries, I tend to agree with Loris and Dubay that the spending is fairly similar in nature to investments in other sectors and shouldn't be singled out.  That is only part of the story, however.  As I noted in an earlier blog post, the argument breaks down when counting the endowment value of extracted raw materials as though it were manufacturing.  It is not, and should not be includible in the calculation of section 199 credits.

2)  Foreign tax credit (FTC).  Loris and Dubay inaccurately portray the rationale for modifying the rules on the FTC.  The reforms would establish a better system and help eliminate abuses that are particularly easy for royalty-paying extractive industries.  The authors' have characterized the discussion of FTC-related subsidies as aiming to kill the FTC entirely for oil and gas firms, a move they say (correctly) would result in the double taxation of foreign operations.  But full elimination of the FTC is not what is being discussed now.  Nor has it been the recommendation of any subsidy study I've ever done or looked at. 

Rather, the goal is to end the abuses:  where corporate tax rates on oil, gas, or mining are more than those levied on other corporations, it is quite likely that royalties (which are deductible against US taxes) are being disguised as corporate taxes (which, under the FTC, would receive the much more generous tax credit).  This should end; and if doing so drives up the effective tax rate on foreign producers of oil, gas, or other minerals because they have been gaming the system for decades, so be it.

3)  Expensing.  The authors argue for immediate expensing of all capital equipment.  This same argument is included in a more recent posting by Loris here.  I will defer a detailed discussion on whether immediate expensing makes sense or not for our economy, as I've asked Nick for more info on the empirical justifications for such a move so we can have a more useful discussion on the topic at a future time.  However, the argument put forth in the posts is that immediate expensing reduces the cost of capital, and that this outcome somehow justifies the policy of full expensing. 

Such an outcome is self-evident, and not at all relevant to the underlying policy issue.  Expensing is a subsidy to capital (you are increasing the speed at which multi-year capital may be written off from current year taxes, creating a time-value of money benefit similar to an interest-free loan from the government), and subsidies generally reduce costs or prices. Government loan guarantees, insurance caps, and investment tax credits all reduce the cost of capital as well.  But minimizing the cost of capital is not the primary objective of economic policy.  If fact, subsidizing multi-year capital can distort economic choices across sectors and between capital-intensive and capital-saving methods to provide similar goods and services.  This is not a good thing.

On the positive side, the way Heritage covered the issue implicitly recognizes that under our current system of capital depreciation, special rules for one asset class versus another do create differential levels of subsidy support.  Thus, if we were to decide not to shift to the full expensing system of taxation Heritage is advocating, Heritage should be supporting policies that properly match depreciation periods with the actual asset service lives as their fallback position.  This would eliminate the political use of depreciation periods to reward favored industries, enhancing tax system neutrality across sectors.  Unfortunately, their actual fallback position appears far more partisan:

All companies, including oil and gas companies, should be able to expense their full capital costs immediately. Until that critical change in the tax code is made for all businesses, Congress should retain all provisions that move the tax code in the direction of expensing  [emphasis added].

Since the special rules have generally gone to the most effective lobbies rather than to the most effective technologies, maintaining the status quo does little more than protect the incumbent industries.

4)  Percentage depletion.  The assessment of percentage depletion allowances mimics the issue framing taken by the American Petroleum Institute (it is simply an "alternative" way to write off assets).  This is simply wrong.  Heritage notes that:

A depletion allowance is analogous to depreciation and is appropriate when the quantity of the potential resource is unknown, such as the amount of recoverable oil from a well. Independent oil and gas producers use a depletion allowance to recover capital investments over time. This is also available to producers involved in mining, timber, geothermal steam, and other natural deposits. The depletion allowance for independent oil and gas producers is 15 percent of the producer’s gross income from its average daily production, up to 1,000 barrels of oil. While there is nothing wrong with percentage depletion in theory, the question is whether at 15 percent it is overly generous or, possibly, not generous enough and should be raised.

But there is something wrong with it in theory:  percentage depletion rules allows certain industries to deduct from taxes more than they have actually invested into an asset.  As a result, the policy is a clear subsidy.  End of story. 

The issue of allowable percentage depletion rates matters only in terms of how big the subsidy is for one mineral versus another.  Recall that what is measured by Treasury and JCT is not the percentage depletion allowance per se, but the excess of percentage depletion over cost depletion.  Firms can shift to cost depletion in any year it is more favorable, so if they are using percentage depletion (and they are, because it shows up every year in the federal tax expenditures budget) it is because they are saving money.

The size of the deposits or the market value of that production is irrelevant to basic concepts of depreciating investments over time. The authors are perhaps mixing up tax accounting and financial reporting.  For tax accounting purposes, only the cost of the investment matters.  Absent the gain or loss on the sale of a well or mine, the IRS shouldn't care what your asset is worth because in a normal industry it does not affect taxable income (though obviously with percentage depletion it does). 

Assets across many industries shift in value year-to-year.  And, as with oil properties, the estimates of the remaining lives and gross future production capacity are also volatile for nearly all businesses -- dependent on broader market conditions regarding demand, market prices, and evolving production technologies.  Factories can be shuttered in bad times, and re-opened (at a cost) if market prices change.  Changes in the operating environment can have dramatic effects on asset values.  A biotech company that had invested $100m into its production facility, for example, might see that asset surge in value if FDA extended the medical conditions for which its approved drug could be prescribed.  Conversely, the rise of a competitor would not change the plant, but would alter expected future cash flows, and therefore depress the market value of the facility.  Yet, absent a bankruptcy, neither case would change tax depreciation schedules one whit.  Substitute "oil well" for biotech facility, and percentage depletion deductions would surge in the first and drop in the second.  It makes no sense.

If the firm wants to track well depletion for financial reporting, no problem.  The data may help its managers and investors assess future market trends and investment needs.  But the appropriate method for tracking assets for internal financial reporting is no justification at all to keep percentage depletion subsidies in our tax code.