accelerated depreciation

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.

Fresh off of a financial crisis that risked throwing the US into a depression, my hope was that lessons would be learned.  Nothing dramatic, perhaps, but at least the basics on incentive structures in financial deals.  Like when you let people bet only with somebody else's money, they are far less careful about what they bet on, and how much they put at risk.  And the related issue that if you let investors take their own cash out of the game too quickly, the probability of project failure rises sharply.  And finally, if the one left fronting (or guaranteeing) all the cash is you, it is time to worry.

Worrying does not seem to be the strong suit of Senators Kerry and Lieberman (K-L) in their American Power Act (APA) proposal issued in May.  They have joined a line of political backers for nuclear power who want to give reactors a pass on the market test, adding to the already rich pot of subsidies that nuclear investors would receive.

I've just completed a detailed analysis of three of the nuclear tax subsidies within the APA for Friends of the Earth:  5 year accelerated depreciation for nuclear investments; a 10% investment tax credit; and an expansion of the nuclear production tax credit.  The full memo is available here; a summary by Friends of the Earth is here.

Keep in mind that the scope of this analysis was quite limited:  many other subsidies to nuclear in APA were not quantified; and the large set of existing subsidies to nukes also ignored.  But even so, it appears that through the 5 year depreciation and ITC alone, K-L have kicked in the final 20 percent to the "policy-enhanced  investing" that the industry seems increasingly to be relying on. 

This "20 percent" was the equity required to be at risk for nuclear projects that were getting the remaining 80 percent guaranteed by the feds under the Title 17 advanced energy loan program.  While the investors woudl still need to put in the equity at the beginning, the generous tax breaks effectively allow them to take most of it off the table within three years of reactor operation; and the full capital at risk (or nearly all in our low estimate using more favorable capital cost assumptions) within five.  After that, gentle taxpayer, it is you and I who bear the financial risk from projects going bad.  And no, we don't get to share in the upside if the project turns out well.

The main findings from the memo include:

• K-L subsidies worth billions per reactor.  The new subsidies will be worth between $1.3 and nearly $3.0 billion per new reactor on a net present value basis.  This is equivalent to between 15 and 20 percent of the total all-in cost of the reactors, as projected by industry.

• New subsidies will undermine equity requirements of the nuclear loan guarantee program.  Despite significant structural weaknesses in DOE's Title 17 loan guarantee program, the rules at least required investors to hold a 20 percent equity stake in the new project.  A key goal of this requirement is to ensure investors have a strong interest in the long-term success of the venture and feel substantial pain from its failure.  However, the K-L bill would in effect allow investors to recover funds equal to this equity share within the first few years of plant operation.  Financial risks from project failure would then rest almost entirely with taxpayers.

• New nuclear subsidies on offer under K-L are worth 15 to more than 50 percent of the expected market value of power the plants will produce.  This is in addition to the many other subsidies the nuclear projects would already receive.

• K-L “progress payments” allow ITCs to be claimed before reactor opens, greatly increasing taxpayer risks.  Bill language to recapture these credits is unlikely to be effective in a situation where a reactor project goes into bankruptcy.

• Aggregate tax subsidies to new reactors could reach tens of billions of dollars (net present value) from K-L's two main tax breaks alone. The national cost of K-L's tax provisions can be benchmarked by evaluating two build-out scenarios:  6 reactors, matching the number likely to be supported under K-L's expanded nuclear loan guarantee pool; and 22 reactors, matching the number going through NRC licensing as of May 2010.  As not all reactors will be the same type, the calculations assume half are AP1000s and half Areva EPRs.  Under a 6 reactor scenario, K-L will add $9.7 to $15.6 billion in tax subsidies to nuclear power on a net present value basis.  Under a 22 reactor scenario, the net present value of subsidies on offer just through 5-year depreciation and ITCs reaches $35.7-$57.3 billion.  Unlike the PTC, neither of these other subsidies have any national caps, so the taxpayer cost scales linearly with reactor count.  
  

Check out these links for more on subsidies in APA; and for an assessment of APA's loan guarantee retention fee.

Just last week, the Economist magazine noted in an editorial that:

However you measure the full cost of a gallon of gas, pollution and all, Americans are nowhere close to paying it. Indeed, their whole energy industry—from subsidies for corn ethanol to limited liability for nuclear power—is a slick of preferences and restrictions, without peer. The tinkering that will follow this spill will merely further complicate it.

As if on cue, out comes "The American Power Act."  For some reason, idle hands in Congress always find particular comfort in working on energy bills, and an early summary of the latest of a long line of government energy initiatives has just been released.  A short summary of that summary can be accessed here.  The American Power Act will dole out all sorts of goodies, with some huge potential gains to coal and nuclear power.

Before going into what the bill contains in giveaways, it is useful to note some of the key things it does not do.  It does not remove the government from the role of choosing technology winners and losers, and it does not build a neutral policy platform on which all energy technologies must compete for whatever public support is offered.  In fact, the bill summary views this not as a bug, but as a feature, noting that the bill is "investing in innovation across all energy sources."  Investing in everything is not a very good theory of change, as I've examined in detail previously.  Finally, it does not work to quickly establish greenhouse gas price signals for key energy and industrial sectors, but rather seeks to shelter them from these prices for many years.

In terms of the new subsidies in the bill, in depth analysis requires the specific legislative language.  However, some choice nuggets are already evident in the summary:

Nuclear

• 5 year depreciation on nuclear reactors expected to last 60 years.
• Formally increases Title 17 loan guarantees to nuclear by $36 billion, to $54 billion (there is an additional $2-4 billion above this total that is already in place for front-end facilities such as enrichment).
• Introduction of a "loan guarantee retention fee" on nuclear loan guarantees, supposedly to expedite repayment of the guarantees.  (The language here is strikingly weak:  "to ensure that money is returned to the program as expeditiously as practicable").  The actual form and meaning of these fees is not clear from the summary however.  It could be a withholding from the loan guarantee amount (in which case firms will overstate need to create a buffer).  Also not clear is how the retention fee will interact with the credit subsidy payments already required.
• A tripling of the coverage for nuclear delay insurance, from $2 billion to $6 billion in face value; covering 12 rather than 6 reactors.
• Accelerated licensing and review procedures for new reactors, and elimination of some review steps.  How these complex projects can be properly overseen with the expedited process remains to be seen.
• Increased research push on small reactors and fuel reprocessing.
• Since production tax credits can only be earned once a plant begins operation, the bill adds a 10% investment tax credit that can be captured earlier, and likely even if the plant is never completed.  A 10% federal grant would be available to non-taxable entities involved with reactor construction, as such entities can't use tax credits.  Detailed legislative language is needed to see whether these can be combined with other subsidies, such as production tax credits, or much be used instead of them.
• Allows nuclear to access Advanced Energy Project Credits, providing up to a 30 percent tax credit for manufacturing eligible project components (credits may be carried forward up to 20 years).  The credits have a national cap, so look for subsequent legislation to dramatically increase the available support.  The current cap of $2.3 billion is rounding error in nuclear projects, and remains low even after the APA's  additional $5 billion (Section 4003) in credits is included. 
• Expanded use of tax-exempt private activity bonds in the nuclear power sector.  Because nuclear projects are so big, this provision may not be popular with other users of private activity bonds.  Usage of Build American Bonds (BABs), another tax-advantaged financing tool, by the Vogtle reactors is among the largest BAB projects in the country.
• Allows existing production tax credit (PTCs) for nuclear to be entirely allocated to private participants on a project that includes both taxable and non-taxable entities.  This will increase the effective value of existing nuclear PTCs.
• Extends suspension of import duties on imported nuclear components.  Although nuclear is touted as a solution to energy security concerns, many of the most expensive reactor elements are manufactured outside of the United States.

Coal

• The bill provides some additional subsidies to advanced coal and carbon capture and storage.  However, the most valuable subsidies to the coal sector will likely come through the grants of emissions credits.  The impact of these schemes is difficult to gauge without more detailed language, but Section 1431 of the bill does indicate that where plants or utilities capture and store carbon, they will actually earn GHG allowances.  Under a strict cap and trade, such facilities would simply avoid the need to buy credits by reducing emissions. 
• Section 798 appears to buy off up to 35 GW of premature closure of merchant coal plants by allowing them to continue to receive emissions permits even if the plant has been closed or repowered.  There is no detail suggesting that the buyouts will go first to the dirtiest plants (whether merchant or not), or require high levels of operations in order to be eligible.  The risk of this subsidy being gamed seems high.

Clean Energy Funding

• Section 1801 establishes a "Clean Energy Technology Fund" to promote development of new energy technologies, though provides little additional details on eligibility, structure, or funding levels.  One concern is that the wording sounds like this could be an effort to implement some type of clean energy bank, along the lines of poorly structured earlier proposals for a Clean Energy Deployment Administration (critiqued here). 

Credit Offsets and Allocations

• Title II of the bill attempts to establish some centralized vetting of offset claims, both domestically and internationally, to ensure that offsets are awarded for behaviors that actually reduce emissions.  This is a useful element of the bill, though likely extremely difficult to do well.
• As with other climate bills, this one contains broad giveaways of carbon credits for a sizeable period at the inception of the new law.  As explained by Joe Romm, the bill also attempts to deal with credit price volatility through gradually increasing floors and caps.
• Title IV provides widespread rebates and allowances to industrial emitters of GHGs, suggesting that key industrial sectors will see little price incentive to curb emissions.

"Fast" Mitigation of Hydrofluorocarbons

• Though "extremely potent greenhouse gases," HFCs are to be reduced to 15 percent of baseline, but not for another 22 years.  Hard to imagine what "slow" mitigation looks like.

Oil and Gas

• Section 1204 allows state opt-out of oil and gas drilling within 75 miles of its coastline (otherwise federal laws pre-empt state wishes).  While this provision was introduced in response to the recent Gulf oil spill, its actual protection of coastal resources may be more symbolic than real.  As of May 11th, the Gulf spill oil slick was 130 miles long and 70 miles wide -- enough to have blown through the proposed buffer zone.
• Provides substantial subsidies to convert vehicles to natural gas (starting section 4121).  This is another example of government micro-managing technology selection.  The transport policies should be neutral with respect to any option (better engines, hybrids, electric vehicles, improved fleet management) that reduces oil demand.

Update:  The full bill, in all 987 pages of glory, has now been released.  It will obviously take some time to go through.