Proposition 87 tax plan

Sixteen of the 191 pages that Californians are asked to read in order to vote intelligently in the upcoming election are devoted to discussion of Proposition 87, the Clean Alternative Energy Act. This calls for $4 billion or more in new taxes and spending. In this post, I discuss only the tax side of this proposal, and hopefully will have an opportunity to take up the spending details in a sequel.

California’s Clean Alternative Energy Act calls for a new tax to be levied on “any person who takes oil from the earth or water in this state in any manner”, stating:

The fee shall be applied to all portions of the gross value of each barrel of oil severed as follows:

(a) 1.5% of the gross value of oil from $10 to $25 per barrel.

(b) 3.0% of the gross value of oil from $25.01 to $40 per barrel.

(c) 4.5% of the gross value of oil from $40.01 to $60 per barrel.

(c) 6.0% of the gross value of oil from $60.01 per barrel and above.

So, if you sell one barrel of oil for $25, do you pay 37.5 cents (1.5% of $25) or 22.5 cents (1.5% of the difference between $25 and $10)? I would have taken the statement above to mean 22.5 cents. However, the legislative analysis that is included in the Official Voter Information Guide concludes that the wording is fundamentally unclear. According to that analysis,

The issue of the application of the tax would presumably be resolved by regulations adopted by the California State Board of Equalization (BOE) and interpretation by the courts.

In other words, according to the instructions that are being distributed to voters, a “yes” vote on Prop 87 means that it is left to a judge to determine what it was that voters actually intended.



Data source:
EIA

cal_oil_prod_oct_06.gif



California crude oil production, like that of the United States as a whole, is on a long-term downward trend owing to the failure of new discoveries to keep up with depletion from older fields. The state produces a little over a third of the oil we consume and must import the rest from elsewhere. This proposal taxes the oil produced in California but not any of the oil that we import, giving imported oil a tax advantage relative to that produced here. If you look just at the tax incidence of the proposal, it is inconceivable that the tax change could have any effect other than to reduce the amount of oil California produces and increase the amount we import from other states or countries. And yet, proponents of Proposition 87 advance as one of their arguments the claim that the Act would reduce our dependence on imported oil!

How can it make sense to tax imported oil at a lower rate than that which is produced domestically? One argument might be that oil production has environmental externalities, and Californians prefer to see this environmental degradation occur outside our state boundaries. However, it seems clear to me that the use of oil (both in refining and combustion) entails more significant environmental externalities than production of the kind that currently takes place in California, so if that is the aim, it makes far more sense to tax the users of oil rather than its producers. Furthermore, if the effect is to replace some of the seemingly benign production around Bakersfield with Alberta tar sands or Colorado oil shale, it seems absurd to try to justify that on the basis of environmental considerations.

An alternative justification for taxing domestic production more than imports might be a claim that the U.S. should try to extend the life of domestic resources– perhaps we’ll need the oil more later than we do now, and should therefore attempt to import as much oil as we can now while oil is still cheap. However, one of the main margins that producers adjust along when the net price received by the producer falls (as it would under the proposed tax) is to shut down a producing field more early than they otherwise would. Once this is done, it can often be prohibitively expensive to try to go back later and start everything back up. At least some of the oil production that this legislation will discourage will essentially be lost for good.

The only reason I can imagine for a specific tax on California oil producers is the apparent belief by the proponents of the tax that these costs will be borne not by California drivers but instead by big oil companies. One of the most curious features of the Act is Section 42004(c):

The assessment imposed by this part shall not be passed on to consumers through higher prices for oil, gasoline, or diesel fuel. At the request of the authority, the board shall investigate whether a producer, first purchaser, or subsequent purchaser has attempted to gouge consumers by using the assessment as a pretext to materially raise the price of oil, gasoline, or diesel fuel.

The standard explanation economists give for why a tax like this would of course raise the price to consumers is that it will cause the least profitable California oil reserves not to be extracted. With less supply, the price has to rise. This is not a conscious decision of anybody to “pass on” a cost or “gouge” a buyer, but simply is the way that markets work. The designers of this legislation evidently recognized this as a potential concern, and decided simply to rule out the natural and necessary market outcome with the stroke of a pen, leaving yet another job for judges to try to divine whatever California voters must have intended by terms like “pass on” or “gouge”.

A far more logical way to raise revenue is with a tax on the gasoline consumed in California rather than a tax on the oil that is produced in California. But that would require Californians to take responsibility for our own problems, and violates Russell Long’s immortal principle for the politics of tax revenues: “don’t tax you, don’t tax me, tax that fellow behind the tree.”


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27 thoughts on “Proposition 87 tax plan

  1. wcw

    My only explanation for the Legislative Analyst’s confusion is opposition. I read that tax the way you do. I don’t think there is a shred of doubt. Just look at 42007b, which exempts stripper wells (used on the marginal fields you don’t want shuttered, either) under $50. Above it, they pay 3% “of the gross value of oil above $50.01,” in other words, 0% below. It’s a marginal tax all around, full stop.

  2. Joseph

    I think most people agree that a tax on gasoline users would have better results than a tax on gasoline suppliers, but what are you going to do in a toxic environment where Republicans practically equate raising taxes with aiding the terrorists. Something as unpopular as a user gas tax would require bipartisan support or else would be political suicide. As long as the Republican position is absolute about no new taxes, Democrats are understandably reluctant to stick their head in the noose. So they substitute a more palatable but less effective tax.

  3. Dick

    James,
    I read the law as saying that the gross sold at a particular rate is taxed in full. That would mean that $25 would be totaly taxed at 1.5%, $0.375.
    I think your analysis is spot on. It appears that those promoting the tax are using static analysis to determine the tax revenue, but it is pretty clear that the tax will significantly reduce oil revenues and a reduction in tax revenue.
    I would like to see a dynamic analysis of this reduction in revenue. Perhaps you are planning to include this in your analysis of the cost.
    Does anyone know the chances of this passing?

  4. HZ

    I agree that the intent is clear, whatever the wording. And I am equally disappointed that this is a tax on domestic producers instead of a gas tax. We might as well call it the “California Terrorism Support Act” — let’s import more oil and not give a damn where that money might go to.
    There are so many bond issues as well. Could you discuss some of those here too?
    What do you think of our initiative process any way? How many voters will actually read the 191 pages? And if we all do, is that truely time well spent? In my mind, the initiatives should be used to vote on simple voter intent issues (things that can be said in one statement) instead of enacting complicated legislations and spending and appropriation bills. Those are what we elect and pay our representatives for.

  5. HZ

    One way to address these abuses is to require those who sign on petitions to also sign a statement stating that under penalty of perjury that they have read and understood the entire act that they are petitioning for. We could even lower the threshold of the number of signatures required.

  6. Lord

    Conserving production for a time when it will be more valuable is certainly the strongest argument in its defense. The criticism against it has been all too hokey though. Oil companies have been telling us for years they just pay market prices. This is simply too small an amount of tax on a globally produced commodity to have any significant effect on price. Sure prices will rise, but will it be 1 cent a gallon or less? I would guess less. No one will notice it in the volatility of prices. The real reason it will fail is the squandering of the proceeds.

  7. Ted Green

    California’s nonpartisan Legislative Analyst points out that Prop. 87 would also have the effect of reducing the state’s general fund and local property taxes.
    That’s one of the big reasons Prop. 87 is opposed by the California State Association of Counties, California Professional Firefighters, California Coalition of Law Enforcement Associations and the California Special Districts Association.
    Also, as of 10/12, twenty-one of California’s daily newspapers (including the Los Angeles Times, San Francisco Chronicle, Sacramento Bee and San Diego Union Tribune) have editorialized AGAINST 87.

  8. pgl

    A tax on local production only does seem odd. Isn’t this equivalent to taxing consumption and then passing an import subsidy. Precisely the opposite of what one would expect if we wanted to reduce oil imports. Of course, I find it strange that anyone would place tariffs on the importation of fossil fuels.

  9. Lord

    It would make a lot of sense if California was a net exporter since the tax would be shifted in part to external consumers, but as it is a net importer, no shifting is possible, and it is mostly a just a shift from local producers to the state. That wouldn’t be bad in itself if it were well spent (invested), but that is unlikely.

  10. Lord

    Being a shift from local producers to the state does shift the burden to external shareholders though, perhaps not unwarranted in times of exorbitant profits. What the feds giveth, the state taketh away.

  11. Dick

    Lord,
    You are assuming that the price of California oil makes not difference to consumers. Increasing the tax on California oil means either the consumer must pay more or the producer must earn less.
    If the consumer has an alternative he will stop purchasing California oil and shift to a less expensive alternative. The Professor is correct that this would actually increase foreign imports. This is exactly the opposit effect that has been claimed by the proponents of the increase (Al Gore).
    If the tax is absorbed by the producer then there will be less producers because the marginal producers cannot opperate at a loss. Again the Professor points this out.
    The only honest point the proponents can make is that the tax will reduce oil production in California, but they will not make this claim because they know it is a lossing proposition.

  12. Lord

    No, I am just pointing out the rise in prices due to this tax will be insignificant. By far the largest costs will fall on shareholders. Producing less is little cost to Californians.

  13. Benn

    For those talking about the dynamic effects — the oil industry’s medium- and long-run supply is very inelastic at the current range of prices. California oil is profitable at $25 a barrel so a reduction in the effective producer price from $60 to $60 – t has virtually no impact on willingness to invest or produce for t

  14. Hal

    Today I saw a full page ad in the Los Angeles Times by the No on 87 campaign. It was a statement of opposition that was signed by a bunch of economists. I was surprised to see that JDH was not there. I did recognize my old college econ prof, Charles Plott, as well as a couple of other names.
    However the No on 87 blog today recognizes JDH and links here:
    http://nooiltax.com/blog/?p=102

  15. wcw

    For the record, despite considering it a bad law (not for the tax on production, which seems a moderate response to offshore leases to me) I probably am going to vote for 87, simply because I hate all the money going in to defeating it. Historically, my supporting something because I dislike its ad buys is essentially a guarantee that it shall, indeed, go down in flames.
    Per Field, the gold standard in polling this state, perhaps as a result of all those ads that so offended me 87 is down from 53/40 in July to 44/41 in late September.
    My bet is that the money takes it, and it loses.
    While I don’t love the law, I don’t see it as all that bad if it wins, though. Slightly less from CA is a pimple on the rump of global crude production. ‘Tain’t the tax that offends me, it’s all the proscriptions for spending it.

  16. Hal

    The No on 87 campaign isn’t doing all that badly money-wise. Here’s an article published today:
    http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2006/10/17/BAG7ULQPOC1.DTL
    “A television ad featuring the former president’s running mate, Al Gore, also has been on the air for a week, rounding out an impressive list of big-name supporters to fend off the opposing campaign backed by Big Oil, which has poured in more than $68 million to defeat the measure.
    “But even beyond the likes of Clinton and Gore, supporters of Prop. 87 have a formidable force of their own in Stephen Bing, a Hollywood mogul who has donated $40 million to the Yes on 87 campaign and is an influential figure within the Democratic Party as one its most generous donors.”
    The article is largely about Bing, quite a colorful character, famous for initially denying his paternity of Elizabeth Hurley’s baby, as well as dating hot Hollywood stars like Sharon Stone and Uma Thurman. It also focuses on the question of whether these celebrity endorsements can make up for the funding difference. Still, with Bing giving $40 million, and I guess everybody else chipping in with a dollar-fifty, the No team has about 2/3 as much money as the Yes side.

  17. Ragerz

    Im afraid Hamilton missed a very basic point. Essentially, all of the revenue raised by the tax will be used to promote alternative fuels (including research and development). To the extent that such subsidization creates new technology and creates infrastructure that enables alternative fuels, it will decrease ALL oil dependence, including foreign oil dependence.
    Focusing on the static and not the dynamic is a mistake. Its easy enough to draw supply and demand curves for static effects. Unfortunately, that is only part of the picture. The dynamic effects could be even more significant. I think Hamilton seriously messed up by not addressing this issue.
    -Ragerz, the ex-libertarian

  18. Don

    Hold on just a moment.
    The price of gasoline in California can’t be different from the price in Arizona by any more than the cost of driving a tanker truck from Phoenix. And it can’t be any different from the price in Alaska by any more than the cost of sailing a supertanker from Anchorage. That won’t change with the tax. So it seems to me that it’d be very hard for producers to pass this tax along to California consumers specifically.
    I think the right framework here is taxing domestic production of a good that’s both produced domestically and imported. The standard analysis is that domestic production decreases, imports increase and there’s no effect on consumers, assuming the production decrease is small relative to the size of the world market. If the production drop is significant, it’ll raise the world price of oil and part of the burden of the CA tax would then be faced by all world consumers. But most of the burden will be borne by producers.
    But I don’t think the production drop will be significant. My guess is that oil extraction technology has high fixed costs and low marginal costs, and that already existing wells will still find it profitable to operate in the face of the tax (I’m saying here that in the short run, the domestic supply curve is inelastic, and therefore deadweight loss is small). In the longer run, the tax will discourage oil exploration and further drilling in CA as prices increase and/or technology improves, as some oil extraction that would be profitable in the absence of the tax will become unprofitable due to the tax. So the domestic supply curve will be more elastic in the long run, leading to an increase in deadweight loss.
    But wait, there’s more! If we assume the world oil price is influenced by OPEC’s supply restriction, then the world price is artificially high. In this case, the reduction in domestic production may in fact be second-best optimal; locations for extraction that would be unprofitable before tax and OPEC activity would become profitable due to OPEC activity and then become unprofitable again due to the tax.
    All of that is prelude to my main point: It seems to me that this tax will be borne by domestic (California) producers. To the extent that oil extraction has high fixed costs and low marginal costs, the tax is simply a confiscation of the wealth of the shareholders of companies who made investments in oil extraction in CA. In effect, California is partially “nationalizing” its oil industry. The big danger of this is: Why stop there? Why not confiscate the wealth of other (politically unpopular) institutions, corporations and individuals? This possibility may lead astute, shrewd individuals to forego investing in California altogether — not just the oil industry, but anything — if California demonstrates a proclivity for confiscating your wealth after you’ve sunk your costs.
    Do I pass the exam, Professor?

  19. JDH

    I can’t argue with your analysis, Don, but would just add a couple of things. First, the impact on global markets depends on the current market conditions. At several times over the past few years, we have faced a situation of extremely tight excess capacity, where a small probability of further disruptions put a big speculative premium into the price. In such an environment, I think even a few hundred thousand barrels a day would make a difference. Second, I am concerned that the language in the bill on “gouging” and “pass-through” invites litigational ambiguity that could have some very undesirable consequences.

  20. Don

    James,
    Disclosure: I’m a prof, too.
    I think you’re saying that global oil demand is inelastic and even a small reduction in supply (and I argue it’ll be small due to the already-sunk fixed costs) will raise prices. You may well be right. But if you are, it’ll raise the world price of oil and therefore be paid by all oil consumers in the world, not just specifically California consumers.
    I agree that the language on gouging is a Bad Idea, as are gouging laws generally. But I don’t think you’ll see too much ‘gouging’ since (I argue) the price in CA won’t increase relative to the price in the rest of the world.
    I think the best argument against this bill is the potential impact it’ll have on investment generally in CA if voters demonstrate a willingness to partially confiscate them ex post.

  21. JDH

    Don, just because you don’t expect there to be much of a price effect of this legislation does not mean that there won’t be a lot of court cases that arise out of the clause I quote. The price of oil can and will go up and down by large amounts over the next decade for a variety of different reasons. I have no confidence whatever as to what the lawyers and judges may claim to have found under authority of this part of the legislation.

  22. Reeves

    Allen’s never met a tax he didn’t love. Amazing how reluctance to raise taxes is a bad thing in Allen’s little collectivist mind.

  23. Will

    Don’s anlaysis makes sense to me although I recognize JDH’s concerns about litigation costs that could arise from poorly worded clauses. Does anybody know where to find a marginal cost based supply curve for crude oil delivered at some location in California? By analyzing this, you can determine the shorter-term impact to crude oil prices in california. If crude oil from CA is close to the point at which demand meets supply then changing its marginal cost will impact both of the cost of crude oil in the market and the amount produced in CA. If the additional tax doesn’t fundamentally change the cost of the marginal cost of the barrels of oil that set the price, then in the short-term it shouldn’t change the price of crude oil or affect production. In the long-term, the tax will clearly reduce the net present value (NPV) of executing exploration and development projects in california. However, if the price of crude oil is held artificially high by OPEC, as Don mentions as well, then it is possible that the NPV will still be positive for most projects and that it will not have a significant effect on how much oil is produced in CA. If you also add in the fact the externalities of oil consumption and production, then it is also not clear that any increase in gas prices is necessarily a bad thing. Finally, if the funds do go to research related to clean energy, this could benefit california substantially if California were able to translate this into developing a leading cluster of businesses and research around clean/alternative energy technologies. Studies have shown that R&D in both universities and companies can strongly contribute to the development of industry clusters. Developing an alternative energy cluster (I’m using the definition of cluster in the way that Michael Porter does) would have significant economic benefits to CA. Just look at what has happened in California with respect to semiconductors, computers, software and internet. The benefits of developing this kind of cluster could easily swamp the possibility of a medium term increase in crude oil costs due to lower E&P investment in california.

  24. Charlie Peters

    The $0.51 per gal. corporate welfare to the oil refiners for adding 5.6% ethanol to California gas is about $500,000,000.00 per year.
    The ethanol may add over $1.00 per gal. to the gas profit in California.
    That may be about $100 billion in oil profit from California motorists.
    The science is interesting but so is the money.
    A $4 billion Prop. 87 oil tax may add $40 billion in oil profit.
    Charlie Peters
    (510) 537-1796
    Clean Air Performance Professionals

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