Today we are fortunate to have a guest contribution written by Jeffrey Frankel, Harpel Professor of Capital Formation and Growth at Harvard University, and former Member of the Council of Economic Advisers, 1997-99. A shorter version was published at Project Syndicate.
World oil prices have been highly volatile during the last decade. Over the past year they have fallen more than 50%.
Should we root for prices to go up, down, or stay the same? The economic effects of falling oil prices are negative overall for oil-exporting countries, of course, and positive for oil-importing countries. The US is now surprisingly close to energy self-sufficiency, so that the macroeconomic effects roughly net out to zero. But what about effects that are not directly economic? If we care about environmental and other externalities, should we want oil prices to go up or down? Up, because that will discourage oil consumption? Or down because that will discourage oil production?
The answer is that countries should seek to do both: lower the price paid to oil producers and raise the price paid by oil consumers. How? By cutting subsidies to oil and refined products or raising taxes on them. Many emerging market countries have taken advantage of the last year of falling oil prices to implement such reforms. The US should do it too.
Congress continues to shamefully evade its responsibility to fund the Federal Highway Trust Fund. On July 30 it punted with a 3-month stop-gap measure, the 35th time since 2009 that it has kicked the gas-can down the road! There is little disagreement that the nation’s roads and bridges are crumbling and that the national transportation infrastructure requires a renewal of spending on investment and maintenance. The reason for the repeated failure to put the highway fund on a sound basis for the longer term is the question of how to pay for it. The obvious answer is, in part, an increase in America’s gasoline taxes, as economists have long urged. The federal gas tax has been stuck at 18.4 cents a gallon since 1993, the lowest among advanced countries. Ideally the tax rate would be put on a gradually rising future path.
Fuel pricing is a striking exception to the general rule that if the government has only one policy instrument it can achieve only one policy objective. A reduction in subsidies or increase in taxes in the oil sector could help accomplish objectives in at least six areas at the same time:
- The budget. It is estimated that energy subsidy reform globally (including coal and natural gas along with oil) would offer a fiscal dividend of $3 trillion per year. The money that is saved can either be used to reduce budget deficits or recycled to fund desirable spending, such as US highway construction and maintenance, or cuts in distortionary taxes, e.g., on wages of lower-income workers.
- Pollution and its adverse health effects. Outdoor air-pollution causes an estimated annual 3.2 million premature deaths worldwide. A gas tax is a more efficient way to address the environmental impact of the automobile than alternatives such as CAFÉ standards which mandate fuel economy for classes of cars.
- Greenhouse gas emissions, which lead to global climate change.
- Traffic congestion and traffic accidents.
- National security. If the retail price of fuel is low, domestic consumption will be high. High oil consumption leaves a country vulnerable to oil market disruptions arising, for example, from instability in the Middle East. If gas taxes are high and consumption low, as in Europe, then fluctuations in the world price of oil have a smaller effect domestically. It is ironic that U.S. subsidies to oil production have often been sold on national security grounds; in fact a policy to “drain America first” reduces self-sufficiency in the longer run.
- Income distribution. Fuel subsidies are often misleadingly sold in the name of improving income distribution. The reality is more nearly the opposite. Worldwide, fossil-fuel subsidies are regressive: far less than 20% of them benefit the poorest 20% of the population. Poor people aren’t the ones who do most of the driving; rather they tend to take public transportation (or walk). As to producer subsidies, owners of US oil companies don’t need the money as much as construction workers do.
The conventional wisdom in American politics is that it is impossible to increase the gas tax or even to discuss the proposal. But other countries have political constraints too. Indeed some governments in developing countries in the past faced civil unrest or even overthrow unless they kept prices of fuel and food artificially low. Yet some of them have managed to overcome these political obstacles over the last year. The list of those that have recently reduced or ended fuel subsidies includes Egypt, Ghana, India, Indonesia, Malaysia, Mexico, Morocco, and the United Arab Emirates which abolished subsidies to transportation fuel subsidies effective August 1.
Besides raising taxes on fuel consumption, the US should also stop some of its subsidies to oil production. Oil companies can “expense” (immediately deduct from their tax liability) a high percentage of their drilling costs, which other industries cannot do with their investments. Most politicians know that sound economics would call for this benefit to be eliminated. But they haven’t been ab le to summon the political will. Among the other benefits given to the oil industry, it has often been able to drill on federal land and offshore without paying the full market rate for the leases.
Those who complain the loudest about the evils of government handouts are often the biggest supporters of handouts in the oil sector. Political contributions and lobbying from the industry must be part of the explanation. Even so, it is surprising that self-described fiscal conservatives see more political mileage in closing the Export-Import Bank – which earns a profit for the US Treasury while it supports exports – than in ending oil subsidies, which cost the Treasury a great deal.
A recent study from the IMF estimated that global energy subsidies at either the producer or consumer end are running more than $5 trillion per year. (Petroleum subsidies account for about $1 ½ trillion of that. A lot also goes to coal, which does even more environmental damage than oil.) US fossil fuel subsidies have been conservatively estimated at $37 billion per year, not including the cost of environmental externalities.
Leaders in emerging market countries have now recognized something that American politicians have apparently missed, that this is the best time to implement such reforms. Oil prices have recently fallen to around $50 a barrel – down from a level well over $100 a barrel in the summer of 2014. So governments that act now can reduce energy subsidies or increase taxes without consumers seeing an increase in the retail price from one year to the next.
For the US and other advanced countries it is also a good time for fuel price reform from the standpoint of macroeconomic policy. In the past, countries had to worry that a rising fuel tax could become built into uncomfortably high inflation rates. Currently, however, central bankers are not worried about inflation except in the sense that they are trying to get it to be a little higher.
Congress will have to come back to highway funding in September. If other countries have found that the “politically impossible” has suddenly turned out to be possible, why not the United States?
This post written by Jeffrey Frankel.
A couple of thoughts…. One, not taxing is not the same as redistributing wealth. The government subsidizes when it takes money from a taxpaying group and gives to a non-taxpaying group. The government refrains from taxing when there are economic or political advantages from that restraint. If energy companies benefit from tax policies of restraint and that benefit flows to consumers and other industries in the form of lower energy prices, then that is not subsidizing; that is restraint in taxing.
Two, fuel taxes have been insufficient to fund road maintenance and expansion as an unintended consequence of forcing automotive companies to manufacture more fuel efficient vehicles… the Tesla S as an extreme example of fuel efficiency. As more vehicles become more fuel efficent (a $25,000 Ford Fusion hybrid will get 40+ mpg), the per gallon tax makes less and less sense. States are looking toward different registration fees or even per mile fees based on varying vehicle weights. Why should an electric car buyer be subsidized (given a tax rebate) for the purchase of a vehicle and then the government show restraint (taxing per gallon of gas rather than miles driven)? A mile of road use is a mile of road use. The only factor of variance is the weight wear and tear.
Yes, but rather than funding transportation, I would use the money to reduce other taxes.
This is a rather muddled post conflating a number of different issues.
Let’s take them in turn:
“…countries should seek to do both: lower the price paid to oil producers and raise the price paid by oil consumers. How? By cutting subsidies to oil and refined products or raising taxes on them.”
If one looks at the Q2 financials of the IOCs and shale oil producers, the financial results were terrible, and that was at an oil price $15 / barrel higher than currently. On what basis should we ‘lower the price paid to producers’? Is the intent to bankrupt the industry?
As for raising taxes, I think one could make the case that high European fuel taxes have been instrumental in causing Eurosclerosis. Here’s my article on the topic:
http://www.prienga.com/blog/2015/1/21/refuting-larry-summers-the-case-against-fuel-taxes
And let’s talk about road taxes. For example, the toll on the NJ Turnpike from my exit, Exit 9, to the Holland Tunnel is $6.65. The distance is about 25 miles, and my car averages better than 25 mpg. Thus, the effective highway tax I am paying is $6.65 / gallon. This is not cheap, not even by European standards! Nor is the $14 toll on the GW Bridge, which is set sufficiently high to discourage minimum wage workers from crossing the Hudson to seek employment. Not cheap at all!
And then there’s the reality that more than 50% of that GWB toll is going to build the Freedom Tower–which has absolutely nothing to do with roads. And similarly, the Highway Fund is also used to pay for mass transportation–again, nothing to do with roads. So the author is all about raising taxes to pay for roads–but these taxes have an unwelcome habit of being spent on other programs. Want legitimacy for higher road taxes? Simple, make sure road taxes are spent on roads.”
“Traffic congestion and traffic accidents.”
The cure to traffic congestion is to build new roads. Like an extra six lanes on I-95 north of NY. Or maybe another bypass around NY. I am not opposed to paying for it, and I would not have been opposed 25 years ago either. As I have pointed out elsewhere, we will see a rapid recovery in VMT in the next 2-4 years, bringing us back to new highs on per capita VMT. (Historically, the recovery would occur in two years. If so, well, congestion could be extreme.) I would add that per capita VMT fell by 8% from 2005-2013. In other words, the average driver was driving one month less in 2013 than he was in 2005. You think that will get you stagnation? You think that explains John Fernald’s 2005 turning point in productivity growth? I think it does.
“National security. If the retail price of fuel is low, domestic consumption will be high. High oil consumption leaves a country vulnerable to oil market disruptions arising, for example, from instability in the Middle East.”
This is just plain wrong. A country is well insulated from oil shocks if it is a net oil exporter. Did Saudi Arabia or Norway suffer during the Great Recession? Not much. Of course, you’ll see sectoral imbalances, so an oil shock is inherently undesirable. But it’s not high consumption, but high production, which insulates a country from oil shocks.
Moreover, we have reason to believe that the marginal utility of oil is higher in countries with lower levels of per capita consumption. Therefore, losing that consumption should have a greater impact on low usage countries, for example, Europe. The key is really the share of oil imports in GDP. And where was this share high? Greece, Spain and Portugal, for example.
Oil production is not subsidized net anywhere in the world to the best of my knowledge. Government take ranges from 50-98% of oil production pretty much everywhere. Let me quote the World Bank (a dated, but still largely accurate report):
The government take for most fiscal systems in Europe ranges from about 35 percent to 65 percent—though a few outlier values stretch the actual range for
the region from 18 percent to just over 80 percent (figure 2). In Sub-Saharan Africa, North America, and the Asia-Pacific region, government takes typically range from roughly 40 percent to 80 percent. In the central region, which includes North Africa, the Middle East, and the countries of the former Soviet Union, government
takes are 60 percent to 95 percent. Countries in each region seem to compete within that region’s range of government takes. Latin America is the only region in which countries compete more or less globally, setting government takes that range over the entire spectrum—from 25 percent to 90 percent.
Oil provides 90% of the government budget in Alaska, Saudi Arabia, a very solid bit in Norway, and of course, to Scotland as well. And then there are places like Newfoundland, Nova Scotia and Alberta–the governments in all these places depend heavily on oil revenues.
Now, fuel subsidies in emerging countries are truly ridiculous and should be eliminated. They are, as the author states, regressive subsidies which primarily help the middle class, and they almost inevitably lead to fiscal crisis when oil prices are high. So these absolutely need reform.
But that’s not the US. The US needs more oil to get people moving again and back to work–and we’re getting both! US oil consumption is up 4.6% for July yoy and labor markets are robust. But Europe needs fuel tax cuts the most. The single best way to stimulate the continent’s economy would be through a material reduction–more than 50%–in fuel taxes.
It should be noted, the emergence of abundant and cheap energy from fossil fuels has raised living standards and extended life spans substantially.
I heard, the most generous estimate of the EPA plan to reduce carbon in the atmosphere would cost tens of trillions of dollars and result in a reduction of the earth’s temperature by 15/1,000th of a degree by the year 2,100.
We should get rid of all energy subsidies and taxes, to promote economic growth and raise government tax revenue, along with reducing the costs of regulations in the energy industry.
Can you please cite a source for “tens of trillions of dollars”?
EPA estimates costs at $4.3 – $8.8 billion per year, depending on the scenario and discount rate. My back-of-the-envelope conversion to the NPV of this as a perpetual flow cost at discount rates of 3% and 7% gives a range of costs of $61 billion (=$4.3b/7%) to $293 billion (=$8.8b/3%). Source: Tables 8-1 and 8-3 of http://www2.epa.gov/sites/production/files/2014-06/documents/20140602ria-clean-power-plan.pdf
The economists hired by the coal industry give higher estimates, unsurprisingly. They put the NPV of costs between $366 billion to $479 billion. Of course, industry has historically tended to overstate compliance costs, so this should really be considered an upper bound. Source: Figure ES-2 of http://americaspower.org/sites/default/files/NERA_CPP%20Report_Final_Oct%202014.pdf
Even industry’s estimates put NPV costs under $0.5 trillion. Not sure where you got $10 trillion from.
I can’t comment on the effect on temperature as I am not an atmospheric scientist, but EPA estimated climate benefits on the order of $5 billion per year to $50 billion per year, plus non-climate benefits of $17 billion to $52 billion per year due to public health benefits from reductions in PM2.5, ozone, SO2, and NOx. (Again, the ranges represent different scenarios and discount rates). Based on this, it seems that the rule likely has a positive NPV even if you ignore the impact on earth temperatures.
And if you don’t believe EPA’s benefit numbers, use the coal industry’s estimates of emissions reductions: 456 to 825 million metric tons reduced per year, on average, from 2017-2031 (source: same document above, Table ES-1). Using the $48 social cost of carbon for 2025 (source: https://www.whitehouse.gov/sites/default/files/omb/inforeg/social_cost_of_carbon_for_ria_2013_update.pdf) gives annual benefits on the order of $22 billion to $40 billion (48*456 b, 48*825 b). (Of course the $48 is in is in 2007 dollars. Adjusting to 2015 dollars it would be $25 bilion to $46 billion. This is similar to the annualized costs estimated by industry, suggesting costs roughly on par with benefits, of course before accounting for the non-climate benefits mentioned above.
I heard those numbers on the radio, which may be an exaggeration.
Here’s what Cato says:
“The EPA’s regulations seek to limit carbon dioxide emissions from electricity production in the year 2030 to a level 30 percent below what they were in 2005. It is worth noting that power plant CO2 emissions already dropped by about 15% from 2005 to 2012, largely, because of market forces which favor less-CO2-emitting natural gas over coal as the fuel of choice for producing electricity.
The rise in projected future temperature rise that is averted by the proposed EPA restrictions of carbon dioxide emissions from existing power plants is less than 0.02°C between now and the end of the century assuming the IPCC’s middle-of-the-road future emissions scenario.”
http://www.cato.org/blog/002degc-temperature-rise-averted-vital-number-missing-epas-numbers-fact-sheet
If these regulations slow annual real GDP growth slightly, real GDP will be much lower in the year 2,100.
If we had these type of regulations a hundred years ago, there would’ve been some benefits, but they would’ve been tiny compared to the costs.
It was only because fossil fuels boosted national income substantially, that we could afford more and more regulations.
And, too many regulations, or more regulations in an overregulated economy, does more harm than good.
Pardon for appearing to be picking at nits but the energy sector pays lots and lots of taxes and their products are taxed even more on down through the supply chain. Whether you are using the API calculations or some less partisan source they clearly pay taxes. I resent having the meaning of “subsidy” usurped by people who merely advocate for taxing the sector more. Huge difference and a clear abuse of the common meanings we rely upon when discussing complex subjects.
Can you or Kopits clarify this?
“Oil companies can “expense” (immediately deduct from their tax liability) a high percentage of their drilling costs, which other industries cannot do with their investments. ”
I thought all industries could expense their costs, not just O&G.
There’s a lot going on today.
So, back in 2014, an anti-oil group prepared the following document on preferential treatment of the oil and gas business. You can find the document here:
http://www.taxpayer.net/images/uploads/Understanding%20Oil%20%20Gas%20Subsidies(2).pdf
Here are the main issues:
1. Capitalize versus expense
Certain IDCs (intangible drilling costs) can be expensed rather than capitalized. This changes the timing, but not value, of tax payments. Given that shale wells decline by 70% over the first two years of production, this difference should not be huge. In any event, we’re talking about the time value of money to the US government, which is about 3% right now I think.
2. Deferred Taxes
Deferred taxes, which I can’t claim to fully understand, are a critical source of funds. For example, EOG increased deferred taxes by $2.6 bn in 2013-2014, representing a source of funds equal to fully half of net income. I believe much of this is due to simple increase in working capital resulting from breakneck growth. However, once growth ceases (EOG oil production is down 10% from Q4 2014 peak), this category reverses and becomes a drain on cash. EOG paid $156 m more in deferred taxes in Q1-Q2 than its formal tax expense for the period. Given the size of these movements, calculating breakeven for the company can be quite tricky. In any event, a reversal of deferred taxes is one reason I put the breakeven of EOG for Q2 2015 at $78 / barrel. (And that is a whopping high number if you’re an industry analyst.)
3. Deduction of tertiary injectants, ie, enhanced oil recovery fluids. Generally the benefit of such fluids will be enjoyed within a 12 month period. Nothing wrong with deducting these.
4. LIFO accounting. Both GAAP (IFRS), and as I recall, the IRS allow a company to account for inventory changes on a LIFO, FIFO or weighted average basis. The watch-dog group noted above claimed that LIFO (last in, first out), in a time of rising oil prices, was favorable to the oil companies as the ostensible barrels sold had a high cost base, and therefore lowered the tax bill. Of course, now that logic is turned on its head, as oil prices have fallen. Therefore, LIFO accounting will give you a higher tax bill in the current period than using the other methods. Can an oil company change methods? Yes, but the IRS limits how often you can do that, as I recall.
5. MLPs are used for pipelines and the such and are, as I recall, pass-through tax entities (I think like REITs). There are no upstream MLPs to the best of my knowledge, but are frequently employed for midstream assets (ie, oil pipeline networks), MLPs allow dividends to be treated as a kind of rental income, similar to property rental income. As I recall, MLPs have to distribute a high proportion of their cash, that is, they are limited to maintenance capex. MLPs are used with a wide range of assets, generally infrastructure related.
If you’re really interested in tax rates and how these evolve, the right place to look is government take. This is the share of production which the government retains for its own purposes and represents the key source of value generated by oil and gas production to governments. We can debate whether the government take is ‘taxation’ or ‘ the government’s share of its own resources’. As a practical matter, however, it acts a tax, and it is swings in this category which are principal drivers of the value transferred to the government.
Here’s a piece I wrote on the North Sea outlook, and if you scan down to the second graph, you can see my forecast for UK government take from the North Sea.
http://www.prienga.com/blog/2014/9/16/fk6ouox1xgg5vnfbaheixwudiim083
This is a pretty superficial and cursory analysis, but it’s the best I have today.
Interesting, thanks for the insight.
Steve,
I read the document you referred to. “Deferred taxes” refer, basically, to the difference between the taxes that would be paid on income determined under financial accounting rules (GAAP in the US) (i.e., a theoretical amount) and taxes paid on income determined under the tax code. “Deferred taxes” can refer to assets or liabilities. Normally, it is the former, because income determined under the tax code is generally lower than it is under financial accounting. This is pretty much true for all industries. It is not unique to oil and gas. An example would be the difference between “normal” depreciation for financial accounting purposes and “accelerated” depreciation as may be allowed under the Tax Code. An issue that is simply taken for granted is that one assumes here that “financial accounting income” more accurately reflects “economic income” than would income determined under tax accounting. That may be true in many cases, but it is indeed a fictional construct. Baselines are important!
In general, a “deferred tax asset” would reflect the cumulative total of all the other “benefits” as reflected in that article. So, to refer to deferred tax assets and each individual benefit that add up to make the total “deferred tax asset” number would be double counting. Properly understood, I don’t think deferred tax assets should be characterised as a “source of funds”.
Whether MLP’s constitute a “tax subsidy” is a good question. Basically, all businesses are allowed to operate as partnerships or LLC’s with pass-through treatment. The importance here is not really the tax treatment but the ability to also be listed and traded on a public exchange. If it is a subsidy, it would likely be a subsidy on the ability to raise capital from small investors through the convenience of an exchange. MLP’s are to oil and gas as REIT’s are to real estate. (As an aside, I notice that there is now an ETF of MLP’s trading under the name “Alerian”, stock symbol ALMP–interesting, perhaps).
Finally, I think it is disingenuous of the author here to speak of “tax subsidies” without considering:
1. That the “tax incidence” of the “subsidies”, to the extent there are any, is really to a significant extent on the consumer. Is it not appropriate, in the larger scheme of things, to then also consider the Pegouvian and other downstream taxes to determine the “net subsidy”, if any? While consumer taxes are “mentioned” here (as inadequate(!)), I don’t think the necessary “netting” has been done to give one an accurate overall picture;
2. Whether oil and gas benefits from tax “subsidies” in any real sense should also be considered against the extent to which other industries have the same “benefits” and in particular the extent to which the main competitors to oil and gas get even more favourable treatment. How does oil and gas compare with, e.g., the electric and alternative energy sectors?
If one takes all taxes into account, is oil and gas currently “subsidized” or “penalized”?
Sorry, Steve, when I referred above to deferred tax “assets”, I really should have written “liabilities”. While the ability to pay lower taxes currently is indeed a “benefit”, the extent of that benefit is subsequently listed on the balance sheet as a “deferred tax liability”, because that past benefit will be recaptured, eventually. So, I should have written “normally it is the latter” in para 1 and “In general, a “deferred tax liability” in para 2. Mea culpa.
My work was admittedly pretty shoddy, but hey, I have other fires to tend.
So, a company will record a deferred tax liability when the tax expense recorded on the income statement is more than the taxes actually paid in the period. That difference, Deferred Taxes (or more precisely, Increase in Deferred Tax Liabilities) will show up as a source of funds on the company’s cash flow statement.
As for the subsidizing of the oil industry: If this were so, there would be no petro-powers. Alaska would be bitterly poor and Saudi Arabia would languish at the income levels of Yemen. Germany would have twice the per capita income of Norway, not vice versa–as is the case in reality.
So, no, oil is not a subsidized industry.
Good piece. Though it is all too short in terms of the potential benefits for ordinary Americans.
This is an interesting issue where the elite/commoner divide is quickly apparent. The technocrats support higher excise taxes (much higher excise taxes) and the ‘populists’ oppose it. In that respect, conservative American populists and Latin American Neo-Marxist guided populists share a lot in common.
Ironically enough, those who support using violence against American citizens for political purposes generally view the USA as willing to kill large numbers of innocent civilians in order to support the cheap energy entitlement. That view has resulted in American deaths and will result in more American deaths.
As to whether ordinary Americans see these deaths as worthwhile cost of maintaining cheap energy, I am not sure. The War on Drugs debate has shown that Americans are willing to tolerate high rates of sexual assault, rape and automobile death brought on by alcohol consumption so maybe Americans are quite willing to sacrifice their own for the sake of ‘cheap energy’.
That view that Americans will easily kill civilians for cheap energy would go away with high Nordic-style taxes on gasoline and diesel.