Taxes meant to raise revenues for the government or to change human behavior?
Plentiful and inexpensive energy is a current requirement for an advanced economy. This is as true of centrally planned, manufacturing economies (such as China), as it is for democratic, service based economies (such as the United States). However, formulating and adhering to a consistent energy policy is much more difficult for a democracy than an authoritarian regime, as the United States experience shows.

The policy of the United States has been, in general, to encourage through federal income tax treatment, the rapid development and draining of oil and gas reserves within the United States. Certainly, during times of high oil prices, such as 1974 through 1981, the United States has imposed additional taxes on oil and gas companies. However, the trend in the United States over the last 90 years has been to give tax incentives for domestic oil and gas exploration and production.

The United States has also unintentionally given tax incentives to foreign oil and gas exploration and production. This tax incentive is a product of globalization and the ownership of oil and gas reserves by the same foreign national governments that set income taxes on income derived from those reserves.

In recent years, global warming attributable to human activities has become a political issue within the United States. Proponents of reducing carbon emissions in the interest of slowing global warming generally favor government policies that discourage the use of oil and gas. Increasing the tax burden on oil and gas is a logical method for reducing carbon emissions. This article, therefore, discusses some of the key oil and gas tax initiatives of the Obama Administration to achieve such a purpose.

As part of reducing carbon emissions, the Obama Administration proposes the following with respect to the oil and gas industry:

1. Repeal the last in, first out inventory accounting method.
   
   
2. Elimination of the enhanced oil recovery credit.
   
   
3. Elimination of the marginal wells credit.
   
   
4. Requiring capitalization, rather than expensing, of intangible drilling costs.
   
   
5. Eliminating deductions for tertiary injectants.
   
   
6. Elimination of percentage depletion.
   
   
7. Inclusion of working interest ownerships in the passive loss limitation rules.
   
   
8. Exclusion of the oil and gas industry from the domestic manufacturing deduction currently available to U.S. taxpayers.
   
   
9. Increase geological and geophysical amortization periods from two years to seven years.
   
   
10. Reinstate Superfund excise taxes.
    
    
11. Modify the tax rules for dual jurisdiction oil and gas companies (production abroad).

The reasoning of the Obama Administration for this proposed tax program is best presented with quotes from the Administration:

1. Overview of the Administration's.
   Environmental and Energy Policy The Obama Administration believes that our nation must build a new, clean energy economy, curb our dependence on fossil fuels, limit the emissions of greenhouse gases (GHGs), and make America more energy independent. It is no longer sufficient to address our nation's energy needs solely by finding more fossil fuels. Instead we must take dramatic steps towards becoming a clean energy economy. These include encouraging the use of, and investment in, clean energy infrastructure and energy efficient technologies.1
   
   
2. Targeting Oil and Gas as an Industry.
   The manufacturing deduction generally is available to all taxpayers that generate qualified production activities income, which under current law includes income from the sale, exchange or disposition of oil, natural gas or primary products thereof produced in the United States.
   
   Reasons for Change.
   The President agreed at the G-20 Summit in Pittsburgh to phase out subsidies for fossil fuels so that the United States can transition to a 21st century energy economy. The manufacturing deduction effectively provides a lower rate of tax with respect to a favored source of income. The lower rate of tax, like other oil and gas preferences the Administration proposes to repeal, distorts markets by encouraging more investment in the oil and gas industry than would occur under a neutral system. To the extent the lower tax rate encourages overproduction of oil and gas, it is detrimental to long-term energy security and is also inconsistent with the Administration's policy of reducing carbon emissions and encouraging the use of renewable energy sources. Moreover, the tax subsidy for oil and gas must ultimately be financed with taxes that result in underinvestment in other, potentially more productive, areas of the economy.2
   
   
3. Cross Jurisdictional Problems. Modify the tax rules for dual capacity taxpayers.
   Current U.S. tax rules attempt to identify the portion of a foreign levy paid by a dual-capacity taxpayer that constitutes an income tax eligible for a foreign tax credit versus a payment for a specific economic benefit. In making this determination, current rules place significant weight on the formal characteristics and terms of the foreign levy. In many cases, the terms and the structure of the foreign levy as it applies to U.S. taxpayers have been structured or negotiated to meet, in form, the U.S. requirements of an income tax. The fact that recently certain foreign countries (in particular, Qatar and the United Kingdom) have reduced their statutory corporate income tax rates except with respect to oil and gas companies further indicates that at least a portion of the foreign levies paid by such companies are in fact in exchange for the right to exploit natural resources (that is, a specific economic benefit) and not an income tax. Under the proposal, dual capacity taxpayers will be permitted to claim a credit for the portion of the foreign levy that the taxpayer would pay if it were not a dual capacity taxpayer.3
   
   
4. The new fuel economy standards of the Administration are expected to eliminate the consumption of 1.8 billion barrels of oil between 2012 and 2030.

In assessing the realism of reaching the policy objectives of the Obama Administration through raising taxes on oil and gas, the impartial Joint Committee on Taxation observes the following:

1. These tax changes will increase the after-tax costs of oil and gas, reduce the amount of capital invested in oil and gas and potentially increase the price of oil and gas.4
   
   
2. Decreases in the U.S. production of oil targeted by tax increases will increase oil imports but will probably have little impact on the global price of oil.5
   
3. If these tax proposals are really about pollution, this is not a good approach to reducing greenhouse gas emissions.
   
   If fossil fuel prices were to rise as the result of the repeal of incentives for fossil fuel production, there could be substitution from fossil fuels and into other energy sources, including nuclear or renewable sources of energy. The impact on pollution of any such substitution is unclear and would depend on the type and quantity of pollution associated with the alternative energy resource. To the extent that addressing pollution concerns was a major objective, economic theory would suggest the need for a tax on the externality from the consumption of fossil fuels that equaled the social harm from the consumption. Simply removing selected subsidies related to the production of fossil fuels does not address the issue of establishing proper prices on the consumption of goods that cause pollution.6
   
   
4. The national security implications of the Administration's targeted tax provisions are not clear.
   
   If the proposals caused substitution into alternative resources of energy, reliance on foreign sources of fossil fuels could be reduced because nuclear and renewable energy sources are domestically produced. Alternatively, to the extent that the proposals primarily affect domestic production of fossil fuels, it is possible that any substitution into these alternate energy sources reflects a substitution from domestic production of fossil fuels into domestic production of these alternate sources, thus leaving the United States' reliance on foreign fossil fuels unchanged. Furthermore, as the proposals are likely to have no effect on the world price of fossil fuels, any increase in prices for domestically consumed fossil fuels is likely to be attenuated, and the proposals could primarily result in substitution of foreign fossil fuel sources for domestic sources whose production is more reliant on the subsidies provided in current law. Such an outcome would further imply that the proposals would not lead to any shift into the alternate energy sources of nuclear or renewables.7

The economic stakes are high. According to a Wood Mackenzie study commissioned by the American Petroleum Institute, released August 17, 2010, eliminating both the expensing of IDC and the domestic manufacturing credit would shift the average break-even points for U.S. oil from $47 to $52/bbl and from $5.40 to $6.00/Mcf for natural gas. On November 18, 2010, the spot market price of oil was well above $52/bbl, but the spot market price for U.S. natural gas was considerably below $6.00/Mcf. Based on the study's numbers, the Obama Administration's proposed tax changes would discourage the domestic development of lower carbon natural gas rather than higher carbon oil.

While the Joint Committee on Taxation views the potentially affected oil and gas extraction industry as employing 166,600 workers in the United States, the American Chamber of Commerce reports that the number of oil and gas industry workers that would be affected by the proposed tax increases is 9,200,000. Either way, the number of jobs that could be affected by the Obama Administration's proposed changes should not to be taken lightly.

Forbes Magazine reports that, from public filings of ExxonMobil, on a global profit of $45.2 billion dollars in 2009, no U.S. federal income tax was paid. Thus, expect Congressional scrutiny of the current U.S. system of cross-border taxation.

Republican control of the House, record deficits, and a continuing weak economy make adoption of the Obama Administration's oil and gas tax initiative in the near term unlikely. Longer term, the United States will ultimately adopt a policy on whether to encourage or discourage oil and gas use through taxation, either purposefully or through inaction.

So, are taxes meant to raise revenues for the government or to change human behavior?

Chris Wolfe is a partner with Haynes and Boone, LLP. He has more than 23 years of experience in representing energy-related businesses. He also practices in the areas of mergers and acquisitions and tax business planning.


Endnotes
1. Policy) of the Department of Treasury before the House Ways and Means Committee (April 14, 2010).
2. Id.
3. Id.
4. Joint Committee on Taxation, Present Law Energy-Related Tax Provisions and Proposed Modifications Contained in the President's Fiscal Year 2011 Budget, (JCX-23-10) April 12, 2010.
5. Id.
6. Joint Committee on Taxation, Present Law Energy-Related Tax Provisions and Proposed Modifications Contained in the President's Fiscal Year 2011 Budget, (JCX-23-10) April 12, 2010.
7. Id.