Why FCNL Lobbies to End Fossil Fuel Subsidies

Jul 18, 2011

U.S. laws are filled with perverse incentives that make it hard to change from an old carbon-based energy system to a renewable system. Eliminating perverse incentives is every bit as important as adopting policies that support renewable energy. Indeed, if the U.S. does not eliminate them, they will undermine positive policies like a renewable electricity standard.

Fossil fuel energy companies have had more than 100 years to lobby Congress for favorable treatment in the tax code and other laws that govern their industry. Not surprisingly, the existing U.S. legal system is filled with incentives to continue a dependence on fossil fuels, waste resources and engage in environmentally risky activities like drilling for oil in very deep offshore water.

The current budget crisis offers the best chance we have had in 100 years to start dismantling this system of preferences for the oil and gas industry. Below is a short policy brief, which describes specific subsidies we are asking Congress to repeal. They share two important characteristics: 1) they are not needed because the current high price of oil is a powerful market incentive; and 2) they reduce the risk to oil companies of drilling in fragile, challenging environments.

Eliminating these subsides is just the beginning; many more need to be repealed.

FCNL Urges an End to Oil and Gas Subsidies

We urge Congress to pass two bills, S. 940, the Close Big Oil Tax Loopholes Act and H.R. 2307, a Bill to End the Ethanol Tax Credit. Together these bills would repeal or limit oil and gas subsidies that are expensive, encourage carbon pollution and drilling in extreme environments, impede development of a sustainable energy system and no longer serve any public purpose.

Taxpayers for Common Sense estimates that S. 940 and H.R. 2307 would save up to $62.85 billion over the next five years by ending or limiting the subsidies described below.

Volumetric Ethanol Excise Tax Credit (VEETC)

VEETC is the largest single energy subsidy. In 2011 the credit will cost the United States $6 billion in lost revenues. Over the next five years it will cost $31.05 billion dollars.

The credit benefits petroleum refiners. They receive $0.45 for each gallon of ethanol they blend as a credit against the gasoline excise tax they would otherwise have to pay.

VEETC is particularly pernicious because the Renewable Fuels Standard (RFS) forces the cost of the credit to grow rapidly. The RFS sets the volume of biofuels that must be used each year until 2022. The required annual volume will almost triple in the next decade.

As a practical matter, ethanol blended into gasoline will be used to meet the standard. Because the VEETC is based on the volume of ethanol blended, the RFS will force the cost of this subsidy to rise rapidly. The graph below shows the resulting impact on the annual cost of VEETC, assuming that ethanol is used to meet the standard.

Foreign Tax Credit

Companies that operate in both the United States and foreign countries are entitled to take a credit for income taxes paid to other countries. This means that the income taxes they pay to the United States are reduced, dollar for dollar, by the amount paid to the foreign country. The credit will cost $5.35 billion for the five years from 2011 to 2015

Many oil-producing countries have a much higher income tax for oil companies than for most businesses. Saudi Arabia, for example, has an oil and gas income tax of 85%; other businesses pay a top rate of 28.5%. The Saudis do not charge a royalty for the oil extracted. Instead, they convert royalties into income tax because it benefits them and the oil companies. The tax credit allows oil companies to recoup the full amount paid to Saudi Arabia. If they paid royalties, which are deductible business expenses, their U.S. taxable income would be reduced, but they would recoup no more than $.35 for every dollar paid to Saudi Arabia.

The Foreign Tax Credit not only confers a significant monetary benefit on oil and gas companies, it also has the effect of subsidizing oil producing countries. Such countries can raise enormous amounts of money through high taxes on oil revenues without any negative impact on oil companies.

Section 199 Domestic Manufacturing Deduction

Companies that manufacture or produce certain goods in the United States are entitled to deduct 9% of the net revenues when calculating their taxable income. Section 199 disproportionately benefits oil and gas companies, even though they are limited to a 6% deduction. Because this deduction is only available for domestic production, it encourages drilling in challenging environments, like the Arctic and deep offshore waters, that might not otherwise be economically viable. The deduction also supports expensive and environmentally destructive energy production like oil shale. This deduction will cost $6.21 billion for the years 2011 – 2015.

Intangible Drilling Cost Deduction

This deduction was first enacted in 1918, presumably to encourage production of oil during World War I. It allows oil and gas companies to treat costs like salaries and supplies needed to drill for oil and gas as capital expenditures. This means that rather than being forced to take these expenses as deductions in the year the well is drilled and is probably not producing much revenue, a company can take the deduction in future years when the well is producing income that can be reduced with the deduction. This deduction will cost $8.96 billion for the years 2011 – 2015.

Oil Depletion Allowance

The Internal Revenue Code allows people who have invested in domestic oil leases to recover the cost of their investment as the withdrawal of oil decreases the value of the lease. This is called a depletion allowance. Eligible taxpayers are required to take the greater of a deduction that reflects the decrease in value or 15% of gross revenues produced by the lease. The percentage deduction is almost always bigger for any lease that is producing oil. It is common for taxpayers to get a depletion allowance much greater than what they paid for in the lease initially.

Like the Section 199 Domestic Manufacturing Deduction, the oil depletion allowance encourages oil drilling in difficult environments. By increasing the rate of return for domestic oil and gas wells it encourages drilling in leases that would not otherwise be economically viable. This allowance will cost $4.33 billion for the years 2011 – 2015.

Tertiary Injectants Deduction

Companies can deduct as an expense the cost of chemicals they inject into the ground to remove particularly viscous forms of oil that cannot be pumped out otherwise. This subsidy also encourages drilling for and pumping oil and gas in marginal areas and poorly producing wells that otherwise would not be economically viable. This deduction will cost $34 million for the years 2011 – 2015.

Royalty Relief for Off Shore Oil Drilling

The Deep Water Royalty Relief Act of 1995 allows oil companies to pump a certain amount of oil without paying royalties. The deeper the water the more royalty relief the companies get. A company drilling in 400 meters of water gets the first 5 million barrels of oil royalty free; a company drilling in 2000 meters of water gets 16 million barrels royalty free. This and other incentives to drill in risky, extreme environments are in part responsible for the BP oil spill at the Macondo well in the Gulf of Mexico. Royalty relief will cost $6.9 billion in lost revenues for the years 2011 – 2015.

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