Given the recent publicity surrounding this issue, this statement may come as a surprise, yet it is 100 percent true. Also true is that the industry pays more than $86 million to the government every single day and has an effective income tax rate of 41 percent. Why then have so many readily bought the notion that the taxpayers are supporting this highly profitable industry?
A fundamental pillar of the U.S. income tax system is that businesses are taxed only on net income. This means that there needs to be some practical method for businesses to recover costs. There are many tax code provisions that allow companies to recover their costs, but tax deductions and cost recovery mechanisms should in no way be confused with subsidies.
For example, many inaccurately classify the ability to recover costs associated with drilling a well as some sort of unique subsidy for the industry. When companies drill, they incur intangible drilling costs, such as site preparation, labor, engineering and design. These “intangible” costs associated with drilling a well usually represent 60-80 percent of the cost of the well. Independent producers can deduct 100 percent of these costs in the year they occur while larger, non-independent companies can deduct 70 percent of the costs in year one and amortize the remainder over five years.
This is the same treatment afforded many different types of taxpayers. Small businesses can expense 100 percent of certain equipment costs and mining companies can deduct mine development costs. Further, research and development (R&D) costs incurred by industries such as biotech, pharmaceutical and software firms can be immediately expensed.
As is the case with research and development, oil and gas development is no sure thing. Despite great advances in technology, drilling a well is the only means to determine the actual presence of hydrocarbons in reservoir rock or sand. And when companies drill, they often rely on new and innovative methods. While these methods have led to the recovery of domestic reserves few thought possible a decade ago, they remain, essentially risky ventures.
Deductions allowed for the U.S. oil and natural gas industry are often more restrictive when compared with other industries. For example, in 2004, Congress enacted the Section 199 Domestic Manufacturers Deduction to spur job creation and retention for all businesses that grow, extract, produce and manufacture goods in the United States. Contrary to assertions, this is not a deduction unique to oil and natural gas manufacturing. It applies to all qualifying industries, from newspapers to home builders, electric companies to movie studios and — logically — oil and gas companies.
For most U.S. manufacturers, the deduction is 9 percent of their domestic net income. However, recent legislation has already penalized U.S. oil and natural gas companies by freezing their deduction at 6 percent.
It is misleading to say this deduction is a subsidy for one industry but a legitimate business deduction for other industries receiving the full amount. Those who argue that oil and natural gas companies are not entitled to the same tax considerations available to other industries ignore the substantial revenue generated by the oil and gas industry for federal and state governments. Every single day, U.S. oil and gas companies pay more than $80 million to the federal government in the form of rents, royalties, lease payments and income tax payments. This goes above and beyond motor fuel excise taxes or state income, property and severance taxes. And they ignore the fact that, since 2000, the industry has invested almost $1.7 trillion right here at home in U.S. capital projects to advance all forms of energy, including alternatives, while reducing the industry’s environmental footprint.
Making the false claim that the industry gets subsidies in order to tax it more has made little impression on voters. As indicated by a recent poll, 62 percent of more than 10,000 voters surveyed oppose efforts to increase taxes on the industry. Perhaps these voters understand something very basic that some politicians and pundits don’t: with some oil and natural gas companies bearing an effective tax rate of more than 40 percent and a real need to develop domestic reserves, policies to impose almost $90 billion in additional taxes do not make any sense.