Repeal Certain Tax Preferences for Energy and Natural Resource–Based Industries

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

Billions of Dollars 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2017-2021 2017-2026
Change in Revenues                        
  Repeal the expensing of exploration and development costs 0.9 1.4 1.4 1.4 1.5 1.4 1.0 0.7 0.6 0.5 6.6 10.7
  Disallow the use of the percentage depletion allowance 0.7 1.1 1.2 1.2 1.3 1.4 1.4 1.5 1.6 1.6 5.5 12.8
  Both alternatives above 1.6 2.5 2.6 2.6 2.8 2.8 2.4 2.2 2.2 2.1 12.1 23.5

Source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2017.

When calculating their taxable income, firms in most industrial sectors in the United States are generally allowed to deduct a portion of the investment costs they incurred that year and in previous years. The portion of those costs that is deductible depends on prescribed rates of depreciation or, for certain natural resources, depletion. Costs are deducted over a number of years to reflect an asset’s rate of depreciation or depletion.

In contrast, the U.S. tax code treats the energy industry and industries that are heavily based on natural resources more favorably. Tax preferences are provided through a mix of temporary and permanent provisions in the tax code. Tax preferences for the renewable-energy sector are provided largely through temporary provisions, whereas tax preferences for extractive industries that produce oil, natural gas, coal, and hard minerals are provided largely through permanent provisions. Two permanent tax preferences in particular give extractive industries an advantage over other industries:

  • One preference allows producers of oil, gas, coal, and minerals to “expense” some of the costs associated with exploration and development. Expensing allows companies to fully deduct such costs as they are incurred rather than waiting for those activities to generate income. For extractive companies, the costs that can be expensed include, in some cases, those related to excavating mines, drilling wells, and prospecting for hard minerals. Specifically, under current law, integrated oil and gas producers (that is, companies with substantial retailing or refining activity) and corporate coal and mineral producers can expense 70 percent of their costs; those companies are then able to deduct the remaining 30 percent over a period of 60 months. Independent oil and gas producers (companies without substantial retailing or refining activity) and noncorporate coal and mineral producers can fully expense their costs.
  • A second preference allows extractive industries to elect to use a percentage depletion allowance rather than the amount prescribed by the cost depletion method, which is a method that allows for the recovery of investment costs as income is earned from those investments. Through the percentage depletion allowance, certain extractive companies can deduct from their taxable income between 5 percent and 22 percent of the dollar value of material extracted during the year, depending on the type of resource and up to certain limits. (For example, oil and gas companies’ eligibility for the percentage depletion allowance is limited to independent producers who operate domestically; for those firms, only the first 1,000 barrels of oil—or, for natural gas, oil-equivalent—per well, per day, qualify, and the allowance is limited to 65 percent of overall taxable income.) For each property they own, firms take a deduction for the greater of the percentage depletion allowance or the amount prescribed by the cost depletion system. The amount of deductions allowed under cost depletion is limited to the value of the land and improvements. As a result, the percentage depletion allowance can be more generous than the cost depletion method because it is not limited to the cost of the property.

This option includes two different approaches to limiting tax preferences for extractive industries. The first approach would replace the expensing of exploration and development costs for oil, gas, coal, and hard minerals with the rules for deducting costs that apply in other industries. That approach would increase revenues by $11 billion over the 2017–2026 period, according to estimates by the staff of the Joint Committee on Taxation (JCT). The second approach would eliminate the percentage depletion allowance, forcing all companies to use the cost depletion system rather than choose the more generous of the two methods. That approach would raise $13 billion over that 10-year period, according to JCT. If the two approaches were combined, revenues would increase by $24 billion over the 2017–2026 period.

The principal argument in favor of this option is that the two tax preferences for extractive industries distort the allocation of society’s resources in several ways. First, for the economy as a whole, the preferences influence the allocation of resources between the extractive industries and other industries in a manner that does not reflect market outcomes. Those incentives encourage some investments in drilling and mining that produce output with a smaller market value than such investments would produce elsewhere because, when making investment decisions, companies take into account not only the market value of the output but also the tax advantage that expensing and percentage depletion provide. Second, for the same reason, the preferences also lead to an allocation of resources that does not reflect market outcomes within the extractive industries. Third, the preferences encourage producers to extract more resources in a shorter amount of time. In the case of oil, for example, that additional drilling makes the United States less dependent on imported oil in the short run, but it accelerates the depletion of the nation’s store of oil and could cause greater reliance on foreign producers in the long run.

An argument against this option is that it treats expenses that might be viewed as similar in different ways. In particular, exploration and development costs for extractive industries can be seen as analogous to research and development costs, which can be expensed by all businesses. Another argument against this option is that encouraging producers to continue exploring and developing domestic energy resources may enhance the ability of U.S. households and businesses to accommodate disruptions in the supply of energy from other countries.

Another argument against this option is that it would alter permanent tax preferences for extractive industries but would not make any changes to temporary tax preferences for the renewable-energy sector. This report, however, does not include options to eliminate or curtail temporary tax preferences. Under current law, temporary tax preferences for the renewable-energy sector are scheduled to expire over the next several years; consequently, eliminating those preferences would not have a significant effect on deficits over the decade. Nonetheless, some temporary tax preferences are frequently extended and so resemble permanent tax preferences. For example, the tax credit for renewable-energy production is classified as temporary but has been in effect since 1992. In 2015, JCT estimated that if policymakers extended that credit so that it remained in place from 2015 to 2024, federal revenues would be reduced by $23 billion over that period. Limiting temporary tax preferences for renewable-energy sources would further reduce the distortions in the way resources are allocated between the energy sector and other industries, as well as within the energy sector. However, producing energy from renewable sources may yield wider benefits to society that a producer does not take into account, such as limiting pollution or reducing dependence on foreign governments as domestic reserves are depleted; in that case, preferential tax treatment could improve the allocation of resources.