Recently, the U.S. government has both voiced the need to be "energy independent" and scrutinized the amount of money the oil and gas industry has been recording as profit. While President Bush is speaking about weaning the country from imported oil and asking the energy industry to find alternatives, Congress is holding hearings declaring the industry is making huge windfall profits and may have monopolistic tendencies.

That government at virtually all levels speaks out of both sides of its mouth is nothing new. But the resulting collection of conflicting signals sent by the federal and state governments regarding energy production, distribution and consumption is enough to make one’s head spin and, frankly, lies at the core of the disagreement about what U.S. energy policy should be. Should American consumers and businesses have access to relatively cheap and plentiful energy – particularly that derived from crude oil and natural gas – no matter the source? Or should consumption be limited in some fashion, either by legislative fiat, taxation or higher prices resulting from limitations on production and importation? At the same time, should we really be discussing making U.S. companies too small to compete in the global arena?

In the midst of these contradictions, one thing is certain: The energy industry provides a cash cow for governments at all levels. Both consumption and production are taxed whenever an opportunity occurs. The revenue that flows to state and federal governments seems to trump all else in the policymaking arena. This revenue emphasis makes it nearly impossible to formulate a sound and coherent energy policy. Now, once again, the government is discussing policies that seem counterintuitive. On the one hand, they’re looking to interfere with the energy industry by breaking up our largest companies. On the other, they’re looking to add another tax on the energy industry without understanding that they are already taking a disproportionate amount from both the general consumer and the industry that provides the commodity.

In recent years, as prices for crude oil, natural gas and the products that are derived from them have risen – in particular, that benchmark measure of U.S. energy consumption, a gallon of gasoline – the rhetoric from policymakers is predictable: Prices are too high, and someone must be punished. Astoundingly, virtually no lip service, even from the consuming world, is given to the notion that the price of a gallon of gasoline would be an average 45 cents less if the state and federal taxes were subtracted. While these consumption taxes continue to rise, the resulting call to action has been to take the industry to task rather than object to the increased tax burden.

Unlike other sales taxes assessed as a percentage of the sales total, state and federal gasoline taxes are levied as a set amount per gallon, adding as much as 50 to 60 cents/gallon in some states (the federal gasoline excise tax is 18.4 cents/gallon). This means the effective tax rate goes down as the price goes up. In Texas, the state gasoline tax is 20 cents/gallon, making the total state and federal excise tax 38.4 cents/gallon. This makes for some price models that are interesting, to say the least. In 2005, for example, the average unleaded price was $2.27.

	At $2.27/gallon, subtracting the tax from the price results in an actual price for the gasoline itself of about $1.89.
	The combined effective tax rate, dividing 38.4 cents into $1.89, is about 20 percent.
	Obviously, when gasoline was less expensive, the effective rate was even higher. At $1.50/gallon including state and federal taxes, the rate of taxation is about 34 percent, and when gasoline was $1.20 (not so long ago), the combined state and federal tax rate was a whopping 46 percent.

There is no federal sales tax, so to understand the effect, let’s look at Texas.

	At the state level, the 20 cents/gallon tax results in an effective tax rate of about 11 percent when the total price is $2.27/gallon, compared to the state sales tax rate of 6.25 percent.
	If we remove the 20 cents but leave federal taxes, the reduced cost of a gallon of gasoline would be $2.07.
	Once the standard sales tax is added, it would be $2.20, saving the consumer 7 cents a gallon.
	With the federal taxes removed and a standard tax rate added, the per-gallon cost is only $2.00.

From a consumer’s perspective, this puts an unfair burden on the purchase of a commodity that is required to move from point A to point B. Nor do the gasoline retailers shoulder this burden. In fact, were the Texas state legislature to adopt an 11 or even a 10 percent tax rate on, say, bottled water or golf clubs, the citizenry would at minimum "throw the you-know-whats out," and at maximum take to the Capitol with baseball bats.

And yet consumers willingly and with little complaint pay these tax rates for a product that is among the most basic to our very economic existence. This is also an area where the government can be immediately responsive to the needs of the consumer in times when the price of gasoline is rising faster than supply can be provided, as was seen during the recent hurricane disasters.

Just after Katrina and Rita hit the Gulf coastline, the price of gasoline spiked. As refineries shut down and supply was constrained, Texas opened its doors to an influx of storm evacuees. To ease the burden on those unexpected guests, the city of Houston lifted the luxury tax on hotel rooms. Rather than profit from others’ misfortune, Houston offered what relief the city government could provide. They did not reduce the price of the rooms charged by the hotels. Of course, the city quickly ran out of hotel rooms.

If the state and federal government wanted to have an immediate impact on the price of gasoline at the pump, a temporary lifting of the tax would have reduced the price in Texas by some 38 cents, were the combined state and federal taxes lifted from evacuees during the crisis. Of course, we probably would have run out of supply like we ran out of hotel rooms.

And for all the huffing about recent major oil company profits, governments have been the greater "profiteers" from the gasoline tax alone, never mind other taxes, fees and licenses. What began as a 1-cent temporary tax (a stark lesson in itself about the nature of taxation) imposed by the federal government in 1932, and was only 4 cents/gallon as recently as 1981, has ballooned to the current 18.4 cents today.

At the state level, all U.S. states have followed the lead of Oregon, which in 1919 was the first state to adopt a tax on gasoline; today, the average state gasoline tax exceeds 20 cents/gallon. In addition, local excise taxes are often levied on consumers, further adding to the price burden. Interestingly, a review of the 10-K’s of publicly reporting convenience-store companies such as 7-Eleven, Couche-Tard and Alon would find 2005 fuel retail margins in the range of 12 to 14 cents per gallon. While this may seem high, a comparison to the margin for a cup of coffee would show otherwise.

An October 2005 report from the Tax Foundation estimates that major oil company profits in the period of 1977 to today were an inflation-adjusted $643 billion, compared to inflation-adjusted government tax receipts, again just on the gasoline tax alone, of some $1.34 trillion. This broad trend was certainly not undone in 2005, even with the "record profits" reported by major integrated U.S. energy companies. So while the oil industry tries to justify its recent profitability, the consumer receives an ever-growing burden from their elected officials at the local and federal level.

While the consumer is taxed on gasoline consumption, the industry has a myriad of other taxes imposed directly on the production of oil and gas at the federal, state and local levels in the form of personal and corporate income taxes, payroll and franchise taxes, production/severance taxes, property taxes, sales taxes and so on.

One can at least draw a distinction, though, between those taxes to which a broad range of persons and businesses are subject (income, sales) and those for which the energy industry is singled out either on the consumption side (gasoline tax) or the production side (production/severance taxes).

One thing is clear: This industry and its products plainly are singled out, and they are the focus of tax treatments to which no other U.S. industry is subjected, not even the American tobacco industry with all of its public-image problems. Sure, tobacco consumption is heavily taxed. But not only is tobacco production not taxed, it has historically been subsidized by U.S. taxpayers! Only in 2004 and 2005 have programs been put into place to end federal encouragement of tobacco production in the United States. And even the elimination of such subsidy programs do not amount to direct taxation of production.

In most major production states, the industry is taxed just for the sheer privilege of producing crude oil and natural gas. They may be called severance, gross production or extraction taxes; they may be paid by the producer or the first purchaser; but make no mistake – they are taxes on production, and they raise big dollars for state governments.

	In Texas, the severance tax alone as a percentage of all collected state taxes roughly equals the oil and gas exploration and production (E&P) economy as a percentage of the state economy as a whole (7 to 8 percent).
	In Oklahoma, the severance tax as a percentage of all state taxes (11 to 12 percent) is considerably higher than the size of the E&P industry as a portion of the state economy (6 to 7 percent).
	In Alaska, production taxes account for a whopping 50 percent-plus of the state’s total tax intake, while the petroleum E&P sector comprises some 20 percent of the state’s economy.
	This pattern exists across the spectrum of major producing states with the exception of Louisiana, in which the petroleum E&P economy as a percent of the state’s total economy exceeds oil and gas severance taxes as a percent of all state taxes collected. (This is not the case when other taxes paid by the industry are added to severance taxes.)

While severance/production taxes may be the most prominent in terms of the singling out of a particular industry, they are certainly not the only taxes paid by the E&P sector in the United States, particularly at the state and local levels. A recent study in Oklahoma (conducted by your coauthor, Karr Ingham) conservatively estimated that the state’s petroleum E&P industry accounted for more than 20 percent of all state tax collections when considering all taxes paid by the industry, including income, sales, automobile and other taxes, combined with the petroleum excise tax and gross production taxes  for oil and natural gas.

Again, the state’s petroleum E&P sector accounts for some 6 to 7 percent of the state economy as a whole. The industry in other states is similarly affected to one degree or another when considering the range of taxes to which it is subjected. And these figures do not even include more localized ad valorem taxes on reserves or equipment depending on the ad valorem structure in the various producing states.

Of course, tax revenues to states from oil and gas activity have ballooned in recent years with hefty increases in the price of crude oil and natural gas, and many would make the point that the industry can certainly afford the current tax burden. After all, severance/production taxes are generally nothing more than a percentage of the value of production, which quite naturally increases in tandem with price, and greatly increased production receipts make other taxes easier to swallow. Let’s look at how this burden has increased from 2003 to 2005.

	In Texas, the oil and gas production industry constituted about 6 percent of the state’s economy in 2003, and the industry is estimated to have paid 10 to 11 percent of all taxes collected by the state; in 2005, the industry will likely constitute 7 to 8 percent of the state’s overall economy, but the taxes paid by the industry as a percentage of all taxes collected will likely exceed 15 percent.
	In Oklahoma, the industry in 2003 made up some 5.7 percent of the state’s total economy, and the tax burden paid by the state’s E&P sector was an estimated 14 to 15 percent; in 2005, the oil and gas industry will make up an estimated 7 to 8 percent of the state’s economy, but the industry will likely pay well over 20 percent of all taxes collected.
	In Louisiana, the percent of total taxes paid by the industry comes much closer to matching the size of the state’s E&P economy as a portion of the total state economy, largely because the industry makes up a more sizable share of the state’s total economy. However, industry taxation as a percent of total taxes paid has increased much more rapidly from 2003 to 2005 than has the size of the industry in the state.

The percentage of the economy coming from the oil and gas sector has remained fairly constant, while the growth in the amount of the tax burden borne by the industry is in some cases three times this percentage.

As a matter of sound economic theory, it makes little sense to claim to want to maximize the production of crude oil and natural gas, and then tax the dickens out of those products at the point of that production. All taxes levied at the production end of the spectrum have the ultimate impact of constricting production by lowering the effective price received by the producer, but severance/production taxes are particularly egregious in this regard for the obvious reason that such taxes are the vehicle by which production is directly taxed.

State and federal gasoline taxes have the obvious direct impact of raising gasoline prices; state crude oil and natural gas production taxes have a less direct but no less real effect of increasing energy costs to business and household consumers by restricting supply. So why impose such taxes? For the money, obviously. Over time, of course, state and local governments have become dependent on that revenue, and any tax that makes up a sizable portion of total state tax revenue will be extraordinarily difficult to do away with. The state of Oklahoma actually refers to the natural gas gross-production tax alone as one of the "four major taxes" collected by the state, along with income, motor vehicle and sales taxes.

Further, the industry doesn’t seem to do much complaining about these taxes; they’ve been around for quite a while, and the producing world is accustomed to paying them. So rather than bearing the brunt of criticism for taking "windfall profits," oil and gas producers should be receiving the gratitude of the state for providing a good percentage of its revenue. It is, therefore, pure folly to suggest with a straight face that production taxes be phased out or eliminated. However, if the government is serious about increasing domestic production, it would make sense to reduce or eliminate this burden on the industry.

While industry leaders would never call for the elimination of these taxes, they would have good reason to raise their voices.

First, practically nothing produced in the United States is taxed at the point of production either by the states or the federal government. Our nation’s energy resources certainly should not be. And if ever it did make sense, it doesn’t now. The bulk of these taxes were originally established long ago, during very different economic times. Supplies were perceived to be plentiful, and irreversible declines in production may have been foreseen but were not yet on the horizon. The very nature and makeup of the national and various state economies were completely different, and the present tax structure with regard to America’s energy resources is simply antiquated and outdated.

Second, production taxes create artificial market distortions that are harmful to producers as well as to consumers. Producers are denied the full range of proper incentives offered by the marketplace and a fully functioning price system, and consumers are deprived of a market structure that assures them of prices based on maximized production (which always has the effect of dampening prices, rather than raising them) and the full utilization of production resources.

Finally, state and local governments in production areas are overly reliant on taxes generated from what is clearly a declining industry in the United States, at least in terms of production volume. Does it not make sense to begin to wean governments from their dependence on a source of revenue that by its very nature is dwindling away at an ever-increasing rate? Texas crude oil production has declined by more than 30 percent in the last 10 years alone. Natural gas production in Texas was higher in 2005 than it was in 1995, but lower than it was in 2004. Other states, and indeed the country as a whole, are staring full into the face of brutally declining production curves, and tying one’s tax wagon to that particular horse is no longer the way to go. When these taxes were originated, oil was straining to come to the surface, and oil wells were gushers. Now, oil and gas have to be hunted down and coaxed to the surface through increasingly costly production techniques, and production taxes have become incrementally more burdensome with each barrel and mcf pulled from the ground.

So again, what is, or should be, the broad objective of U.S. energy policy? Plainly, even that question has yet to be answered, and the reasons for this are not altogether bad. People in this country simply have widely differing views – based on widely differing motives – concerning energy matters, and they choose a similarly diverse crew to represent them at all levels of government. The result is a predictable mishmash of conflicting policies that at once encourage and discourage production and consumption. It should be obvious at this point that the development of a coherent energy policy is confounded by the fact that the industry is affected by tax, environmental and other policies at different levels of government – national, state and local – none of which feels the need to consult with the others in terms of enacting policies that complement rather than conflict.

One thing seems clear: Consumption taxes at the state and federal levels, and production or ad valorem taxes at state and local levels, are based almost entirely on revenue and spending models that require money to continue to flow from whatever source possible, reducing energy policy to nothing more than a hunger for the revenue produced by the industry. The problem is, particularly at this stage of domestic energy production, "we need the cash" is simply not a viable or sound economic policy. However, when one then turns to the industry and says that there is too much profit and we should tax it more, it rings with the sound of unfair practices.

The use of taxes to limit energy production or consumption is not sound policy, either. The implementation of further taxes to limit consumption is very often proposed based on the notion that higher prices will encourage greater levels of conservation. The existence of a fully functioning market and price system renders this tactic wholly unnecessary. Market-based price increases have the remarkable effect of at once encouraging production and reducing consumption. Why would an artificial price increase as a result of raising taxes be preferable to market-driven price increases? It wouldn’t – unless you need the cash.

Adam Smith, often referred to as the father of modern economics, spoke to matters of taxation at length and issued a set of fundamental principles that should apply. To paraphrase Mr. Smith, taxes should be inherently low and as unobtrusive as possible; they should be broadly applied to spread the burden of funding government as thinly as possible; they should not be used to engineer particular economic outcomes or to provide specific incentives or disincentives; they should not be used to reward or punish (can you say windfall profits tax?); they should be conveniently and transparently assessed; and they should be imposed with the goal of maximizing market efficiency.

As it’s easy to deduce, energy-related taxation in the United States comes nowhere close to meeting these standards. If getting from here to there seems like an unmanageable task, the country should undertake the undoing of bad tax policy the same way it was implemented: incrementally. 

Let’s start with not beginning a new tax and drop the windfall tax discussion altogether. Let’s look at policies that will improve the consumer’s position. The country needs to control more of the reserves so it can affect more of the price of the commodity. States should reconsider using the gasoline consumption tax to provide a majority of the funding in producing states. Lastly, the nation needs to make its producing companies more competitive by removing barriers to growth instead of accusing them of becoming monopolies.

© 2006 Richard L. Loomis & Karr Ingham
Reprint Permission granted from World Energy Monthly Review, Vol. 2 No. 4, April 2006
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