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

Background

Extractive industries that produce oil, natural gas, coal, and hard minerals receive certain tax preferences relative to other industries. In particular, extractive industries receive more favorable tax treatment with regard to the timing of when costs can be deducted from taxable income.

One preference allows firms in the extractive industries to fully deduct (or "expense") certain costs in the year in which they are incurred. Producers of oil, gas, coal, and minerals are allowed to expense some of the costs associated with exploration and development. 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.

By contrast, firms in other industrial sectors are generally allowed to deduct only a portion of the investment costs they incurred that year and in previous years. In such cases, the percentage of the costs that can be deducted from taxable income in each year depends on the type of investment. There are exceptions, however. Firms with relatively small amounts of qualifying capital investments, primarily equipment, can expense the full costs of those items in the year in which they are incurred. (That exception is generally referred to as section 179 expensing.) In addition, a temporary provision included in the 2017 tax act (known as bonus depreciation) allows most of the costs of equipment to be expensed through 2022. After that, the portion of investments that can be expensed as bonus depreciation will gradually be reduced until the provision expires at the end of 2026.

A second preference for extractive industries concerns how cost-recovery deductions for natural resources are calculated. Extractive companies, unlike companies in other natural resource industries, can choose between using the cost depletion method, which allows for the recovery of investment costs as income is earned from those investments, or percentage depletion, which allows companies to 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.) The value of deductions allowed under the cost depletion method is limited to the value of the land and improvements related to extraction. Because the percentage depletion allowance is not limited in that way, it can be more generous than the cost depletion method. For each property they own, firms take a deduction for whichever is more generous: the percentage depletion allowance or the amount prescribed by the cost depletion system. By contrast, companies in other natural resource industries have less flexibility in how they can deduct their investment costs.

Option

This option consists of two 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 methods for deducting costs that apply in other industries. (The option would still allow other costs that are unique to extractive industries, such as those associated with unproductive wells and mines, to be expensed.) The second approach would eliminate percentage depletion, forcing all companies to use cost depletion rather than choose the more generous of the two.

Effects on the Budget

The first approach would increase revenues by $2 billion over the 2019-2028 period, according to estimates by the staff of the Joint Committee on Taxation (JCT). The effect would be smaller in later years, even with the phasedown of bonus depreciation, because eliminating expensing would change only the timing of when costs were deducted: The option would reduce the deductions that could be taken in the year costs were incurred, but that would result in higher deductions in later years. The second approach would raise $6 billion over the 10-year period, according to JCT. If the two approaches were combined, revenues would increase by $8 billion over that time. All estimates account for reductions in the activities that would otherwise have received a tax preference in response to the less generous tax treatment.

The estimates for this option are uncertain for two key reasons. First, the projections of taxable income in extractive industries largely rely on the Congressional Budget Office's projections of total income, the size of different sectors within the economy, and energy prices. Those projections are subject to considerable uncertainty. The estimates also rely on estimates of how firms in extractive industries would change their investment decisions in response to the changes in tax policy, which are likewise uncertain.

Other Effects

The principal argument in favor of this option is that the two major tax preferences for extractive industries distort the allocation of society's resources in two key ways. First, for the economy as a whole, the preferences encourage an allocation of resources between the extractive industries and other industries that does not reflect market outcomes. 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. The tax preferences thus encourage some investments in drilling and mining that produce output with a smaller market value than similar investments would produce elsewhere. Second, 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 currently can be expensed by all businesses. A second 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 reduce their reliance on 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 volume, however, does not include options to eliminate or curtail temporary tax preferences. Under current law, temporary tax preferences for the renewable-energy sector, such as tax credits for investment in renewable energy, are scheduled to expire over the next several years; consequently, eliminating those preferences would not have a significant effect on deficits over the coming decade. Nonetheless, some temporary tax preferences are frequently extended and therefore resemble permanent tax preferences. For example, the tax credit for renewable-energy production is classified as temporary but has been in effect since 1992. JCT estimates that if policymakers extended that credit so that it remained in place from 2022 through 2028, federal revenues would be reduced by about $11 billion over that period. Limiting temporary tax preferences for renewable-energy sources would further reduce 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 producers do not take into account, such as reductions in pollution or in dependence on foreign sources of energy as domestic reserves are depleted. In that case, preferential tax treatment could improve the allocation of resources.