DI Blog

Insights across the energy value chain

Whether we like it or not, the government has to tax us in order to pay for schools, roads, and all the things governments do.  Economists do a lot of thinking about the best way for governments to raise money, and have come up with a couple strategies.  First off is to tax things that we want less of anyway – like cigarette smoking, or alcohol consumption.  But these “sin taxes” don’t raise nearly enough money to pay for the whole government.

The next approach economists like is to minimize the economic distortion of the taxes.  It turns out that this means taxing things that raise revenue, but that people don’t really otherwise respond to (beyond paying taxes).  One example is taxing the value of land – they’re not making more of it, so taxing land holdings doesn’t result in less land.   This is also a rationale for income taxes – most people work even though their income is taxed because they still have to pay mortgages and buy groceries.

Figure 1: One place they did make land is Ellis Island, which was mostly made of ballast from ships landing in New York!

Figure 1: One place they did make land is Ellis Island, which was mostly made of ballast from ships landing in New York!

The next step is to figure out what taxes are least distortionary.  If we raise income taxes by a dollar, does that distort the economy more or less than raising severance taxes (taxes on oil and gas production) by a dollar?  What are the right units for this question?  Economists use “elasticities” to answer this question.  An elasticity describes the percent change in an economic outcome (like oil production) when you change a tax by one percent.

A few economists have tried to figure out how much oil production, or oil drilling, responds to taxes.  In a recent paper, we find that that the elasticity of oil drilling with respect to severance taxes is about -.3 or -.4.  That is, a one percent increase in the severance tax rate would reduce drilling by about 0.3 to 0.4 percent.  So if a state is thinking about increasing their tax rate from 5% to 6%, that’s a 20% increase.  That means we expect about 6-8% less drilling and an increase in revenues of about 12-14%.

This is comparable to income taxes – recent estimates for the elasticity of overall income are as small as about -0.1, but have larger magnitudes for taxable income, high earners, and itemizers.

Figure 2: Reservoirs used in our analysis (orange dots)

Figure 2: Reservoirs used in our analysis (orange dots)

How do we come up with these numbers?  In this study, we looked at how many wells are drilled in each month in each reservoir on either side of a state line.  Figure 2 shows the reservoirs we use.  When oil prices go up, firms drill more wells.  But if we look across a state line, the increase in well drilling is bigger on the side of the state line with lower taxes!  By looking at this difference, we can figure out the effect of the taxes.

There are several important simplifications in this analysis.  I’ll highlight three.  First, we only look at drilling, not production after drilling.  With conventional reservoirs, this is probably fine, but with refracking becoming increasingly popular, this is a real shortcoming for shale.  Second, we effectively assume all wells are the same.  Third, our treatment of other taxes (corporate taxes, property taxes, deductions, etc) is pretty simple.  A strength of this approach is that by looking across state lines, we can effectively compare like resources, by assuming that the plays aren’t too different on either side of the border.

Overall, I think the takeaway from this analysis is that severance taxes can be an effective tool for raising revenue, but that the tradeoff is real.  Raising severance taxes really does lead to less drilling, and thus fewer jobs and less revenue for everybody.

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Peter Maniloff

Assistant Professor, Division of Business and Economics, Colorado school of Mines

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