Taxation Presentation: Severance Tax on Natural Gas

Katie Koziara, Maddie Wheatley, Garrett Wood, Richard Swoope, Najee Jones __________________________________________________________________
Intro Concerned with air emissions, water contamination, and damage to infrastructure, many state governments have adopted some form of regulation to mitigate the environmental cost associated with oil and natural gas extraction. One of the policy tools governments use to counterbalance the environmental cost to their states is the use of a severance tax. State officials have begun to debate severance tax levels and implementation methods as natural gas production has taken off in the United States. While the growth of natural gas extraction has tremendous economic benefits, the costs associated with its production have also grown. These taxes cover costs associated with drilling, such as road maintenance, construction, and environmental protection. Case for Government Intervention Many economists and environmentalists state that incentives to make environmentally costly choices are not properly aligned with their costs; thus, the situation requires government intervention.1 The scenario in which an individual's choices result in environmental harm, in which the individual feels none, or only a fraction, of the cost is referred to as The Tragedy of the Commons.2 Put another way, because individuals receive the full benefit of consumption despite only bearing a fraction of the environmental cost all individuals have an incentive to consume beyond the socially optimal level, disregarding that their choice is not in long-term best interest for the group, depleting the natural resource. Because incentives are not aligned, the government may impose a severance tax on natural gas, to balance the benefits consumers and industry receive with the environmental cost the extraction and use of natural gas has on society.3

The argument for government intervention in the natural gas industry is bolstered when we assess a second claim: that individuals do not receive direct feedback on the environmental consequences of their consumption choices. By creating a severance tax on natural gas, the government is able to create a situation in which the environmental harm created through the demand for natural gas is reflected in the price. Under typical economic models, the increased price of natural gas as a result of the severance tax would decrease the quantity of natural gas consumed. This new quantity will be closer to the social optimum, while allowing those that wish to still consume natural gas to pay for the environmental consequences of their choice.4 This theory is reflected in the implementation of severance taxes on natural gas; it is common for governments to use at least some of the tax revenue, for environmental restoration and protection, and infrastructure development in the impacted zones.5 Positive and Normative Issues Our hypothesis is that if we impose a severance tax on natural gas then it will bring us closer to the socially optimum consumption of natural gas. In our case study of Pennsylvania, we will explore their impact tax and how it does not accomplish the goal of reaching the social optimal quantity and how a severance tax would accomplish this.6 The positive issue is that Pennsylvania has tried to create a pro-industry environment by attracting business to Pennsylvania rather than neighboring states. This has been accomplished by only charging a one-time impact fee from natural gas companies. However, the Pennsylvania Budget and Policy Center estimates that the impact fee generates roughly a quarter of what a per unit severance tax would (Pennsylvania Budget and Policy Center).7 Normative issues that arise when discussing a severance tax include the opinion that the tax should be imposed because in the long run consumers will seek out alternative, cleaner forms of

energy. Another issue is that states shouldn't impose a severance tax because it will discourage business in that state. Some would argue, however, that a severance tax should be imposed because it will decrease the speed at which natural resources are depleted. 8 Economic Analysis: A Case Study of Pennsylvania A severance tax can be imposed either as a specific tax where the amount levied is related to the quantity of the good extracted or as an ad valorem tax where a percentage of the sales price is given to the state. Pennsylvania does not impose such a tax, however, the state recently introduced a $45,000 per well local impact fee charged to producers who extract natural gas in the municipalitys jurisdiction.9 This impact fee does generate some new revenue, but it fails to generate the revenue a severance tax would. 10 The ability of a tax to effectively meet its policy goals relies on the elasticity of demand and supply. The elasticity of the demand for natural gas is relatively inelastic especially as new regulation on coal results in a loss of a substitute for natural gas.11 Natural gas fuels twenty-five percent of electricity production in the United States, making it a vital input in the production of a necessary good. All of these factors result in a relatively inelastic demand; it is estimated that in the short run a ten percent decrease in price of natural gas would only result in an one percent increase in consumption. The supply side of natural gas is pretty inelastic as well, especially in the short run, because hydraulic fracturing requires so much initial investment of money and time. This investment means it is not possible for natural gas producers to change the quantity they are producing quickly in response to a change in price this keeps the quantity supplied relatively stable regardless of price, the definition of inelastic supply. All of the states producing more natural gas than Pennsylvania impose severance taxes. Texas, the top producer, imposes an ad valorem severance tax of 7.5% of the sale price.12 The specific tax imposed by Louisiana, the

second top producer, is 14.8 cents per thousand cubic feet. As a result of other states also imposing severance taxes, new tax legislation in Pennsylvania would not lead to a mass exodus of natural gas producers. 13 The demand for natural gas was previously more elastic as coal was a viable substitute, but with an influx of new, strict regulations on the coal industry the amount of coal being produced has dropped dramatically.14 Eliminating coal production means natural gas has no viable substitutes; at least until alternative energy production increases dramatically and becomes cheaper. Consumers are also unable to easily switch energy sources regardless of the price variations between different energy sources. No cheap alternatives of a necessary good means the demand is inelastic. Where the tax incidence falls is who pays the burden of the tax either consumers or producers.15 When a demand is inelastic the tax incidence falls on the consumer. Tax incidence is calculated by comparing the difference between the change in price divided by the change in tax with the change in the amount of money received per unit by the producer divided by the change in tax. When the change in price divided by the change in tax is larger than the change in the amount of money received per unit by the producer divided by the change in tax the tax incidence is said to fall on the consumer, which is the case with natural gas. Conclusion It is clear from the analysis that a severance tax on natural gas would raise money for the state to spend on public services. In some states opposition to taxation might hinder policy promoting a severance tax due to the economic analysis that showed severance tax increases the burden to consumers and the normative view that this is not a fair tax. The economics of this tax show us that it would be regressive because people of lower incomes will spend a higher portion of their income paying the natural gas tax than people with higher incomes. Additionally, public

opinion of natural gas extraction varies state to state, it is impossible to make a generalization about whether or not issues such as negative public views towards taxation in general or proponents for encouraging a booming natural gas business will impact tax policy at a federal level. In a state like Pennsylvania, public opinion supports a severance tax and there seem to be enough natural gas resources that companies would not be driven away by this policy. The economic analysis provides justification for the tax fiscally and can invalidate those that are against the tax for normative issues. This is just an examination of one state's factors, and each state must analyze the economics of the impact of this policy and how it affects the stakeholders, the state budget, and the environment and make their own decision as to whether or not a severance tax is a politically viable option.

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! "!"Oil and Gas Severance Taxes: States Work to Alleviate Fiscal Pressures Amid the Natural Gas Boom." Oil and Gas Severance Taxes: States Work to Alleviate Fiscal Pressures amid the Natural Gas Boom. N.p., n.d. Web. 05 Nov. 2013.
#!Rabe,

Barry. Energy Development Versus Environmental Protection: The Case of Hydraulic

Fracturing. Gerald R. Ford School of Public Policy.

$!Rabe,

Barry. Energy Development Versus Environmental Protection: The Case of Hydraulic

Fracturing. Gerald R. Ford School of Public Policy.

%!Times,

William E. Schmidt, Special To The New York. "WESTERN STATES GIRD TO

FIGHT ATTEMPTS TO LIMIT COAL TAX." The New York Times. The New York Times, 28 June 1981. Web. 21 Oct. 2013.
&!Thaler,

Richard H., and Cass R. Sunstein. "Saving the Planet." Nudge: Improving Decisions

about Health, Wealth, and Happiness. New Haven, CT: Yale UP, 2008. N. pag. Print. http://www.ncsl.org/research/energy/oil-and-gas-severance-taxes.aspx#state
'!The (!

Pennyslvania Budget and Policy Center, Marcellus Shale Tax Policy, August 8th, 2013.

IRS publication 510 Excise Taxes, Accessed 20 October 2013. Barry. Energy Development Versus Environmental Protection: The Case of Hydraulic

)!Rabe,

Fracturing. Gerald R. Ford School of Public Policy.

*!+,-.-/01!2-3/45!67890:;!<-44=>:?/4@/!A/B!C/D0,/:!E/=!<,9;0FD@94G6!29,4@43!+/::H04!#(!

#I"I5!<,9J0-=D5!K-L5!#%!MFD5!#I"$!5!
"I!Langley,

Karen. "Schwartz Calls for PA Infrastructure Bank." Postgazette.com. N.p., 9 Oct.

2013. Web. 24 Oct. 2013.

""!Legere,

Laura. "Marcellus Shale Coalition Warns against Tax Proposals." Stateimpact.npr.org.

National Public Radio, 11 Oct. 2013. Web. 24 Oct. 2013.

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! !
"#!Murphy,

Jan. "Faculty and Students Press for Funding Restoration for Pa. State System of

Higher Education." The Patriot-News. PA Media Group, 16 Oct. 2013. Web. 24 Oct. 2013.
"$!Levy,

Marc. "Voice for Pa.'s Gas Industry Picks Second Leader." Mercury News. N.p., 22 Oct.

2013. Web. 24 Oct. 2013.

"%!"MARCELLUS

SHALE: Is The Battle Over?" Philadelphia Public Record. N.p., 3 Oct. 2013.

Web. 24 Oct. 2013.

"&!Long,

Cate. "Pennsylvania to Forgo $24 Billion in Fracking Royalties." Reuters. Thomson

Reuters, 24 Jan. 2012. Web. 24 Oct. 2013. !