Look for a Call to End Oil “Subsidies” in Tonight’s State of the Union

Tonight President Obama will give his State of the Union address. In this year’s speech, he will undoubtedly mention the need to eliminate those “special tax breaks for oil and gas companies” as he has done in addresses 2010, 2011, and 2012. As recent as two weeks ago, the administration offered the idea of eliminating the $4 billion of oil and gas “subsidies” as part of a deal to offset the impending sequestration. While the president is right to take a stand against preferential treatment of specific industries, he is wrong when he defines these as “subsidies” and “special” tax breaks for big oil.

As a recent article from Forbes explains, “the oil and natural gas industry does not actually receive any tax ‘subsidies’ from the federal government,” yet politicians and the media continue to say otherwise. The confusion comes from the mischaracterization of a couple tax provisions that the president often classifies a special to oil and gas.

A commonly mentioned so-called loophole for oil companies is actually the Domestic Manufacturing Activities Deduction, or the Section 199 deduction. Congress passed the 199 deduction in 2004 and phased it in over six years from 3% to 9%. Instead of a cut in the corporate tax rate for everyone, congress decided to grant a deduction available only to manufacturers, which permits those company to deduct up to 9% of net income from domestic activities.

A measure pursued in congress last March would have eliminated this and other provisions used by the oil and gas industry. Eliminating section 199 completely for oil and gas would put them at a greater disadvantage compared to other manufacturing companies operating in the U.S.

Eliminating other provisions could have damaging economic effects. Intangible Drilling Costs are often mentioned as a loophole for oil companies. IDCs have been a part of the tax code since 1913 and are used to deduct the cost oil companies face when exploring for reserves and drilling wells.

Oil and gas companies receive different treatment based on size. Independent oil and gas companies are able to deduct 100% of their IDCs costs in the year. The tax code treats small businesses in a similar manner, allowing them to deduct all equipment costs up to certain level. Integrated oil and gas companies can deduct 70% in the first year. This differs from large companies outside oil and gas in that beyond the specified limit on deductions (outlined in Section 179), most large companies can only deduct 50% as a part of bonus depreciation.

But cost deduction is hardly a loophole for oil and gas. Good policy would allow businesses, large and small, to deduct these types of costs fully. Full expensing on a permanent basis would encourage economic growth and investment. This encourages companies to expand production, something especially important with oil and gas where the laws of supply and demand control the price of gas at the pump.

Another targeted “subsidy” is the foreign tax credit in its treatment of dual capacity tax payers. The U.S. operates under what is called a worldwide system of taxation. In this system, when a U.S. headquartered company operates in foreign country they are subject to both that country’s tax provisions, as well as those of the United States.

For example, if an American oil company were to operate in Canada, on all profits they would be subject to Canada’s 15% corporate tax rate, and America’s 35% rate. When calculating the amount owed, the company pays the U.S. government the different between the Canadian rate and the U.S. rate to maintain the company’s rate of 35%. So if profits were $100, $15 would go to the Canadian government and $20 to the U.S. The foreign tax credit under dual capacity would be the $15 dollars that is only taxed by the Canadian government and not double taxed.

Conversely, the elimination of the foreign tax credit would lead to further double taxation in the corporate tax code (i.e. capital gains). This would place U.S. companies at a greater disadvantage than they already experience on the international stage.

But this all ignores whether or not oil companies are not paying their fair share. Our report from 2010 shows that from 1981 to 2008, the oil industry paid $388 billion in corporate income taxes to state and federal government. They paid an additional $683 billion to foreign governments. When you include all the taxes oil companies paid over that time frame, the total taxes exceeds the profits by 40%. From 1981 to 2008, the profits of the oil industry totaled $1.4 trillion where the total taxes topped $1.95 trillion.

Bad analysis often misrepresents the effective tax rate of oil companies. Groups like Think Progress pegged the rate paid at 13% for Exxon Mobile, but when you include foreign profit and taxes, the effective rate is actually 42%. Meanwhile, Chevron paid an effective rate of 43.3% and ConocoPhillips an even higher rate at 45.6%.

This debate is not going to be over anytime soon and tonight probably won’t be the presidents only mention of ending the “subsidies” for oil and gas in the near future. But preferential treatment is not sound tax policy, and placing oil and gas companies at a disadvantage at home, and abroad, will increase costs at the pump and certainly will not lead to the growth that the U.S. economy needs.