An Alaska Energy Tax Proposal Meant to Shoot Alaska In the Foot

When proponents of a tax increase resort to the age-old argument that it is justified because those prospectively subject to it are paying less than their “fair share,” observers safely can make two assumptions. First: The proposed tax increase cannot be justified on the basis of standard public finance principles. Second: Those being threatened are a political minority. Those truths are confirmed by Alaska Ballot Measure No. 1, the “Fair Share Act” (FSA)---the proponents see no need to be subtle---to be decided by state voters this November.

Under current Alaska tax law, oil producers pay the larger of a 4 percent gross tax or a 35 percent net profits tax after application of an $8 per barrel production credit. In brief, the FSA would impose a minimum “gross” tax rate of 10 percent, rising up to 15 percent depending on the market price of the oil produced (net of transportation costs); and it would eliminate the current $8 credit per barrel while imposing an additional 15 percent tax to the current “net” rate of 35 percent of per-barrel “net profit,” a concept vastly more slippery than commonly recognized. For example, the FSA would disallow the deduction of purportedly “unrelated” costs that apply to more than one producing field; but such joint costs are necessary and thus are very far from irrelevant in terms of investment decisions. The new taxes under the FSA would apply to a given field only after 400 million barrels have been produced and if the production rate was over 40,000 barrels per day (bpd) for the previous year.

The proponents argue that the FSA would increase Alaska revenues by roughly $1 billion per year, while actually being imposed upon only three major fields: Alpine, Greater Kuparuk, and Prudhoe Bay. (Those three fields represent over 80 percent of current Alaska oil production.) That asserted limitation in terms of which fields would be subjected to the higher tax payments ignores the expectations effect of the higher taxes upon exploration and development investments for major new fields. Can anyone believe that the higher taxes to be imposed under the FSA, and the implicit threat of still-higher taxes in the future, would have no effect upon such investments?

Indeed, it is not difficult to construct a simplified but realistic scenario in which the FSA would reduce the present value of future revenues to the state. Consider a potential new producing field with 1 billion barrels of reserves, an expected average production rate of 100,000 bpd, and an expected life of 30 years. (The prospective Pikka and Willow developments are rough analogues.) At an assumed market price of $60 per barrel, average annual sales revenues would be about $2.2 billion per year. Under the current Alaska tax structure---very roughly 4 percent---tax payments would be about $88 million per year, the present value of which (at a 10 percent discount rate) would be about $830 million.

Under the FSA, the tax increase would begin around year 11. Assume that production declines below 40,000 bpd after year 25. Accordingly, there would be 15 years of tax payments of roughly 12 percent of the value of the oil produced during that period instead of the current 4 percent. (Under the FSA, the tax rises above 10 percent by an additional 1 percent for each price increment of $5 above $50 per barrel.) So for years 11 through 25, tax payments would be about $263 million per year instead of the current $88 million, an increase of $175 million per year. (For simplicity I shunt aside here the transportation cost complication.) Given the proponents’ claim of $1 billion per year for the three existing fields noted above, that number is conservative. The present value of that increase when production begins would be about $513 million.

Accordingly, in this simplified but realistic example, the FSA increases the present value of the tax payments by over 60 percent, an estimate consistent with the findings of a recent IHS Markit study of the FSA. Suppose that exploration, development, and production costs average $40 per barrel. Net sales revenues are $20 per barrel; at 100,000 bpd, annual net sales revenues are $730 million, a stream that has a present value of about $6.9 billion. Accordingly, the FSA reduces the present value of the net revenue stream by about 7.5 percent ($513 million/$6.9 billion).  

It is very far from impossible that this expected tax increase would render the project uneconomic; after all, if capital costs (exploration, development, etc.) for this hypothetical field are, say, $5 billion, the present value of the tax increase ($513 million) reduces the expected total return by over 10 percent. (The IHS Markit study estimates that at the $60 price benchmark, the FSA would reduce the per-barrel net present value of a given oil reserve by 83 percent. These two estimates are not directly comparable, but neither are they inconsistent.) Even if various federal tax provisions soften that effect to, say, 5 percent, no one can argue seriously that no adverse effect on investment would result; after all the FSA is little more than an excise tax on exploration, development, and production. If the FSA eliminates one project similar to the hypothetical one just described, the present value of the lost tax revenues merely under existing law would be the $830 million noted above. If only about 40 percent of such potential projects are rejected because of the FSA---that is the approximate point at which the revenues lost from forgone projects begin to exceed those gained from new projects under the FSA---the FSA in the long run will shoot the Alaska state budget in the foot.

Notice that the amount that a bidder (oil producer) is willing to offer for a lease is the present value of the net revenues expected after deducting the present value of the costs borne for the lease, amortization of capital outlays, production and labor costs, royalty payments, taxes, and other costs. An increase in the expected tax payments for future production from forthcoming lease sales would reduce the amount that a given bidder would bid for the lease itself. Because the FSA trades lower lease bids now for (assumed) higher tax payments later under conditions of uncertainty with respect to prices and production, it changes the timing of payments to the state. Translation: It shifts risk from the producers onto the taxpayers of Alaska (or the beneficiaries of state spending programs). There is no obvious reason to believe that the taxpayers are the more efficient bearers of risk in this context.

Taxes are payments for public services, which in theory may not be provided efficiently by competitive markets. (That does not mean automatically that government will do better, a topic for another day.) Under this “contract theory” of the relationship between the citizenry and the state, such taxes should reflect the value of public services as perceived by given taxpayers, if the goal is efficiency in the size and composition of the government budget. Accordingly, a tax increase should reflect an increase in the provision, cost, and/or value of such services. The proponents of the FSA have made no such argument. Instead, they argue, dubiously, that other jurisdictions impose heavier taxes upon oil and gas production than does Alaska, a stance that is irrelevant whether correct or not. They argue in addition that the state budget faces substantial stringencies: The state needs the money. Thus have the proponents more-or-less explicitly descended into the Willie Sutton argument: It is appropriate to impose heavier taxation upon the oil industry because that is where more dollars are to be found. Why, then, not a tax on shoes? The proponents of the FSA would have far more difficulty with that question than one might assume casually; in part it is obvious that consumers of shoes are not nearly as unpopular a target as the oil industry. Is unpopularity an appropriate criterion for choices among alternative tax policies?

The discovery and production of natural resources is an expansion of aggregate wealth, the division of which among investors, suppliers, and workers---and government if public services are required---is driven by economic productivity as estimated crudely in competitive markets. The tax increase to be imposed by the FSA is not a benefit for society or the economy as a whole. It is instead a wealth transfer benefitting the beneficiaries of public spending programs, who have no special claim to given portions of aggregate wealth. Accordingly, the FSA is not a policy that would improve the productivity of resource allocation, and the argument that the state needs the dollars is no argument at all:  Anyone can adopt that stance, including burglars. The appropriate overriding policy goal is a maximization of the size of the economy; in the context of the FSA that means more fossil production rather than less. That is the eternal truth that Alaska voters should keep in mind.