In my last post, I made a reference to governments favoring renewable sources of energy over fossil fuels. Most who read this blog probably accepted that statement with little question. Plus, I did provide three examples of governments making it harder to use fossil fuels but providing financial incentives to use renewable sources of energy. So my case was made, right?
Perhaps not. Many people will vehemently make the argument that it is actually the fossil fuel industries that receive billions of dollars in subsidies from the state and federal governments in the United States.[1] Some even go so far as to say that these fossil fuel subsidies are an impediment to the much needed transition to renewable energies.[2] Is it true that it is the fossil fuel industry that benefits from government subsidies, and not the renewable sector?
I decided to look into this topic, and this blog post is a report of my findings. Thus, it will deviate from its typical subject of science and the Bible. However, we will encounter some familiar topics, namely how headlines are not always trustworthy and topics can be a lot more complicated than they seem at first.
For starters, there are plenty of websites that talk about the billions of dollars that fossil fuels get in subsidies, but most of them are not very specific about what those subsidies are. I did encounter a few references to fossil fuels industries, especially oil, getting a significant tax break, a tax break that is embedded within the current tax code of the United States. So I tried following that argument, to see where it would lead.
I eventually found a document titled “United States — Progress Report on Fossil Fuel Subsidies” which was published in 2014. This report was helpful because it actually broke down what where the various subsidies the fossil fuel industries received. As a quick side note, not all of the subsidies that they list are exclusive to fossil fuels. For example, one of the subsidies is the Domestic Manufacturing Deduction, which, according to the report, gives the fossil fuel industry $1.25 billion dollars annually. However, the report also makes it clear that this tax provision is not unique to fossil fuels: the report specifically says that “[t]his deduction is widely available and not targeted at fossil fuel industries.” Even though this is widely available to many industries, it is the third biggest tax break listed in the report. Frankly, I do not think it is fair to characterize fossil fuels as having an unfair advantage if anybody can utilize the benefit.
I decided to focus on a tax benefit that is specific to the fossil fuel industry, one that is targeted to the petroleum and natural gas industry specifically. One such benefit given in the “Progress Report on Fossil Fuel Subsidies” is “Expensing of Intangible Drilling Costs,” which was listed as the biggest tax incentive for fossil fuels (having an annual cost of $1.459 billion). What are these intangible drilling costs, and how are their expenses used to prop up the oil industry?
It costs a company a lot of money to drill a new oil well (or a natural gas well, but we will focus on petroleum). Equipment for the well itself, the cost of operating the machinery, wages of employees, and so on. In fact, drilling the well is the biggest expense an oil company faces. Plus, the well may not produce, or may not produce as much as expected, so drilling a new well is also a risk to oil companies. Intangible drilling costs are those costs that cannot be recovered.[3] Things like wages, surveying costs, clearing the land, and so forth. Other costs, such as equipment, can be picked up and moved to a new well, if need be, but the intangible costs are those that are sunk into one well and one well only. These intangible costs can comprise 60% to 80% of the cost of drilling a well.
Now that we know what intangible drilling costs are, how does the tax code use them to benefit oil companies? By allowing these costs to be deducted when calculating the company’s taxes. More specifically, by allowing oil companies to deduct them the same year the expenses are made.[4] Initially, that sounds like a major handout: the Federal Government is giving oil companies money to drill wells! No wonder the supporters of renewable energy are so upset about fossil fuel subsidies!
Except, this “tax break” is not nearly as nefarious as it sounds. To explain, let us first establish that a company pays taxes on profit, not on revenue. As an example, let us say that a company ears $10,000 dollars in one year. However, in that same year, the company spent $4,000 in order to earn that $10,000. The $10,000 is revenue, but the company only made $10,000 – $4,000 = $6,000 in profit. The cost to the company is deducted from the revenue to find the profit. The company pays taxes on the $6,000, not on the $10,000. That is the way our tax system works.
Now, some companies have a lot of up front costs before they can make a profit. It takes a lot of resources to drill a well, for example, and no profit is gained until the well and pump are functional. So for some companies, the cost comes first and profits come later. In cases like this, the initial costs are typically spread out over the time revenue is made. For example, suppose a company spends $4,000 in one year, and then earns revenue of $5,000 the second year and $5,000 the third year. The company still gets to deduct the cost, but they have to spread it out over the two years of revenue. That means that they make a profit of $5,000 – $2,000 = $3,000 the first year of revenue and $5,000 – $2,000 = $3,000 the second year. Note that the amount of profit is the same: it is still $3,000 + $3,000 = $6,000 over the two years, which is the exact same amount of profit that a company makes if they earn all $10,000 and spend $4,000 in one year. This is the way most companies calculate revenue.
However, a special exception is made for drilling wells. Rather than spreading the cost over the several years of revenue, the intangible costs can be deducted the same year those costs are made. For example, if the intangible costs of drilling a well are $4,000 dollars, the oil company can deduct those costs the same year they are made: it does not have to wait for revenue. Now, there is a trade-off: when revenue comes in, the deduction is already made, so there is nothing to deduct when revenue comes in. Suppose the company that spent $4,000 on intangible costs earns $5,000 the second and third years. The very first year, the company gets a deduction of $4,000, since that was the year the costs were made, but then it has to pay taxes on the total revenue, $5,000 + $5,000 = $10,000, made in the subsequent two years. They get the deduction early, but then the trade-off is that they have to pay taxes on total revenue in the subsequent two years. Notice that, once again, the total profit is the same. If we count the $4,000 as a negative number, since it is a deduction, the company still pays taxes on -$4,000 + $10,000 = $6,000 of profit. In other words, there is no reduction of taxes to the oil company: they still end up paying taxes on the same profit.
Why, then, would it benefit oil companies to deduct their intangible costs early? So they can get some of their investment back immediately, so they can spend it on the drilling of more wells right away.[5] Keep in mind, the oil company still has to pay taxes on the same amount of profit in the long run, they just get to shuffle their costs around so they get their deduction early. There is no net transfer of money from the Federal Government to oil companies.
Lest you think that I have my numbers wrong, here is what the website AXPC.com has to say about the tax benefit:
Intangible drilling costs (IDCs) allow oil and natural gas companies to recover their intangible costs more quickly, freeing funds up to reinvest in developing, resulting in more jobs. Unlike tax credits, IDCs do not reduce the total taxes paid over the lifetime. IDCs allow operators to immediately deduct expenses, which is similar to other tax mechanisms to encourage investment, such as the deduction for R&D expenses allowed for other industries.[6]
There you have it. One of the biggest tax breaks provided to oil companies[7] is not a subsidy at all. Oil companies end up paying the same amount in taxes, they just shift around when they pay those taxes. I am not sure why this is considered to be a $1.459 billion cost to the Federal Government. Perhaps they consider the delayed taxes a cost or they look at the loss of taxes the first year without considering the increased taxes in subsequent years. Whatever the reason, it should be clear by this point that this, one of the biggest tax benefits to oil companies, is not a net transfer of wealth from the government to fossil fuel industries. So much for fossil fuel being propped up by subsidies.
That was as far as I researched. Sure, there are more tax breaks and incentives to investigate, but I figured that looking at two of the biggest tax breaks fossil fuels get was enough. When it comes down to it, fossil fuel companies either get the exact same subsidies available to other industries, like the Domestic Manufacturing Deduction, or they have special incentives that do not reduce their costs in the long run, like intangible drilling costs. That certainly blunts the argument that fossil fuels are being unfairly propped up by the government.
Moreover, I found a Congressional Budget Office Testimony titled “Federal Support for Developing, Producing, and Using Fuels and Energy Technologies” which was given in 2017. According to this testimony, renewables have been given greater tax preferences since at least 2008. Below is a graph from the testimony, which clearly shows that by 2008, the proportion toward renewables exceeded that given to fossil fuels, and it has remained higher ever since.
That should put to rest any idea that fossil fuels are supported at the expense of renewables. Instead, renewables are clearly the favored source of energy in the eyes of our government.
Thoughts from Steven
[1]Bertrand, Savannah (2021) “Fact Sheet: Proposals to Reduce Fossil Fuel Subsidies” Environmental and Energy Study Institute, retrieved from https://www.eesi.org/papers/view/fact-sheet-proposals-to-reduce-fossil-fuel-subsidies-2021 on November 9, 2023
[2]Generation180 (2023) “The Absurd Truth About Fossil Fuel Subsidies” Generation180, retrieved from https://generation180.org/blog/the-absurd-truth-about-fossil-fuel-subsidies/ on November 9, 2023
[3]DW Energy Group (2023) “What Is Intangible Drilling Cost?” DW Energy Group, retrieved from https://www.dwenergygroup.com/what-is-intangible-drilling-cost/ on November 11, 2023
[4]Committee for a Responsible Federal Budget (2013) “The Tax Break-Down: Intangible Drilling Costs” Committee for a Responsible Federal Budget, retrieved from https://www.crfb.org/blogs/tax-break-down-intangible-drilling-costs on November 2, 2023
[5]DW Energy Group (2023) “What Is Intangible Drilling Cost?” DW Energy Group, retrieved from https://www.dwenergygroup.com/what-is-intangible-drilling-cost/ on November 11, 2023
[6]AXPC (unknown year) “Intangible Drilling Costs (IDCs)” AXPC, retrieved from https://axpc.org/intangible-drilling-costs-idcs/ on November 2, 2023
[7]Committee for a Responsible Federal Budget (2013) “The Tax Break-Down: Intangible Drilling Costs” Committee for a Responsible Federal Budget, retrieved from https://www.crfb.org/blogs/tax-break-down-intangible-drilling-costs on November 2, 2023
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