The Tax Debate

It's not unusual for politics to focus more on perceptions than reality, but there are few areas in which those perceptions are more divorced from fact than on the subject of taxes, and that is particularly true in this election cycle. Various candidates propose tax cuts, the repeal of tax cuts, a "fair tax", and other options affecting taxation, but few of them begin by describing the magnitude of current taxation, its allocation between individuals and corporations, and the relative tax rates paid by these different segments. The resulting distortions are especially glaring when it comes to the taxes paid by the energy industry.

The debate over whether to tax the oil industry to fund subsidies for alternative energy and energy efficiency is a small aspect of the larger discussion over the appropriate level of taxation on businesses and individuals. The argument to withdraw certain tax benefits from the highly-profitable US oil industry is founded on the perception that the oil industry is under-taxed, violating Americans' sense of fairness. While it is indisputable that the domestic oil and gas industry has been making money hand over fist, the perception that it pays less tax than other industries is not only false but entirely contradicted by the government's own data in this regard.

The income tax on individuals raises about $1 Trillion annually, three times the amount collected from taxing corporate income. According to the Energy Information Agency of the Department of Energy, in 2006 the 29 companies included in its Financial Reporting System paid $90 billion in income tax--or 25% of all US corporate income tax receipts--on pre-tax income after adjustments of $222 billion. That yielded an effective tax rate of 40.7% before counting the $8 billion in production and other taxes they paid. This group of companies, which includes ExxonMobil, Chevron, ConocoPhillips, Valero, Tesoro and the US operations of BP and Shell, had combined revenues of $1.4 Trillion and accounted for about half of US oil and gas production and 80% of refining. By comparison, the effective tax rate on all US manufacturing companies was 22%. In other words, the oil and gas industry is already taxed about twice as heavily as all US industry.

It shouldn't surprise us that our perceptions about the tax burden on the energy industry are wrong, because commonly-heard assertions about the relative income taxation of individuals turn out to be equally flawed. In contrast to our sense that this burden falls mainly on middle-class Americans, the most recent data from the Congressional Budget Office show that the 2nd, 3rd and 4th quintiles of households by income, roughly corresponding to lower-middle, middle, and upper-middle income Americans, together earned 41.6% of all income and paid 16.6% of federal personal income tax liabilities in 2005, while the top 20% earned 55.1% of income and paid 86.3% of the personal income tax. The lowest quintile actually received a net credit. Nor is it true that this allocation has become less fair over time. Since 1980, the share of the income tax collected from the middle class has fallen by half, from 35%, and the load carried by the top quintile has increased by a third.

Now, it's possible to evaluate these figures and conclude that oil companies and wealthy individuals should pay out an even higher fraction of their incomes in taxes. The US still has a substantial budget deficit, and the likelihood of reducing expenditures by enough to close that gap seems low, when entitlements, defense spending and interest on the national debt account for most of the federal budget. But we need to understand that raising those taxes will have consequences, too. Energy companies already pay double the effective tax rate of all manufacturers, and raising their taxes will make them less competitive with other sectors of the economy, and with foreign firms, at a time when we claim to place a high premium on energy security.

We must also be realistic about how close alternatives and efficiency really are to being able to displace our oil imports. Domestic oil and gas still account for 45% of US energy production--eight times the contribution of the rapidly-growing non-hydroelectric renewable energy sector. Doubling our ethanol output over the next decade will only replace 3% of our net petroleum imports. In that light, penalizing our largest domestic energy sources to support our smallest, and basing the argument on a fundamental misunderstanding of how the country's tax burden is apportioned, seems unlikely to advance the cause of energy independence.