The five largest oil companies last week announced first-quarter profits of $32 billion, up 30 percent from the first quarter of 2010. Exxon Mobil Corp. alone reported quarterly earnings of $11 billion, nearly 70 percent higher than a year ago, while BP p.l.c., Chevron Corp., ConocoPhillips, and Royal Dutch Shell p.l.c. reaped the remaining $21 billion.

At a time when gas prices exceed $4 a gallon, these profits are coming out of ordinary people’s pockets, and not just at the pump. American families are also padding the oil companies’ enormous profits with their tax dollars. In effect, U.S. taxpayers wrote a collective $7 billion bonus check to the oil industry when they filed their taxes last month.

That’s because the tax code is stuffed with a host of subsidies for oil and gas. These subsidies are delivered through the tax code but they are essentially no different from government spending programs that provide money directly.

Some of these tax earmarks have been around for nearly a century, and the deep-pocketed industry has successfully challenged previous repeal attempts. But today’s high gas prices and inflated profits have undermined the industry’s argument that their tax breaks benefit consumers. Meanwhile, federal budget deficits have sharpened Congress’s focus on eliminating wasteful government spending—of which oil subsidies are one of the worst examples.

Even congressional Republicans—who voted unanimously to retain oil tax breaks in March—now seem to be backing off their defense of the indefensible. Both House Speaker John Boehner (R-OH) and Budget Committee Chairman Paul Ryan (R-WI) have said, albeit in vague terms, that they now support rolling back oil and gas tax subsidies. A growing number of rank-and-file Republicans have echoed these comments.

It’s time to turn these sentiments into action, and momentum is building on Capitol Hill.

Senate Majority Leader Harry Reid (D-NV) said he intends to hold a vote as early as next week on ending the oil and gas earmarks.

In the House, all 15 Democrats on the tax-writing Ways and Means Committee this week urged Chairman Dave Camp (R-MI) to schedule a session to move a tax subsidy repeal. Thirty other members of Congress, led by House Democrat Earl Blumenauer of Oregon, recently wrote Boehner urging him to allow an up-or-down vote on the “Ending Big Oil Tax Subsidies Act.” Democrats may offer amendments repealing oil subsidies to legislation on the House floor this week.

The Center for American Progress has repeatedly in the last year scrutinized the hidden world of oil and gas tax subsidies, emphasizing that they represent wasteful government spending. Here’s a summary of the major oil and gas tax breaks and their cost to taxpayers:[1]

Percentage depletion ($11.2 billion over 10 years)

Companies are generally allowed to deduct the costs of an investment over the term of that investment’s useful life. But oil companies get to use a special method for calculating their deductions called “percentage depletion.” Instead of deducting the costs of an oil or gas well as its value declines, oil companies are allowed to deduct a flat percentage of the income they derive from it. Because the deductions are based on revenues, not costs, the subsidy actually increases at times when prices are high, which of course is when oil companies enjoy their greatest profits.[2]

The oil and gas industry maintains that this is not a special tax break because other companies receive similar deductions. But the percentage depletion method permitted for oil and gas is fundamentally different and more favorable. In some cases, it can eliminate all federal taxes for these companies. Moreover, percentage depletion is a poorly designed subsidy because it “doesn’t specifically target hard-to-find or difficult-to-extract oil,” as CAP’s Richard Caperton and Sima Gandhi have written.

Domestic manufacturing deduction for oil production ($18.2 billion over 10 years)[3]

Oil producers successfully lobbied for inclusion in a 2004 bill that gave the beleaguered manufacturing sector a special tax break designed to discourage outsourcing of jobs. For a number of reasons—including the capital-intensive nature of oil production, the relative mobility of investments, and of course the level of profitability—there are vast differences between the oil industry and traditional U.S. manufacturing. As Sen. Bob Corker, a Tennessee Republican, has explained: “Congress was trying to solve a manufacturing issue in this country” by enacting the deduction and included oil producers “almost inadvertently.”[4]

Whatever rationale there was for allowing oil producers to claim the manufacturing deduction has evaporated in the intervening time, as oil prices have nearly tripled. Eliminating oil producers from a benefit never intended for them “will have no effect on consumer prices for gasoline and natural gas in the immediate future,” and is unlikely to have any effect over the long run, according to a recent report by Congress’s Joint Economic Committee.

Expensing of intangible drilling costs ($12.5 billion over 10 years)

Another special tax rule dating back to 1916 permits independent oil companies (and major integrated oil companies to a lesser but still significant extent) to “expense” certain costs associated with drilling oil wells. This means they can take immediate deductions for these costs rather than spreading the deductions out over the useful life of the wells, which is the normal tax code rule for other types of investments. Taking deductions immediately means the companies lower their tax bill in the first year, in effect getting an interest-free loan from the government.

“Dual capacity taxpayer” rules for claiming foreign tax credits ($10.8 billion over 10 years)

Our tax system allows companies that do business abroad to reduce from their tax bill any income taxes paid to other governments. The rules are supposed to prevent oil companies from claiming credit for royalty payments to foreign governments. Royalties are not taxes; they are fees for the privilege of extracting natural resources.

Notwithstanding these rules, so-called “dual capacity taxpayers,” which are overwhelmingly oil companies, have been permitted to claim credits for certain payments to foreign governments, even in countries that generally impose low or no business tax (suggesting that these payments, or levies, are in fact a form of royalty).[5] Dual capacity taxpayer rules, therefore, are a subsidy for foreign production by U.S. oil companies. President Obama and others have proposed limiting the tax credit for these companies to what it would be if they did not have the special “dual capacity taxpayer” status.

Amortization of geological and geophysical expenditures ($1.4 billion over 10 years)

Another way many oil producers get to postpone their tax liability is by writing off the costs of searching for oil over an accelerated time period of two years. The president has proposed that all oil companies write off these costs over seven years, a relatively minor tax change that would have a negligible impact on investment decisions. According to the Congressional Research Service: “If the industry were experiencing a time of stagnant oil prices that were near the cost of production, relatively small changes in tax expenses might affect investment and production activities. However, in a time of high and volatile oil prices, small changes in tax expense are overshadowed by price variations.”[6]

“Last-in, first-out” accounting for oil companies (as much as $22.5 billion over 10 years)[7]

A tax accounting method known as “last in, first out,” or LIFO, provides a significant tax benefit for oil companies, especially when prices are rising. LIFO allows oil companies to calculate profits based on the cost of the oil they most recently added to their inventory. Since the most recently acquired inventory costs the most when prices are rising, this method can minimize a company’s taxable income. LIFO is available to businesses in other industries but large oil companies are perhaps the biggest beneficiaries.[8]

Taken together, these oil and gas tax subsidies represent a colossal waste of taxpayer resources since they pay companies, in the form of tax breaks, to do what they do anyway—especially at a time of price-fueled record profits.

American consumers have for years been waiting for the benefits of these tax subsidies to trickle down to them in the form of lower gas prices. It hasn’t happened. In fact, these subsidies existed during the 2008 oil shock when prices hit a record $147 per barrel, yet did nothing to lower oil prices or increase production. And repealing them won’t increase prices at the pump. “Gasoline prices are a function of world oil prices and refining margins,” explains Severin Borenstein, co-director of UC-Berkeley’s Center for the Study of Energy Markets. Any incremental impact on production “will have no impact on world oil prices, and therefore no impact on gasoline prices.”

Oil tax subsidies are simply a waste of taxpayer dollars. Oil and gas companies, like all companies, make investment decisions based on the profit potential. Those decisions are driven primarily by market conditions, including the price of oil on world markets, not marginal tax incentives.

“With $55 oil we don’t need incentives to the oil and gas companies to explore,” said President George W. Bush in 2005. “There are plenty of incentives.”

Oil prices today are double what they were then. It’s time to stop giving away tax dollars to some of the world’s most profitable companies.

Seth Hanlon is Director of Fiscal Reform for CAP’s Doing What Works project.

Endnotes

[1]. There are also several other special tax provisions with a smaller cost to taxpayers (or no estimated cost due to current circumstances). These include the enhanced oil recovery credit, the credit for oil and gas produced from marginal wells, the deduction for tertiary injectants, and the exception from the passive loss rules for working interests in oil and natural gas properties.

[2]. Alan B. Krueger, Testimony before the Senate Committee on Finance Subcommittee on Energy, Natural Resources, and Infrastructure, September 10, 2009.

[3]. All revenue estimates are, unless otherwise noted, from: General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals (Department of the Treasury, 2011).

[4]. Chuck O’Toole, “‘Gang of 10’ Energy Compromise Would Strip Oil and Gas Deduction,” Tax Notes, August 4, 2008).

[5]. Joint Committee on Taxation, Description of Revenue Provisions Contained in the President’s Fiscal Year 2011 Budget Proposal (Government Printing Office, 2010), p. 318.

[6]. Robert Pirog, “Oil and Natural Gas Industry Tax Issues in the FY2012 Budget Proposal” (Washington: Congressional Research Service, 2011).

[7]. This is the industry estimate of the effect on oil companies of President Obama’s proposal to eliminate LIFO as a whole. See: American Petroleum Institute, “Significant Industry Tax Issues Contained in President Obama’s FY 2012 Budget” (2011), available at http://www.api.org/policy/tax/upload/FY2012_Budget-Short_Tax_Issues_Paper.pdf.

[8]. In 2005 the use of LIFO inflated the cost of goods for the five biggest oil companies by a combined $12 billion, thereby reducing their taxable income. See: David Reilly, “Big Oil’s Accounting Methods Fuel Criticism,” The Wall Street Journal, August 8, 2006.