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Excerpt on effect of reserves tax on timing of production
by Mason Gaffney, Consultant, June, 1981
The proposed rate at 2.5% is not high enough to have major disincentive effects in any case, but to the extent that it might, these are thought to be two: it might unduly accelerate extraction; and it might discourage and reduce exploration effort. Let us consider these in order.
1. Accelerating production
a. Earlier experiences in the lower 48 with hyperaccelerated production were in non?unitized fields. Alaska fields are unitized. The ""Signal Hill Effect"" is a bogey under Alaska conditions.
b. Production rates already are controlled by noneconomic factors, viz. the state controls over production, based on the concept of M.E.R.
c. Production rates are capped by pipeline capacity.
d. To the extent that economic factors affect production rates, there are narrow limits on how much a reserves tax will accelerate production. This is the result of several factors. First, a reserves tax is "capitalized", that is, it lowers the value of its own base, so that doubling the rate will not nearly double the tax, because the base falls by, say, 25% (depending on particulars). The tax is the product of the rate times the base, and in the above case will now increase by only 50%. This of course abates the effect on the taxpayer. (I trust that the Dept. ot Revenue has accounted for this effect in its revenue projections. I have not seen any evidence on this.) Next, the valuation of a reservoir rises as the production plan calls for faster production. This increases the tax, and so puts a limit on the producers' gains from speeding extraction plans. There are at least three possible scenarios.
i. Speeding production calls for more wells, closer spaced. If the added wells are in the tax base (or some municipal jurisdictions' tax base) this raises the valuation and the tax, limiting the gains from acceleration.
ii. If the added wells are not in the tax base, at least they are not deducted from it as costs (as they are under a corporate income tax), and the tax base still increases because of the faster production plan.
iii. Only if the added wells are deducted from the base could faster production fail to raise the tax base.
Notice is taken of Appendix I (Eye) of my 1976 report on oil and gas leasing policy. This Appendix shows how an Ad Valorem Charge, which operates like a reserves tax, has only the most limited effect on production rates. I suggest that more time should be spent expanding and developing the analysis in Appendix I, as Alaska moves toward heavier reliance on reserves taxation.
e. A faster rate of production would call for added capacity in transportation, stock tanks, and company infrastructure of all kinds, all along the line, all adding to the tax base. If there is any net effect of a reserves tax to increase production rates, therefore, this would not necessarily be undesirable fiscally. It is doubtful if there is much such tendency; but on the other hand, a reserves tax is not a drag on production, like a severance tax, which adds to the reserve tax’s desirability compared to other taxes.
f. The weight of other taxes and charges are on a unit of production basis. In this context, any tendency of a reserves tax to speed production would simply compensate in part for the opposite bias, which is paramount. These other taxes and charges include the severance tax, the state's largest?yielding tax on oil; royalty payments off the top; the Federal excise, or Windfall Profits Tax (WPT); the Federal income tax (less capital recovery allowed on a unit?of?production basis); and pipeline tariffs in excess of marginal costs, which may be viewed as a kind of tax.
2. Effect of reserves tax on exploration incentives
a. Comparison with other taxes. Any tax of any kind levied after discovery will in some way discourage discovery but in general this is no special argument against a reserves tax, as compared with other kinds of taxes.
b. Bidders for leases will presumably bid somewhat lower bonuses, in anticipation of future taxes, just as they would react to a higher royalty or other deferred charge in the lease. Thus, taxation is a means not of increasing levies by the state on the industry, but of stretching out the payments over more time. I see little reason why firms would react by exploring less. Rather, they would simply bid a little lower for leases.
c. A reserves tax at 2.5% does not lower the present value of cash flows from producing wells by nearly as high a factor as a 2.5% property tax affects other kinds of land. This is because the cash flow of wells is bunched near the present. For example, at an interest rate of 15%, the present value of $100 due after 5 years is $49.72. But after a 2.5% reserves tax, it drops to $44.65, a drop of about 10%. If we take about 5 years as the weighted average life of wells (the year in which half the reserves are recovered) then 10% is a fair estimate of the drop in present value caused by the 2.5% tax. It is not an overwhelming matter.
d. In its present form, the tax does discourage post-leasing exploration because it is limited to leases on which there is commercial production.
C. Reliability of revenues
1. Stable volume of base. A reserves tax is inherently much more stable than any unit?of?production tax, because the latter are turned on and off at the convenience of the producers. While this has not yet been a major problem in Alaska, it always could become one.
2. Tendency of revenues to lead output. Even though the tax is limited to leases "having commercial production”, there is a need on an active lease to step out and prove reserves some time in advance of production. Sec. 43.58.151(9) of SSHB#200 defines taxable property as "a property having commercial production”. That seems to mean that production on any part of a leasehold, calls for assessment of reserves on the entire leasehold. Thus, in spite of the exemption of nonproducing leaseholds, there will be a substantial cushion of reserves being assessed in advance of their specific production. This will lend more stability to revenues, as well as advance their timing. It will of course call for aggressive action by state assessors to assert their investigative right created by statute.
3. Stability of unit values. The tax base depends on the unit value of reserves as predicted over a long period. This is substantially independent of short?run fluctuations in spot prices. On the other hand, reserve values are sensitive to interest rates,and could be undercut by a sharp rise of long term rates, under the present approach. I will suggest that a proper approach would legislate a constant ratio of tax rate to discount rate, thus overcoming this problem.
4. A reserves tax sustains revenues over a longer period than other taxes, by virtue of beginning earlier (cf. point #2, just above.) As to sustaining revenues when production declines,there is no tax that accomplishes that. Only the state, by wise investment of its permanent fund, can accomplish that goal. Note, however, that taxation, to the extent that it may damp down early exploration, does work in the direction of causing the oilrevenues of the whole state to be found and extracted over a longer period.
D. Thoroughness of extracting the economic surplus.
a. The source of the economic surplus is the rent of the state's oil deposits. A reserves tax focuses on this surplus more directly than most other taxes do.
b. On the other hand, a reserves tax does not take a large share of the surplus when production is concentrated up front. Thus, for $100 which is to be realized at the end of one year, the present value (given the statutory 19% interest rate and 2.5% tax rate) is $82.30. The tax on this value is $2.06, which is due at the same time as the $100 is received (i.e. one year after the assessment date.) I hope this makes it clear why a reserves tax, to be effective, must begin before production. That is, the reserves must be taxed for some years as they lie in the ground, else the state's share is minimal.
http://www.earthrights.net/docs/timingproduction.html