Taxing an Infant Industry to Death

Member Group : Commonwealth Foundation

Home to the first oil well in the United States, Pennsylvania has returned to the drilling scene in recent years, looking to tap into an estimated 50 trillion cubic feet of recoverable natural gas in the Marcellus Shale formation.

The sudden growth in the number of exploratory wells in the northern and western regions of the state has not gone unnoticed by Gov. Rendell and Rep. Bill DeWeese. But instead of seeing this as an opportunity to bring jobs and resources into Pennsylvania, they see a source of tax revenue to fill a massive state budget deficit caused by years of wasteful overspending. They have proposed: 1) applying a severance tax on extracted natural gas; and 2) making the value of unrecovered gas subject to property taxation.

The substantive natural gas find adds to Pennsylvania’s recoverable natural resource deposits, which include the fourth largest coal reserves in the country. There has never been an attempt to place a severance tax on coal, because doing so would severely undermine the industry. Instead, the new tax proposal discriminately applies to natural gas, a cleaner-burning fuel source, before the industry has even had a chance to develop.

The Marcellus Shale formation is thick and difficult to drill. These relatively low-yielding wells have only recently become viable due to new drilling technology and higher market prices. Pennsylvania’s natural gas reserves, while large and close to destination markets, only remain attractive investments if costs are carefully controlled and expenses minimized. Yet Rendell’s proposal would only make it more costly.

Complicating the matter is the fact that the market price of natural gas has plummeted to one-third of its 2008 peak. This development removes one of the major factors that brought investors and drilling companies to Pennsylvania in the first place. Now, Rendell has proposed a severance tax of five percent of market value plus $.047 per thousand cubic feet. This amounts to approximately a 33 percent income tax on each well’s average cash flow—removing any incentive to continue operations in Pennsylvania.

Gov. Rendell defends the proposal by claiming he modeled it after West Virginia’s tax. However, West Virginia’s severance tax drove many would-be investors to Pennsylvania. If a similar tax is applied in Pennsylvania, drilling companies will take their money to New York, which has no severance tax and imposes a lower corporate income tax. One company, Seneca Resources Corporation, has already left PA due to higher-than-expected costs.

Consider instead Oklahoma and Texas, two of the largest producers of natural gas in the country. The severance taxes in both states (7 percent and 7.5 percent, respectively) are higher than West Virginia’s rate, but they are models for the development of Pennsylvania’s system.

Oklahoma exempts all enhanced recovery projects and horizontally drilled wells (the type necessary for drilling in Marcellus Shale) until payback, the length of time required to recover the cost of the investment. Texas reduces the tax on all natural gas extraction in the Barnett Shale formation, the region to which the Marcellus Shale is most commonly compared, for the first 10 years. Both Oklahoma and Texas pair these exemptions with significantly lower corporate income tax rates.

A moratorium on any sort of severance tax until the industry becomes profitable, like Oklahoma and Texas implemented, would allow natural gas drilling to emerge—bringing jobs and economic development to Pennsylvania. However, this doesn’t meet the priorities of Gov. Rendell. He wants more money to spend, and he wants it now.

Governor Rendell expects to collect $107 million in the upcoming fiscal year from the proposed severance tax, and $632 million by 2013-14. However, his scheme will never materialize, because increased taxes will deter new investment and cause developers to move production to more tax-friendly states. Since much of the recoverable natural gas reserves are located under public lands, Pennsylvania could earn more revenue from lease payments and royalties than Rendell’s severance tax.

Pennsylvania can’t afford a job-killing tax that would destroy the state’s fledgling gas industry.

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Christopher Dodds is a Research Intern with the Commonwealth Foundation (www.CommonwealthFoundation.org), a public policy education and research institute located in Harrisburg.

Permission to reprint is hereby granted provided the author and affiliation are cited.

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