Hazards of tax reform

Jan. 9, 2017
Tax reform, newly in fashion in the US, presents a dilemma to the oil and gas business. It's both desirable and treacherous.

Tax reform, newly in fashion in the US, presents a dilemma to the oil and gas business. It's both desirable and treacherous.

It's desirable because the current system is hopelessly complex, distorted by political mischief, and globally noncompetitive. It's treacherous because reform implemented recklessly would do more harm than good.

A crossfire

Any political fight over tax reform now will catch the oil and gas industry in a crossfire. The outgoing administration treated taxation as one among many tools with which to discourage the production and use of fossil energy. Each of its annual budget proposals identified tax mechanisms favorable to the oil and gas industry as subsidies needing to be repealed. The categorical attack failed. But it will reappear in opposition to initiatives from an administration more hospitable to oil and gas. Industry representatives must remain prepared to challenge misstatements typical of their antagonists, such as that the manufacturer's deduction represents a tax break exclusive to oil and gas and that expensing of intangible drilling costs (IDCs) is a give-away to producers.

President-elect Donald Trump has concerns more pressing than the economics of percentage depletion and the difference between timing options and preferential tax credits. But he seems unlikely to sustain his predecessor's campaign against anything in the Internal Revenue Code that benefits oil and gas. The industry should worry, however, about the protectionism that colored Trump's campaign and motivates his postelection strong-arming of manufacturers planning to build plants outside the US.

How willing is Trump to use tax law to keep US investment in the US? And how might this predisposition affect his approach to the foreign tax credit? For that mechanism, which avoids double taxation of income, the Obama administration sought rule changes that would discourage overseas investments by US producers. Under discussion now is a shift from worldwide to territorial taxation, which would conform the US with the rest of the developed world and ease the double-taxation problem. Also under discussion, however, is a protectionist border tax adjustment that, without exemptions, would hurt refiners needing foreign crude.

Tax policy is never perfect. Improving it is a worthy goal. But the pursuit of reform is hazardous. By following a few principles, Trump and his advisors can avoid most of the problems inevitable when peculiarities of oil and gas confound a subject already very complex.

They should, for example, recognize that starting over is not an option. Business today reflects investment decisions made under yesterday's tax regime. While that regime has flaws, it's part of the economic foundation. It needs repair, not replacement.

Among its many evolutions, moreover, US tax policy has come to accommodate physical and financial realities unique to extractive businesses and, in cases, oil and gas specifically. Current-year expensing of IDCs, for example, accelerates capital recovery for a risky, capital-intensive activity in which most investment is for supplies and services spent during construction of assets with almost no salvage value. It doesn't lower tax liability over time.

Decisions to invest in upstream work overseas, moreover, reflect not efforts to exploit advantages of labor cost but rather the sometimes inconvenient locations of hydrocarbon prospects. Similarly, companies built refineries on US coasts for access to seaborne supplies of crude oil. They should not now be punished for those decisions. The US still imports crude.

Founding principles

Beyond those practicalities, Trump's team should remember founding principles of government in the US and what they imply about taxation. The government exists primarily to defend liberty, including economic choice. A derivative role with regard to business is to ensure fair access to opportunities and to promote competition. Properly oriented, government views taxation as a task unfortunately necessary to fund its essential-and essentially limited-foundational activities. In the performance of that task it should be fair and, to the extent possible, limit economic damage.

If the government had followed those principles over the past century or so, tax reform wouldn't now be necessary.