Tax breaks for horizontal drilling and other forms of oil and gas production are projected to cost the state over $300 million this fiscal year and next, according to new calculations by Oklahoma Policy Institute. This does not include the $118 million annual cost of paying out deferred credits over the next two years.
The cost of oil and gas tax breaks is calculated from revenue estimates prepared in December by the Oklahoma Tax Commission (OTC) that became part of the State Board of Equalization’s December certification. The OTC provided estimates and forecasts of oil and gas revenues for FY 2014 and FY 2015 that allowed the cost of tax breaks for horizontal and deep well production to be calculated.
As displayed below, the tax break for horizontal drilling, which is taxed at 1 percent for the first 48 months of production rather than at the 7 percent rate for traditional production, is estimated at $251 million in FY 2014 and $237 million in FY 2015. The remaining breaks are for deep well production, which is taxed at 4 percent, and for other forms of production – 3-D seismic shoots, at-risk wells, inactive wells, enhanced recovery projects, and new discovery wells – on which producers can claim rebates for tax paid. The FY 2015 estimates may be understated as they appear to suppose that the share of total production from horizontal drilling will remain flat between 2014 and 2015; if, as is likely, horizontal wells account for a greater share of production in 2015, the revenue loss may be substantially higher.
In addition to the tax breaks provided for current production, the state will continue to pay back tax rebates to the oil and gas industry through FY 2015 that were accrued based on a deal struck in 2010 during the last budget downturn. The state deferred payment of tax rebates for horizontal and deep well drilling accrued in FY 2011 and FY 2012; in return, the state agreed to tax horizontal production at 1 percent on the front end, rather than have producers pay the full 7 percent rate and then later claim rebates. Initially expected to amount to $150 million, the deferred credits were later calculated at $294 million. It now looks as if the final tally will be some $333 million in rebates paid out between FY 2013 – 2015.
The Tax Commission’s latest projections reveal that the cost of gross production tax breaks are escalating rapidly, as some have been predicting now that horizontal drilling accounts for some 90 percent of new drilling and a majority of total production in Oklahoma. Taxing horizontal production at 1 percent cost the state less than $40 million before 2009. This rose to $84 million in FY 2010, $108 million in FY 2011, $98.5 million in FY 2012 and $148 million in FY 2013. Without legislative action to address this situation, the annual revenue impact from taxing horizontal drilling at 1 percent is soon likely to reach $400 million. The cost of tax breaks for other forms of production, especially 3-D seismic shoots, has also been rising, and now exceeds $50 million annually.
As State Finance Director Preston Doerflinger candidly acknowledged this past July, there is a clear and direct relation between the growing magnitude of oil and gas tax breaks and sluggish state revenue collections. In FY 2013, when the state paid out $321 million in current and deferred tax breaks, General Revenue collections barely made the certified estimate. In FY 2014 and FY 2015, the state would have over $1 billion in gross production tax revenues for appropriations if all production were taxed at 7 percent; instead, there will be just over $600 million in FY 2014 and $575 million in FY 2015.
Another way of considering the magnitude of the tax breaks for oil and gas production is by comparison to other categories of state spending. The $307 million in tax breaks being provided for oil and gas production in the form of lower tax rates and rebates in FY 2014 is more than the appropriations of all but six state agencies (common education, higher education, Health Care Authority, DHS, Corrections and Mental Health). The state is spending more to subsidize horizontal drilling alone in FY 2014 – $252 million – than the combined state funding for the Agriculture Department, Commerce Department, Corporation Commission, Health Department, Tax Commission, Arts Council, Veterans Affairs, OETA, Military Department and State Bureau of Investigations.
These state tax incentives are unnecessary because they do not significantly influence the decision to drill or the profitability of drilling, and companies are unlikely to shift production elsewhere based on tax breaks. As the recent report from Headwaters Economics showed, if Oklahoma were to tax all production at 7 percent, its effective production tax rate on oil would rank sixth lowest among seven peer producing states and third (along with Texas) among seven natural-gas producing states.
With the state facing real and urgent budget problems, now is truly the time to reconsider the tax breaks provided for horizontal drilling and other forms of production. It is encouraging that several state leaders, including Treasurer Ken Miller and Finance Secretary Preston Doerflinger have acknowledged the need for change. However, with House Speaker T.W. Shannon stating his opposition to allowing the tax break for horizontal drilling to expire, it is clear a tough battle lies ahead.