With the start of the new fiscal year tomorrow (July 1), many new laws are set to take effect. Perhaps the most consequential new law is one passed last session, HB 2562, which extended and made permanent tax breaks for the state’s oil and gas producers.
Under current law, the standard tax on gross production is 7 percent. However, over the years the Legislature has enacted a series of exemptions that lower the tax rate for various forms of production, including enhanced recovery projects, inactive wells, new discovery wells, and 3-dimensional seismic shoots. The most significant of these exemptions is for horizontally-drilled wells, which are taxed at just 1 percent for the first 48 months of production. As the lion’s share of new oil and gas drilling in Oklahoma has shifted from vertical to horizontal production over the past decade, the cost of the horizontal tax break has ballooned to $282 million in FY 2014 from just $2 million in FY 2004. The cost in FY 2015 was projected at $379 million by the Tax Commission in December.
With the tax break for horizontal drilling scheduled to sunset in 2015, the 2014 legislative session was marked by an epic battle between those who argued that the tax break had become unnecessary and unaffordable, and those who claimed that it remained necessary as an incentive to production. Where the two sides found some common ground was in agreeing that maintaining a differential rate between horizontal and vertical production no longer made sense.
Under HB 2562, virtually all new wells, both horizontal and vertical, drilled on or after July 1st will be taxed at 2 percent for the first 36 months of production and then at 7 percent thereafter (there will still be different treatment for a limited number of wells defined as enhanced recovery projects, production enhancement projects, inactive wells, and economically at-risk oil or gas leases). The bill did away with the sunset clauses previously attached to lower tax rates. Click here for a PDF table that summarizes the rates on various kinds of production before and after HB 2562 takes effect.
Since HB 2562 applies only to new production, horizontal wells drilled prior to July 1st will still be taxed at 1 percent for the full 48 months. Deep wells drilled prior to July 1st will continue to be taxed at 4 percent for 48 months, while most other wells drilled prior to July 1st will be taxed at 7 percent throughout [this sentence has been updated for clarity].
For wells taxed at 2 percent, half the revenue (1 percent) will be split between counties and school districts, the same as when wells were taxed at 1 percent. The other half will be apportioned to the General Revenue Fund.
When HB 2562 was under consideration, the Tax Commission was unable to determine how the proposed changes would affect state revenue collections. The House fiscal note for HB 2562 simply stated:
The fiscal impact of replacing the existing gross production taxing system in future years is difficult due to the constant price fluctuations upon which the tax is based and other variables.
The new law was officially determined to be “revenue neutral” for FY 2016.
In December, the Tax Commission provided estimates of gross production tax revenues for FY 2016, the first year that the new tax rates will apply for new production. Based on their price and production forecasts at the time, we calculated the total cost of the lower tax rates – which includes 1 percent and 4 percent tax rates for prior production, as well as the 2 percent rate on new production – to be $308 million in FY 2016. Since new horizontal, deep well, and traditional production are no longer differentiated, there is no way to calculate how this amount compares to what the tax breaks would have been under the law prior to HB 2562.
As Oklahoma struggles with a structural budget deficit that has led to funding shortfalls even when the state’s economy is benefiting from high energy prices, the Legislature’s failure last year to rein in tax breaks for oil and gas production will be remembered as a great and enduring lost opportunity.