Fossil Fuel Subsidies: Should they Stay or Should they Go?

Fossil fuel tax breaks cost the U.S. $4 billion per year. A former Treasury Department Environment and Energy official looks at whether that’s money well spent.

The U.S. fossil fuel industry benefits from $4 billion a year in government subsidies, most in the form of tax breaks. But over the past decade debate over the need for subsidies has intensified.

The energy industry argues that these subsidies promote the development of domestic energy and support oil and gas jobs. Opponents say there is little justification for subsidizing fossil fuels when government’s focus should be on clean energy and climate. And politicians from both sides of the aisle argue that the government could better use the money spent on subsidies elsewhere.

Guest Gilbert Metcalf, Professor of Economics at Tufts University and a Research Associate at the National Bureau of Economic Research, takes a look at the real impact of subsidies on the economics of energy development, renewables and on the environment.

Andy Stone: Hello and welcome to the Energy Policy Now Podcast from the Kleinman Center for Energy Policy at the University of Pennsylvania. I’m Andy Stone. The fossil fuel industry in the U.S. benefits from $4 billion a year in government subsidies most in the form of tax breaks. The industry argues that these subsidies are needed to promote the development of domestic energy and to support oil and gas jobs.

However, over the past decade, opposition to subsidies has intensified. Opponents say there’s little justification for subsidizing fossil energy when government’s focus should be on clean energy and climate. And politicians from both sides of the aisle argued that the government could simply better use the money spent on subsidies elsewhere. Here to discuss the latest in the decades old debate around energy subsidies and to explain their true impact is today’s guest, Gilbert Metcalf. Gilbert, welcome to the podcast.

Gilbert Metcalf: Thank you, Andy. It’s a pleasure to be here.

Stone: Gilbert is a Professor of Economics at Tufts University and a Research Associate at the National Bureau of Economic Research. He is a visiting scholar at Harvard’s Kennedy School of Government and at the Kleinman Center for Energy Policy. He formerly served as a Deputy Assistant Secretary for Environment and Energy at the U.S. Department of Treasury.

His research focus is applied public finance with particular interests in taxation, energy, and environmental economics. So Gilbert, just to get started, oil and gas subsidies are frequently discussed, and more frequently these days, but just how much do they actually cost government, how much should we be concerned about them?

Metcalf: So there are dozens and dozens of subsidies in the tax code for oil and gas, but there are three big ones that together count for about $4 billion a year in lost federal revenue. And that’s the expensing of intangible drilling cost, percentage depletion, and the domestic manufacturing deduction that oil and gas production gets. Those are the big three, about $4 billion a year.

Stone: Now these go back a century in some case. What’s a bit of the history? Why were they implemented? What was their purpose?

Metcalf: So two of them go back, the big ones, intangible drilling costs and percentage depletion go back really to the beginning of the federal tax code back in the early part of the 20th century. And part of the reason for putting them in the tax code was to help the then infant industry if you will, oil and gas industry, get established in the United States. Automobiles were beginning to be produced, a mass production. And the view was we really needed to support this industry.

So they go back a long way. The domestic manufacturing deduction is a more recent innovation in the tax code and that was put in place to support all kinds of demands, domestic manufacturing, not just oil and gas. And it was put in place in a federal law called the American Jobs Act. And that pretty much tells you why this provision was put into the tax code.

Stone: So you said that these are three basic different forms of essentially tax incentives that we’re talking about. Is that right?

Metcalf: That’s right. And they’re incentives, why we call them subsidies is because they’re particular to these industries, not everyone gets to take advantage of them. And so because it is a departure from what tax economists like to refer to as a sort of a normalized or standard tax code, when you get these kinds of preferential treatment that not everyone gets to take advantage of, then that’s when we’d start talking about subsidies or tax loopholes.

Stone: So $4 billion a year, these had been around for quite some time. There has been talk over time and kind of ebbing and flowing about eliminating these. But why is this discussion intensified now? What is the view, I guess, at the federal level surrounding these subsidies?

Metcalf: So let me give you slightly longer answer to the question. It goes back to the beginning of the Obama Administration. There was a meeting of the G20, the G20 of the finance ministers and leaders of the biggest countries in the world, developed countries in the world. And the G20, develop and developing China’s part of this, the G20 agreed that we should eliminate fossil fuel subsidies as part of a global strategy to address greenhouse gas emissions. So that’s the beginning of the modern efforts to get rid of these tax preferences.

Now even more recently, you see House Speaker Paul Ryan’s tax plan, a better plan or a better way to improve the tax system to bring down tax rates, particularly to bring the corporate income tax rate down to 20% from its current level in the mid-thirties. How do you do that? Well, you have to do that by getting rid of a lot of loopholes in the tax code. We need to broaden the base of the tax code in order to bring down rates without hemorrhaging revenue in the federal tax system. So one of the proposals as part of the Republican tax plan is to get rid of a lot of loopholes, a lot of tax preferences, including these for oil and gas.

Stone: To what extent have the subsidies been critical to the oil and gas industry and how have they influenced our use of fossil fuels?

Metcalf: Well, if you go back to the beginning of the tax code, they clearly were very helpful to the establishment of the oil and gas industry. Today, when I talked to oil and gas executives, and I spent a lot of time down in Houston talking to executives as I was doing the research for this project, you hear a lot about the value of the expensing of intangible drilling costs. It’s a big moneymaker for them. It really helps them with their cash flow and it was even more valuable and important to them in an era where oil and gas drillers, the exploration and production companies, the E&Ps, they could not go to the market and borrow money for these projects. They had to finance it internally through cashflow.

Now that’s changed a little bit. One of the remarkable developments in the shale oil and gas revolution, the fracking revolution, has been that debt markets have opened up to lend money to oil and gas production, particularly with subprime lending. And it’s an innovation that has made cashflow a little bit less important than it was in the old days when you really needed it in order to finance your next project.

Stone: So financing is more widely available to the industry than it was in the past. Yet these subsidies continue. If the subsidies were to be taken away tomorrow, what would the impact be in terms of exploration and development anywhere along actually the oil value chain?

Metcalf: And that was precisely the question I wanted to answer doing this study because if you look at the industry studies, they, the American Petroleum Institute commissioned to study and it was a doom and gloom kind of scenario. If we’re going to lose 20 to 30% of domestic production according to their estimates. It was a kind of a cataclysmic kind of view. But the problem was those studies didn’t really explain how they did their analysis. So you couldn’t really kick the tires on the analysis.

So I really wanted to do an analysis. It was transparent that the industry could understand that would get at this question. And what I found was if you get rid of these big three deductions, we’d get a reduction in drilling on the order of about 8 to 10% reduced drilling activity in the United States. In the long run over time, over a period of about 8 to 10 years, we would get a reduction in oil, domestic oil and gas production on the order of 5%.

It’s not the end of the industry by far, by any means if we were to get rid of these. What would be the impact on jobs? Again, it would be a pretty modest impact on the order of 4 to 5% reduction in jobs in the drilling industry, less of an impact in refining or in the transportation sector, biggest impact would be in drilling.

Stone: So it’s interesting so you’re saying there’s not going to be that big of an impact if these were taken away from the industry. Obviously, from the government’s perspective, this is money that could potentially be spent on other purposes. Why do these the subsidies persist?

Metcalf: Well, I think a couple of reasons. One is that policy makers have not had a good appreciation for what the impacts would be of eliminating these subsidies. They had the industry studies that suggest that it would be quite bad for domestic production. We’d lose a lot of jobs. You always hear the notion of energy security and energy independence being invoked. That flag is waived quite madly when these kinds of policy changes are being discussed.

And that’s one of the reasons I did this analysis is to try to bring a little bit more of a dispassionate or interest free point of view, if you will, to, I  don’t have a stake in this game. I’m an academic. I’m curious and getting to the truth and understanding what’s going on. I don’t work for industry. So I think having better analysis will help policymakers.

The second barrier, if you will, is that $4 billion is helpful for the federal budget, but it’s not going to go as we spread it around amongst different programs. The benefits of reducing this are kind of diffuse, and it may be it’s 25 cents in my pocket and 25 cents in your pocket, but the $4 billion hit to industry is very real to the oil and gas industry. So they’re going to fight very hard to keep these tax preferences and they’re going to continue to put out studies that are saying you know, predicting doom and gloom. And so it’s always hard to overcome the kind of inertia of policies in place that that disproportionally benefited a few where the impact being sort of spread around amongst millions of people.

And that’s where I think the current situation lends some hope that we can actually reform these policies. There’s a great interest in tax reform. Trump wants to reduce tax rates, he wants to finance lots of infrastructure spending and he doesn’t have a plan for how to pay for that yet. So $4 billion can go, can help a lot in that regard. So I think we’re going to have to look at these deductions as well as a number of other deductions if we’re going to actually do some of these spending initiatives at the federal level without breaking the bank of the federal deficit.

Stone: So what is the actual impact on consumers of these subsidies? What’s the bill that consumers are paying?

Metcalf: So that’s a great question and that’s a really an important question because one of the things you hear from industry is that we’re going to drive up the price of gasoline at the pump if we get rid of these subsidies. Well, the reality is that if you get rid of these subsidies, it drives up the price of a barrel of oil by about 40 to 50 cents a barrel. That’s just noise. We’re talking, we were talking an increase in the price of gasoline and maybe 2 cents.

Stone: Markets sway much more than that.

Metcalf: Market’s sway way more than that, just with a spade of bad weather. So the impact on consumers is really quite trivial.

Stone: If we look at the subsidies, you know, do they preferentially treat oil and gas versus particularly, for example, in the electric electricity generation sector? Do they give an advantage to natural gas in those markets and distort markets?

Metcalf: So they do. And oil and gas, natural gas is the relevant ones since very little oil is used in electricity production. But natural gas certainly it’s a big, it’s very big for electricity. But the calculations I do suggest that we’re looking at a price impact on the order of about 8% for natural gas. In other words, if we get rid of these subsidies, we would see that the price of natural gas would go up by about 8%. So it would, it’s creating a bit of a distortion between say wind and solar on the one hand and natural gas on the other. But it’s probably not a not a major distortion.

Stone: Your research indicates that there’s little impact of subsidies on climate, can you talk about that?

Metcalf: So I want to distinguish between the direct and indirect impacts. So the direct impacts are definitely very small. First off, we would see a very modest reduction in domestic oil production. Let’s just focus on oil for a moment. A similar story for natural gas, 4% reduction. So we get a pretty modest decline in oil related emissions. But keep in mind that about half of that is going to be made up, the lost domestic production gets, leads to an increase in some foreign production. So the overall reduction in oil consumption is smaller, about half of the domestic cuts.

So there is some decrease in U.S. emissions and a slight increase in foreign emissions. So it’s a very, very modest impact on emissions. Now that’s the direct impact. I think the indirect impact is significant. And here’s what I have in mind. The U.S. is the second largest emitter of greenhouse gases after China. And we, along with China, are leading players in the international climate negotiations to reduce greenhouse gas emissions internationally. If the U.S. were to eliminate these subsidies for domestic oil and gas production, it would have a huge impact politically in the climate negotiations and on other countries that have much, much larger or oil and gas subsidies, Indonesia, Brazil, countries in Africa.

If the U.S. were to move to reduce these subsidies it would undercut one of the arguments in those countries not to take action because they say, well, the U.S. isn’t doing it, why should we do it? So I think politically it’s a huge deal and that’s even truer now in the Trump administration because Trump has clearly walked back from the Clean Power Plan. It’s clear that the, if the Trump administration stays in the Paris Agreement, they are going to play a backseat role, at best. China, seeding leadership to China and the European Union. But if as part of tax reform, these subsidies were eliminated, it would help to rebuild a bit of credibility for the United States in these international negotiations. So that we are not entirely marginalized going forward.

Stone: What’s the handicap on those subsidies being eliminated?

Metcalf: You know, the handicap is, I’m not a betting man, so I never quite know how to phrase those, but I would not bet a lot of money on these things getting eliminated, put it that way. But I will say this, while the odds on there being eliminated may not have gone up after the election, the uncertainty has gone up considerably. We just don’t know what Trump is going to do in terms of the various promises he made during the election.

He wants to build a wall, he wants to build infrastructure, he wants to cut taxes. He doesn’t want to blow up the deficit. Well, you can’t square those things unless you come up with some revenues somewhere. Now, let me go way off in left field and say he could get $100 billion a year with a carbon tax. And if we went down that route, you would see a lot of pressure to get rid of any kinds of subsidies for clean energy. And while we’re at it, we could get rid of the subsidies for fossil fuels as well as part of a grand bargain.

Stone: In talking about clean energy development for just a moment, has, from your research, the subsidies that have gone to the fossil fuel industry, have those negatively impacted the development or the market for clean energy technologies?

Metcalf: I think it has had, at best, a marginal impact. I think the fracking revolution has had a much bigger impact because with hydraulic fracking and the advances in horizontal drilling and seismic imaging, meaning we are getting a lot of natural gas now that we weren’t getting before natural gas. The low price of natural gas is really sort of cutting wind and solar off at the knee in terms of their contribution for electricity generation. It’s tough. It’s tough to do wind and solar with the current price of natural gas. And if we got rid of the subsidies for the production and investment tax credits for wind and solar, it would just freeze up those industries entirely, I think.

Stone: So what’s your final word on these subsidies? Should they remain, should they go?

Metcalf: Well, the subsidies for fossil fuels should definitely go. They played no constructive role in the tax code. It’s just free money for the oil and gas industry. It’s money we could spend elsewhere to greater effect. And it would increase our standing in the world as we’re trying to persuade other countries to take better positions in terms of their tax codes and getting rid of subsidies. It’s just no reason to keep them any longer.

Stone: We’ve been talking with Gilbert Metcalf, Professor of Economics at Tufts University and Visiting Scholar at the Kleinman Center. Gilbert, thanks for talking.

Metcalf: Thank you. It’s been a pleasure.

Stone: And thanks to our listeners for tuning in to this episode of the Energy Policy Now Podcast. You can get the latest energy and environment updates from our Twitter feed @kleinmanenergy. Keep up to date on the latest news, research and events from the Kleinman Center by visiting our website, www.kleinmanenergy.upenn.edu. Have a great day.


Gilbert Metcalf

Professor of Economics, Tufts University
Gilbert Metcalf is a professor of economics at Tufts University and was a 2016-2017 visiting scholar at the Kleinman Center.

Andy Stone

Energy Policy Now Host and Producer
Andy Stone is producer and host of Energy Policy Now, the Kleinman Center’s podcast series. He previously worked in business planning with PJM Interconnection and was a senior energy reporter at Forbes Magazine.