Meet “Dirty Dozen” Tax Break #2: The “Percentage Depletion” Deduction

Blog Post by: Benjamin Landy , on December 10, 2012

In 2002, The Century Foundation convened the Working Group on Tax Expenditures to examine and propose reforms to the tax code. The resulting report, Bad Breaks All Around, identifies twelve tax breaks with little or no economic justification. These "dirty dozen" are no less ripe for the chopping block a decade later, as Congress finally takes up the task of simplifying the tax code. Follow along at Blog of the Century and on the "Dirty Dozen" expenditures homepage as we reintroduce each of the "dirty dozen" and explain why it's long past time to eliminate these costly tax breaks.

To encourage domestic production, the U.S. government provides subsidies through the tax code to the oil and gas industries worth billions of dollars each year. One of the largest of these tax expenditures is the so-called "percentage depletion" deduction, which allows independent oil and gas (and other fuel mineral) producers to automatically deduct 15 percent of their gross income from production, rather than simply writing off the real cost of their investments based on the fraction of resources extracted ("cost depletion"). Since the "percentage depletion" deduction is a flat rate, the resulting tax break often exceeds the normal depreciation or cost depletion deduction, thus acting as a sizable subsidy to qualifying energy companies.

Although the total revenue loss from the excess of percentage depletion over cost depletion has fallen somewhat since the deduction was first created in 1926, it still costs taxpayers over $1 billion annually—a substantial increase since 2001.

Excess of percentage over cost depletion

According to the Tax Policy Center, an Obama administration proposal to eliminate the percentage depletion deduction would save an estimated $11.5 billion over the next decade. Other administration proposals to limit energy subsidies, and their estimated ten-year savings, include:

  • Repeal the deduction for intangible drilling costs for oil and gas, and the deduction for exploration and development costs for coal: $14.3 billion
  • Increase the geological and geophysical amortization period independent producers to seven years: $1.4 billion
  • Repeal capital gains treatment for coal royalties: $400 million
  • Repeal the exemption to the passive loss limitation for working interests in oil and natural gas properties: $100 million
  • Eliminate the deduction for tertiary injectants (fluids, gases and other chemicals that are pumped into oil and gas reservoirs to extract reserves that cannot be extracted by conventional recovery techniques): $100 million
  • Eliminate the enhanced oil recovery credit and the credit for oil and gas produced from marginal wells (no projected revenue effect)

Subsidies like these are ripe for the chopping block as policymakers look for ways to reform the tax code and reduce the deficit. There is little reason to spend billions of dollars a year on an industry that is, by all accounts, on the brink of an unprecedented boom in proven shale oil and natural gas reserves. Just as the 94th U.S. Congress limited the percentage depletion deduction to independent producers in 1975, when soaring after-tax profits became unjustifiable, so should the incoming 113th Congress resolve to dismantle the present system of corporate welfare.

Learn more about the "Dirty Dozen" tax breaks here.

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