By Kenneth B. Medlock III and Anna Mikulska
Pennsylvania policymakers are nearing a 2 month budget stalemate between Governor Tom Wolf and state GOP leadership, at least part of which can be attributed to their divergent views on the implications of a proposed severance tax on the production of unconventional natural gas. The tax was proposed by Governor Wolf last February in place of the current impact fee, and the new revenues are supposed to benefit education and environmental stewardship. While an increase in the state severance tax may be an appropriate mechanism for these types of funding initiatives, the benefits are not unequivocal and policy makers have a lot more to consider.
As of now the effective tax rate on natural gas extraction in Pennsylvania ranges between 2 and 4 percent- the lowest rate among the gas producing states. As proposed by Pennsylvania’s governor Wolf, this tax would be raised to become the highest reaching up to 17.3 percent in 2016 (the year of its commencement) and about 7.3 percent in the 2020s as prices rise and more pipeline infrastructure is built. The proposed piece of legislation establishes minimum value of natural gas ($2.97 per thousand cubic feet) that would be independent of its market price, thus ensuring the floor level of income flowing to the state from the natural gas production.
The proposal is motivated by budgetary reasons with the new tax revenues intended to fund education, and environmental oversight. Per acting Department of Revenue Secretary Eileen McNulty, the tax would provide additional $2 billion to contribute to basic education over the 4 years after its commencement, and $10 million for operations that monitor air and water quality. It also would fund debt service payments for the Economic Growth Bond proposed by the governor to support business expansions, relocations as well as investments in energy and technology.
The proposal seems like an economically savvy move considering the benefits. Moreover, according to recent testimony by Matthew Knittel, the Director of the Independent Fiscal Office, the cost increase associated with the tax would be passed from the producers to end users, the majority of which (80%) reside outside of Pennsylvania. Thus, the state’s residents would be compensated (in greater educational and environmental spending) for the negative externalities associated with natural gas extraction, while the cost would be primarily borne by out-of-state consumers.
However, a recent Center for Energy Studies (CES) report – which examines in detail how new potential and proposed regulations could influence the natural gas market in the United States on a regional, national and international level – suggests the incidence of a severance tax may not be as clear cut as portrayed by its proponents. More specifically, the burden of the tax may not be shifted to out-of-state consumers in such a clear and discrete manner. The CES study underscores the importance of sensitivity of demand for inputs into the production of natural gas – including land, rigs, equipment and labor – to changes in cost, none of which has been included in Mr. Knittel’s analysis.
Whenever producers must compete with producers in other states they may not be able to pass the cost onto the consumers, as price is set by the source of supply at the margin. Thus, in order to maintain a commercially competitive profit margin, producers in Pennsylvania will attempt to distribute the increase in costs through the production value chain. This, in the end, is more likely to shift the tax burden on Pennsylvania landowners, as they have the least flexibility to remarket their land to another suitor. In other words, they are the providers of the most inelastic input to production, and, as such, the tax will be effectively negotiated into lower lease payments. Additionally, the producer may also reduce acreage purchases (leases) and/or overall development activity in the region, especially if a competing opportunity becomes more viable in a neighboring region without the same tax burden. In this way, the impact of the local severance tax is like a declining price of natural gas, only the effects are much more localized. While the proposed plan does have a mechanism to prevent loss of revenues in the case of lower natural gas prices, it can do very little to prevent capital flight to regions (states) where taxes are lower. This is in line with the fears among Pennsylvania’s shale industry. For example, the President of the Marcellus Shale Coalition, David Spigelmyer, predicts a decline in regional capital outlay in his testimony before the Senate.
The actual impact is unlikely to be so dramatic because regional development costs are relatively low, and because landowners have an incentive to negotiate to a lower royalty – after all, 18% of something is better than 22% of nothing. But, there is a need for careful consideration by Pennsylvania’s policy makers of both the intended and unintended consequences that a high severance tax may bring. Specifically, they need to assess its overall contribution to state welfare including the possibility that the taxes will put the burden on local landowners rather than out-of-state consumers. In addition, although not highly likely, policy makers must also be wary that natural gas producers may reduce their interest in Pennsylvania, preferring other places with lower taxes to drill. Lower capital investment and decreased drilling activity mean not only lower than expected severance tax revenues, but also fewer jobs and a decrease in indirect economic activity stimulated by natural gas exploration and development. In sum, severance taxes are a common tool that may work well but a more rigorous accounting of the economic impacts of a dramatic increase in the local severance tax must be done if the dreaded “law of unintended consequence” is to be avoided.
Kenneth B. Medlock III is the Senior Director for the Center for Energy Studies at Rice University’s Baker Institute for Public Policy.
Anna Mikulska is a Scholar in Energy Studies at the Center for Energy Studies at Rice University’s Baker Institute for Public Policy.
