Accurate and Honest Tax Accounting for Oil and Gas

12 Pages Posted: 10 Nov 2009 Last revised: 3 Dec 2009

Calvin H. Johnson

University of Texas at Austin - School of Law

Date Written: November 2, 2009

Abstract

Tax accounting for the oil and gas industry does not describe the economic income from the investment. Indeed, for a broad range of reasonable assumptions, oil and gas accounting delivers anti-tax or subsidies to profitable investments. The combination of four important tax preferences generates a subsidy that is a negative 42 percent of real income. The four preferences are the expensing of intangible drilling costs, the pool of capital doctrine, the percentage depletion allowance, and the domestic manufacturing deduction. The subsidy from the combination means that an oil and gas investment can in reality lose more than half of its cost of capital before tax and still be profitable after tax. Uncle Sam is going to need significant revenue. The Obama administration estimates that the federal budget deficit for 2009 will total $1.4 trillion, or 9.9 percent of gross domestic product.1 Once the need for short-term stimulus has passed, that deficit must be closed. In the impending revenue crisis, base-protecting revenue provisions that were not possible under ordinary politics become political necessities.

In raising revenue, it is better to go after the low tax and anti-tax transactions before raising tax rates. A tax system does the least harm to the private economy if it is broad, unavoidable, and neutral between investment choices. A broad, healthy tax base allows us to raise the necessary revenue at the lowest feasible tax rates. A broad, least-damaging tax would impose uniform effective tax rates on all alternative investment choices. Investment decisions should be governed, not by tax accounting, but by the real nontax merits of the investments. We need to get the tax accounting right to describe real economic income. Tax accounting is like lab data. We need to keep our laboratory data honest and accurate, no matter how important the experiment.

The Shelf Project proposes capitalization of intangible drilling costs; repeal of the pool of capital doctrine; repeal of the working interest exemption from section 469 passive loss limitations; limitation of percentage depletion to basis; repeal of the exclusion of domestic production; recovery of geological and geophysical costs by cost depletion; repeal of last-in, first-out accounting for oil inventory; and repeal of the tax credits for tertiary and marginal
wells.

Keywords: Shelf Project, tax reform, tax accounting, oil and gas

JEL Classification: E62, H21, H25

Suggested Citation

Johnson, Calvin H., Accurate and Honest Tax Accounting for Oil and Gas (November 2, 2009). Tax Notes, Vol. 125, No. 5, pp. 573-583, 2009; The Shelf Project. Available at SSRN: https://ssrn.com/abstract=1503574

Calvin Harsha Johnson (Contact Author)

University of Texas at Austin - School of Law ( email )

727 East Dean Keeton Street
Austin, TX 78705
United States
512-232-1306 (Phone)
512-232-2399 (Fax)

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