Tim Bradner: Alaska struggles to pin down a 'sweet spot' on oil tax

Tim Bradner | Alaska Journal of Commerce

Will we ever settle on what's a fair share for Alaskans from the extraction of our mineral resources? What does "fair share" mean? And how do we calculate it?

This is the second of my columns in which I attempt to explain the mysteries of our oil tax system.

In August, voters will consider a repeal of last year's Senate Bill 21, which changed our taxes. Critics called it a "tax giveaway," but supporters credit it with renewing industry activity on the North Slope.

What will sharpen this debate is that it now appears there may be no giveaway. The state Department of Revenue's latest estimate for fiscal year 2015, the state budget year starting next July, is that SB 21 is essentially a wash between what the former tax, called ACES, would have brought in and what the new tax law will earn. If oil prices slide a bit more, as the U.S. Energy Information Administration now expects, SB 21 would actually bring in more money than ACES would have.

For the current state budget year, FY 2014, there is a revenue loss of between $250 million and $300 million because of the changeover between ACES and the new law, which occurred Jan. 1.

The department also says much of a $1.8 billion drop in overall state general fund revenues this year would have occurred even if the new tax law had not passed. All of the $2 billion revenue drop estimated for next year, FY 2015, would have occurred even if the former ACES tax had been left in place, the department says.

The decline is caused by falling oil prices, falling production and higher costs. The combined effects of these are now blowing a hole in our budget.

This is a real turn of events from last April when the tax change was enacted, and said to be a tax reduction. This is complicated, and state legislators, now meeting in Juneau, will examine these effects carefully.

I hope to explain more of this in future columns but for now let's start with some basics.

What is a "fair share?" No one really knows. Some feel it's the maximum the state can extract. Others say the industry has to earn a reasonable profit for putting its money at risk. In the end what's important is that we extract our fair share and leave the companies with enough to encourage them to drill and find new oil. We need that because our production is declining.

Someone once asked Jay Hammond, who was governor when our oil boom started in earnest, what he thought a "fair share" was. Hammond's response, according to people who were there, was: one third for industry (in profits), one third for the state (in taxes and royalty) and one third for the federal government (in taxes).

How do we measure up against Hammond's goals? It's is a moving target because our oil tax system has a lot of moving parts. Under our net profits-type oil tax, the market price of oil, production costs and volume all play a part.

Last year, under ACES, the total government "take" of profits, in the form of taxes and royalties, was a bit over 70 percent (combined federal and state share), leaving industry less than a third, so we were a little under Hammond's target for industry.

When legislators passed SB 21 last April, it appeared that it would reduce the government take to just more than 60 percent, enlarging industry's share. That was at oil prices and production costs then forecast, however. Prices now are lower and costs are higher, so the numbers have shifted in the state's favor. It's important to remember that what's being taxed are the production profits, which are influenced by costs as well as oil price changes.

How does our oil tax system work to create these effects? It all starts, just like our personal income tax, with a calculation of taxable income. The tax rate, whatever it is, is applied against that.

Simple enough, but things get complicated. Because the tax is applied to values on the North Slope, but no crude oil is actually sold there, we calculate taxable income by starting where oil is actually sold, the U.S. West Coast, and subtracting transportation charges (tanker and pipeline fees) from the total market sales revenues.

Those deductions give us a gross earnings figure on the Slope. Before 2006 we levied the tax rate, a percentage, on that gross revenue. We called it a "gross revenues" tax. In 2006, we changed to a net profits-type tax to allow production costs to be deducted.

Why the change from a gross to a net revenues tax? The gross revenues tax had certain effects as oil prices changed. When prices were higher, the companies earned more and their share of profits grew larger than the state's. When prices dropped, the companies' share dropped fast, mainly because they had to absorb production costs (it's a tax on the gross, remember?). The state's share of the profit pie got larger.

Many saw this as a protection in times of low prices, because the state's revenues were sheltered. A real-life example of this came in 1998 when oil prices crashed to $8 a barrel. Industry took it in the shorts, but the state was somewhat protected.

However, as a cycle of higher oil prices began after 2000, many worried the state was losing out in capturing those gains. This led to the push for the net-profits tax in 2006, which is basically what we have today.

As it made this change in 2006, the Legislature inserted a minimum gross revenues tax as a "floor," a protection in case oil prices really crashed, but the inherent structure of a net profits tax leads to the state capturing gains on the "upside" and giving up revenues on the "downside." We're seeing these effects today as the taxable value of the oil drops.

There is more to all this, of course. The state's net profits oil tax is simple in concept but tax credits and other special provisions were added that seemed like good ideas at the time, but which later become expensive problems with unintended consequences.

I'll write about that in my next column.

Tim Bradner is an Anchorage-based business writer. He was a member of BP's external affairs staff in the 1970s and early 1980s.

Tim Bradner