U.S. Tax: The Big Oil Discount

By Sima J. Gandhi, 13 May 2010 -- The price tag for the Gulf Coast oil disaster could go as high as $14 billion. This includes cleanup expenses, which could cost as much as $7 billion, and related damages, such as losses to Louisiana's fishing businesses of possibly $2.5 billion. British Petroleum, the company that operated the offshore drilling site that exploded, will pay for cleanup costs it directly incurs. But BP's liability for economic damages inflicted on area residents and businesses is capped at $75 million under federal law.

The mismatch between the amount BP will pay for cleanup and the costs the public will bear as a result of the spill is exacerbated by the many loopholes and subsidies the government provides oil companies. Oil companies need stronger incentives to act responsibly. That means holding them liable for the costs of their actions and cutting the billions in subsidies these profitable companies currently receive.

Sens. Robert Menendez (D-NJ), Frank Lautenberg (D-NJ), and Bill Nelson (D-FL) have introduced legislation that would expose BP to potential liability of well over $75 million. The Big Oil Bailout Prevention Act (S. 3305), their proposed legislation, would retroactively replace the $75 million liability cap with a $10 billion cap.

Not only is liability capped on compensatory damages from oil spills, but payment of punitive damages is also tax deductible. Courts can impose punitive damages against a company when its actions cause harm. The tax code, however, lets companies write off their payment, which produces an after-tax savings worth about 40 percent.

Take the case of the Exxon Valdez, a tanker ship that ran aground and released nearly 11 million gallons of oil into Alaska's Prince William Sound in 1989. Following this spill a court set punitive damages at $5 billion. Exxon litigated the decision for nearly 20 years until 2005 when the Supreme Court slashed the company's punitive damages to $500 million. Of that, Exxon paid about $300 million after taking its tax deduction for punitive damages. Exxon's profits that same year totaled $36.1 billion.

Higher fines and penalties for safety and regulatory infractions would also establish stronger economic incentives for companies to adopt precautionary steps. If fines are too low, companies may find it cheaper to break the rules and pay the fines than to actually fix the problem.

Offshore drilling accidents resulted in 41 deaths and 302 injuries between 2001 and 2007. BP's accidental explosion, which allowed oil to flow from below the sea floor into the gulf, killed 11 workers. Yet according to ProPublica the average penalty paid by offshore drillers over the past 12 years was $45,000. This amount is a pittance compared to oil company profits — BP made about $62 million a day during the first quarter of 2010 — offering little deterrence to risky behavior.

Indeed, early reports suggest BP may have compromised its ability to catch warning signs prior to the explosion. And the subsequent flow of oil into the sea may have been prevented had BP installed an extra precautionary switch that would remotely shut off the oil flow — a type of switch that is required in other countries like Brazil and Norway. This is not BP's only lapse. The New York Times reports that between 1996 and 2009 BP-operated platforms spilled a total of about 7,000 barrels of oil — 14 percent of the amount spilled in the gulf by any company.

The underlying problem, of course, is our reliance on oil. Reducing our reliance on oil would reduce the need for offshore drilling along with the risk of oil spills — not to mention other problems associated with oil consumption, such as global warming. Yet transitioning to alternative energy sources is challenging when highly profitable oil companies have a competitive boost — through receipt of billions in generous government subsidies — over start-up companies that offer safer, cleaner energy alternatives.

Congress passed legislation in 1995 — when oil prices were low — that provides royalty relief for oil companies that drill in certain federal waters off the Gulf of Mexico. Royalties are generally paid to governments for the right to use resources like oil and gas located on land that is owned by the public. Oil companies take advantage of the legislation's ambiguity to improperly enjoy relief from royalty payments even when oil prices are high. Government Accountability Office testimony suggests that forgone royalties from leases issued during 1996 to 2000 could be as high as $80 billion. Congress should change the law so that oil companies pay a reasonable rent for extracting resources from these public waters.

Oil companies also receive large subsidies through tax expenditures — special deductions, credits, exclusions, rates, exemptions, and deferrals that are delivered through the tax code. President Barack Obama's fiscal year 2011 budget proposes cutting nine tax expenditures that primarily benefit oil companies (listed here), which would save about $45 billion over the next 10 years. These include the "percentage depletion allowance," which provides oil companies a subsidy — at a cost of $10 billion over the next 10 years — to pump oil out of existing wells. And the tax expenditure for "intangible drilling costs" gives companies a subsidy worth $8 billion over the next 10 years to drill new oil wells.

The "foreign tax credit" provides another way for oil companies to avoid paying their taxes. This credit is intended to prevent the double taxation of corporate income that is taxed abroad but is also subject to tax in the United States. Companies have managed to exploit this subsidy even when they don't pay income taxes abroad. Oil companies particularly abuse this tax expenditure. In total, companies will avoid about $8.5 billion in taxes over a 10-year period as a result.

We cannot afford to provide these subsidies. The nation's current and long-range fiscal challenges demand that we get maximum value out of every taxpayer dollar spent. Oil companies are highly profitable — they don't need these subsidies. Nor does it make sense to subsidize oil companies for producing oil as we are trying to move to cleaner, safer forms of energy.

As long as these subsidies are in place the market will be distorted to the oil companies' competitive advantage. And oil companies will not have to pay the full costs of the health, safety, and environmental damages they cause. Congress should act to change these distortions. It's time for oil companies to pay their fair share.


Policy recommendations that would push companies to internalize the costs of their actions:

- Raise the liability cap on economic damages that result from oil company accidents
- Eliminate the tax deduction that allows companies to avoid paying about 40 percent of any court-ordered punitive damages
- Raise penalties for breaking safety regulations so there is a meaningful incentive to adopt preventive measures
- Require oil companies to pay a reasonable rent for extracting resources from public waters
- Eliminate nine tax expenditures for oil companies and save $45 billion over 10 years
- Reform the "foreign tax credit" to ensure that oil companies pay U.S. tax when they don't pay taxes abroad