How Energy States Could Better Weather the Boom-and-Bust Cycle

As major oil-producing states face budget shortfalls, a new report calls on states to rethink how they’re collecting and spending severance tax revenues.
by | April 20, 2016
Oil pumps in North Dakota, one of several states that have been hit hard by declining oil prices. Charles Rex Arbogas/AP

Following a sharp decline in oil severance tax revenues, Alaska lawmakers are considering bringing back the state’s personal income tax for the first time in nearly four decades to help close an estimated $4 billion budget deficit. Earlier this year, North Dakota Gov. Jack Dalrymple similarly ordered 4 percent budget cuts for most state agencies to make up for a $1 billion shortfall. In Louisiana, which had its credit ratings downgraded by two rating agencies, lawmakers are debating several proposed cuts and tax increases to balance the budget.

Given their struggles, a Brookings Institution report published this week calls on states to rethink how they’re collecting and spending severances taxes derived from natural resources. States can do a better job, the report authors say, of channeling oil revenues to stable trust funds that better weather the boom-and-bust cycle.

Most states rely little on severance or extraction taxes – usually less than 2 percent of total tax collections. But for the states with the largest oil reserves, the drop in oil prices has wreaked havoc on budgets.

“The consequences of inaction are especially visible now,” said Brookings senior fellow Mark Muro, who co-authored the report. “The bust period is the right time to look at this.”

Several state legislatures have weighed proposals to modify severance taxes or initiate new fees in recent years.

The Brookings report recommends that a portion of states’ annual severance tax revenues be diverted to permanent trust funds, which encompass different types of investment products and are intended for long-term use. Fund earnings can be used to fund projects or programs, while spending the principal is typically restricted. Along with those tied to severance taxes, trust funds have also taken the form of land grant funds to support public school systems in the U.S.

Eight states have established trust funds supported by severance taxes. For the most part, however, fund balances remain small relative to the amount of production that’s occurred in states over a number of years. Consider the North Dakota Legacy Fund, which has a market value of approximately $3.2 billion, or Alabama’s $2.5 billion fund.

In two oil-rich states that levy little or no severance taxes – Ohio and Pennsylvania  – not much discussion has occurred around new trust funds as governors have targeted tax increases to fund policy priorities.

Pennsylvania Gov. Tom Wolf has called for a severance tax to boost education funding. The state is the only major oil-producing state without a severance tax, although it does impose an impact fee. Wolf, a Democrat, initially proposed a 5 percent severance tax and an additional charge based on the volume of natural gas that would have raised an estimated $855 million in fiscal 2016-17 and $933 million the following year, according to the state’s Independent Fiscal Office.

The issue, however, has divided lawmakers along partisan lines in the state legislature, where Republicans control both chambers. If a tax were passed, it’s unlikely that enough money would be raised to both finance meaningful education initiatives and establish a trust fund given low tax revenues, said John Hanger, who served as Gov. Wolf’s secretary of policy and planning until earlier this year.

In Ohio, Republican Gov. John Kasich has sought to raise the state’s low severance tax to fund income tax cuts. Currently, drillers pay 20 cents per barrel of oil and 3 cents per 1,000 cubic feet of natural gas in severance taxes and regulatory assessment fees – far lower than other states.

The issue isn’t as partisan as it is in Pennsylvania as Republicans hold large majorities in both the state House and state Senate. But lawmakers have resisted proposals for a few years now, instead forming a commission to study the state’s tax policy last year.

“The legislature has had ample time to understand this issue and no shortage of recommendations,” said Wendy Patton, a senior project director for Policy Matters Ohio.

Under Kasich’s plan, the bulk of the additional revenues raised would fund income tax cuts. Patton, though, says the funds would be better spent on infrastructure and other long-term investments. Policy Matters Ohio advocates for a 5 percent severance tax and, when markets are strong, an additional 2.5 percent tax for a permanent trust fund.

“Personal income tax is far more stable than the severance tax,” Patton said. “You don’t want to swap out one for the other.”

The oil and natural gas industry has pushed back against proposed tax hikes in states, arguing they can’t afford the added expense at a time when prices are low.

“New taxes, coupled with duplicative and onerous regulations, will only exacerbate the difficult fiscal challenges facing the natural gas industry and the thousands of men and women whose livelihoods are dependent upon it,” said Marcellus Shale Coalition president David Spigelmyer in a news release earlier this year.

Trust fund revenues, the Brookings report argues, can further play a role in better diversifying states’ economies so they aren’t as vulnerable to economic shocks. Investments in tech-based industries and renewable energy, for instance, are much less volatile than oil and natural gas.

“There’s an opportunity to develop economies that deliver prosperity for a broader range of the state over time,” Brookings’ Muro said.

Despite falling oil prices, Texas has weathered the boom-and-bust cycle better than other major oil-producing states as its economy is more diversified. By contrast, Alaska, North Dakota, Louisiana, Oklahoma, West Virginia and Wyoming all recorded declines in total employment last year despite overall job growth nationally.

The report authors further outline a series of recommendations for states that have already established trust funds. They include a solid governance framework, clear investment strategy, transparency standards and well-defined fiscal rules, such as when money can be withdrawn. While some state trust funds reviewed had some features, none had implemented all recommendations.

One trust fund cited in the report as an example to follow is Montana’s coal tax trust fund. Half of annual coal severance tax revenues are diverted to the fund, and its revenues cannot be appropriated without approval from three-quarters of the state legislature.

State Oil and Natural Gas Rig Counts

Oil production has slowed across the country as prices have fallen. Select a state to view changes in numbers of oil and natural gas rigs over time.