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Best Practices for Oil and Natural Gas Extraction Tax Policy

The independent think tank Headwaters Economics has released a report on the best fiscal practices for states and local governments with oil and natural gas extraction. The report states,

Drilling for oil and natural gas is a high-impact economic activity that presents opportunities and challenges for state and local governments seeking to reconcile the benefits of job and revenue growth with the impacts of rapid industrialization and population growth. The rush to develop unconventional oil and natural gas resources—underway in many parts of the nation and on the horizon in others—requires more wells compared to conventional oil and natural gas, meaning higher costs, more jobs, and greater impacts to extract an equivalent amount of oil or natural gas.

The report goes on to outline many of the challenges faced by states with rapid natural gas development, some of which we are experiencing here in West Virginia.

The report also addresses some fiscal policies that can help states like West Virginia address those challenges. Two of the policy suggestions stood out to me as particularly relevant to West Virginia.

The first is, “Maintain a High Effective Tax Rate.” The report states, 

“The effective tax rate is a measure of how much money is actually paid in taxes after accounting for various loopholes in each state’s tax code. States that maintain higher effective tax rates have more resources to mitigate the impacts of industrial development and population growth, and can invest revenue in permanent funds for long-term economic development. Experience suggests that the state competition for industry activity through low tax rates and tax incentives is largely ineffective, meaning states can set fiscal policy to meet community needs and state priorities without deterring industry investments.”

This is a relevant lesson for West Virginia, because, as we’ve shown here, here, and here, West Virginia’s effective production tax rate is below most other states with significant extraction industries. The Headwaters report contained this figure, showing effective state and local production tax rates for oil and gas producing states out West. Effective rates for these states ranged from 4.6% to 10.3%, while West Virginia’s effective production tax rate on natural gas is 4.4%, lower than all the states examined.

The second relevant lesson for West Virginia is, “Invest Revenue to Provide Stable Long-Term Income.” The report states,

It is impossible to avoid volatility in tax collections that are based directly on the production value of oil and natural gas. Instead, stabilizing revenue streams to fund state and local services can be accomplished by investing a portion of annual revenue into funds that can disburse consistent amounts of money over time.

Example: New Mexico has a large permanent fund that distributes an amount equal to five percent of
the principal balance annually. If deposits and interest earnings exceed five percent in a given year, the
principal balance will grow, but even when annual revenue and interest earnings decline, the fund will
still distribute a stable revenue stream.”

This suggests that West Virginia should join most other energy producing states, and create a severance tax trust fund.

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