The fine line between a subsidy and a tax credit

Targeted tax breaks are necessary for risky businesses, but do they work?

July 01, 2011

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Is oil subsidized? The billions of dollars which purportedly flow from government coffers to oil companies make for a great sound bite, but what’s the real story? As any good economist will tell you, the answer depends on your assumptions. What do you define as a subsidy? How, and using what methodology, do you measure subsidies? Once you figure out the answer to that, you also should ask whether we could find a better balance between government revenue and oil sector activity.

What counts as a subsidy? The definition must be far broader than the value of novelty checks presented by government MPs. There are three categories that should be included in any calculation. First, you need to add up the value of the novelty checks and any other direct transfer of funds from the government to oil and gas firms. Second, you need to ask which tax write-offs or exemptions are made available to oil and gas and other similar industries, and not to other sectors. Finally, you need to calculate the value of any goods or services sold to firms in the oil and gas sector at below market value by the government. Sounds easy, right? Not so fast.

Direct transfers are the easiest to calculate, since these are clearly documented in government budgets. The novelty checks are also helpful in this regard. There are few of these transfers in the oil and gas industry in Alberta.

Unequal tax treatment is more difficult to assess. The two types of programs most often cited are enhanced tax credits for exploration and development expenses and accelerated capital cost allowance programs. Both of these may increase the after-tax value of oil and gas projects, relative to projects with the same costs and revenues in another sector, depending of course on the tax relief programs from which that other sector benefits. The International Institute for Sustainable Development, in a 2010 report, estimated that the Canadian federal government allows the oil industry to claim special tax deductions and exemptions, over and above standard corporate income tax deductions, worth $1.4 billion per year.

Should these tax credits count as subsidies? It depends on your perspective. Some, including Jack Mintz of the University of Calgary, argue correctly that oil and gas exploration is risky and taxing risky investments at the same rate as low-risk ones would discourage these activities. You can also make the case that research and development activities are risky, and so should benefit from enhanced tax relief. Further, if tax credits increase the value of an oil play, then that increased value should be reflected in lease and land sale prices. If so, only firms drilling on land leased or purchased before drilling credits were announced are subsidized.

Should the tax system be used to level the risks between investment opportunities or to advance a set of goals? If you believe that it shouldn’t, then profits should be taxed at the same rate across all industries, and any industry-specific tax credit is a subsidy. The value of goods and services sold by governments to firms at below market value is most difficult to assess. Imagine if the government were leasing office space to your least favorite industry at half the market rate charged for similar space from commercial providers. You would likely scream and yell that the industry should not be subsidized if it can’t pay its own rent. Well, what’s good for the goose is good for the gander.

Most of the millions of barrels of oil equivalent produced in Canada each day is from Crown-owned mineral rights – the resource belongs to the people. Oil and gas is “sold” to companies at a price determined by royalty regimes. Are these taxes or subsidies? It depends on the true value of the oil and gas resource. Importantly, the value is not just the price today – it’s the future value of the oil if it were left in the ground to be extracted at a later date. That is what the Crown is giving up by allowing production today. Unfortunately, we don’t have an easy comparable – like the commercial office tower down the block in the analogy above – for the sale of oil and gas assets through royalties to know if companies are being charged too much or too little.

The International Institute for Sustainable Development estimates that royalty relief programs in the province of Alberta amount to a subsidy worth over $1 billion per year. The institute contends this conclusion was based on an assumption of the value of the resource – that the government got the value right in its New Royalty Framework, and subsequently decided to undercharge for the oil.

If that’s true, then royalty relief is a subsidy. If the New Royalty Framework overcharged for the resources, the adjustment would be warranted, and would not be a subsidy. A royalty rate set too high is equivalent to an added income tax, and a royalty rate set too low is equivalent to the sale of a capital asset below its market value – a subsidy. Regardless of what words you use to describe them, many tax and royalty deduction and deferral programs are offered to the oil and gas sector. As with any government program, two questions should be asked. First, what are the objectives of these programs, and, second, are they working?

Royalty relief programs are equivalent to a direct transfer of funds, with the giant novelty check replaced by barrels of oil. What are we, as owners of the resource, getting in return? A pessimist would say we are getting jobs in a labor shortage, inflationary pressure which dissipates rent from all of the oil being extracted, plus increased production of the province’s finite resources at lower values. An optimist would say that “subsidies” are protecting jobs and increasing incomes, boosting land sale revenues and keeping Alberta competitive. The truth lies somewhere in the middle, and as with all economic analysis, it depends on your assumptions.

Andrew Leach is an Associate Professor at the Alberta School of Business. He blogs on energy, environment, and oil sands issues at and is on Twitter @andrew_leach

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