tax reform

Analysis of the early post-tax reform data from large public companies suggests that many profitable firms are paying no federal income taxes, and often getting refunds.  Firms involved with fossil fuels have been big winners.  An April paper by the Institute on Taxation and Economic Policy in Washington, DC reviewed data on Fortune 500 firms.  They found 60 that paid zero federal corporate income taxes despite having significant pretax income.  Indeed:

The report finds that in 2018, 60 of America’s biggest corporations zeroed out their federal income taxes on $79 billion in U.S. pretax income. Instead of paying $16.4 billion in taxes at the 21 percent statutory corporate tax rate, these companies enjoyed a net corporate tax rebate of $4.3 billion.

Goals versus political reality of tax reform

Good tax reform isn't supposed to do this.  In return for cutting tax rates on everybody to spur economic activity, properly-structured reforms are supposed to eliminate tax subsidies to everybody at the same time.  Lower rates, broader base.  Reforms should yield a lower tax burden on all economic activity while simultaneously removing politically-driven disparities between different sectors of the economy.  People keep more of what they make, market pricing signals are cleaner, and revenue impacts are reduced.

Or so goes the theory.  This ideal policy outcome for society as a whole is very different from what "winning" tax reform looks like at the firm level.  Industry lobbyists want to see rates cut on everybody, but cut even more for their sector.  And they would like for everybody else to lose their tax subsidies while somehow keeping their own. 

This type of political outcome flows only to the powerful.  In the massive Tax Reform Act of 1986, many tax subsidies were cut -- though most of those to oil and gas remained.  And despite lots of new windmills and solar cells popping up around the country, the fossil fuel industry remains powerful.

As the tax reform package was nearing a vote at the end of 2017, I noted this concern in my review:

A combination of key subsidies to fossil energy remaining untouched while core subsidies to renewables are repealed, along with significant use of tax‐favored corporate structures by oil and gas both suggest that were the current proposals to become law, they would materially benefit fossil fuel industries relative to other energy market participants.

Unfortunately, this seems to be how things are playing out.  The Tax Cuts and Jobs Act (TCJA) did greatly cut corporate rates across the board (from 35% to 21%).  But it also cut the overall tax burden (corporate plus personal) on Master Limited Partnerships used mostly by oil and gas firms even more.  For example, a special amendment by Senator Cornyn of Texas ensured that an ability to deduct 20% of income was not limited by the wage payments made by the partnership, a constraint applicable to most other partnerships under TCJA.1 

Capital equipment expensing was also broadly implemented, with the majority of the gains flowing to capital-intensive industries with long-lived capital assets, such as fossil fuels.  And those deductions can be taken on used assets too, not just new.  Here's the Oil & Gas Journal:2

Importantly, the Act allows the 100% deduction for capital expenditures used to acquire pre-existing (that is, used) property from unrelated persons. In the current oil and gas environment, where companies are shedding non-core assets, the 100% bonus depreciation regime provides an extra incentive for buyers of such assets to close deals in the next 5 years.

The Oil & Gas Journal review reported on modeling by long-time industry consultant Wood Mackenzie.  Wood Mack looked at how the TCJA affected asset values within the exploration and production sector of US oil and gas markets.  They indicated a post-tax increase of more than $190 billion.

ITEP:  More than one-third of profitable firms in their review that paid no federal taxes in 2018 were oil and gas or utilities

ITEP periodically analyzes the effective tax rates of publicly traded companies.  Earlier this month, their analysts looked at Fortune 500 companies post tax reform and found that 60 of the profitable firms were paying zero in federal income tax.3  I sorted their data by industry to focus in on the sub-groups most directly linked to fossil fuels:  oil, gas & pipelines; and gas & electric utilities.  Twenty-two of the 60 firms paying no taxes were in these two sectors.  As shown below, they comprised 47% of the group's total pre-tax income and 41% of the net federal tax refunds.

ITEP notes that renewable production tax credits were one of the causes of low tax rates for the utility firms.  To assess the import of this factor, I included data on renewable PTCs claimed, as reported by ITEP; and assessed the share of tax underage from the new statutory rates that the renewable PTCs comprised. 

In a few cases, the benefits were significant:  renewable PTCs dominated the underage for one utility and were material in a second.  However, for most of the utilities (and all of the oil, gas and pipelines segment), other factors drove the results.  The utilities include renewable and nuclear infrastructure, but continue to be dominated by natural gas and coal in most cases. 

 

Table 1:  Many profitable firms in oil, gas, and utility sectors paying no federal tax under TCJA

 

Company Industry US pre-tax income Federal Tax Avg. Effective Federal Tax Rate Corporate rate, 21% Spread: Actual vs. statutory @ 21%  Renewable PTCs Claimed  PTCs as share of tax underage at new rates
    A B B/A   C = (.21*A) - B  D  D/C
Chevron Oil, gas & pipelines $4,547 ($181) -4.0% $955 $1,136    
EOG Resources Oil, gas & pipelines $4,067 ($304) -7.5% $854 $1,158    
Occidental Petroleum Oil, gas & pipelines $3,379 ($23) -0.7% $710 $733    
Duke Energy Utilities, gas and electric $3,029 ($647) -21.4% $636 $1,283  $           129 10.1%
Dominion Resources Utilities, gas and electric $3,021 ($45) -1.5% $634 $679  $             21 3.1%
American Electric Power Utilities, gas and electric $1,943 ($32) -1.6% $408 $440    
Kinder Morgan Oil, gas & pipelines $1,784 ($22) -1.2% $375 $397    
Public Service Enterprise Group Utilities, gas and electric $1,772 ($97) -5.5% $372 $469    
FirstEnergy Utilities, gas and electric $1,495 ($16) -1.1% $314 $330    
Xcel Energy Utilities, gas and electric $1,434 ($34) -2.4% $301 $335  $             75 22.4%
Devon Energy Oil, gas & pipelines $1,297 ($14) -1.1% $272 $286    
Pioneer Natural Resources Oil, gas & pipelines $1,249 $0 0.0% $262 $262    
DTE Energy Utilities, gas and electric $1,215 ($17) -1.4% $255 $272  $           223 81.9%
Wisconsin Energy Utilities, gas and electric $1,139 ($218) -19.1% $239 $457  $             12 2.6%
PPL Utilities, gas and electric $1,110 ($19) -1.7% $233 $252    
Halliburton Oil, gas & pipelines $1,082 ($19) -1.8% $227 $246    
Ameren Utilities, gas and electric $1,035 ($10) -1.0% $217 $227    
CMS Energy Utilities, gas and electric $774 ($67) -8.7% $163 $230  $             14 6.1%
Atmos Energy Utilities, gas and electric $600 ($10) -1.7% $126 $136    
Cliffs Natural Resources Oil, gas & pipelines $565 ($1) -0.2% $119 $120    
UGI Utilities, gas and electric $550 ($3) -0.5% $116 $119    
MDU Resources Oil, gas & pipelines $314 ($16) -5.1% $66 $82    
Total, oil & gas; gas & electric utilities   $37,401 ($1,795) -4.8% $7,854 $9,649    
All companies in study   $79,027 ($4,329) -5.5% $16,596 $20,925    
Oil, Gas and Utility share of study total 47% 41%          

Source:  ITEP (2019)

  • 1. James Chenoweth and David Sinak (2017). "Houston, We have New Tax Rates – Guiding Oil and Gas Companies Through Tax Reform," Gibson, Dunn & Crutcher, 21 December (accessed 4/23/2019).
  • 2. Conglin Zu, "US upstream and tax reform," Oil & Gas Journal, 2/26/2018.
  • 3. Matthew Garder, Steve Wamhoff, Mary Martellotta and Lorena Roque (2019). "Corporate Tax Avoidance Remains Rampant Under New Tax Law: 60 Profitable Fortune 500 Companies Avoided All Federal Income Taxes in 2018," (Washington, DC: ITEP), April.
US Internal Revenue Service logo
US Internal Revenue Service logo

The optimal position for your industry in any tax reform is to see general tax rates drop while also keeping all of your old subsidies.  The political lobbying on these bills is enormous, and given the scale of the energy sector in the US economy, and the need to transition towards lower carbon fuel sources, it seemed important to look at the tax reform proposals through the lens of energy.

When the Joint Committee on Taxation assesses the cost to Treasury from the proposal, they are focused on the new rules or repealed line items a particular bill may put forward.  But the economic impacts of a new tax regime is affected by three major threads:  whether general changes in tax rules disproportionately affect some energy resources relative to others; energy-specific line items being repealed, changed, or added; and whether political power among particular industry-subsectors has enabled them to have their cake and eat it too by keeping their old subsidies while also getting lower top tax rates.

This working paper is a first cut at doing this.  I've no illusions I'veworking paper cover extract captured everything, or mapped out all of the interactions.  But even the first order effort to combine these three main threads is important in gauging winners and losers under the proposals.  This is a discussion draft, so email your comments, concerns or corrections if you've got them. 

To better see patterns, the tax line items have been grouped into three general energy categories:  conventional energy (mainly fossil); emerging resources; and mixed (which includes the grid and transport policy).  Both new and (apparently) surviving tax expenditures are included.

There's a great deal of detail in the full summary, but my key takeaways are below:

  • Largest subsidies to fossil fuels are not touched by tax reform proposals, and post-reform subsidies to fossil will remain very large. Although a handful of tax subsidies to oil and gas are eliminated in tax reform, the largest ones remain untouched by either proposal and exceed the reductions by a large margin. As shown in Table 4, net subsidies to conventional energy after tax reform are still at a staggering $52 to $67 billion dollars over the 2018-27 time period. Fossil fuels comprise more than 80% of the total, with nuclear the remainder.
     
  • Effective tax rates on fossil energy are likely to remain well below those on competing resources as a result. The residual tax subsidies, in combination with a lower top corporate rate, and lower top rates on income flowing from pass-throughs, will bring down the effective tax rate on key fossil fuel sectors even further.
     
  • Tax subsidies to nuclear are increased or untouched via tax reform. Further, the large subsidies flowing to nuclear via other transfer mechanisms in credit, insurance, and government ownership of fuel cycle functions, will also remain in place.
     
  • In contrast, significant reductions in subsidies to renewable energy are being implemented, particularly under the House proposal. Although the eligibility period for a handful of these subsidies is being extended, changes to the production tax credit for wind are estimated to be much larger, more than offsetting the gains to other renewable resources. Net subsidies to emerging energy resources will drop significantly under the reform plans. There will be some gains through reduced corporate rates and pass-throughs, though renewables are not likely to benefit to the same degree as fossil energy will due to differences in industry scale and the use of large partnerships.
     
  • In the “mixed” category, the largest changes are in the area of transportation and parking. Commuting via bicycle or mass transit will no longer be subsidized, though the largest shift is likely the elimination of employer-subsidized parking – which could shift ridership to less carbon-intensive modes.
First 37 of 565 privately held corporations involving President Trump; most will see sharply reduced taxes under tax reform plans
First 37 of 565 privately held corporations involving President Trump; most will see sharply reduced taxes under tax reform plans

Republican-led plans to reform our tax system have now been introduced in the Senate and passed in the House.  This is trillion dollar legislation (the extra deficits alone are estimated at $1.5 trillion between 2018 and 2027), and a feeding frenzy for lobbyists trying to get new perks in the bill or protect the ones they have.

Press attention has rightfully focused on how the proposals will affect the poor and middle-class, as compared to the wealthy.  This post looks at two aspects this issue.  The first are the average impacts by income quintile, which many groups have analyzed.  The second, which has not gotten the attention I think it deserves, is how the tax plans will erode the role tax rules play in hedging large risks that individuals face with major life events -- a function the income tax system has always played, and continues to play, for corporations. 

A future post will look at the tax reform proposals and energy subsidies. 

I.  As configured, tax reform helps the poorest a little and the wealthiest a lot

According to the non-partisan Tax Policy Center, the distributional effects of the House bill aren't great:

The largest cuts, in dollars and as a percentage of after-tax income, would accrue to higher-income households. However, not all taxpayers would receive a tax cut under this proposal—at least 7 percent of taxpayers would pay higher taxes under the proposal in 2018, and at least 24 percent of taxpayers would pay more in 2027.

At lower income levels, the dollars in savings here are pretty immaterial.  For example, the lowest quintile earner in 2018 will save a whopping $60 in federal taxes.  The next two income quintiles save $310 and $830, respectively -- though savings in 2027 would be lower for all three.  Further, the raw distributional assessments of tax changes don't fully incorporate the fact that taxes are only one part of people's lives.  If the government is also stripping other programs that help these groups many people will end up way worse off than they are now.  This does seem to be what is going on:  the Congressional Budget Office expects nearly $136 billion in cuts to ancillary federal programs, many of which support the poor and middle classes.  CBO estimates roughly $25 billion will come from medicare.  That sixty bucks in tax savings isn't looking so good anymore.

Indeed, continued erosion in health care benefits and increased co-pays for most people can easily eliminate any savings well up the income quintiles -- particularly given the worsening access to medical insurance.  The proposed loss of medical expense deductions (see below) would do the same.  At lower levels of expense, the increased standard deduction helps; but if a family faces a medical emergency, the loss of medical-specific deductions will really matter.

TPC's models estimate that the top 0.1% will save nearly $175,000 per year in 2018, jumping to $320,000 annually in 2027.  In part this is because they pay more taxes overall.  But it is also because so much more of their earnings come from from partnerships (which will see a reduced tax rate at the recipient partner level) and dividends (which are likely to increase due to a lower tax rate on corporations which will leave more to pay out). 

Despite President Trump's claim that the proposal would be bad for him, his estate tax exemptions will double.  Many of the 565 private company interests he holds (the first 37 are shown in the image above) according to his June 2017 financial disclosure form will pay lower taxes.  He, and his family, will save an enormous amount of money.

Eric Toder, a co-director of the TPC remarked of the proposal to the Washington Post that “A major feature is tax collections would shift dramatically, from businesses to individuals.”  This continues a long-term trend in the US:  in the early 1940s, US corporate income taxes comprised nearly a third of federal revenues.  Since the 1970s, however, the corporate share has been less than 15% according to historical data from the US Office of Management and Budget. 

II.  Tax reform will eliminate protections to individuals from adverse life events

I'm also interested in how the changes will shift the tax system from a risk-sharing partner to an impediment for individuals grappling with life's big expenses.  The shift to standard deductions in the tax code is quite similar in structure to the push for block grants to the states as a replacement for federal cost sharing:  it works a little bit for average circumstances.  But the long-term expectation is for the grants (and cap on standard deductions) to limit federal exposure to a variety of risks, saving the Treasury money in the process. 

There may also be incentives at the state (with block grants) or family (with eliminated deductions) to deploy resources differently, but it is notable that with very few exceptions (e.g., trying to limit corporate debt and very highly compensated individuals) this "cap-and-shift" approach is not being used with corporations.  The capped policies fray quickly where underlying costs are rising sharply, or individual (states or people) are hit with adverse circumstances such as job loss or a medical emergency.

Offsetting losses and gains across years 

Here's what I mean.  Imagine a small restaurant owner who struggles to build a place that everybody wants to eat.  For the first four years of its existence, the owners borrow from friends and family; work 100 hour weeks; and max out their credit cards to stay afloat as they build their dream.  Finally they hit their stride and the tables are full.

Or consider a guy named Bezos who thought it might be possible to sell more books online at a lower price than what brick and mortar stores could do.  Others think maybe there is something there, or maybe the guy is nuts.  But he believes, and risks it all to build his platform and advertise like crazy to make this idea a reality.  And as soon as he hits his stride with books, he wants to sell everything.  He's hemorrhaging money the whole time. 

What if when these ventures finally started to make money the federal government just pretended all of those prior losses didn't exist and instead whopped them with a massive tax bill?

Luckily, it doesn't.  The federal tax system lets firms track historical losses to offset profits at such time as those profits occur.  If they never occur, too bad for the investors and owners.  But often they do, and because firms can "carry forward" losses across many years, they offset taxes due on new-found profits. 

This process of loss carryforwards doesn't just buffer start-ups:  existing companies can go through severe market cycles as products or consumer tastes change; the broader economy is in recession; or commodity cycles wrench at their margins.  Losses from the  lean years help offset the gains during the good years:  the government is effectively sharing risk with the private firms.  

It is a very useful function of the tax system, and one that can be seen clearly in the extract from the federal receipts below, covering the period just before and after the credit crisis and recession we went through starting in 2008.  The corporate share of federal receipts began dropping even in 2008, and halved in 2009.  Profits were down sharply, so this isn't surprising.  But the rebound in corporate tax contributions has been slow, muted by the use of tax loss carryforwards in subsequent years. 

Tax Loss Carryforwards Helped Corporations Weather the Downturn
Share of total federal receipts by sector

Year Individual Share Corporate Share

2007

45.3

14.4

2008 45.4 12.1
2009 43.5 6.6
2010 41.5 8.9
2011 47.4 7.9
2012 46.2 9.9
2013 47.4 9.9
2014 46.2 10.6
2015 47.4 10.6
Source:  OMB

Some tax policy for corporations goes even further.  Refundable investment tax credits, as were available for a time for wind power investments, allowed firms with no profits to claim tax refunds anyway.  In other cases, as is being proposed for the nuclear power production tax credit, credits earned by non-taxed entities can be used or sold to taxable entities to claim.  Both are examples of more active risk-taking in private ventures by the federal government via the tax code.

Buffering of income and losses on the individual side has been less generous

This type of offsetting losses seen for companies exists to a much lesser extent for individuals.  True:  losses on the sale of stocks or bonds may be used to offset similar gains, and carried forward year-to-year if there are not enough gains to offset in any single year.  However, wealthier individuals own the vast majority of stocks (80% of stocks are owned by the richest 10%).  As a result, this buffering is of limited value to the lower income quintiles who earn nearly all of their money through wages.

The trouble is that if the expense side of the ledger for individuals surges in a year, the taxes on wages are adjusted only through itemized deductions of those expenses.  And the tax proposals now under consideration strip away the vast majority of those deductions.  Here are some examples:

Health problems.  Unfortunately, health problems are a reality for many families in the United States.  However, healthcare is in many ways a dysfunctional market:  surging prices year-after-year, insurers who provide expensive policies under which it is often difficult to tell what is being covered, and individual purchasers who can rarely see prices let alone shop them.  Medical expenses are also often unpredictable, going from fairly low to levels that can bankrupt a family should an adverse event occur.  Indeed, they are a major cause of personal bankruptcy. 

While current law does treat unreimbursed medical costs as a deductible expense, this benefit only kicks in if a taxpayer is spending more than 10% of their income on those costs (up from 7.5% a few years ago).  Further, the IRS has a very detailed list of what items count and what don't.   Both provisions help target the deduction to families that really need it.  The tax bill that passed the House of Representatives eliminates medical expense deductions entirely -- as well as medical savings accounts that were developed as a way to boost private savings to cover medical cost surges in order to reduce reliance on government.

Of the less than 6% of filers claimed the itemized medical expense deduction in 2015, nearly half who did had income levels of less than $50,000; and nearly 70% had income less than $75,000.  These are lower- and middle-class people, often dealing with very challenging medical expenses in their family.  One aspect of this deduction I was hoping to find data on, though couldn't, was the degree to which the 6% claiming the deduction changes year-to-year.  For many families, there is an acute medical issue hitting a loved one and driving costs up -- but the surge may last only a couple of years either because the medical intervention stabilizes the situation, or because the person dies.

Dealing with family or employment challenges.  In addition to medical costs, other financial challenges to building a family can arise - such as infertility or having to care for disabled relatives.  The House bill eliminates the elderly and disabled credit, the credit for adoption expenses, the exclusion of employer benefits on dependent care programs from gross income, the deductibility of moving costs incurred to take a new job, and a slew of costs often required of employees for them to take or keep a job (e.g., buying a uniform, or malpractice insurance if a doctor).  In many cases the revenue impacts of these changes aren't that large on a national basis, but as with medical costs, they can be more significant for specific individuals.  A business is routinely allowed to deduct the costs of earning income; but these tax bills make it much harder for individuals to do so.   

Tax preparation fees.  Perhaps the most ironic aspect of the House bill is the removal of tax preparation expenses as a deductible expense.  Here's a massive new change to tax laws that no layperson in their right mind and can figure out; yet if one needs to hire a tax preparer to ensure ones taxes are properly calculated, this is no longer viewed as an eligible offset to ones taxable income.  As with so many of these provisions, the exact same practice within a corporate form remains deductible. 

Owning a home.  There are large proposed changes to the tax treatment of home ownership.  This includes eliminating the tax deductibility of mortgage interest on second homes (which I think is a good idea); on home equity loans (more mixed); and halving the eligible size of a loan that can get that benefit even on first homes.  There is also a proposed cap on the ability to deduct local property taxes paid from federal tax bills.  These policies will greatly affect real estate markets and could have unintended side effects even if some of the changes make sense.  This includes a downturn in home sales, and a shift towards rental housing.

It is also notable that the tax reform proposals don't seem to be stripping away tax subsidies to rental housing -- the tax-exemption for publicly-traded real estate partnerships called real estate investment trusts (REITs), for example.  Indeed, the effective tax rate on these will drop, since REITs are pass-through entities and income from pass-throughs in both proposals will see a new, lower top tax rate. 

It is also notable that when the really wealthy own really large real estates, they often own it within a corporation -- so will be able to continue to deduct all of the expenses that are being limited for individuals.  Yes, there is a pattern here...