End the Expensing of Exploration and Development Costs for Extractive Industries

Current tax law treats the extractive industries that produce oil, natural gas, and minerals more favorably than it does most other industries. One incentive designed to encourage exploration for and development of oil, gas, and hard minerals allows producers to "expense" rather than capitalize some of their costs. Expensing allows companies to fully deduct the costs of exploration and development from taxable income as they are incurred rather than waiting to deduct those costs over time as the income they produce is generated.

Other industries, by contrast, must deduct costs more slowly, according to prescribed rates of depreciation or depletion. The Tax Reform Act of 1986 established uniform capitalization rules that require certain direct and indirect costs related to property either to be deducted when the property is sold or to be depreciated over several years. In either case, the businesses involved must postpone the deduction of those costs from their taxable income. Intangible costs (such as maintaining a working- capital fund) that are related to drilling and development and the costs for mine development and exploration are exempt from those rules. The ability to expense such costs gives extractive industries a tax advantage that other industries do not have.

The costs that companies can expense include those incurred for excavating mines, drilling wells, and prospecting for hard minerals. The rules do not apply across the board to producers of oil and natural gas, however. Although current law allows independent oil and gas producers and noncorporate mineral producers to fully expense their costs, that practice is limited to 70 percent of costs for "integrated" oil and gas producers (companies with substantial retailing or refining activity) and for corporate mineral producers. Those companies must deduct the remaining 30 percent of their costs over 60 months.

This option would replace the expensing of exploration and development costs for oil, gas, and minerals with the standard capitalization rules set in the Tax Reform Act of 1986, increasing revenues by $8 billion from 2012 through 2016 and by a total of $10 billion over the 2012-2021 period. (Those amounts reflect the assumption that businesses could still expense some of their costs, including those associated with unproductive wells and mines.)

An argument in favor of this option is that expensing distorts the allocation of society's resources in several ways. First, it encourages the use of resources for drilling and mining that might be employed more productively elsewhere in the economy. Second, it could influence the way resources are allocated within the extractive industries. A company could decide what to produce not on the basis of factors related to economic productivity but on the basis of the size of the advantage that expensing provides (for example, the difference between the immediate deduction and the deduction over time, which reflects the true useful life of the capital involved). Such decisions also could rest on whether the producer must pay the alternative minimum tax, under which expensing is limited. Third, expensing encourages producers to extract more resources in a shorter time. That, in the short run, could make the United States less dependent on imported oil; but, in the long run, it could deplete the nation's store of oil for extraction and cause greater reliance on foreign producers.

An argument against such a policy change is that exploration and development costs should be expensed because they are ordinary operating expenses. Supporters of expensing also argue that the tax advantage is necessary to encourage producers to continue exploring and developing the strategic resources that are essential to the nation's energy security.