Association for Public Policy Analysis & Management

The recent fracking boom caused oil production to increase by 84 percent from 2007 to 2017, while tax revenue from oil and gas production increased to over 20 percent of tax receipts in the top ten revenue states. Proponents of increases in severance tax rates see opportunities to increase government revenue, especially during periods of high oil prices and activity. Conversely, opponents argue that increases in taxation will lead drilling companies to invest in neighboring states. Some states have chosen to subsidize drilling by foregoing severance tax revenue on certain wells in order to attract more drilling activity. For example, Oklahoma lawmakers reduced the state's severance tax on new horizontally-drilled wells to one percent for the first 48 months of production, which equated to $379 million in tax breaks in 2015.

We study how state production taxes effect firm investment decisions using a rich dataset on the location of oil drilling investments over time in the United States. Our empirical exercise is motivated by a theoretical model that demonstrates that changes in location-specific tax rates affect firms in qualitatively different ways than changes in output price. While both price and tax changes affect the revenue earned from drilling in a given state, our theoretical model of firm capital allocation over multiple regions shows that a price change also affects the opportunity cost of drilling and leads to a different net effect.

By exploring the effects of state oil production (`severance') taxes on firm investment, we make two contributions to the literature on taxation and economic activity. First, using 30 years of spatially explicit data on drilling in 91 reservoirs across 17 oil-producing states, we find that oil firm drilling investment decisions respond inelastically to changes in state tax rates. We show that a one-dollar increase in the price of oil leads to a 1 percent increase in wells drilled, but a one-dollar decrease in tax leads to at least an 8 percent increase in wells drilled.

While our estimates do not account for the long-run supply response to prices or taxes, they provide valuable information about how an important economic activity across many parts of the country responds to changes in state tax policy. Over the long run, less oil production in the present could lead to higher production in the future. Nevertheless, many policymakers remain concerned about the medium-run impacts of policy changes. If our estimated impacts lead to a re-timing of drilling, the long-run elasticity could be smaller than the short-run response estimated here. Alternatively, if higher taxes deter exploration, this could lead to larger long-run impacts. We show that the response to a change in tax paid per barrel of oil is inelastic, implying that an increase in the tax rate per barrel leads to increases in tax revenue. The policy implication is that state governments should use caution when considering the use of lower tax rates to attract more drilling from neighboring states.