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«Volume 4 • Issue 14 • September 2011 THE TRICKY ART OF MEASURING FOSSIL FUEL SUBSIDIES: A Critique of Existing Studies Kenneth J. McKenzie and ...»

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SPP Research Papers

Volume 4 • Issue 14 • September 2011

THE TRICKY ART OF MEASURING

FOSSIL FUEL SUBSIDIES:

A Critique of Existing Studies

Kenneth J. McKenzie and Jack M. Mintz*

The School of Public Policy, University of Calgary

SUMMARY

Fossil fuel subsidies are of enormous import to policy-makers and public opinion, making it

critical to properly define them. However, traditional methodologies tend to place subsidies in the realm of tax expenditure analysis, presenting a flawed picture. A recent report on government subsidies to the Canadian energy sector prepared for the International Institute for Sustainable Development exemplifies this flawed approach along several dimensions: it is not based on a robust underlying economic framework, it fails to account for complex interactions between tax and royalty systems in existing fiscal policy, and it uses a definition of subsidies that was created for a different purpose. The authors of this paper propose an alternative “economic view”, based on economic rents, which provides a neutral benchmark against which subsidies, royalties and other energy-focused fiscal measures can be measured. Using marginal effective tax rate (METR) analysis, the authors show that it is possible to obtain a more accurate picture of energy subsidies and their impact on resource allocation and economic activity. This improved schema will ideally allow governments to better understand subsidies and devise sound policies, leading to less waste and distorted investment choices.

* Professor of Economics and School of Public Policy and Palmer Chair of Public Policy, University of Calgary respectively. We thank three reviewers for their helpful comments.

w w w. p o l i c yschool.ca

INTRODUCTION

This paper examines methodologies used to analyze the magnitude of “subsidies, which may be in the form of grants or tax relief given to consumers and businesses. In Canada, the focus has been on subsidies provided to the oil, gas and coal industries, of which most have been in the form of tax reductions for specific investment decisions made by the fossil fuel industry.

We believe that the typical approach to measuring fossil fuel subsidies — most of which is essentially rooted in the concept of tax expenditures1 — is fundamentally flawed and misleading in several ways. The purpose of this paper is to examine these flaws and suggest what we think is a more appropriate methodological approach to evaluating taxes and subsidies in the oil and gas sector.

We present instead what we call the economic view of subsidies. The economic view is based upon an optimizing model of investment in the oil and gas industry. Any definition of subsidy must be based on an underlying benchmark — subsidy relative to what? The economic view suggests a natural benchmark against which subsidies, taxes and royalties can be measured;

neutrality with respect to the investment decisions of oil and gas companies and in comparison with other business activities. While the notion of neutrality can itself be defined in numerous ways — we consider some alternatives — it is a concept well grounded in both economic theory and the realities of investing in the fossil fuel sector.

We provide an alternative analysis to the tax expenditure approach, which offers, in our view, a more meaningful understanding of the economic effects of tax subsidies on the allocation of resources. Upon taking into account the impact of taxes and royalties on investment decisions, we find that oil and gas industries are not subsidized in aggregate once negative tax expenditures, not just positive ones, are taken into consideration.

Studies of taxes, royalties and subsidies in the energy sector are very much of interest to policy makers. In the statement issued at the conclusion of their 2009 summit in Pittsburgh, the

leaders of the G-20 Group of countries noted that:

–  –  –

We support this sentiment. Our view is that the appropriate principle for business fiscal policy is to raise revenue in the most efficient manner by setting tax rates as low as possible on neutral bases that do not favour one form of activity over another. Explicit subsidies should generally be avoided. Royalties should be efficiently set to capture rents accruing to the government that owns the resources available for extraction. Only in a limited number of cases is some deviation appropriate from these principles; for example, the imposition of taxes (or regulations) to reduce environmental harms or tax incentives or subsidies to encourage innovative activity that would otherwise not be undertaken due to the inability of firms to appropriate the full social returns to research.

1 Stanley Surrey, Pathway to Tax Reform: The Concept of Tax Expenditures, Cambridge: Harvard University Press, 1974.

2 Quoted in OECD Secretariat (2010), Measuring Support to Energy — Version 1.0, Background paper to the joint report by IEA, OPEC, OECD and World Bank on “Analysis of the Scope of Energy Subsidies and Suggestions for the G-20 Initiative,” on March 23 at http://www.oecd.org/dataoecd/62/63/45339216.pdf, page 5.





2 A good illustration of the difficulties inherent with measuring tax subsidies is contained in a 2010 report conducted for the Global Subsidies Initiative (GSI) of the International Institute for Sustainable Development (IISD) (hereinafter, the Report). This Report examines government subsidies to the oil and gas sector by the federal government and three Canadian provinces — Alberta, Saskatchewan and Newfoundland & Labrador.3 The Report identifies a total of 63 subsidy programs for the upstream oil and gas sector totalling over $2.84 billion (2009 dollars).

Most of the subsidies included in the study are of the nature of so-called tax breaks and royalty reductions.

We use the IISD Report as a foil to discuss our views on the appropriate way to think about and evaluate subsidies in the oil and gas sector (or any other sector for that matter), and to highlight difficulties with the tax expenditure approach. The Report exemplifies a common approach to measuring subsidies that we think is methodologically flawed. Using the Report as a concrete example is a useful way to present our views, as it provides us with a convenient and concrete context.

In this regard, it is important to emphasize that it is not the intention of this paper to systematically dissect and critique the IISD Report. Rather, we view the Report as representative of a methodological perspective that seems to permeate popular thinking about subsidies in general, and subsidies for fossil fuels in particular. As such, the Report plays the role of a proxy for similar types of analysis.

The proper measurement of subsidies is a matter of no small consequence. The Report seems to have provided the fodder for some recent controversial statements by Canadian politicians.

In the most recent federal election campaign the late Jack Layton, at the time leader of the NDP, suggested that if elected he would eliminate $2 billion in subsidies to the oil sands.4 More recently, Ontario Premier Dalton McGuinty claimed that “hundreds of millions” of dollars in federal oil and gas subsidies provided to Alberta and Saskatchewan were “paid for” by Ontario.5 The remainder of the paper is organized as follows. In the next section, we provide a more detailed discussion of the measurement of subsidies, especially with regard to the use of tax expenditure analysis. In the following section we discuss the GSI approach to subsidies used in the Report and present our assessment of it. This is followed by a discussion of the economic view, including a presentation of some illustrative calculations using this approach. This view is motivated by the well-accepted marginal effective tax rate literature. In the following section we discuss other issues, including the incorporation of environmental considerations and the use of appropriate instruments to achieve stated objectives. The last section concludes and summarizes.

3 Dave Sawyer and Seton Stiebert (2010), Fossil Fuels — At What Cost? Government support for upstream oil activities in three Canadian provinces: Alberta, Saskatchewan and Newfoundland and Labrador. The Global Subsidies Initiative of the International Institute for Sustainable Development, on March 23, 2011 at www.globalsubsidies.org/research/fossil-fuels-what-cost-government-support-upstream-oil-activities-three-canadianprovinces.

4 The Globe and Mail, “Visiting Quebec, Layton rips into oil sands,” March 31, 2011. At http://www.theglobeandmail.com/news/politics/visiting-quebec-layton-rips-into-oil-sands/article1964853/ 5 The Vancouver Sun, “East-West battle brews over oil, gas subsidies,” July 21 2011. At http://www.vancouversun.com/business/East+West+battle+brews+over+subsidies/5136180/story.html

3 WHAT IS A SUBSIDY?

Typically a subsidy, whether a grant or tax relief, is viewed as a reduction in the cost of buying a good or service. With a reduction in the price of a product, purchasers will be more willing to buy more of it and producer will be more willing to supply it. Grants provided by governments are well-understood subsidies since the expenditure is budgeted. Subsidies provided through the tax system — tax expenditures — need to be understood in terms of the benchmark used for determining the appropriate level of tax to be paid by business. The difficulty is to determine whether the tax relief given to a firm is an explicit subsidy or, instead, an offset to make sure taxpayers pay taxes according to a benchmark system. This point is discussed in more detail below.

Subsidies can be measured in different ways depending on the focus of a study. For governments, the total cost of subsidies is important to determining their impact on public budgets. For economic and environmental objectives, subsidies should be measured in terms of their impact on the allocation of resources in the economy. This latter approach critically depends on how subsidies affect consumer or business decisions, which is a focus of many recent analytical reports.

Two concerns are particularly important with respect to business subsidies: waste and impact on the allocation of resources.

Waste arises when subsidies have a large revenue cost without impacting behaviour, either because the recipients would have undertaken the activity anyway, or the subsidy does not influence their economic decisions. In this case, taxes must be increased in order to fund ineffective subsidies and these taxes in turn impose economic costs by discouraging economic activity or distort business decisions. While we are particularly critical of subsidies that are wasteful in this manner, they are not in fact the focus of many fossil fuel subsidy studies, such as the Report, which view subsidies as having economic and environmental impacts due to fossil fuel investments encouraged by the subsidies.

The misallocation of resources results when businesses are directed to activities because the subsidy is available rather than investing solely on the basis of economic criteria. Businesses invest in capital until the risk-adjusted return is equal to the financial cost of capital. If a subsidy lowers the cost of capital or augments revenue, more investment would take place than otherwise, at least in principle. Thus, if the main concern over subsidies is their impact on economic behaviour, the appropriate measure is to look at how subsidies influence marginal decisions. In recent years, economists have developed methodologies that are used to assess how fiscal policies influence economic decisions. These methodologies are based upon the notion of the marginal effective tax rate on investment, which will be further discussed later.6 In the following section, we examine in detail the GSI Report that illustrates well the difficulties involved with measuring fossil fuel subsidies under the tax expenditure approach.7 6 For the initial methodologies that were developed, see M. King, and D. Fullerton, The Taxation of Income from Capital, Chicago: University of Chicago Press, 1984 and R. Boadway, R., N. Bruce and J. Mintz (1984), “Taxation, Inflation and the Effective Marginal Tax Rate on Capital in Canada,” Canadian Journal of Economics, 17 (1), 62-79.

7 Sawyer and Stiebert (2010), Fossil Fuels — At What Cost, International Institute of Sustainable Development, Winnipeg, Manitoba, 2010, p. 11.

4 THE GSI APPROACH TO MEASURING SUBSIDIES

The GSI approach to subsidies is based upon the notion of preferential treatment.8 This begs the obvious question: preferential relative to what? While this question will be returned to throughout this paper — and can indeed be viewed as the primary unifying theme — the

approach is to label a program as a subsidy if preferential treatment is provided:

• To selected companies;

• To one sector or product when compared to other sectors;

• To sectors or products in one country when compared internationally.

The definition of subsidy employed by the GSI is based on the WTO’s Agreement on Subsidies

and Countervailing Measures (ASCM). Article 1 of the ASCM identifies four types of highlevel subsidy categories whereby:

• Government provides a direct transfer of funds or potential direct transfer of funds or liabilities;

• Revenue is foregone or not collected;

• Government provides goods or services or purchases goods;

• Government provides income or price support.

Article 2 of the ASCM requires that a subsidy be specific to an enterprise, industry or group of enterprises or industries.

The Report takes a four-step approach to assessing subsidies for fossil fuels in Canada:

1. Identify programs in the oil sector that are not available to other sectors;

2. Sort the programs (by jurisdiction) into the four high-level subsidy categories identified above;

3. Quantify the number of the subsidies and their value;

4. Estimate the environmental and economic impacts of the subsidies.



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