By now, you have probably heard the call by democrats and environmentalists to “end the $4 billion in subsidies for big oil.”

The five major oil companies that have a significant presence in the United States - Exxon, Chevron, Shell, BP and Conoco - are some of the biggest businesses in America, and have some of the highest gross profits of all U.S. Companies. They can probably afford to pay a little bit more in taxes. But does it make sense to repeal the tax breaks for the oil industry?

Generally, the answer is no.

First of all, the $4 billion in subsidies are not subsidies, they are tax deductions. And, the majority of the deductions do not even go to big oil companies; they go to independent oil producers - small businesses, the majority of which have less than 20 employees, not the big oil companies that we often associate with oil drilling. Repealing the tax breaks would likely hurt these small American businesses, increase the amount of oil we have to import, and actually reduce the tax revenues from oil.

But why do we have these tax deductions in the first place? They exist to incentivize small companies to produce oil from marginal wells – wells that are unprofitable in the normal tax configuration, but marginally profitable with the tax breaks. These are old or very small wells that do not produce very much individually, but combined, produce a lot of oil for U.S. markets. To understand the impacts of repealing these tax breaks, let’s look at two of the biggest deductions: The Domestic Manufacturing tax deduction and the Percentage Depletions deduction.

The purpose of the Domestic Manufacturing tax deduction is to get companies to do business in America. The tax burden on some domestic industries, including oil companies, is already extremely high. For example, in the first quarter of 2011, Exxon made $18.9 billion in profits, and paid $8 billion of that to the U.S. government in the form of corporate income tax. That is 42% tax rate.

With such high tax rates in the U.S., many companies find economic arguments for moving overseas, and the Domestic Manufacturing tax deduction it is a way to encourage business to stay in America. It is an anti-outsourcing incentive, if you will. This deduction allows all producers to deduct 6% of their profits, and saves the oil and gas industry (mostly independent producers) about $1.7 billion in taxes per year. However, this deduction is available to many industries and businesses – not just oil companies - including software developers, video game developers, and companies that sell, lease, and license motion pictures that were made in American – that’s right, Hollywood movies. Except, all these other industries get a 9% deduction, whereas the oil industry gets a 6% deduction.

The Percentage Depletion deduction is the second largest type of deduction for oil companies, and it is a cost recovery method that allows taxpayers to recover some of the money that they invest in mineral leases. It is available to all extractive industries (gold, iron, clay, etc) and it saves the oil industry about $1 billion in taxes. However, it is not available to big oil and gas companies. It is only available to independent producers that do not refine or market oil.

Generally speaking, if these tax deductions were repealed for oil companies, it would likely do three things:

1. Disproportionately hurt independent producers, and have little effect on the major oil companies (‘big oil’)

2. Cause the U.S. to import about 700,000 more barrels of oil per day than we already do (an increase of 6%)

3. Decrease the government’s tax revenue from oil and gas

None of these are favorable outcomes for America, but let’s look at the reasoning behind each outcome.

1. Repealing the tax breaks could disproportionately hurt independent producers

Most of the tax breaks go to independent producers for two reasons: First, because most of the oil and gas produced in this country is produced by smaller oil companies. According to the Independent Petroleum Association of America, independents produce 68% of our domestic oil and 82% of our domestic natural gas. Second, some of the deductions, like the Percentage Depletion deduction, are actually off limits to integrated oil and gas companies – integrated meaning the majors (Exxon, Chevron etc), but also the larger independent companies like Hess and Marathon. Repealing the tax breaks may not significantly affect big oil companies, but it could be devastating to many of the small independents.

2. Increasing the tax burden could cause us to import about 700,000 more barrels of oil per day than we already do.

A recent study by Wood McKenzie explains what would happen to American production if the tax burden on oil companies was increased. Here is a summary of their findings:

Total Potential Production Impact:

- Estimated loss of 0.7 million barrels per day (mmboed) by 2020, with an additional 1.7 mmboed put at increased risk (of not being developed due to unprofitable project economics).

If we were to end all oil industry tax deductions, it would be harder for small producers to do business, and many wells would become unprofitable. American production would likely decrease significantly, and instead of producing that oil from our own country, we would have to import that oil from somewhere else. One of the safer options is importing from Canada through pipelines, and we have seen how much resistance that causes. Alternatively, we could import from Middle East, Venezuela or Russia. Either way, importing an incremental 0.7 million barrels per day would increase our trade deficit by about $60 million per day or $22 billion per year. In other words, what the government is currently doing is making a $4 billion investment with a $22 billion payout.

3. Repealing the tax breaks could decrease the government’s tax revenue from oil and gas

As a result of lower production, the government has less domestic production to tax, as such, tax revenues go down significantly.

The McKenzie study outlines this impact on tax revenues:

Total Potential Government Revenue:

- Averages a positive $3 billion per year the first five years 2011-2015.

- An estimated $6 billion less in 2020 with an additional $8 billion put at increased risk.

- An estimated $10 billion less in 2025 with additional $8 billion put at increased risk.

For the record, this is not to say that we should not be investing in renewables and efficiency and move away from a predominately fossil-fuel dependent energy economy. We should. We should do everything possible to develop renewables. However, it is possible that the oil tax deductions could actually help develop renewables. If these tax deductions result in a net profit for the government, perhaps these profits could be used to invest in emerging technologies. Instead of bashing oil companies, we should leverage a good financial situation to help small American businesses, and to invest in the next era of energy at the same time.

About the author:

Scott McNally has a B.S. in Chemical Engineering from the University of Texas. He has worked as an Environmental Engineer for Valero Energy Corporation, a Project Engineer for Shell Oil Company, and an energy and climate research intern for the White House Council on Environmental Quality. Scott is a frequent guest blogger at Plugged In – he was invited to be a guest blogger by of Plugged In’s Melissa C. Lott. You can reach Scott via e-mail at scottmcnally at gmail dot com.