Effectiveness of Severance Tax Incentives in the U.S. Oil Industry

This paper develops a dynamic empirical framework that can be used to test the effectiveness of state-level severance tax incentives in the U.S. oil industry. The framework embeds U.S. state-level panel data estimates into Pindyck's (1978) widely received theoretical model of exhaustible resource supply and can be applied to any of 20 states that produce significant quantities of oil. The model allows for interactions between taxes levied by different levels of government and for the first time addresses potential interstate differences in exploration costs, extraction costs, and reserve additions. In general, results show that severance tax incentives (in the form of tax rate reductions) substantially reduce state tax revenue collected, but yield moderate to little change in oil drilling and production activity. This outcome suggests that states should be wary of arguments asserting that large swings in oil field activity can be obtained from changes in severance tax rates.