The Future of West Virginia’s Severance Tax

In West Virginia a 5% tax is imposed on those engaging in the extraction of coal, oil, gas and other natural resources from the lands of the state. This is the “severance tax.” While the tax is ostensibly on the privilege of engaging in the business of extraction, the tax is calculated based on the volume of production. 

We depend on severance tax revenues for 10% to 12% of the general revenue budget of the state, making us more dependent on this revenue source than most other states. Our dependence subjects the state budget to boom and bust cycles caused by volatility in the price of the commodities. The state’s oil & gas industry is now booming even though coal is in the midst of a long-term decline. Most analysts believe both these trends are likely to continue for decades. So the future is bright for the state’s budget if we manage our oil & gas patrimony carefully.

West Virginia had no severance tax until 1987. Before that we taxed natural resource extraction at a higher rate through the “business and occupations tax” upon the gross receipts of the extraction business. Despite this, the extraction industries complain that the 5% severance tax rate is high relative to neighboring states. But this nominal 5% rate is reduced to an effective tax rate of around 3.2% by various exemptions and tax breaks created by the Legislature. One such break is a reduced tax rate on coal mined from thin seams. Another is a tax credit on oil & gas wells that produce a small volume. Our effective tax rate on severed natural resources compares favorably to our neighbors.

Historically the revenues from coal severance were often four times the revenues from all other severance taxes combined. Given the huge leap in gas production made possible by hydraulic fracturing, this is changing. Table 1 shows that as of 2015 tax revenues from oil and gas production represented more than half of the amount from coal production. By 2030, the revenues are expected to be roughly equal.

Table 1 – Severance Tax Revenue 2011 to 2015 (in 000s)

Source: WV State Tax Department   

How Severance Tax Revenues Are Allocated.

The West Virginia Center for Budget & Policy did a study of the severance tax in December 2011 that is quite helpful in understanding these issues. The CPB described how severance tax revenue was distributed in FY 2011, which is typical of distributions in later years. 

The first $24 million in severance tax revenue in FY 2011 went into an infrastructure fund to cover the externalized costs of extraction industries, such as damage to roads and bridges. This is required by law every year. 

The large bulk of the revenue, more than 86% in FY 2011, went into the general revenue fund with no spending strings attached. 

Finally 8.9% of the tax revenue was distributed to counties and municipalities. This happens in two ways. One formula directs a portion of the revenues to counties from which the resources are actually severed. There is a list of these counties for coal and one for oil & gas. For example, six counties (Marshall, Tyler, Harrison, Wetzel, Doddridge and Ritchie) principally benefitted from the formula for distributing oil & gas tax revenues.

But under a second formula all counties and municipalities benefit from direct distribution of severance tax revenues based on population. For example, in FY 2018 Martinsburg received $20,000 from oil & gas severance taxes, Charles Town received $5,000 and Shepherdstown $6,000.

Should We Increase the Severance Tax Rate on Oil & Gas?

There has been a lot of debate on this question recently. In the April 11, 2018 issue of the Spirit of Jefferson, former Delegate John Doyle argued that we should double the severance tax rate on oil & gas. Then in the Charleston Daily-Mail for April 14, 2018, the former President of the West Virginia Independent Oil & Gas Association (and current lobbyist) Philip Reale argued that we should be cautious in raising the tax and increasing production costs because oil & gas producers might choose to drill wells in other less costly states. In my opinion, Doyle gets the better of this argument.

First, as Doyle points out, if the state’s production of oil & gas continues to expand as predicted, doubling the severance tax could mean an additional $560 million in revenue for the state. That would be a huge shot in the arm for a state struggling to address daunting social and economic problems. The injection of that additional revenue into the state’s economy would also have a multiplier effect. A 2010 study from Penn State found that for every $100 million in severance tax revenue, Pennsylvania would see a net gain of 1,100 jobs from increased state spending in areas such as infrastructure and schools.

The beauty of the West Virginia severance tax is that, for the most part, West Virginians don’t pay it. The tax burden of a severance tax on oil & gas mainly falls out of state in increased consumer prices for gas and oil consumption. Furthermore, most of the companies involved in gas drilling and production upon which the tax would be levied are not West Virginia companies and their stockholders are spread world-wide. Think of the oil & gas severance tax like the hotel/motel tax that travelers to West Virginia pay on their hotel stay. They get the tax burden; we get the benefit.

But what about Reale’s point that raising production costs in West Virginia might discourage drilling activity here in favor of other states like Ohio and Pennsylvania? The empirical evidence does not support this concern. Severance and income taxes are only a small part of the overall cost of operating for an oil & gas company. Pennsylvania has no severance tax whatever, but still West Virginia gas & oil production set a new record in 2016, and our prime producing counties are a stone’s throw from the Pennsylvania border.

A 1999 study in Wyoming and a 2008 study in Utah both came to the conclusion that the severance tax rate had very slight effect on the level of industry activity. Different tax rates and structures between states seem to have little impact on amount of investment in each state.  In 2001 Montana reduced severance tax rates and while Wyoming increased rates. Both states had a boom, but Wyoming experienced better growth in production and revenue. Industry certainly did not flee Wyoming.

The West Virginia Future Fund

In my opinion, the only downside to increasing the oil & gas severance tax rate substantially is that it would make our budget even more exposed to the boom and bust cycle. As severance tax revenue becomes an ever larger proportion of our general revenue fund, the sudden loss of those revenues because of price volatility can wreck budgets. But we may already have a solution to this problem.

In 2014, the West Virginia Legislature exercised rare foresight when it established the West Virginia Future Fund. This is a sovereign wealth fund that is intended to capture and invest 3% of severance tax revenue that would otherwise go into the general revenue fund. The idea is to permit us to benefit over the long term from the interest in the invested funds. Several western states have taken the lead on this type of fund. Wyoming, a large coal producing state, created its Permanent Wyoming Mineral Trust Fund in 1974. As of 2015, the Fund had assets of $6.8 billion and had generated $4.7 billion in interest income for the state’s general revenue fund.

The Future Fund is different than our “rainy day” fund. We actually have two of these – one into which budget surpluses are deposited and the other into which the state’s tobacco litigation settlement payout was deposited. These rainy day funds have been used to make up budget shortfalls in the last two years.

The Future Fund is entirely empty at present because of restrictions on when severance tax revenues can be diverted to it. One restriction is that no deposit to the Future Fund can be made unless the rainy day fund is at least 13% of the state’s general revenue fund budget for the preceding year. Another is that no deposit can be made if the rainy day fund was called upon in the preceding year to make up a shortfall in the general revenue fund budget.

It is hard to quibble with these restrictions, but as anyone knows who is trying to save for retirement, putting money away for the future requires discipline. The Future Fund will never work as intended if the restrictions prevent a deposit most every year. If this continues, the restrictions will have to be revisited.

The interest from the Future Fund can, by law, only be spent on economic development and diversification projects, infrastructure improvements and “tax relief.” It cannot be used directly to smooth out the effects of the boom and bust cycle on the general revenue fund. However, once we begin drawing down interest from the Future Fund for these specified purposes, our tax dollars that would otherwise be spent on them can be freed up to deal with other spending needs — even during years when market conditions create a bust in severance tax revenue.

Increasing our oil & gas severance tax to take advantage of the current boom coupled with actual, sustained use of the Future Fund is smart business for West Virginia.