The Interacting Effects of Royalty Taxation and the Depletion Allowance on Natural Resource Exploitation

A great deal of attention has recently been given to the effects of various tax policies on energy production. However, of the many publicly available studies none have addressed the dynamic interaction effects of percentage royalty taxation and the various types (cost and percentage) of depletion allowances which generally prevailed on natural resources prior to recent legislation. Though the depletion allowance resulted in greater resource production at any given price, percentage royalty taxation has the opposite effect. For efficiency in production both tax rates, i.e. the royalty and depletion, should be equal. This paper analyzes the joint effects of royalty taxation and the two types of depletion allowances in the context of a dynamic model using as a pardigm hydrocarbon exploitation on the U.S. Outer Continental Shelf. Although this specificity allows for concreteness of examples, it does not limit the generality of the analysis. It appears that the Congress´ recent removal of the percentage depletion allowance on oil was a serious mistake unless, of course, the interest of the legislation was to distort production or raise prices.