Introduction to Severance Taxes
A brief look at U.S. state severance taxes, risks, and climate transition.
Severance taxes are a unique revenue source. In mining and other natural resource areas, they are a levy on the extraction of minerals from the earth. The most common severance taxes are on coal, oil, and other fossil fuels. This guide builds on our “Introduction to State Budgets” and will provide an overview of these taxes, what they are used for, and how they relate to climate transition.
Severance Taxes and Other Fees on Mining Activities
The major types of severance taxes are on the extraction of coal, oil and gas, and other minerals. A small number of states also tax sand, gravel, and other non-metallic minerals.
If a tax is levied it is likely a production or ad valorem tax, based on the value of the resource extracted. The value of the mineral being mined is based on market conditions and the amount of the resource extracted from the ground. For example, this is how West Virginia determines its coal severance tax:
Some companies must also pay a lease to use public lands for mineral extraction. While technically not a severance tax, it is one way governments tax mining companies. These payments can be charged by the federal government, with the proceeds often shared between the two levels of government.
As an alternate to severance taxes, some states charge an impact fee. This fee is assessed on each new well or other facility built. The revenue collected from these fees is intended to pay for the increased cost of infrastructure and services needed from these new developments, such as additional police and fire protection, road repairs, and so on. Pennsylvania, for example, levies an impact fee and not a severance tax.
What States Levy Severance Taxes, Whose More Reliant
States with the largest amount of their revenues derived from severance taxes include Alaska, Wyoming, and North Dakota. The taxes raised in these states account for a significant percentage of their overall revenue. In Wyoming it is over 30% and prior to the 2014 rout in oil prices, all of Alaska's general government expenses were paid for by oil-related revenues.
The states receiving the largest portion of their revenue from severance taxes shouldn't be surprising -- they are also the most dependent on mining for economic activity (either from employment or mineral extraction). At the onset of the COVID-19 pandemic, IHS Markit forecasted that Texas, North Dakota, New Mexico, Oklahoma, and Alaska could “endure significant economic losses as mining output shrinks.”
Texas' economy has significantly diversified away from oil and gas activities, but they remain a significant contributor. The state's oil severance tax and other revenues is primarily used to fund education — the Permanent School Fund (PSF). PSF which pays for public education in the state has a balance of over $45 billion (2020), making it the largest education endowment in the country.
State Wealth Funds and Mining Activities
Like Texas, a number of states have derived revenues from mining to create wealth funds. At least seven states operate severance tax-based sovereign wealth funds. Some notable examples:
Alaska's Permanent Fund was established in 1976 with revenues from the state's oil severance tax. The fund has over $65 billion in assets and pays an annual dividend to all Alaskans.
North Dakota's “Legacy Fund” was created recently in 2010 with revenues from the state's oil and gas severance taxes. The first mandated transfer of earnings to the General Fund occurred in July of 2019 — over $450 million.
Wyoming's Permanent Mineral Trust Fund has been used primarily for education spending, and has a balance of nearly $8 billion (2020).
Risks to State Revenues from Severance Taxes
Severance taxes are linked to economic activity and commodity prices. An increased reliance on these taxes creates revenue volatility. In it's study of state revenues, the Pew Charitable Trusts found states with the highest volatility occurred in Alaska, North Dakota, and Wyoming, "all natural resource-dependent economies that rely heavily on severance tax revenue." The Brookings Institution had similar findings: “despite these taxes’ efficiency and distributional advantages, relying too much on them poses real downside risks for state.”
Alaska is one such state that went from a 100% reliance on oil-related revenues to 20% over the course of five years. In 2013, the state legislature was forced to make significant cuts to education and public services due to a $900 million decline in oil revenues. Some of those cuts continue as the state balances paying a dividend to residents (derived from investment earnings) or funding government services.
The potential for revenue volatility is also seen in other states. Oklahoma, which does not have state wealth fund, has seen its severance tax revenue drop by over 50% since 2014 as a result of the oil price rout. In 2020, the decline in oil prices lead to revised revenue estimates of $500 million less than what was projected in 2019.
States with Severance Taxes and Carbon Mitigation
It is difficult to ascertain how states that levy severance taxes will respond to carbon mitigation and efforts to reduce green house gases. Even if commodity prices rise, these states are likely to face a long-term change in the demand for oil and other fossil fuels. During the height of the pandemic in 2020, BP forecasted that reduced demand growth may have resulted in peak oil consumption in 2019.
When commodity prices fall and economic activity slows, severance tax revenue declines as well. States with high reliance on these volatile revenue sources typically carry higher reserves, some in excess of 100% of expenditures. But as reliance of reserves increases it can leave the state in a vulnerable position for future shocks, particularly if revenues don’t rebound as quickly.
While the long-term effects of climate transition on economic activity and commodity prices are unknown, it is likely that severance taxes will become more volatile in the future.
Revenue and economic diversification is the best way to protect against boom and bust commodity cycles. Even if states are able to draw on vast fiscal reserves, it can’t last forever.