NORTH SEA OIL REVENUE: A FUTURE TAX TARGET FOR THE GOVERNMENT?
The government’s decision to abolish petroleum revenue tax (PRT) in 1993 led to substantial losses in tax revenues but had little positive effect on oil producers’ plans to develop North Sea oil fields. Indeed, despite its high marginal tax rates, the old regime was both tax efficient and quite close to being neutral in its effects on firms’ investment behaviour.

These are the conclusions of Lei Zhang of the University of Warwick in an article published in the latest issue of the Economic Journal. He thinks it likely that new oil taxes will be introduced as and when real oil prices recover or substantial new fields are discovered. This could involve reintroducing PRT but it might also involve auctioning licences to offshore tracts as in the US.

Zhang notes that for almost two decades, the extraction of oil from the North Sea has on average added more than 2% to UK Gross Domestic Product. Yet the licences to develop the UK Continental Shelf and extract oil are allocated without charge. Applicants for permits to develop submit detailed plans for development, indicating expected outgoings and planned production: if approved, development proceeds without any licensing fee. It is left to the tax system to recover the economic rents transferred to the private sector in this way.

The fiscal regime in force in the UK Continental Shelf prior to March 1993 consisted of three principal taxes: PRT, corporation tax and royalties (though royalties have not in fact been charged on any field given development consent since March 1982). Key features of the fiscal regime were: first, the high effective marginal rate implied by the combination of PRT and corporation tax; and second, the substantial tax deductibility of development costs.

The first feature, marginal rates as high as 83%, reflected the government's intention to recoup most of the resources transferred to the private sector by the free allocation of licences. But this ran the risk of deferring development of new fields as sunk costs are substantial and the oil price highly variable. The second feature, which gave tax relief to all development costs plus 35% ‘uplift’, was intended to correct any such distortionary effect.

Zhang uses a model of irreversible investment under uncertainty about oil prices to see whether the interaction of these two features can yield a system that is non-distortionary as regards the decision to develop an oil field and also tax efficient in extracting the economic rent arising from oil production.

His main result is that, under PRT, there is a unique rate of deductibility for development costs that ensures tax neutrality, that is, a situation where the introduction of PRT does not distort the firm's decision to develop an oil field compared to what would have taken place in the absence of any taxes. (Note that, as the investment is made in the face of volatile oil prices, the firm needs to add the ‘value of waiting’ to its total costs to reach the correct decision: and this affects the neutral rate of deductibility.) Second, it turns out that, given the rate of neutral deductibility, varying the tax rate on revenue has no effect on development decisions.

Using the approximate tax parameters in force in the UK Continental Shelf, Zhang’s calculations show that the regime was both tax efficient and quite close to being neutral despite the high marginal rates; abolishing PRT has little effect on development decisions but causes substantial losses in tax revenues.

If this analysis is correct, the question immediately arises: why was such an effective tax regime essentially dismantled in 1993? One reason may be that PRT had some distortionary effect on secondary investment (for which there was insufficient allowances) and on exploration and appraisal (which had almost full PRT deductibility). So the regime, in practice, may have had more distortionary effects than are calculated in Zhang’s work.

However, as an alternative, Zhang shows that a regime with only corporation tax in place is grossly inefficient in recouping economic rents. Hence, it is reasonable to expect some additional taxes will be introduced as and when real oil prices recover or substantial new fields are discovered. This could involve reintroducing PRT (perhaps as a ‘resource rent tax’); but it might also involve auctioning licences to offshore tracts as in the US.

Note: ‘Neutrality and Efficiency of Petroleum Revenue Tax: A

Theoretical Assessment’ by Lei Zhang is published in the July 1997 issue of the Economic Journal. Zhang is in the Economics Department at the University of Warwick.

For Further Information: contact Lei Zhang on 01203-522983 (fax: 01203-523032; email: ecrsm@csv.warwick.ac.uk); or Melanie Dean of the RES/ESRC Economists in the Media Initiative on 0171-878-2913 (email: mdean@cepr.org).