Effects of Severance Tax on Economic Activity: Evidence from the Oil Sector
AbstractState and local policymakers must balance taxing economic activity to generate
government revenue with the potential loss of activity with higher taxation. Despite the
important fiscal and economic implications of how drilling activity responds to changes in
severance tax rates, there is little empirical evidence on the sensitivity of drilling activity to state
severance tax rates. Moreover, little is known about the degree of spatial spillovers from tax rates
in neighboring states. The purpose of this paper is to estimate how responsive firms are to
differences in severance tax rates across states and over time. We investigate if firms respond
differentially to oil prices and severance taxes, and whether or not firms respond to neighboring
states’ severance tax rates.
Using data from Drillinginfo, we look at all oil wells drilled between 1980 and 2015 in
reservoirs that cross state lines. By focusing on reservoirs that cross state lines, we use fixed
effects to control for both reservoir (i.e., unobserved geologic quality) and unobserved state
characteristics such as permitting and regulatory ease. We find a stable and inelastic short-run
price elasticity of drilling equal to 0.8. We also find an inelastic response to severance taxes,
with a 1 percent increase in the dollar-per-barrel tax rate associated with a 0.3 percent reduction
in drilling. The positive response to neighboring states’ tax rates is small and does not differ
statistically from zero. It is also statistically smaller than the own-state elasticity.
Our estimates indicate that an increase in revenue from higher severance tax rates more
than offsets the resulting decrease in drilling activity. The policy implication is that small
increases in severance tax rates can allow states to increase revenue. Furthermore, engaging in
tax competition may lead to revenue losses in competing states.