BACKGROUND PAPER

The Decontrol of

Domestic Oil Prices:

An Overview

May 1979

Congress of the United States

Congressional Budget Office

Washington, O.C.
THE DECONTROL OF DOMESTIC OIL PRICES:

AN OVERVIEW

The Congress of the United States

Congressional Budget Office

For sale by the Superintendent of Documents, U.S. Government Printing Office Washington, D.C. 20402

Stock No. 052-070-04964-2

PREFACE

On April 5, 1979, the President announced his decision to decontrol

domestic oil prices over the period from June 1, 1979, to October 1, 1981, at

which time all controls would expire. Since the President was given

discretionary authority over the pricing of domestic crude oil during this

period by the Energy Policy and Conservation Act (EPAA) of 1977, only new

legislation could limit this authority. If the decontrol plan proceeds, the

Congress must then decide whether excess profits taxes on the increased

producer revenues are needed and how to use these increased tax revenues.

At the request of the Senate Energy and Natural Resources Committee, the Congressional Budget Office has prepared this analysis of the

President's plan. In keeping with CBO's mandate to provide objective

analysis, this report contains no recommendations.

The report was prepared under the supervision of Raymond C.

Scheppach of CBO's Natural Resources and Commerce Division with the

assistance of Everett M. Ehrlich, who also contributed to individual chapters. Major sections of the report were written by Lawrence Oppenheimer,

Beth Blattenberger, James Sawyer, and Mark Sharefkin of the Natural

Resources and Commerce Division; Lawrence DeMilner and Stephen Zeller

of the Fiscal Analysis Division; Charles Davenport, Peter Karpoff, and

Michael Deich of the Tax Analysis Division; and John J. Korbel of the

Human Resources and Community Development Division. Kevin Mann and

John Meggs also assisted with the report.

Robert L. Faherty and Patricia H. Johnston edited the manuscript,

assisted by Brice S. McDaniel. The several drafts were typed by Angela Z.

Evans, Phyllis Gustely, Lynne Zett, and Misi Lenci.

Alice M. Rivlin

Director

May 1979

111

CONTENTS

Page

PREFACE iii

SUMMARY xi

CHAPTER I. INTRODUCTION 1

CHAPTER H. THE PRESIDENT'S PLAN AND ALTERNATIVE

STRATEGIES 5

Current Domestic Crude Oil Pricing 5

Pricing Alternatives 8

Taxing Alternatives 10

CHAPTER HI. OIL IMPORT REDUCTIONS 13

Reduction in Consumption of Petroleum Products . . 14

Increase in Production of Petroleum 18

CHAPTER IV. PRODUCER REVENUES AND FEDERAL TAXES . . 27

Producer Revenues 27

CHAPTER V. THE IMPACT ON THE ECONOMY 41

CHAPTER VL ALTERNATIVE REVENUE USES 47

The Trust Fund Mechanism 47

Energy Research and Development 48

Mass Transit 52

Spending Alternatives 54

CHAPTER VH. DISTRIBUTIONAL IMPACT AND ASSISTANCE

TO LOW-INCOME FAMILIES 59

Current Family Expenditures on Oil 59

Future Expenditures on Oil and Impact

of Decontrol 65

Assistance for Low-Income Families 70

TABLES

TABLE 1.

TABLE 2.

TABLE 3.

TABLE 4.

TABLE 5.

TABLE 6.

TABLE 7.

TABLE 8.

TABLE 9.

PETROLEUM CONSUMPTION BY SECTOR: IN

THOUSANDS OF BARRELS PER DAY ... .

DOMESTIC CRUDE OIL PRODUCTION UNDER

THE BASE CASE AND THE PRESIDENT'S PLAN:

IN MILLIONS OF BARRELS PER DAY

NEW DISCOVERIES: DRILLING, RESERVES,

AND PRODUCTION

Page

14

20

24

WINDFALL REVENUES ACCRUING TO DOMESTIC

PRODUCERS FROM LOWER- AND UPPER-TIER OIL

RESULTING FROM ALTERNATIVE, DECONTROL

PROPOSALS: IN MILLIONS OF CURRENT DOLLARS

WINDFALL REVENUES ACCRUING TO DOMESTIC

PRODUCERS FROM LOWER- AND UPPER-TIER OIL

RESULTING FROM ALTERNATIVE DECONTROL

PROPOSALS, ASSUMING RISING REAL OPEC

PRICES: IN MILLIONS OF CURRENT DOLLARS . .

DERIVATION OF EFFECTIVE CORPORATE TAX

RATES ON INCOME GAINS

PRODUCER TAX LIABILITIES RESULTING FROM

ALTERNATIVE WINDFALL TAX PROPOSALS:

IN MILLIONS OF CURRENT DOLLARS

ESTIMATED ECONOMIC EFFECTS DECONTROL:

DIFFERENCES FROM THE BASE CASE

ADDITIONAL TAX RECEIPTS RESULTING FROM

DECONTROL AND LEGISLATIVE INCREASES

IN SOCIAL SECURITY TAXES: IN BILLIONS OF

CURRENT DOLLARS

28

31

37

39

45

57

via

TABLES-CONTINUED

TABLE 10.

TABLE 11.

AVERAGE ANNUAL GASOLINE EXPENDITURES

PER FAMILY FOR FAMILIES RANKED BY MONEY

INCOME AND FOR FAMILIES BY REGION AND AREA

OF RESIDENCE, 1973-1974 61

AVERAGE ANNUAL HEATING OIL AND KEROSENE

EXPENDITURES PER FAMILY FOR FAMILIES

RANKED BY MONEY INCOME AND BY REGION AND

AREA OF RESIDENCE, 1973-1974

TABLE 12.

TABLE 13.

AVERAGE ANNUAL INDIRECT EXPENDITURES ON

OIL PER FAMILY FOR FAMILIES RANKED BY

MONEY INCOME, 1973-1974

64

66

DOMESTIC OIL EXPENDITURES UNDER

CONTINUATION OF PRICE CONTROLS AND

INCREASES IN EXPENDITURES FROM THE

PRESIDENT'S DECONTROL DECISION, TOTAL

AND PER FAMILY, UNDER ALTERNATIVE OPEC

PRICE INCREASES, 1982: IN DOLLARS 67

IX

48-429 0-79- 2

SUMMARY

On April 5, 1979, the President announced his decision to decontrol

domestic crude oil prices gradually starting on June 1, 1979, so that

domestic prices would reach the world price by October 1, 1981. Since the

Energy Policy and Conservation Act (EPCA) of 1975 gave the President

discretionary authority to decontrol prices during that period, only new

legislation by the Congress could limit the exercise of that authority.

The President's decontrol plan would generate large increases in

revenues to the oil producers over what they would have received under a

continuation of controls. Thus, the Congress must decide how these

increased producer revenues from decontrol can be put to best use. The

President has proposed that the Congress enact a "windfall profits tax" to

capture some of these revenues and to establish an Energy Security Fund

that would channel these captured revenues to investments in energy

research and development, to assistance for mass transit, and to assistance

for low-income households burdened by higher energy prices. Alternative

uses of these revenues that might also be considered include allowing them

to remain with the private sector to finance exploration for new oil or using

them to provide general tax relief.

THE DECONTROL OF DOMESTIC OIL PRICES

The Current System of Controls. Although government policy had

affected the price and availability of crude oil for sometime, direct federal

regulation of crude oil prices was introduced by the Emergency Petroleum

Allocation Act of 1973 and was modified in 1975 by EPCA. Essentially, the

present regulatory system divides all domestic crude oil into the following

three classifications, or tiers:

o Old oil, or lower-tier oil, which is oil from properties that began

producing before 1973. Currently, about 3.0 million barrels per day

of old oil are produced and it receives a price of approximately

$5.86 per barrel at the wellhead.

o New oil, or upper-tier oil, which is oil from properties that began

producing during or after 1973. Approximately 3.0 million barrels

per day of domestic production are new oil and it receives a price

of about $13.06 per barrel at the wellhead.

XI
o Uncontrolled oil, which is oil that earns as much as refiners are

willing to pay for it. Three types of oil are allowed this treatment:

Alaskan North Slope oil, Naval Petroleum Reserve, and "stripper"

oil—that is, oil from wells that produce 10 or fewer barrels per

day. Approximately 2.6 million barrels per day of current domestic

production are uncontrolled and receive a price of about $18.50 at

the refinery gate. \J

Under EPCA the average, or composite, price for these three types of

domestic oil (with some special adjustments for stripper oil) can increase at

a rate up to 10 percent per year. 2/ Barring new legislation, all controls on

domestic oil prices will end on October 1, 1981, and domestic production

will receive world prices.

The President's Decontrol Decision. In order to phase out controls on

domestic crude oil, the President has decided to:

o Redefine all old oil as new oil between June 1, 1979, and October

1, 1981; and simultaneously

o Raise the price of new oil to the world price by October 1, 1981, so

that by that date all old oil will have become new oil and all new

oil will receive the world price.

Relative to an indefinite continuation of controls, the President's plan

would entail both benefits and costs. The following benefits are critical:

o Increasing domestic oil prices to the world level would encourage

consumers to reduce their demand for oil through both the substitution of alternative fuels and outright conservation. The price

increase for oil would also encourage investment in solar and

synthetic fuels, but it would not be sufficient to make unconventional fuels such as liquefied coal or shale oil economical. By 1985,

it is estimated that decontrol would decrease demand for oil by

_!/ Technically, Alaskan oil can only receive the upper-tier price at the

wellhead, but because of high transportation costs it receives the

world price at the refinery.

2/ The President can authorize increases in the composite prices that are

greater than 10 percent, subject to a veto by one house of the

Congress.

Xll
approximately 215,000 barrels per day. 3/ The potential savings

are expected to be substantially greater during the late 1980s and

early 1990s since energy is used primarily in connection with

capital goods such as industrial boilers and automobiles which take

5 to 20 years to replace.

o Decontrol would stimulate additional supply from tertiary

recovery, new discoveries, and existing oil from proven reserves. 4/

In total, these three major sources should provide 200,000 and

405,000 barrels per day of additional supply by 1981 and 1985,

respectively.

o The demand reductions and supply increases would decrease oil

imports by approximately 620,000 barrels a day by 1985, or about 5

percent of total U.S. oil imports in that year. This would represent

a shift of approximately $6 billion in the 1985 U.S. balance of

payments. In later years, as demand reductions continue to grow,

the magnitude of the oil import relief would continue to increase.

o Adoption of the world price could improve U.S. relations with

member nations of both the Organization for Economic Cooperation and Development (OECD) and the Organization of Petroleum

Exporting Countries (OPEC), which view the current subsidy of

domestic energy consumption created by price regulation as evidence of U.S. unwillingness to address the energy problem.

The President's plan would also impose the following costs:

o The price increases for domestic oil would increase inflation, and

they might slow economic activity and increase unemployment. By

the end of 1982, it is estimated that decontrol would increase the

level of prices by 0.6 to 0.8 percent above that anticipated if

controls were continued. If OPEC continues to increase the real

price of oil over this period, the inflationary impact of decontrol

3/ This estimate, like all others presented in this paper, presumes that

the full increase in the cost of crude is passed on to consumers. If

refiners have to absorb a percentage of the increase, the demand

response will be proportionately lower.

4/ Tertiary recovery is a technology that injects either heat or chemical

compounds into an oil reservoir to loosen oil so that it will flow more

freely.

xni
could be considerably higher. The effects on real Gross National

Product (GNP) and unemployment are relatively minor and generally occur after 1982.

o Low-income families would pay a disproportionate share of their

income on the higher oil prices caused by decontrol. Specifically,

decontrol would cost an additional $64 per family for the lowest

fifth of families as ranked by income; this would represent

approximately a 1.3 percent decline in their real income by 1982.

In contrast, families in the highest fifth of the income distribution

would suffer only a 0.5 percent decline in their real income by

1982. Any increases in real OPEC prices would worsen the impact

on low-income families.

o The price increases under decontrol would transfer what has been a

windfall income gain for consumers, who have been paying less

than the world price for oil, to a windfall profit for producers, who

will be receiving higher prices for oil that could have been

produced at current prices. Relative to an indefinite continuation

of controls, and assuming no increase in real OPEC prices, this

windfall profit to producers would total approximately $68.9 billion

between 1979 and 1985. If OPEC prices increased by 3 percent in

real terms over this period, the windfall would be an additional

$25.7 billion.

The benefits and costs summarized above are all relative to an

indefinite continuation of the present controls under EPCA. If EPCA were

not extended—that is, if decontrol became effective abruptly on October 1,

1981, rather than phased over the 28-month period—then most of the

benefits and costs would take place at that time. As compared with all-atonce decontrol, the President's program has the advantage of phasing the

price increase over a longer period of time and providing for an earlier

supply response. By 1985, however, the effects of a phased and a sudden

decontrol would be virtually identical.

Alternatives to the President's Decontrol Plan. Two alternatives to

the President's decontrol plan are analyzed in this study. The first, the

middle-price option, would decontrol all truly new oil and raise old oil to the

upper-tier price, but would maintain the controls indefinitely on upper-tier

oil. The second, the modified EPCA option, would decontrol truly new oil

and elevate all marginal wells to the upper tier, but would maintain controls

on other upper- and lower-tier oil. Both alternatives are compared with an

indefinite continuation of current controls.

xiv
The middle-price option. This option would decrease the producer

revenues substantially from the $68.9 billion attributable to the

President's program to approximately $24.4 billion over the period

from 1979 to 1985. It would also retain most of the supply

response—that is, 335,000 of the 405,000 barrels per day estimated

for the President's plan. The demand reduction would be about

100,000 barrels per day, or less than one-half of that attributable

to the President's plan. This option would reduce both the burden

on low-income families and the impact on inflation, which would

most likely be less than one-half the impact of the President's plan.

The modified EPCA option. This option would stimulate production

approximately 160,000 barrels per day in new supply as a result of

the provisions to decontrol new oil and to elevate marginal lowertier oil to the upper-tier price. Very little reduction in demand

would occur with this option (less than 50,000 barrels per day by

1985) because the additional producer revenues would be only about

$9.3 billion over the 1979-1985 period. The benefit of this option,

however, could be little additional inflation and little negative

impact on low-income households.

THE TAX ISSUES

Additional profits on lower- and upper-tier oil may be considered

"windfalls" if price increases were not anticipated by producers and are

therefore not needed to make existing production profitable. In addition,

higher prices may be deemed a windfall if they are the product of OPEC's

monopoly power, which distorts world oil markets.

Whether or not windfall profit taxes are considered appropriate

depends not only on these equity considerations, but also on how much new

supply could be obtained under the President's plan, and on whether

additional revenues are necessary to finance this supply. If the price on the

new supply offers sufficient incentives for firms to borrow and invest, then

the additional revenues from existing oil could be taxed away. On the other

hand, if revenues are required for the investment, then they could be left

with the oil producers.

The President's Tax Proposals. The President proposes to apply a 50

percent tax rate to the additional producer revenues after exempting

certain types of lower-tier oil. Of the total $68.9 billion in windfall

revenues that producers would receive between now and 1985, $51.4 billion

is assumed to be the base for the windfall profits tax. The tax on this base

would be $25.7 billion between 1979 and 1985; the residual $25.7 billion, as

xv
well as the $17.5 billion exempted from the windfall tax base, would be

taxed through the normal corporate income tax. These revenues would yield

a corporate tax liability of another $4 billion over the 1979-1985 period.

Thus, of the $68.9 billion in windfall revenues, a total of $29.7 billion would

be taxed away from the producers. If the windfall were subject only to

corporate income taxes, approximately $13.3 billion would be taxed away.

The windfall tax, therefore, more than doubles producers' liabilities on

windfall income.

Alternative Tax Options. Three alternatives to the President's tax

proposals are analyzed in this study:

o A 75 percent windfall tax rate on upper-tier oil and a 50 percent

rate on lower-tier oil would, over the 1979-1985 period, collect $38

billion out of the $68.9 billion windfall; $37 billion would be

collected through windfall taxes and $1 billion through corporate

income taxes. As compared with the President's proposals, this

option would tax an additional $8.3 billion, or 12 percent of the

windfall.

o A 25 percent windfall tax rate would produce $12.8 billion in

windfall tax liability between 1979-1985 and $8.6 billion in normal

corporate income tax, for a total of $21.4 billion. Tax liabilities

would thus be $8.3 billion less than those that would result from

the President's proposals.

o A "plowback" provision would allow producers to deduct increases

in drilling expenditures from the windfall profits tax base. Based

on CBO assumptions about the amount of new investment in

exploration and development, it is estimated that this provision

would allow producers to deduct $31.9 billion from the windfall

profits tax base between now and 1985, leaving a base of $19.5

billion during this period and windfall tax liabilities of $9.7 billion.

Total tax liabilities, after corporate income taxes are added in,

would equal $19.5 billion. This liability would be $6.2 billion more

than what the total liability would have been under the normal

corporate income tax.

The Marginal Tax Rate. The above tax estimates are extremely

sensitive to the assumed marginal corporate income tax, which in turn

depends primarily upon the amount of new investment in exploration and

development. Essentially, the opportunity to treat drilling costs as expenses

instead of capital outlays permits producers to shelter substantial windfall

revenues and the income from new production. In recent years, with the

high rate of inflation and the high level of exploration, expense deductions

xvi
have been sufficient to offset nearly half of the tax that would be due if the

statutory rate of 46 percent were applied to all companies. Under the CBO

assumptions concerning expenditures for exploration and development, the

marginal tax rate is approximately 13 percent for 1980, decreases to 6

percent in 1981 and 1982, and then increases over time to 26 percent in

1985. The marginal rate changes over time because of two factors: when

producers make new expenditures .on exploration and production that reduce

taxable income, and when they receive revenues from new supplies that

increase revenues. Over the 1979-1985 period, CBO estimates that the

average marginal tax rate would be approximately 15 percent.

ENERGY SECURITY FUND

The President has proposed that the Congress establish an Energy

Security Fund, which would redistribute tax revenues to low-income households, to mass transit, and to energy investments that assist in the transition

to a more energy-efficient economy. Given CBO's revenue estimates and no

increase in real OPEC prices, the President's program would create approximately $30 billion in revenues for the trust fund over the 1979-1985 period.

The Trust Fund Mechanism. The Congress has used trust funds in the

past to finance large capital projects; the funds have been obtained by taxes

on specific uses. The primary examples are the Highway Trust Fund and the

Airport and Airway Trust Fund. Trust funds, however, have several

important drawbacks from the standpoint of budgetary and policy coordination. First, since trust funds are only marginally affected by the budget

resolutions and the appropriations process, they limit the Congress1 control

over the federal budget. Second, since both energy investments and mass

transit already have relatively large federal programs, additional expenditures from a trust fund would create coordination problems both for the

Congress in authorizing and appropriating these programs and for the

Executive agencies in administering them. Finally, since revenues are

extremely sensitive to future OPEC price increases, which are difficult to

predict, it may be difficult to plan the expenditures from such a fund.

Energy Investments. The President recommends spending additional

funds on a demonstration plant for solvent-refined coal, a development

program for synthetic liquids, and additional research and development

(R&D) on coal. Such technologies are feasible, and they would increase the

probability that cost-effective synthetic fuel could be produced during the

next 15 to 20 years. This program should, however, be viewed as providing

technical information for future commercial plants rather than providing

any domestic production. Alternative options for R&D funds over the longer

xvii

1)8-429 0-79- 3
run include fusion, solar photovoltaic, solar heating and cooling, and several

fission technologies.

Mass Transit. The mass transit funding recommended by the President

is primarily to purchase new buses and to rehabilitate existing rail systems.

Although there are significant differences in the energy efficiencies of the

various modes of urban transportation, it may nevertheless be difficult to

get people to switch from automobiles to buses, which are about three times

more energy-efficient than automobiles. Through 1985, it is assumed that

funds would be available to purchase about 8,000 additional buses—a 15

percent expansion in the total U.S. fleet. The potential energy saving from

such a proposal would, however, be less than 10,000 barrels of oil per day.

The expansion would also add to current operating costs for bus companies

and would thus create greater pressure for increased federal assistance.

Low-Income Assistance. CBO estimates that oil price decontrol would

increase the nation's oil bill by $12.2 billion in 1982 if real OPEC prices

remain constant and by $15.8 billion if there is a 3 percent per year increase

in real OPEC prices. Since it is assumed that all price increases will be

passed through to consumers, households will ultimately bear the burden of

these additional oil expenditures. Assuming no real OPEC price increase,

the increase in 1982 for families with annual incomes under $5,800 will be

$64 and for families with annual incomes between $5,800 and $11,400 the

increase in 1982 will be $99- (All increases are stated in 1979 constant

dollars.) To offset these increases for both incomes classes, the federal

government would have to provide assistance amounting to between $3.0

billion and $3.7 billion, depending upon whether future real increases in

OPEC prices occur.

Alternatives to the Energy Security Fund. If the Congress determines

that the new revenues resulting from decontrol can be put to best use

through taxation, spending options other than those recommended by the

President can be considered, including the following:

o No earmarking of funds. One major option would be to separate

the tax decision from the expenditure decision. If the tax is

enacted, then it would be up to the budget and appropriations

committees of the Congress to decide on the use of the funds

through the normal budget process. These committees could

recommend spending on projects similar to those of the President

or on other programs, or they could decide to decrease the size of

the deficit. This option would provide the Congress with more

effective budget control and with greater potential for overall

XVlll
planning and policy coordination than the President's proposed trust

fund.

A fund for oil exploration. A second option would be to use the

funds to finance exploration and development of oil reserves in

non-OPEC developing nations. The major advantage of such a fund

is that there is probably greater likelihood of finding relatively

large oil reserves outside the United States than in the United

States because of the amount of exploration that has already taken

place in this country. An exploratory program by the U.S.

government might, however, be redundant with existing efforts.

Reductions in payroll taxes. A third major option would be to

allow the additional tax revenues to be used to decrease payroll

taxes. If it is assumed that 50 percent of the additional revenues

are applied to employee taxes and 50 percent to employer taxes,

then there could be some reduction in the rate of inflation

attributable to the President's decontrol plan. Although considerable uncertainty surrounds these estimates, such a proposal would

improve the price level by an estimated 0.3 percentage point by

1984.

xix

CHAPTER I. INTRODUCTION

The Energy Policy and Conservation Act (EPCA) of 1975 gave the

President discretionary authority over the pricing of domestic crude oil

during the period from June 1, 1979, to October 1, 1981, at which time all

controls would expire; only new legislation by the Congress could limit this

authority. On April 5, 1979, the President announced his decision to

decontrol domestic oil prices gradually over this 28-month period, at the end

of which domestic prices would have reached the world price. At the same

time, the President asked the Congress to legislate a windfall profits tax on

the additional revenues that would accrue to the oil producers as a result of

decontrol. Revenues from both the windfall profits tax and the corporate

income taxes the producers would pay on their increased revenues would

flow into an Energy Security Fund. These funds would then be redistributed

to low-income households to ease the burden of higher energy prices and to

mass transit and "energy investments" to assist in the transition toward a

more energy-efficient economy. \J This trust fund mechanism would

require new legislation.

The President's decision to decontrol prices would entail both benefits

and costs. On the benefit side, it would increase oil prices, thereby

encouraging energy consumers to reduce their demand for oil through both

the substitution of alternative fuels and outright conservation. This

reduction in demand would continue the adjustment to higher oil prices that

was begun with the dramatic increases in 1973-1974. This adjustment

process evolves gradually since energy is used primarily in connection with

capital equipment, which normally takes from 5 to 20 years to replace. The

price increases resulting from decontrol would also encourage investments

in solar energy and conservation, but the increases would probably not be

sufficient to make unconventional fuels such as liquefied coal or shale oil

economic. Higher domestic oil prices would also encourage increased oil

production from older wells and would stimulate exploration for new

production. The combination of reduced demand and increased supply would

decrease the overall U.S. dependence on oil imports.

I/ "Energy investments" include research and development of fossil fuels,

the construction of a refined products reserve, and numerous tax

incentives.
On the cost side, price increases for domestic oil would accelerate

inflation; they might also slow economic activity and increase unemployment. These price increases would place a new burden on low-income

households. Moreover, they would transfer what has been a windfall income

gain for consumers, who have been paving less than the world price for oil,

to a windfall profit for producers, who will be receiving higher prices for oil

that could be produced at the current, lower, regulated prices. Both the

impact on low-income households and the transfer of windfall income could

be minimized by tax and rebate initiatives similar to those proposed by the

President.

The magnitude of these costs and benefits of the President's program

are influenced primarily by two factors: namely, the baseline with which

the President's program is compared, and the assumption about how much of

the price change is passed through from refiners to ultimate consumers.

In this analysis, the Congressional Budget Office (CBO) has compared

the President's plan with an indefinite continuation of the price controls now

in place. Since the legislation that mandates price controls on domestic oil

expires October 1, 1981, domestic oil prices would increase to world levels

on that date unless new legislation were enacted. Consequently, most of the

effects on demand, supply, and inflation that are currently attributed to the

President's plan would take place anyway in October 1981.

With respect to the magnitude of the price change that is passed on to

consumers, CBO has assumed that it is 100 percent. This assumption,

however, is the subject of some debate, since competition from imported

products might prevent U.S. refineries from raising prices for domestic

products by the full amount of the crude oil price increase. It is possible

that as little as two-thirds of the price increase would be passed on to

consumers since Europe, which has excess refinery capacity, could export

refined products to the United States. If a lower percentage were used, it

would lower the inflationary impact, reduce the adverse effects on lowincome households, and lower the demand response; it would not, however,

influence the supply response.

This analysis treats only the major energy and economic effects, such

as the demand reduction, the supply response, the inflationary impact,

additional producer revenues, and potential tax revenues; it is not a

comprehensive treatment of the oil pricing question. The paper does,

however, analyze several alternative pricing strategies as well as a number
of alternative tax options, such as a higher and a lower windfall profits tax

rate and a "plowback" provision. Z/

If a windfall profits tax is enacted, a major question will be how to use

those funds. The President has recommended the enactment of an Energy

Security Fund, which would channel funds into three major programs: a

rebate to low-income households, mass transit assistance, and energy

investments. This report examines these three programs and then compares

them with three alternatives: a revolving fund for oil exploration in less

developed countries; and a rollback of payroll taxes; and no earmarking of

the revenues—that is, allowing the decisions about use of the revenues to be

made by the normal federal budget process.

Chapter n of this report gives background information on the current

system of oil price controls and then describes both the base case (continuation of the controls) and the President's plan. The second chapter also

identifies the several tax and decontrol alternatives that are analyzed in

subsequent chapters. Chapter m addresses the overall effects of decontrol

on demand and supply, which together lead to reductions in oil imports.

Chapter IV discusses producer revenues, as well as tax revenues from the

President's proposals and the alternatives. Chapter V specifies the macroeconomic effects of decontrol. Chapter VI focuses on the question of the

trust fund and examines the advantages and disadvantages of using the

additional revenues to finance mass transit and energy investments; it

compares these uses with those of financing oil exploration in less developed

countries, or rolling back payroll taxes, or not earmarking the revenues.

The last chapter analyzes the impact of decontrol on low-income

households.

2/ Under a "plowback" provision, a tax credit would be allowed to oil

producers on increased revenues that are reinvested in the exploration

and development of oil.

CHAPTER H. THE PRESIDENT'S PLAN AND ALTERNATIVE

STRATEGIES

This chapter provides background information on the present system of

domestic crude oil pricing and describes the President's plan for phased

decontrol and a windfall profits tax. Alternative pricing and taxing

strategies are also presented.

CURRENT DOMESTIC CRUDE OIL PRICING

Although the price and availability of crude oil have been affected by

government policy for some time, the present system of federal regulation

of crude oil prices was first introduced by the Emergency Petroleum

Allocation Act (EPAA) in 1973 to soften the impact of higher OPEC oil

prices and to prevent what the Congress considered would be windfall gains

for domestic producers. The current regulatory procedure was developed in

EPAA, in the Energy Policy and Conservation Act (EPCA) of 1975, and in a

series of amendments and executive actions since EPCA's passage. Barring

new legislation, all controls on domestic oil prices will end on October 1,

1981.

Currently, about 6.0 million barrels per day, out of total domestic

production of 8.6 million barrels per day, are controlled. These controls

create a significant price difference between domestic and imported crude:

as of January 1979, the average barrel of domestic crude purchased by a

refiner cost about $11.00; the average barrel of imported crude cost $15.47.

The present regulatory system divides all domestic crude oil into the

following three classifications, or tiers:

o Old oil, or lower-tier oil, which is oil from properties that began

producing before 1973;

o New oil, or upper-tier oil, which is oil from properties that began

producing during or after 1973; and

o Uncontrolled oil, which is oil that earns as much as refiners are

willing to pay for it. Three types of oil are allowed this treatment:

1+8-1(29 0-79- 4
Alaskan North Slope oil, If Naval Petroleum Reserve oil, and

"stripper" oil—oil from wells that produce 10 or fewer barrels per

day.

Old Oil. About 3.0 million barrels per day of old oil (35 percent of

current domestic production) is currently produced. Old oil is allowed a

price of about $5.86 per barrel at the wellhead, so that refiners pay $5.86

plus transportation costs before "entitlements" treatment. 2j The volume of

oil classified as old decreases over time, as reservoirs are gradually depleted

and their production levels fall. The Department of Energy (DOE) assigns

every old well a "base period control level" (BPCL), which is an adjusted

approximation of this natural rate of decline and tells DOE and the producer

how much an old well should be capable of producing, given its history. If a

well produces 100 barrels, and its historical decline rate has been 1.5

percent per month, then its BPCL for the coming month will be 98.5 barrels.

Any production from that well in excess of 98.5 barrels is considered new, or

upper-tier, oil for pricing purposes. Thus, over time, more and more old oil

receives the upper-tier price as time passes through the mechanism of

declining BPCLs. This procedure gives the producer an incentive to keep

production above the BPCL, in order to receive the higher price for the

reclassified new oil.

A property producing old oil also can be "retired," or shut down. If a

well shuts down for a year or more and then resumes production at a level of

10 barrels per day or less, then its oil moves from the lower-tier to the

stripper well category, and its price is freed from controls.

New Oil. About 3.0 million barrels per day (35 percent) of domestic

production is new oil, which is allowed a price of about $13.06 per barrel at

the wellhead. The volume of new oil increases over time, through both new

discoveries and the transfer of old oil to new through the BPCL mechanism.

\J Although Alaskan oil can net no more than the upper-tier price at the

wellhead, it is allowed to compete freely in order to recoup some of

the enormous cost of transportation to the continental United States.

2/ Under the entitlements system, all domestic refineries are entitled to

equal proportions of lower, upper, and uncontrolled oils, so that their

average crude oil costs are equal. This system will be eliminated as

the tiers are merged and brought to the world price.
Uncontrolled Oil. Finally, about 2.6 million barrels per day (30

percent) of current domestic production is uncontrolled and receives a price

of about $18.50 at the refinery gate. The wellhead revenues from this oil

are equal to the refinery gate price minus the cost of transporting it to the

refinery from the field. The refinery gate price is determined, in turn, by

the cost of imports. Transportation costs vary greatly among the three

types of uncontrolled oil—Alaskan, Naval Reserve, and stripper. Since

stripper oil is generally sold in small quantities to local refiners, it carries a

small transportation charge, as does Naval Reserve oil, which is produced

and sold primarily to nearby California refineries.

Alaskan oil, on the other hand, incurs sizable transportation charges,

especially when shipped to the Gulf Coast -through the Panama Canal.

Because of these costs, Alaskan oil nets the producer even less than the

upper-tier wellhead price. Although, according to law, Alaskan oil cannot

receive net revenues of more than the wellhead price for upper-tier, the

transportation differential makes this constraint irrelevant.

With minor technical adjustments, the prices of lower-tier, upper-tier,

and uncontrolled oils are combined into a weighted average, called the

domestic composite price of crude oil. According to the EPCA, the

President can increase this domestic composite price by no more than 10

percent annually, with the price increase distributed between the upper- and

lower-tiers. 3/ (Uncontrolled oil is not subject to regulation, and, therefore,

cannot be "awarded" price increases.)

Controlled domestic crude prices offer both advantages and disadvantages. Regulated prices ease the burden that would exist on households if

domestic crude prices were to rise to world levels. Lower oil prices also

subsidize both economic activity in general and the domestic refining

industry in particular. In addition, domestic price regulation helps hold

down energy prices for consumers and thus limits the inflationary effects of

OPEC price increases.

The costs associated with these advantages, however, are large. By

subsidizing domestic oil consumption and restricting domestic production,

lower prices encourage imports. Each additional 100,000 barrels of oil

3/ There is a special exception for the President to increase more than 10

percent subject to a veto of one house of the Congress.
imported per day now adds about $650 million to the balance of payments

deficit. Moreover, the current system is cumbersome to administer and

often inefficient, and it is a source of uncertainty in industry investment

decisions. It may be possible to provide many of the benefits of the existing

system without encountering these costs.

PRICING ALTERNATIVES

The President's Decontrol Decision

Currently, the price of about 6.0 million barrels of oil per day is

controlled, either in the lower- or upper-tier. In order to phase out controls

on domestic crude oil, the President has decided to:

o Redefine all old oil as new oil between June 1, 1979, and October

1, 1981, by releasing specific volumes of old oil to the upper-tier;

and simultaneously

o Raise the price of new oil (including the redefined old oil) to the

world price by October 1, 1981.

Old Oil. To hasten the movement of oil from the old to the new

category, the rate of decline of the BPCL on old oil property will be

increased from the present average of about 1.5 percent per month to an

artificial rate of 3.0 percent per month for every property, starting in

January 1980. In addition to this accelerated decline, some old oil will be

transferred to the upper-tier through the "marginal" and "tertiary" classifications.

Marginal wells are "almost stripper" wells—that is, their production

ranges from 10 to 35 barrels per day. These wells produce about 640,000

barrels per day of old oil. Eighty percent of this oil, or approximately

512,000 barrels per day, would be transferred to the upper tier on June 1,

1979. The remaining 20 percent, or 128,000 barrels per day, would be moved

into the upper-tier on January 1, 1980.

Finally, old oil would be classified as new if it is produced through

tertiary recovery projects. (Tertiary recovery is a technology that injects

either heat or chemical compounds into an oil reservoir to loosen the oil so

that it will flow more freely.) If a tertiary project has been certified by

DOE, it is now allowed to receive the world price. Under the decontrol

plan, for every barrel of certified tertiary oil produced, a certain
number of "companion" barrels would be transferred from old to world

prices. (The Administration has not yet decided on the exact number of

companion barrels.)

The transfer of marginal wells and tertiary companion oil, and the

accelerated decline rate of old oil, would account for the redefinition of all

old oil. By October 1, 1981, there would be no old oil left, since it would

have all been redefined as new.

New Oil. While old oil is being moved into the new oil classification,

the price of new oil will be allowed to rise to the world price by October 1,

1981, in equal monthly increments that are estimated to be 32$ per barrel

per month. After that date, all domestic oil would receive the world price.

Decontrol would have been accomplished.

New Discoveries. As was mentioned above, genuinely new oil discoveries currently are assigned to the upper-tier. As of June 1, 1979, these new

discoveries would be decontrolled and thus allowed to receive the world

price. The exact definition of what constitutes new discoveries is yet to be

finally determined. CBO has assumed that something similar to the

definition used in the Natural Gas Policy Act is followed. This act classifies

new gas as that which comes from wells either 1,000 feet deeper than or 2.5

miles from an existing well, or that which the relevant state agency

certifies as being from a new field.

Alternative Pricing Strategies

Two alternative pricing strategies are compared with both the base

case of extended EPCA controls and the President's decontrol plan:

o A "middle price case," under which the lower-tier oil is gradually

transferred into the upper-tier as specified by the President, but

the price of upper-tier oil is held constant in real terms. New

discoveries and tertiary production are allowed the world price,

however.

o A "modified EPCA case," under which lower- and upper-tier oils

are controlled at their present prices, but marginal lower-tier oil is

allowed the upper-tier price. New discoveries and all tertiary oil

would be decontrolled.

These alternatives are discussed in detail in Chapter IV and will be

compared with the President's plan in discussing producer revenues,

supply responses, and demand reductions.
TAXING ALTERNATIVES

The President's Tax Proposals

No special federal taxes now exist on crude oil at the wellhead. Since

the President's crude oil decontrol plan would result in large new

revenues for the industry, the President has proposed a windfall profits tax

to recoup some of this new income for the public. This windfall profits tax

is essentially an excise tax and, therefore, would be applied to the new

income realized on each barrel. Any remaining profits would be subject to

conventional corporate income taxation. Thus, decontrol would add to

federal tax receipts through both windfall taxes and increases in conventional corporate income taxes.

The President's windfall taxes consist of the following three parts:

o Lower-tier tax: a tax on the difference between the lower-tier

price and the "constructive" upper-tier price (the upper-tier price

that would result from an indefinite continuation of EPCA

controls) that would be applied to old oil that is transformed into

new oil at a rate greater than 2 percent per month.

o Upper-tier tax: a tax on the difference between the constructive

and actual upper-tier prices. This tax would be applied to all

upper-tier oil, including old oil as it becomes new under the

decontrol proposals.

o World price tax: a tax on any constant dollar prices above $16.00

per barrel as of the fourth quarter 1979. This tax would be applied

to stripper oil and oil from new discoveries. The tax would

therefore apply to any price that reflects an OPEC "surcharge," as

is currently the case.

Each of these taxes is applied at a rate of 50 percent.

As previously stated, old oil would be allowed to decline at its current

rate (1.5 percent per month on average) until January 1, 1980. After that

date, it would be transformed into new oil by lowering every individual

BPCL at an artificial rate of up to 3 percent per month. Any revenues

derived from transforming old oil into new at a rate greater than 2 percent

per month, however, would be subject to windfall taxation. Those revenues

derived from transforming old oil into new at a rate of up to 2 percent per

month would be subject to corporate income taxation only. Since this

10
transformation would have occurred at the current rate of about 1.5 percent

per month (or less) anyway, only the additional revenues for oil released to

the upper-tier between the natural rate of decline and 2 percent would

create a new net addition to corporate income taxes.

The tax on upper-tier windfalls would be applied to the difference

between the upper-tier constructive price (the price that would have

resulted from an indefinite extension of EPCA) and its actual price (the

world price it would receive under decontrol). This tax would be applied to

all upper-tier oil, including old oil as it becomes new oil and oil released

through the proposed marginal and tertiary mechanisms in excess of the

natural rate at which marginal and tertiary oil would have become uppertier had EPCA controls continued indefinitely.

The tax on OPEC real price increases would be applied to all freely

uncontrolled oil, except that from the Alaskan North Slope and the Naval

Petroleum Reserve. For stripper, tertiary, and oil from new discoveries,

this would constitute a new tax on existing revenues. All other oil, except

Alaskan, would eventually receive the world price at the refinery as the

upper-tier price rises to the world level, and any real OPEC price increases

received for this oil would therefore be taxed as part of the upper-tier tax.

Alaskan is excepted, as stated earlier, because its wellhead price is below

its regulatory ceiling.

Alternative Tax Options

This report presents four alternative tax options:

o The President's proposed 50 percent tax on additional revenues;

o A higher tax of 50 percent on lower-tier additional revenues and 75

percent on upper-tier additional revenues (in which most of total

new revenues occur);

o A lower tax, using an across-the-board 25 percent tax rate; and

o A plowback provision that would allow producers to deduct added

expenditures on exploration from their windfall tax liability, and

would then apply a 50 percent rate to the remainder.

These options are discussed in detail in Chapter IV.

11

CHAPTER m. OIL IMPORT REDUCTIONS

A major benefit from decontrol would be a reduction in oil imports.

Such a reduction would decrease the U.S. vulnerability to supply disruptions,

improve the U.S. balance of trade, and reduce some of the pressures for

OPEC to raise oil prices. The reduction would be accomplished in two ways:

domestic consumption would be constrained slightly because of the higher

oil prices consumers would pay under the President's plan, and domestic

production of crude oil would be encouraged because of the higher prices

producers would receive for their oil. The plan to increase the production of

domestic crude oil accounts for about 65 percent of the reduction of imports

in 1985. Since the mechanisms affecting both production and consumption

become increasingly effective through time, they would be even larger in

1990 than in 1985. Although the reductions will not be great enough to stop

the continued growth of imports, the plan will limit the rate of growth.

Imports in 1979 are about 9 million barrels per day. By 1985, if

controls were continued, imports would be about 12.3 million barrels per

day. Relative to that base, production and consumption responses have been

estimated for three alternative price proposals, as follows:

President's Plan. In 1985, the President's plan would decrease demand

by approximately 215,000 barrels per day and increase domestic production

by 405,000 barrels per day for a 620,000 barrels per day reduction in

potential 1985 oil imports.

Modified EPCA Case. This proposal—continued price controls on

upper- and lower-tier oil—would stimulate approximately 160,000 barrels

per day of new supply by 1985, but would not have any noticeable impact on

demand, because aggregate prices would rise very little over those of the

base case. This supply increase would translate into a similar amount of oil

import reduction in 1985.

Middle-Price Case. This alternative price proposal—continued price

controls on upper-tier oil—would increase domestic supply by approximately

335,000 barrels per day by 1985 and decrease demand by approximately

100,000 barrels, for a net oil import reduction of approximately 435,000

barrels per day in 1985.

13

48-429 0-79- 5
The next two sections provide additional detail on the supply and

demand responses attributable to the President's plan. All the estimates are

relative to an indefinite continuation of price controls.

REDUCTION IN CONSUMPTION OF PETROLEUM PRODUCTS

As shown in Table 1, the increased prices for crude oil and petroleum

products resulting from the President's decontrol plan, as compared with

continued controls, would reduce oil consumption by an estimated 215,000

barrels per day by 1985. The reduction would result from the substitution of

alternative fuels, such as coal in large boilers, and direct conservation. The

estimated decrease is only about 1 percent of projected 1985 oil consumption, however. A primary reason for this is that the percentage change in

the price of oil is small—about 9 percent. Since other costs, such as refining

and marketing, do not increase directly with crude prices, the impact on the

final product is smaller—for example, 3 percent for gasoline and 4 percent

for home heating oil. For many goods or services, the higher price of oil is

only one component of the cost of a final product, such as an airplane

ticket. Thus, the percentage change in the price of such items would be

even smaller than the price change of fuel products.

TABLE 1. PETROLEUM CONSUMPTION BY SECTOR:

OF BARRELS PER DAY

IN THOUSANDS

Sector

Transportation

Electric Utilities

1978 Actual

9,800

1,750

1985

Continued

Controls

10,740

2,290

1985 Reduction in

Demand from

Decontrol

-85'

-25

Residential/

Commercial

Industrial

Total

3,550

3,450

18,550

3,570

4,580

21,180

-40

-65

-215

14
Another major reason for the small effect on demand is the rate of

adjustment. It takes time for the stock of buildings and vehicles to be

replaced by more fuel-efficient substitutes, and retrofitting of existing

capital equipment often takes several years. In fact, adjustment to the

large oil price increases of 1973-1974 is still taking place. Although many

retrofittings or fuel substitutions are already economic at current oil prices,

there are limits to the rate of adjustment because of lack of information on

appropriate technologies and the inability of individuals to borrow to finance

improvements.

The demand reductions in this report are based on CBO judgments

about the demand responsiveness to price changes (elasticities); the judgments were made, in turn, after surveying previous empirical work on this

subject. \J Elasticities differ by sector, depending upon the availability and

price of substitutes, future expectations, and the specific type of capital

equipment that uses the petroleum products. Because of the length of time

needed to purchase more energy-efficient capital equipment, the elasticities

are higher for 1985 than they are for 1982—that is, the demand reduction is

much greater by 1985.

Transportation

The greatest absolute savings—85,000 barrels per day by 1985—would

be expected from the transportation sector, since it is the largest consumer

of petroleum. 2/ However, the limited ability to substitute other fuels for

\J Econometric estimates of demand elasticities have been summarized

by Lester Taylor, "The Demand for Energy: A Survey of Price and

Income Elasticities," in William Nordhaus, ed., International Studies of

the Demand for Energy (North Holland, 1977); and Energy Modeling for

an Uncertain Future, Supporting Paper #2 of the Committee on

Nuclear and Alternative Energy Strategies (National Academy of

Sciences, 1978). Generally, long-run and short-run elasticities are

estimated. "Long-run" implies the amount of time necessary to

change the capital equipment involved in energy use, but that may be

difficult to determine in practical applications. The definition of

"short-run" may vary. Different models measure demands for different categories in different end uses and at different points in the

system (crude or delivered product) so that comparison of elasticities

is very difficult.

2j This assumes an elasticity of 0.2 for 1985.

15
petroleum would curtail the magnitude of potential savings. Electricity

accounts for less than 1 percent of transportation energy and its use cannot

be increased greatly by 1985. Gasohol is growing in popularity in the

midwestern states, but, again, large amounts are not expected to be

available by 1985, and, hi any event, it can only replace 10 percent of a

gallon of gasoline when utilized.

Without decontrol, much of the conservation in transportation fuel

results from EPCA fuel economy standards for automobiles. Still, many

authorities do not expect EPCA standards for new cars to be strictly

adhered to. CBO predicts an average fuel economy for new cars of only

23.3 miles per gallon as opposed to the 27.5 specified in the law for 1985. A

price increase could possibly induce better adherence to the regulations.

Electric Utilities

The savings by electric utilities—25,000 barrels per day by 1985—

would be modest relative to their level of consumption. 3_/ Although there

are a number of alternative fuels (coal, natural gas, and nuclear) for utility

use, and fuel costs are a large part of the cost of producing electricity,

utilities would have little incentive to change their mix of fuels because the

prices of their fuels would not be greatly affected by the President's plan.

Most petroleum consumed by utilities is imported residual fuel oil. The

price of such fuel is set by world markets and by OPEC. The prices actually

paid by utilities would be raised slightly by the President's plan but not

enough to have more than a moderate effect.

There are further limitations to the ability of utilities to reduce oil

consumption. Because it is expensive to transport electricity over long

distances, it is advantageous to generate power close to the point of end

use, but there are obvious problems involved in locating either new coal or

nuclear plants in large urban areas or in converting old plants from oil to

coal. Both natural gas and hydroelectric power supplies will be limited in

the future. For all these reasons, it is unlikely that petroleum would be

substantially reduced as a fuel hi existing electric power plants in the

foreseeable future. Regulations do, however, restrict the use of petroleum

in new generating facilities.

3_/ The assumed elasticity for the electric utility sector is 0.2 for 1985.

16
Residential and Commercial

Price decontrol is estimated to reduce demand in this sector by

approximately 40,000 barrels per day by 1985. 4/ Since natural gas and

electricity (heat pumps) are already more economical than oil in most

regions for residential and commercial use, little growth in petroleum

consumption is expected, even without decontrol. Electricity is likely to be

the fastest growing oil substitute, as natural gas becomes more expensive

and restricted in supply, and as heat pumps, which are more efficient than

resistance heating, are more widely marketed.

Historically, the share of oil in residential and commercial fuel use has

not changed very much. It was about the same in 1950 as it is today—37

percent. During this period, oil use first rose slightly and then started to

fall slowly, and is still falling today. The most dramatic change since World

War II has been the replacement of coal with gas and electricity. Coal once

held half of the market, but now accounts for only a small percent and is

unlikely to increase its share. Electricity, and to a lesser extent solar heat

and wood, will capture the new market, but the change in the residential

component is expected to be slow.

Industrial

Oil demand for industrial use is expected to be approximately 65,000

barrels per day lower in 1985 because of decontrol. 5_/ The share of

petroleum for industrial fuel use was the same in 1950 and 1975—19 percent.

Nonfuel uses of hydrocarbons by industry (for example, lubricants and

asphalt) are about 75 percent oil. The industrial sector has experienced

considerable substitution of gas and electricity for coal over time. Coal

constituted nearly 60 percent of industrial fuel at the end of World War n,

but is now only 22 percent. Although the use of electricity continues to

grow slowly, recent natural gas curtailments induced many industries to

consider gas an unreliable supply of energy and to switch to oil, which is the

simplest quick substitute for natural gas. Coal is still a practical fuel for

boilers, but boilers consume only around one-third of industrial fuel, and new

clean air laws tend to counter the cost differential that would otherwise

increasingly favor coaL Additional problems, such as land availability for

4/ An elasticity of 0.2 is assumed for this sector for 1985.

_5/ An elasticity of 0.3 is assumed for this sector.

17
coal storage, limit the feasibility of burning coal in urban locations. For

nonboiler fuel demand, technology exists for burning coal in up to 20 percent

of industrial applications, although even in these instances problems remain.

In many applications, the need for precise control of temperatures and for

even, clean burning renders the use of coal infeasible at present. 6/

Therefore, although some coal will substitute for oil in industrial use, oil

consumption is likely to continue to grow.

INCREASE IN PRODUCTION OF "PETROLEUM

The President's plan is estimated to increase domestic oil supply by

205,000 barrels per day by 1981 and 405,000 by 1985. Essentially, the plan

provides incentives for three types of additional production, as follows:

o Acceleration of oil production from proven reserves;

o Tertiary recovery; and

o Exploration for new discoveries.

Production from currently known, or proven, reserves would be stimulated by gradually increasing the prices of such oil, thereby increasing the

incentives for additional investment. The plan would increase the price for

incremental production from tertiary recovery by allowing the release of

certain amounts of "companion," nontertiary oil to world price levels for

each tertiary barrel produced. Exploration for new domestic reserves in

new fields would be stimulated by increasing the price allowed for all new

discoveries and, in a very limited way, by providing additional "cash flow"

through higher prices for other categories of crude oil.

This section estimates the probable increase in domestic production

from the incentives in the President's plan. This response is in addition to

that expected under the base case of continued controls through 1985. In

the base case, all oil produced from the Alaskan North Slope, Naval

6/ Congressional Budget Office, Replacing Oil and Natural Gas With

Coal; Prospects in the Manufacturing Industries, Background Paper

(August 1978); and Energy and Environmental Analysis, Inc., Technical

Potential for Coal Use in Industrial Equipment Other than Boilers

(April 6, 1978).

18
Petroleum Reserves, tertiary recovery, and stripper wells would receive the

world price. Upper- and lower-tier prices would continue under the current

controls. Given these assumptions, production in 1979 and 1985 for both the

base case and the President's plan is summarized in Table 2. A detailed

discussion of these estimates is provided below.

Production from Proven Reserves

By 1985, production from known reserves would be about 210,000

barrels per day more because of decontrol than under continued controls.

Crude oil from the nation's proven reserves (about 27.8 billion barrels) is

currently being produced at a rate of about 8.6 million barrels per day, or

3.1 billion barrels per year. 7/ Most of the production comes from mature

fields or properties in which (1) the geology is fairly well understood; (2) the

various owners have established working relationships; and (3) the relative

benefits of alternative production/investment plans have been calculated.

In the aggregate, production from this large variety of fields or properties is

declining.

The plan provides financial incentives to encourage producers to invest

and thereby accelerate production. Prices would be increased to world

levels, although a portion of the increase would be subject to the proposed

windfall profits tax. Many producers are now witholding investments in

anticipation of higher prices in the future. Most producers appear to expect

that eventually both lower- and upper-tier oil will be priced at world levels

and that the prospective gain is significant enough to be worth the wait,

especially for those with lower-tier oil. Accordingly, their incentives to

produce oil now are minimal. In fact, in a number of cases, current

economic incentives encourage allowing production to decline toward

stripper levels so that the properties can receive world prices through that

mechanism.

The above factors indicate that a gain in production would be likely if

the price of oil was increased. They are offset, however, by the fact that

most of the properties are old fields that have produced 50 to 95 percent of

their ultimately recoverable reserves. Thus, resource potential (short of

tertiary recovery) is relatively small and constrained by geological factors.

7/ American Petroleum Institute, Reserves of Crude Oil, Natural Gas

Liquids and Natural Gas in the United States, News Release (April 30,

1979).

19
TABLE 2. DOMESTIC CRUDE OIL PRODUCTION UNDER THE BASE

CASE AND THE PRESIDENT'S PLAN a/: IN MILLIONS OF

BARRELS PER DAY

1985

1979 1985 President's

Estimated Base Case Plan

Production from Proven Reserves

Lower-Tier 2.7 0.8 0.9

Upper-Tier 3.1 1.6 1.6

Stripper 1.3 0.8 0.8

Alaskan and Naval

Petroleum Reserves 1.3 1.7 1.7

Total 8.4 4.9 5.0 b/

Production from Additional

Reserves

Extensions to Present Fields

New Discoveries

Tertiary

Total

Total Production

0.2 1.6

0.5

0.4

0.2 2.5

8.6 7.4

1.7

0.6

0.5

2.8

7.8

SOURCE: The 1979 actual estimates are from the U.S Department of

Energy, Energy Review, (April 1979); the 1985 estimates were

derived by CBO.

a/ In 1982, the increase in supply resulting from the President's plan would

be about 275,000 barrels per day. About 80 percent of the increase

would be in accelerated production of lower-tier oil. By 1985, the

increase in supply would be about 405,000 barrels per day.

b/ This table shows all of the incremental supply from proven reserves as

being from lower-tier wells. In actuality, some increase would also

occur in upper-tier wells.

20
Price incentives that stimulate new investment would increase ultimate

recovery in the aggregate, but the predominant effect would be a shortterm acceleration of production after price increases, followed by a decline

that might eventually drop below the base case. To increase ultimate

recovery substantially, tertiary recovery would be necessary. A broad

increase of prices for all upper- and lower-tier oil, however, would not

result in substantial new tertiary recovery.

In 1979, total upper- and lower-tier oil production will be about 5.8

million barrels per day. Under the base case, this level is expected to

decline to about 2.4 million barrels per day in 1985 (excluding production of

about 1.6 million barrels per day in extensions to present properties). Under

the President's plan, however, price incentives would stimulate investment

to increase production during 1980 to 1986. While the production increment

in specific cases would be of very short duration, the cumulative effect

would be spread over a number of years because all new investment would

not occur simultaneously. The total effect would probably peak in 1982 to

1983 at about 200,000 to 250,000 barrels per day—representing an increase

of about 3 percent in domestic production—and then decline to about

210,000 barrels per day by 1985.

Production From Additional Reserves

Tertiary Recovery. About 250,000 to 300,000 barrels of oil per day

are now being produced by processes that are considered tertiary production

under the President's plan. 8/ Most of the current production is from

thermal-recovery projects, which burn a proportion of the produced oil in

order to provide steam for re-injection. CBO estimates that this production

would grow to 405,000 barrels per day by 1985 under current controls and

that the President's plan would increase this by an additional 85,000 barrels

per day.

A variety of studies have projected the potential resources that could

eventually be added by tertiary recovery but that cannot now be considered

proven resources. Most recent studies estimate that resources fall within a

range of 15 to 45 billion barrels at present world prices, but that many years

would be required to develop those resources. Because the capital requirements and operating costs per barrel are large in comparison to conventional

8/ "U.S. Enhanced Recovery Marked by Uncertainties," Oil and Gas

Journal (September 11, 1978).

21

48-H29 0-79- 6
recovery and because risks are high, the industry has invested in tertiary

recovery with great care. Virtually all projections for tertiary production

made in the mid-1970s now seem to be too high. Estimates for 1982 and

1985 are being continually lowered because of the need for long lead times,

air quality problems, and higher than expected costs. Projections for 1985

range from 300,000 barrels per day to about 1.2 million barrels if the

production receives world prices. CBO has estimated that tertiary production at the world prices without companion barrels would be about

405,000 barrels per day in 1985, mostly through thermal recovery.

The President's plan is designed to reduce economic risk and provide

short-term returns on the initial investment. In return, DOE must approve

the specific projects. Although the exact details of the plan have not yet

been released, it is designed to accelerate development of a number of

technologies that seem on the brink of commercial application. The most

likely candidate for the most investment in the short term is injection of

carbon dioxide (CO J. The industry estimates, however, that it will be more

than five years before production from this technology could be significant

because of the time required to develop a source of CO, and to pipe it to

the oil field. A variety of chemical processes are even less advanced than

those using CO7, and should be expected to have even longer development

times.

DOE anticipates approval of 75 to 100 tertiary projects under this

program. Many of the projects would not be in full operation by 1985, and it

should be expected that production from a number of the projects would be

disappointing. Major projects, which would encompass entire large fields,

are estimated to provide no more than 15,000 barrels per day and only one

or two such large projects are likely to be in operation by 1985, at the

earliest. Many projects would barely reach commercial size, and a

proportion would probably have been funded under the base case anyway.

The program of releasing companion barrels of lower-tier oil would

slightly accelerate the projects and reorient investment into technologies

that have long-term prospects. As a result, while the program would not

provide a large amount of incremental production by 1985, it could

substantially affect investment and production by 1990 or 1995. At best,

the program in 1985 would stimulate approximately 85,000 barrels per day

over and above what would have occurred under the current controls.

22
New Discoveries. This plan would free the price of oil produced from

new fields. By 1985, production from new fields would likely be about

110,000 barrels per day greater as a result of the President's plan. While the

actual definition of what constitutes a new field has not been determined,

CBO has assumed that it will be similar to that used for natural gas. For

natural gas, a discovery must qualify as a "new field" under current state

regulations or be 2.5 miles beyond or 1,000 feet below existing fields. 9/

The potential new production can be projected by estimating the levels

of exploratory drilling and discovery rates. The level of exploratory drilling

depends primarily on the price of new oil and the capacity of the drilling

industry, while estimates of new discoveries depend primarily on recent

experience concerning new discoveries per foot drilled. Past performance

indicates that the initial discovery is usually less than half the reserves

ultimately discovered within the new field. The eventual revisions, extensions, and new pools are discovered or established through developmental

drilling and through increases in recoverable reserves resulting from higher

prices. On average, the reserves of the original discovery are doubled

within 5 to 10 years after the discovery. 10/ Given the level of new

discoveries, future production can be estimated using lag factors and

production profiles based on past performance. In Table 3, the various

drilling, reserve, and production rates for the base case and the President's

plan are summarized.

This analysis concludes that production from new fields in 1985 would

be about 280,000 barrels per day if price controls on upper-tier oil were

continued and 390,000 barrels per day if controls were eliminated. The

difference between cases would be modest in 1985, but would increase

97 The most liberal definition of new discoveries is all oil flowing from

wells that commenced operating in 1979 or after. If this interpretation is used, production in this category would be greater than the

estimate in this paper but accelerated production from known reserves

would be smaller.

10/ R.E. Mast and Janet Dingier, "Estimates of Inferred and Indicated

Reserves for the United States," Geological Survey Circular 725

(1975), pp. 73-78.

23
TABLE 3. NEW DISCOVERIES: DRILLING, RESERVES, AND PRODUCTION

1982 1985

President's President's

Base Case Plan Base Case Plan

Successful Exploratory

Drilling (million feet

per year) a/ 8.8 10.4 7.3 10.6

New Field Discoveries

(million barrels

per year) b/ 176.0 209.0 146.0 212.0

Secondary Discoveries

(million barrels per year) 150.0 195.0 295.0 350.0

Total Discoveries in

New Fields (million

barrels per year) 326.0 404.0 441.0 562.0

Annual Production from

New Field Discoveries

(million barrels

per year) c/ 60.0 71.0 280.0 390.0

SOURCE: Derived from analysis in a forthcoming CBO report, The

Changing Energy Problem; A Perspective.

a/ Most new oil would result from new field discoveries that, in turn, result

from exploratory drilling. It is more valid for the purposes of this

analysis to project successful exploratory drilling than to project all

drilling because of the problem of separating dry oil wells from dry

gas wells. Exploratory drilling is primarily a function of wellhead

prices that the industry expects to receive when production occurs.

b_/ The "finding rate" for new fields is about 24 barrels per successful

exploratory foot drilled in 1979. This rate has declined from a level of

35 barrels per foot in 1970 and is likely to be about 18 barrels per foot

in 1985.

£/ The ratios between reserve discoveries and production are affected by

start-up times and the wellhead price of oil.

24
through time, ll/ It should also be noted that in both cases production from

new fields would be much less in 1985 than production from extensions to

the large, old fields that are already producing.

Conclusions

The aggregate increase in domestic production for 1985 would be

405,000 barrels per day if current price controls are eliminated. About half

the potential increment would result from accelerated production from old

fields. The remaining half would be divided between incremental tertiary

recovery and production from new fields. If controls were continued, total

crude oil production in 1985 is projected to be about 7.4 million barrels per

day. If the President's plan were adopted, production would increase to 7.8

million barrels per day—an increase of 5.4 percent over the base case. In

both cases, production would decline from its present level of 8.6 million

barrels per day.

ll/ After 1985, production from discoveries in new frontier areas could be

significant, but new discoveries in frontier areas are not likely to be

produced before 1985. At the present time, there is very little

production in Outer Continental Shelf areas that is known to be

economical at uncontrolled prices that is not economical at upper-tier

prices.

25

CHAPTER IV. PRODUCER REVENUES AND FEDERAL TAXES

This chapter discusses the amount of additional producer revenues that

would be generated by decontrol as well as two critical tax issues—the

windfall profit taxes and the effective corporate income tax rates. New

producer revenues are estimated for three alternative pricing scenarios: the

President's decontrol plan, the middle-price case (continued price controls

on upper-tier oil), and the modified EPCA case -(continued price controls on

both upper- and lower-tier oil). All are compared to the base case of

continued controls. These figures are given in current dollars under two

OPEC price assumptions—constant real prices and a 3 percent annual

increase in real OPEC prices. Critical tax issues related to decontrol are

then discussed, specifically, the concept of what constitutes a "windfall"

profit and what the effective marginal corporate income tax rate would be

on additional producer revenues. Lastly, estimates of the tax liabilities for

four tax options are presented: the President's 50 percent windfall tax, a 75

percent tax rate on windfalls originating from raising the upper-tier price to

the world price, a 25 percent across-the-board tax rate, and a "plowback"

proposal.

PRODUCER REVENUES

Estimates of producer revenues are based on a CBO projection of

future U.S. oil production as indicated in Chapter Id and price assumptions

stated in Chapter n. The estimates for the three alternative pricing

strategies are presented in Table 4.

The President's Plan

CBO estimates that the President's decontrol decision would create

$68.9 billion in additional producer revenues from existing oil between 1979

and 1985. These revenues would rise from $0.7 billion in 1979, to $4.8

billion in 1980, to $11.0 billion in 1981, and to a peak of $13.8 billion in

1982, and then would decline gradually for the next several years. In

addition, from 1979 to 1985, domestic producers would receive new revenues

of $13.9 billion on the new supplies produced in response to higher prices.

Thus, expected revenue gains to the oil industry would amount to $82.8

billion over this period.

27
TABLE 4. WINDFALL REVENUES ACCRUING TO DOMESTIC PRODUCERS FROM LOWER- AND UPPER-TIER OIL RESULTING

FROM ALTERNATIVE DECONTROL PROPOSALS: IN MILLIONS

OF CURRENT DOLLARS

Calendar

Year

1979

1980

1981

1982

1983

1984

1985

Total

President's

Plan

749

4,785

10,978

13,836

13,351

12,942

12,203

68,864

Middle-Price a/

Case

749

2,460

4,024

4,936

4,440

4,076

3,672

24,357

Modified b/

EPCA Case

967

1,530

1,393

1,317

1,296

1,348

1,496

9,347

a/ Assumes an indefinite continuation of the controls on upper-tier oil.

b/ Assumes an indefinite continuation of the controls on upper-tier and

lower-tier oil.

The Middle-Price Case

An alternative to the President's pricing plan is the middle-price case,

under which lower-tier oil would be transferred to the upper-tier, but

controls on the upper-tier would be extended and upper-tier prices held

constant in real terms. This option would greatly reduce additional producer

revenues by maintaining the difference between the upper-tier and world

prices. It would create $24.4 billion in additional revenues from existing oil

from 1979 to 1985, with a peak of $4.9 billion in 1982. The difference in

28
cumulative additional revenues for existing oil under the President's case

and the middle-price case is $44.5 billion between now and 1985. New

supplies induced under this proposal would generate $9.1 billion in new

revenues over the 1979-1985 period, compared to $13.9 billion under the

President's plan, so that total new industry revenues would total $33.5

billion.

When the middle-price case is compared to the President's plan,

several advantages and disadvantages can be observed. The middle-price

case produces less inflation since it reduces the national oil bill. Between

1980 and 1985, total oil bills for the economy would be lower by about $8

billion annually under the middle-price case than under the President's plan,

even when the incremental substitution of domestic supply for imports and

the additional demand reduction that result from the President's plan are

taken into account. Ultimate increases in the price level by 1982 under the

middle-price case would be considerably lower than would occur under the

President's plan and thus the effect on low-income households would also be

less. By 1985, petroleum product prices, such as that for gasoline, would be

4 cents higher under the President's plan, and 1 cent higher under the

middle-price case, when compared to an extension of price controls.

The middle-price case also has disadvantages, however. While the

supply response from new discoveries and tertiary production resulting from

decontrol would be unaffected by continued controls on upper-tier properties, failure to raise upper-tier price levels to the world price would result

in the forfeiting of some accelerated production from old fields (about

70,000 barrels a day by 1985). It would also decrease demand by about

100,000 barrels per day as opposed to the 215,000 barrel reduction from the

President's plan. It is also argued that failure to adopt world energy prices

would continue to strain relations with both Organization of Economic

Cooperation and Development and OPEC nations.

The Modified EPCA Case

A second alternative to the President's pricing plan is a modified

continuation of EPCA. Lower- and upper-tier price controls would be

retained, but lower-tier marginal oil would be allowed the upper-tier price

as of June 1, 1979. Oil from new discoveries and tertiary recovery would

also be decontrolled but there would be no special incentive for tertiary

recovery. This plan would increase producer revenues by only $9.3 billion

over the 1979 to 1985 period, relative to current controls, and would induce

new supplies valued at $1.9 billion, resulting in total new industry revenues

of $11.2 billion. This increment would have virtually no effect on inflation

when compared to an indefinite continuation of controls.

29
The cost of this plan would be less demand reduction and fewer new

supplies. Since oil prices would be about the same under the modified EPCA

case and present EPCA regulations, the demand reduction would probably be

less than 50,000 barrels per day. Moreover, this plan would limit new

supplies to 160,000 barrels per day more than under current regulations.

Relative to the President's plan, about 250,000 barrels per day would be lost

because of reduced accelerated production from known fields and from

reduced tertiary production.

Real OPEC Price Increases

All the previous estimates in this section have been predicated on the

assumption that real OPEC prices remain constant over this period. But

since real price increases will most likely occur, CBO estimated the

additional revenue effects of the President's plan using an annual 3 percent

real OPEC price increase. Real OPEC price increases of this magnitude

would raise total new revenues from existing oil from $68.9 billion to $94.6

billion between 1979 and 1985. The value of new supplies induced by

decontrol would equal $16.0 billion over this period. Thus, total new

producer revenues created by decontrol would amount to $110.6 billion over

this seven-year period.

Real OPEC price increases also accentuate the differences between

the President's plan and the middle-price case. By 1985, the annual

difference in the aggregate national oil bill between these two cases would

rise from about $8 billion, with constant real OPEC prices, to about $15

billion in the face of rising real prices. Moreover, rising OPEC prices would

widen the differences in the windfall revenues under the middle-price case

and the President's plan. In 1985, for example, the President's plan would

generate $8.5 billion more in additional revenues from existing oil than the

middle-price case ($12.Z billion versus $3.7 billion). If real OPEC prices

should increase, this difference would rise to $15.8 billion ($20.0 billion

versus $4.2 billion).

Both of these cases can be compared to the modified EPCA case. If

OPEC prices increased at 3 percent per year in real terms, this case would

result in additional revenues of $10.4 billion between now and 1985,

compared to $9.3 billion with constant prices. In addition, real OPEC price

increases would raise the value of new supplies induced by the decontrol of

new discoveries from $1.9 to $2.3 billion, for total new industry revenues of

$12.7 billion. Table 5 presents estimates of additional revenues received for

existing oil under the President's plan, the middle-price case, and the

modified EPCA case with rising OPEC prices.

30
TABLE 5. WINDFALL REVENUES ACCRUING TO DOMESTIC PRODUCERS FROM LOWER- AND UPPER-TIER OIL RESULTING

FROM ALTERNATIVE DECONTROL PROPOSALS, ASSUMING

RISING REAL OPEC PRICES: a/ IN MILLIONS OF CURRENT

DOLLARS

Calendar

Year

1979

1980

1981

1982

1983

1984

1985

Total

President's

Plan

749

5,483

13,143

17,462

18,347

19,400

20,040

94,624

Middle-Price

Case

749

2,462

4,036

4,984

4,565

4,354

4,229

25,379

Modified

EPCA Case

967

1,532

1,405

1,365

1,421

1,626

2,053

10,369

a/ Assumes a 3 percent annual increase in real OPEC prices.

TAX ISSUES

The tax issues associated with the President's decontrol plan include

the following:

o What constitutes a windfall revenue gain and how it should be

taxed.

o How much income tax oil companies actually pay after allowing for

the special tax treatment for new drilling.

31
Windfall Profits

The President has proposed to tax the windfall profits that accrue to

oil producers from (1) decontrolling the price of upper- and lower-tier oil,

thereby allowing it to increase to current world levels, and (Z) from any real

OPEC price increases above a given price as of April 1, 1979.

Decontrolling Upper- and Lower-Tier Oil. Whether or not the additional revenues generated by decontrol of upper- and lower-tier oil should be

considered a windfall, and so taxed, depends primarily on two considerations—equity and efficiency.

Equity—While the term equity is very difficult to define in this

context, it is influenced by previous price expectations and the existence of

an international cartel (OPEC) that is currently setting world oil prices. If

the higher prices resulting from decontrol were not expected by the industry

when it decided to explore for and develop production wells, then the

additional revenues could be considered a windfall. If, on the other hand, at

the time the companies made this investment, they expected decontrol to

occur after the expiration of EPCA, then equity would indicate that they

should receive the additional revenues.

It is difficult to judge previous expectations, since investments to

explore and produce currently flowing oil took place over a twenty-to-fiftyyear period. Expectations undoubtedly have changed markedly over time. It

is probable, however, that investments to produce old oil were made with

lower expectations than the current world price level.

The other component of the equity debate concerns the so-called

market power of OPEC. If OPEC prices merely approximate a true market

price and the cartel, in fact, has no monopoly power, then domestic oil

producers should be allowed this price if, in fact, it was expected when they

originally invested. On the other hand, if OPEC members are adjusting

supply so as to maintain a higher than market price, then the domestic oil

producers could be taxed on their additional producer revenues. The

evidence suggests that the OPEC price is somewhat above the true market

price, but the magnitude of the difference is debatable.

Efficiency—The second issue to consider in treating windfalls is

efficiency—namely, whether or not the imposition of windfall taxes would

impair the domestic industry's ability to explore for and produce oil. The

President's windfall taxes would apply to the additional revenues that upperand lower-tier oil would receive if sold at the world price. Most economists

view the question of efficiency in terms of the prices allowed for new oil

production: If the price of oil is high enough, investors will undertake the

3Z
investment required to produce it. All the investment funds need not come

from oil companies' internal cash flow, they argue, for the high price would

be enough to attract the necessary capital from outside investors. Viewed

in this context, the incentives proposed by the President to encourage new

oil exploration and development appear adequate. For truly new oil, the

producers would be allowed the world price, curently over $16.00 per barrel.

For marginal wells, the President would more than double the allowed price,

from $6.00 to about $13.00 per barrel over the next six months. For

expensive tertiary recovery, the marginal revenue to the producers would

actually exceed the world price, since producers undertaking tertiary

projects would also be allowed more rapid decontrol for already flowing oil.

Moreover, the price incentives cited here would be largely unaffected by

windfall taxes which would not be applied to the "margin" where additional

supplies would be produced.

Some producers, along with segments of the banking community, have

argued that, because oil exploration and development is a relatively risky

investment, it is difficult to obtain external financing and internally

generated funds are a necessity. Therefore, they reason, without the

additional cash flow, the required investment for exploration and development would not occur. This view, however, is inconsistent with normal

business behavior. With the large price incentives in the President's

program, all of the domestic oil that could be produced at a price of $16.00

per barrel should be produced. If increased cash flow would result in even

more oil production, then this new production would not have occurred at a

$16.00 price, although this is the price that it would receive. It is extremely

doubtful that increased cash flow would be used to subsidize the production

of oil that is unprofitable at the world price. Moreover, existing studies

demonstrate that the petroleum industry has sufficient access to capital

markets and is capable of borrowing funds. Thus, the President's price

incentives would probably be sufficient to conduct domestic exploration and

production efforts, and any additional revenues for existing oil would exceed

the amount required to expand supply.

Future Real OPEC Price Increases. In addition to the windfall taxes

on additional revenues resulting from raising lower- and upper-tier oil to the

world price, the President has proposed a third tax on real OPEC price

increases above and beyond the market barrel price as of April 1, 1979,

before the subsequent imposition of surcharges. This marker barrel price

(the price of Saudi light oil, the benchmark against which other crudes are

assigned prices based on quality differentials) was $14.54 per barrel on that

date, and oil sold at that price in the Persian Gulf would land on the U.S.

coast at a price of about $16.00 per barrel. Since OPEC oil competes with

domestic oil from its coastal landing point, domestic wellhead prices could

rise over $16.00 per barrel only if OPEC prices rise. (In fact, this is

33
currently the case—domestic stripper oil is now receiving $18.00 per barrel,

since surcharges have added to the OPEC landed price with which stripper

competes.) Thus, under the President's program, this $16.00 per barrel

figure is assumed to be the "world incentive" price, and any wellhead price

received in excess of this price is deemed a windfall and will be taxed at the

windfall rate of 50 percent.

When lower- and upper-tier oil reach the world, price, any incremental

revenues resulting from OPEC price increases over the world incentive level

would also be taxed at the windfall rate as part of the upper-tier tax. Since

a separate tax on OPEC price increases over the world incentive level would

only affect oil that does not rely on decontrol to reach the world price, it

essentially would be a tax on stripper oil, the only kind of domestic oil that

currently receives the world price, and on new discoveries, which would be

decontrolled immediately under the President's plan. _!/ The tax will

therefore be applied to the wellhead revenues of this oil in excess of the

real equivalent of $16.00 per barrel.

The important effects of this tax proposal would grow over time.

Although future OPEC price increases may not be as dramatic as those

witnessed over the past several months, real price increases are very likely

as the oil market tightens over the late 1980s and early 1990s. For example,

should OPEC prices rise by 3 percent in real terms annually between now

and 1985, the price of stripper and newly discovered oil would be $7.00 per

barrel higher than the market incentive price. If 3 percent real price

increases continued through 1991, this difference would rise to $22.29 per

barrel, and since the upper-tier tax as proposed by the President would

expire on January 1, 1991, all domestic oil would then be subject to the tax

on real OPEC price increases. With these conditions, the 1991 tax liability

of producers would be $30.1 billion, an amount greater than the peak

liability for producers between 1979 and 1985 under the President's

proposals.

Whether or not these additional domestic producer revenues, resulting

from increases in the OPEC oil prices are windfalls also depends on the

equity and efficiency arguments, as outlined in the previous section. The

critical factor concerning equity is whether or not the OPEC price approximates a true market price or is substantially above a market approximation. If the price is competitive, it should not be taxed; if it is a

\J Sales of oil from Naval Petroleum Reserve also receive a price close

to stripper's, but the Administration would presumably exempt the

government from this tax.

34
monopoly price, it should be taxed. The efficiency argument, on the other

hand, depends primarily on whether or not the oil producers could efficiently

utilize the additional funds to find and produce additional oil. While this

depends on the probability of locating new reserves and the assumed

inflation rate on exploration and development, it now appears that small

increases in the real price of OPEC oil would generate considerable

additional revenues. Whether or not the companies could productively use

these funds in the exploration and development of domestic oil is difficult to

determine.

Between 1979 and 1985, under the CBO base case, the tax on real

OPEC price increases would create total new liabilities of $5.5 billion.

Liabilities would be $713 million in 1980, $793 million in 1981, and $933

million in 1982, rising to $1.1 billion by 1985. These liabilities would be

incurred, by and large, because any OPEC surcharges ($1.20 per barrel in the

base case) are viewed as increments above the market incentive price.

Should OPEC prices rise by 3 percent annually, these estimates would

increase. Total liabilities would rise from $5.5 billion to $11.5 billion over

the 1979-1985 period. Annually, liabilities would be $0.9 billion in 1980,

$1.3 billion in 1981, and $1.8 billion in 1982, rising to $3.5 billion by 1985.

The Effective Marginal Tax Rate on Corporate Income

Decontrol of oil prices would create significant income gains for oil

companies even after imposition of the proposed windfall tax. These income

gains would produce added federal receipts from the corporate income tax.

Because of the write-offs for oil drilling, the size of these added tax

receipts would depend heavily on the investment responses of oil producers

including the level of profits from those efforts.

Corporate taxes are calculated by applying a tax rate to an income

base. The income base is defined as revenue less allowable deductions.

Operating expenses, other taxes, and accelerated depreciation of invested

capital are normally allowed as deductions from gross revenue to arrive at

taxable income.

Tax provisions relating to oil companies, however, provide some

additional tax benefits for exploration and development costs—benefits not

generally available for investment in other industries. In particular, the oil

industry is allowed to claim drilling costs as immediate deductible expenses,

rather than capital outlays which would be recoverable over the life of the

project of which they are a part. Therefore, for accounting purposes, oil

companies frequently show a large share of their nominal tax liability as

35
"deferred taxes" which are offset by deductions taken over the life of the

projects from which they arise. For tax purposes, however, the deductions

are taken promptly and reduce the taxes on current income. This procedure

substantially shelters the income -derived from prior projects from current

taxation. In recent years, drilling expenditures have provided expense

deductions large enough to offset nearly half of the tax that would have

been due if the statutory rate of 46 percent were applied to oil company net

incomes without this "intangible drilling cost" provision. 2J The opportunity

for oil companies to deduct intangible drilling costs from income amounts to

a plowback provision against the corporate income tax.

As shown in Table 6, calculation of the taxes on new profits attributable to decontrol starts with the incremental revenues and subtracts

expenses and universally available investment-related deductions to arrive

at profits from decontrol using standard tax treatment. From this amount,

oil companies are allowed the additional tax deduction for drilling to arrive

at their increase in taxable income resulting from decontrol. The added

corporate profits tax receipts result from application of the statutory rate

of 46 percent to the estimated gain in taxable income, allowing for all

deductible expenses from incremental income and subtracting the estimated

increase in investment tax credits from the tentative tax liability. The

increase in corporate tax averages 15 percent of profits from decontrol over

the period 1979-1985. The effective rate beyond 1985 depends heavily on

drilling after that time.

The assumed increase in drilling expenditures resulting from decontrol

rises from an extra $200 million in 1979 to a peak of an extra $6.5 billion in

1982, and declines to an extra $3.6 billion by 1985. This new investment

produces substantial deductions that reduce tax liabilities on decontrolrelated income for 1979 through 1985. The estimated tax rate starts at 13

percent in 1980, drops as low as 6 percent in 1981 and 1982 when added

investment is a large percentage of revenues from decontrol, and then rises

gradually to 26 percent by 1985, when assumed incremental investment has

declined as a percentage of revenues from decontrol. Examination of 10-K

data submitted to the Securities and Exchange Commission indicate that

crude oil producers have recently paid an average tax rate of 30 percent on

overall net income.

2_/ This study assumes that drilling-related investments are 70 percent

intangible drilling cost (expensed), and 30 percent capital investment

(depreciated over 10 years using double declining balance). Nearly all

of the 30 percent share is considered eligible for the investment tax

credit.

36
TABLE 6: DERIVATION OF EFFECTIVE CORPORATE TAX RATES ON

INCOME GAINS

REVENUE FROM DECONTROL

Less: Decontrol Expenses

1. Windfall Profits Tax

2. Operating Costs (Royalties, State Taxes, Production Costs)

3. Amortization of Incremental Investment

PROFITS FROM DECONTROL (Using Standard Tax Treatment)

Less: Intangible Drilling Cost Deductions in Excess of Amortization

CHANGE IN TAXABLE INCOME

Times: Corporate Tax at Statutory Rate (46%)

Less: Investment Tax Credit

INCREASE IN TAX LIABILITY FROM DECONTROL ($5.9 BILLION)

Added Tax as a Percent of:

Revenue from Decontrol 5 percent

Profits from Decontrol 15 percent

Change in Taxable Income 38 percent

These tax estimates depend on several key assumptions: the expansion

of drilling expenditures, the revenues resulting from newly discovered oil,

and the production costs for newly discovered oil. Under CBO assumptions

for incremental drilling expenditures, success rates, and production costs,

the effective corporate income tax rate on the net income from decontrol

(allowing write-offs for amortization of investment outlays) is 15 percent.

The corporate tax rate on income from decontrol after the imposition of

windfall taxes (but before the deduction of increased expenses and intangible drilling costs) is estimated at 9 percent.

37
The estimated tax levy on the $82.8 billion of income resulting from

decontrol from 1979 through 1985 would be $25.7 billion in windfall taxes on

lower- and upper-tier oil and an additional $5.5 billion would result from the

windfall tax paid by stripper and newly discovered oil based on OPEC price

increases. Oil companies would also pay $4.0 billion in additional corporate

income tax levies and $4.1 billion in additional state taxes. An estimated

$10.0 billion would be spent for added production costs and royalties, and

$32.1 billion for increased investment. This would leave $1.4 billion (less

than 2 percent of the estimated $82.8 billion of income from decontrol) for

other investments or distribution to oil company stockholders.

Windfall Tax Options

The President's decontrol plan would generate $68.9 billion in windfall

income on existing production and an additional $13.9 billion in revenues

from new production between 1979 and 1985. The $68.9 billion in windfall

revenues is the base to which the four following alternative tax options will

be compared:

o The President's 50 percent windfall profits tax.

o A higher tax that assumes a 75 percent tax on the upper-tier

windfall.

o A lower tax that assumes a 25 percent across-the-board windfall

tax.

o A plowback proposal that allows deduction of new drilling and

exploration expenses from the windfall tax base before application

of a 50 percent windfall tax rate.

For each of these tax options, windfall tax rates were applied to the

windfall tax base as defined by the President. Thus, lower-tier oil from

marginal wells, oil released to accompany tertiary production, and oil

declined at a rate greater than the natural rate but less than 2 percent per

month were not included in the windfall tax base until they reached the

upper tier. The results for the four options are summarized in Table 7.

The President's Windfall Tax. The President's proposals would apply a

50 percent rate to windfalls from decontrol, after the above mentioned

exemption of some lower-tier oil. Out of the $68.9 billion in windfall

revenues, $51.4 billion would be treated as the base for a windfall profits

tax. The difference, $17.5 billion, would be exempted under any of several

categories defined by the proposals.

38
TABLE 7. PRODUCER TAX LIABILITIES RESULTING FROM ALTERNATIVE WINDFALL TAX PROPOSALS a/: IN MILLIONS OF

CURRENT DOLLARS

Calendar President's High-Windfall Low-Windfall Plowback

Year Proposals Rate Rate Case

1979

1980

1981

1982

1983

1984

1985

Total

195

1,635

4,646

5,881

5,647

5,701

5,960

29,665

195

1,993

5,936

7,683

7,475

7,310

7,434

38,026

195

1,199

3,265

4,120

4,042

4,142

4,485

21,448

195

899

2,822

3,577

3,567

3,846

4,552

19,458

a/ Includes corporate income tax liability.

Windfall tax liability on this $51.4 billion would be $25.7 billion

between 1979 and 1985. The $25.7 billion remaining after windfall taxation,

plus the $17.5 billion specifically exempted from windfall taxation, would be

taxed through the conventional corporate income tax. Using CBO's assumptions concerning the effective marginal corporate rate, these revenues

would yield corporate tax liability of $4.0 billion over the 1979 to 1985

period. Coupled with windfall taxes, a total of $29.7 billion out of the $68.9

billion of windfall revenues would be taxed. If this windfall had been subject

to corporate income taxes only, liabilities of $13.3 billion would have

resulted. Hence, windfall taxes, as proposed by the President, more than

double the tax liability that would have been incurred under corporate

income taxes alone.

39
Higher Windfall Tax. To put the President's proposals in context,

estimates have been made for higher and lower windfall taxes. The higher

windfall tax was computed by applying a 50 percent windfall tax rate to

lower-tier oil and a 75 percent tax rate to upper-tier windfalls. This

differential rate reflects the belief that oil production economics justify

upper-tier prices on old oil since a greater supply response is expected from

older wells and this requires new investment. It should be noted that these

rates were applied to the same windfall base as were the President's. Such a

scheme would result in a tax liability, including both windfall and conventional corporate income taxes, of $38.0 billion out of the $68.9 billion

windfall, of which $37.2 billion would be collected through windfall taxes,

and $0.8 billion through corporate income taxes. Compared to the President's proposals, this tax would produce an incremental $8.3 billion, or 12

percent of the total windfall between now and 1985.

Lower Windfall Tax. This lower 25 percent rate reflects the belief

that domestic producers are entitled to receive the larger share of windfalls

resulting from both decontrol and OPEC price increases, irrespective of

revenue needs for exploration and development. Between 1979 and 1985,

this rate would produce $12.8 billion in windfall tax liabilities and $8.6

billion in regular corporate income taxes, for a total of $21.4 billion in tax

liabilities. These liabilities would be $8.3 billion less than those that would

result from the President's proposals.

Plowback. A second, hypothetical lower tax proposal takes the form

of a plowback provision. Producers would be allowed to deduct expenditures

for new drilling from the 50 percent windfall tax base for their upper- and

lower-tier oil, until all of these windfall profits were used up. The argument

for a plowback provision is that even world prices for new oil discoveries are

insufficient to encourage new exploration and development. With world

price incentives for new discoveries in the President's plan, a plowback

provision would represent a subsidy to producers that would raise their

incentives to a level over the world price. Under a full plowback provision,

new exploration and production expenditures are assumed to create deductions against the windfall tax base of $2.3 billion in 1980, $5.7 billion in

1981, and $7.2 billion in 1982, for a total of $31.9 billion from 1979 to 1985.

This total would be subtracted from the $51.4 billion windfall tax base,

leaving a windfall tax liability of $9.7 billion, which., when added to the $9.8

billion corporate income tax liability under plowback, would result in a total

new tax liability of $19.5 billion between 1979 and 1985. This would be

$10.2 billion less than the President's proposals and $6.2 billion more than

the revenues that would have resulted from a simple application of the

corporate income tax to the entire windfall.

40
CHAPTER V. THE IMPACT ON THE ECONOMY

This chapter presents estimates of the likely effects of decontrol and

the proposed windfall profits tax on the overall economy. The major

economic impact of decontrol will be on the rate of inflation. Relative to

an indefinite extension of controls, the cumulative impact on the level of

prices is estimated to be an increase of about 0.6 to 0.8 percent by the end

of 1982. Compared with an immediate elimination of controls, the

President's plan merely spreads these price rises over a longer period of

time. The effects on real Gross National Product (GNP) and unemployment

are estimated to be small and to occur mostly after 1980.

In this chapter, four key issues that influence the impact of

decontrol and the windfall profits tax on the economy are discussed:

o The response of consumers to the rise in oil prices;

o The speed of the oil companies in investing a portion of their new

after-tax earnings;

o The ability of the federal government to return quickly the extra

tax revenues to the private sector; and

o The response of monetary policy.

Finally, empirical estimates of the effects of the President's plan on

prices and the real (constant dollar) economy are presented.

Impact of Decontrol

Consumers could cushion the impact of higher oil prices in a number of

ways. First, consumers could reduce their savings or borrow more in an

attempt to maintain present consumption levels. In the current circumstances, however, many economists believe that the savings rate is already

low and that the burden of consumer debt is beginning to reach a critical

level. Second, consumers could decrease real consumption, not only of

41
energy-related products, but of other items as well. \J Over the medium

term, as the price effects of decontrol further erode real spendable income,

it is reasonable to expect some reduction in real economic activity.

Perhaps the major uncertainty underlying the estimated effects of

decontrol is what would happen to the increased profits accruing to the oil

producers. Some of these extra corporate profits would be taxed away by

the existing corporate income tax. Still more profits would be captured by

the proposed windfall profits tax. 2/ The President has proposed that most

of these receipts be redistributed to low-income households, to mass transit

assistance, and to energy investment. If the increase in federal revenues is

not matched by new expenditures or reductions in other taxes, the federal

deficit will be reduced or the surplus will be increased, depending on the

state of the economy in the relevant budget year. This resulting tighter

fiscal policy will exert a restrictive effect on the economy.

It is generally believed that federal spending increases have a somewhat larger medium-term effect on the economy than do federal tax

decreases of the same amount—especially if these taxes are corporate

taxes. 3/ Consequently, even if the proposed spending is somewhat less

than the increase in corporate taxes, the effects on output and employment

should approximately balance out. It is reasonable to assume, however, that

the spending of these funds will not be synchronized with the receipt of

extra corporate tax revenues. Given the high capital intensity of some of

the possible projects to be funded through the Energy Security Fund and the

degree of planning that must be done before these projects can begin, the

rate of actual spending for these projects will probably be much lower than

\J Some would argue that consumption might actually be temporarily

stimulated in the short-run by decontrol if consumers decide to switch

to more energy-efficient cars, applicances, cind the like, sooner than

they had previously planned. This would necessarily result in additional borrowing and still further reductions in saving.

2/ The windfall profits tax is discussed in Chapter IV. Estimates of the

increased federal government receipts are shown in Table 7.

3/ For a discussion on spending and tax multipliers, see Congressional

Budget Office, Understanding Fiscal Policy, Background Paper (April

1978), Chapter m.

42
the rate at which tax revenues flow into the Treasury. If spending were to

lag behind taxes, then the total decontrol package would exert a net

restrictive fiscal influence on the economy.

The increase in after-tax corporate profits could be disposed of in

three ways: increased investment, reduced borrowing, and higher dividends.

The smaller independent oil companies, which account for about one-third of

newly discovered oil, have limited opportunities to invest in anything other

than exploration and drilling, whereas the major oil companies have

numerous avenues of investment in both nonpetroleum energy and in

nonenergy areas. The net effect of decontrol on investment, of course, is

the difference between the positive thrust coming from the increase in productive reinvestment of higher corporate profits and the negative impact of

a weaker economy as higher prices and a possibly tighter fiscal policy feed

back on consumer demaind.

Dividend payments by the oil companies might rise as a result of

decontrol. These payments would be directed at a relatively high-income

portion of the population, however, and would increase savings relative to

consumption. Because the magnitudes of reallocated consumer savings and

reduced corporate borrowings are expected to be quite small, interest rates

would be little affected by decontrol.

It is unlikely, however, that the additional profits accruing to the oil

companies would be respent quickly enough to replace the reduction in

consumer spending during the decontrol period. First, as pointed out above,

government spending would have to rise almost the full amount of the extra

corporate income tax revenues. Second, extra corporate dividends would

have to be largely respent by their recipients, and the actual expenditures

for any resulting additions to investment might lag behind the consumption

reductions. In addition, if the oil companies reduce their indebtedness, this

could put downward pressure on interest rates and stimulate additional

investment, but this would occur with an even longer lag. By the mid-1980s,

however, it is likely that the economy will have less consumption and more

investment than the base-case scenario, and this additional investment may

ultimately improve labor productivity and help lower the rate of inflation by

easing cost pressures on firms.

On international markets, the dollar might strengthen with decontrol

because of the favorable impact on the U.S. balance of payments, as the

quantities of oil imports are reduced by decreased domestic demand and

increased domestic supply. Appreciation, or at least slowing of depreciation, of the dollar would aid domestic inflation by slowing the rate of price

43
increases of imported goods. On the other hand, it could retard somewhat

the growth of exports and thus dampen the degree of improvement in the

balance of payments.

Empirical Estimates

This section presents estimates of the effects of decontrol and the

windfall profits tax on prices, output, and employment. The rates of

inflation, real output, and unemployment under the President's plan are

compared with what the rates would have been with an indefinite extension

of controls (the base case). The period of analysis is divided into two threeyear segments: 1979-1981 and 1982-1984. Although the quantitative results

presented here offer some flavor of the likely outcome of decontrol, they

depend on the specific assumptions made about the response of consumers,

the oil companies, and the federal government. A summary of these results

is presented in Table 8.

Inflation. The effect of decontrol on inflation will begin gradually,

adding no more than 0.1 percentage point to the inflation rate in 1979. The

effect will add about 0.2 percentage point in 1980 and 0.3 percentage point

in 1981. During and after decontrol, some feedback effects resulting from

larger wage increases stimulated by the initial price increases are likely to

occur. Lagged results of this effect should add another 0.1 percentage point

to the inflation rate in 1982. In the following years, any additional price

impact should be negligible as further lagged feedback effects are dampened

by a slightly weaker level of economic activity. The cumulative impact on

the level of prices as a result of decontrol is thus likely to be a rise of

between 0.6 and 0.8 percent by the end of 1982.

These estimates assume that the prices of substitute fuels are

constant and that 100 percent of the price increase from decontrol is passed

on to consumers. In the event that refiners absorb some of this cost because

of competition from imported refined products such as residual fuel oil, the

inflationary impact will be proportionately smaller. For the purposes of

comparison, the economy without decontrol is assumed to have the domestic

composite price for crude oil increasing at the rate of inflation through

1985. World oil prices are assumed to be unaffected by decontrol.

Output and Employment. The economy experiences the largest

increases in prices in the first three years, but the impact on the real

economy becomes most noticeable in the second three years. By 1981, the

unemployment rate is virtually unchanged, while real output is at most 0.3

44
percent lower than the base case. By 1984, the unemployment rate is

projected to be only 0.1 to 0.2 percent above the base case, while the level

of output is still less than 1 percentage point below the scenario of no

decontrol. Furthermore, the effects of past increases in prices are

beginning to decrease by the mid-1980s, and the gap in real output is

expected to be closing rather than widening as the economy moves into 1985

and beyond.

TABLE 8. ESTIMATED ECONOMIC EFFECTS OF DECONTROL:

DIFFERENCES FROM THE BASE CASE

Economic Variable 1979-1981 1982-1984

Real Output a/

(Annual percent growth rate,

GNP in 1972 dollars) 0.0 to-0.1 0.0 to-0.2

Prices

(Annual percent change in the

Implicit GNP Inflator) +0.1 to +0.3 0.0 to +0.2

1981 1984

Unemployment Rate

(Percent Difference in Level) 0 0.0 to +0.2

Price Level

(Percent Differences in Implicit

GNP Deflator) +0.5 to +0.5 +0.6 to +0.8

An important factor in these estimates is the assumed monetary

response of the Federal Open Market Committee (FOMC) to decontrol. If

the FOMC sought to bring the level of prices back to the no-decontrol

baseline by 1984, for example, interest rates would rise and demand in the

45
private sector would be dampened. In such a scenario, the price effects of

decontrol would be smaller and the output and employment effects would be

larger than the estimates presented here, which assume a partial accommodation of the additional inflation by the FOMC.

46
CHAPTER VI. ALTERNATIVE REVENUE USES

If oil prices are decontrolled, the Congress will face a critical decision

on the distribution and use of the additional revenues. One alternative,

which was discussed briefly in Chapter IV, would allow the oil producers to

.keep these revenues under the assumption that they would invest the funds

in additional exploration and development, thereby increasing domestic oil

production. An alternative would be to enact a windfall profits tax to

recoup the funds for the public and to use the funds to ease the transition to

a more energy-efficient economy.

The President has proposed the latter strategy, which includes the

establishment of an Energy Security Fund to redistribute the tax revenues to

low-income households to soften the burden of higher energy prices and to

mass transit and energy investments to assist in the transition. This chapter

analyzes the advantages and disadvantages of a trust fund mechanism per se

and then discusses the transit and investment uses recommended by the

President. Several alternative spending options are also presented. The

rebate to low-income households is addressed separately in Chapter VII. The

various proposed tax credits and the effectiveness of a regional petroleum

product reserve are not discussed in this report since the expenditures for

these items are expected to be far less than those for mass transit and

energy research and development.

THE TRUST FUND MECHANISM

In the past, the Congress has used trust funds principally to finance

projects requiring large capital expenditures. Since the completed projects

are used primarily by specific groups of people, the view was that these

users should pay for the capital expenditures through user charges. The

prime examples of these trust funds are the Highway Trust Fund through

which federal gas taxes are used to finance the construction of the

interstate highway system and the Airport and Airway Trust Fund through

which taxes on commercial and general aviation are used to construct

airports and airways.

Trust funds do, however, have some major disadvantages from

budgetary and policy coordination standpoints. First, with their long-term

earmarking of funds, trust funds limit budgetary control since they are only

47
marginally affected by budget resolutions and the appropriation process.

Second, since there are already relatively large federal programs for both

energy investments and mass transit, additional expenditures from a trust

fund would create coordination problems for the Congress in their authorization and appropriation processes and for the executive agencies in the

administration of these programs. Finally, since the revenue flow into the

fund would be extremely sensitive to future OPEC prices, which are

difficult to predict, it might be difficult to plan and manage the expenditures from such a fund. This would be particularly true for energy

investments, which are primarily long-term capital projects.

ENERGY RESEARCH AND DEVELOPMENT

The President has specified several major energy research and development (R&D) programs for funding by the Energy Security Fund.

Essentially, the program is oriented toward short-run fossil fuel development, including a second solvent refined coal (SRC) demonstration plant, a

development program for other synthetic liquid fuels (including gasoline

substitutes), and additional funding for coal R&D. These programs are all

realistic candidates for additional funding. It may be possible, however, to

reduce the funding levels of other R&D programs and apply the savings to

these programs. The individual programs recommended by the President are

outlined in the next section. After the President's proposals are discussed,

some alternative options, which primarily represent long-run R&D projects,

are presented.

The President's Proposals

Solvent Refined Coal. Solvent refined coal is a promising synthetic

fuel for the replacement of residual fuel oil or gas used in intermediate- and

peak-load plants hi the electric utility industry. Because of its low sulfur

content and high heat values, SRC burns fairly cleanly and is not expected

to require the expensive stack gas-scrubbing equipment usually needed to

burn coal.

DOE is now completing conceptual design studies for two SRC

processes, SRC-I (producing a solid product) and SRC-H (producing a liquid

one). At the completion of these studies, DOE plans to construct a 6,000-

ton-per-day demonstration plant for one of the two SRC processes. Monies

from the Energy Security Fund would be used to build the second SRC

demonstration plant. (One plant has already been requested.) Capital costs

48
for each demonstration plant are expected to be about $600 million, and

operating costs are expected to run about $100 million for the total

anticipated operating time of two to three years. The demonstration plant

would produce about 1 £5,000 barrels per day of oil equivalent. A second

demonstration plant would provide engineering and cost information regarding the processes, which could speed the transition to commercial plant

construction. The commercial application would not, however, begin to

affect the reduction of oil imports until the early 1990s.

Although little is known about the characteristics of commercial SRC

plants, information now available suggests that only very large commercial

SRC plants could achieve low per unit prices for their product. It appears

that the desirable commercial plant scale for either SRC process would be

about 30,000 tons of coal input per day. Capital requirements for such a

plant are expected to be on the order of $2 billion. The product cost would

be about $25 to $35 per barrel of oil equivalent.

Synthetic Liquids. Although the President's proposals for additional

R&D for synthetic liquid fuels are not spelled out in detail in the public

documentation, this seems to be a large and high-priority program. Of all

the synthetic fuels under consideration, the case for liquid fuels seems most

compelling.

Substitutes are available for most end uses of fuel. For example,

although natural gas is preferable for industrial, residential, and commercial

space heating, an electricity/heat pump combination can be used if gas is

not available. But the transportation sector is almost totally dependent

upon one liquid fuel or another, and nonliquid fuel forms are poor substitutes

at best. Eventually, a variety of substitute liquid fuels will be essential to

supplement diesel fuel, kerosene, and gasoline.

The major U.S. resources from which liquid synthetic fuels can be

made are oil shale and coal. There are extensive oil shale deposits in

Colorado, Wyoming, and Utah. Research and development by several

corporations suggests that, if oil shale is mined and then processed above

ground (termed surface retorting), oil could be produced from shale at a

relatively modest cost of, say, $20 to $30 per barrel. If the mineral could be

processed underground (on-site processing), thereby eliminating the mining

step and much of the equipment, even lower costs of about $15 to $25 per

barrel would be possible. The on-site technologies are being pursued by

several groups.

49
Fuel liquids from coal would probably be more expensive than liquids

from oil shale, with an anticipated minimum cost of $25 per barrel. The

most expensive processes, such as that employed at the Sasol plant in South

Africa, would probably cost in the range of $40 to $50 per barrel of oil

equivalent.

Whether using oil shale or coal, the production of liquid synthetic fuels

faces numerous obstacles. Technological and other uncertainties are

pervasive. If plants were built in the West, consumption of scarce water and

deteriorating air quality would be potential problems. All liquid synthetic

fuel processes seem to require large plant size, with investments in the $1

to $2 billion range, to bring per unit costs down to reasonable levels.

Raising such large sums of money and engaging in very large construction

projects pose serious challenges. Additional federal assistance could be

valuable at this time, if it were used to reduce the uncertainties associated

with developing a synthetic liquids industry.

Environmental Control Technologies for Coal. The third proposal for

fossil energy R&D support from the Energy Security Fund involves accelerated development of technologies that would permit the increased use of

coal without lowering environmental standards. The proposed R&D priorities are:

o Improved combustion processes that would allow the substitution of

coal for an increased portion of the oil currently burned in oil-fired

facilities.

o Accelerated materials and components research that would assist

efforts to produce liquids and gases from coal.

o The development of improved mining systems that would increase

safety, productivity, and health.

o The development of advanced coal-cleaning technologies that

might be used alone or in combination with stack gas-scrubbing

systems to burn coal cleanly.

All of these technologies would facilitate the transition to coal as a major

energy source.

Alternative Energy R&D Technologies

If the Energy Security Fund is enacted by the Congress, the proposals

recommended by the President would be reasonable short-term spending

50
options to assist in the transition to alternative energy sources. However,

some long-term alternatives could also be serious candidates for additional

funding, specifically solar, fusion, and fission energy. If

Solar. The solar energy research and development program is particularly important because solar energy has two unique advantages. First, solar

energy is renewable. Second, it can be used with negligible environmental

disruption. But in each potential solar energy application, cost is the

critical barrier to expanded solar energy use. In solar heating and cooling of

buildings, additional federal assistance might allow exploitation of economies of scale and, moreover, cut distribution costs sufficiently to make

solar energy nearly cost competitive. In the science of solar photovoltaic

electricity, more intensive research in semiconductor physics in general, and

in the photoelectric properties of semiconductors in particular, might help

reduce the substantial cost gap that now bars this energy source from

practical application. Both technologies are candidates for increased

funding.

Fusion. Fusion energy could prove to be a depletion-proof source of

central station electricity that is free from the waste disposal and reactor

safety problems that currently bar expanded use of nuclear fission-based

reactors. But both scientific and commercial feasibility remain to be

established. While impressive recent experiments have indicated that

scientific feasibility—that is, net fusion energy production—may be

achieved soon, many extremely difficult materials and engineering problems

will stand between that achievement and a commercial fusion reactor. An

expanded effort in the development and testing of candidate materials and

components for fusion reactors might help ensure that engineering and

materials problems do not restrict fusion reactor development.

Fission. Two lines of long-term fission reactor development might

benefit from funding by the Energy Security Fund. Among nonbreeder

reactors, one is both relatively far along in development and attractive on

both safety and proliferation-resistance grounds—the High Temperature Gas

Reactor (HTGR), particularly the direct-cycle variant in which a gas

turbine, rather than an intervening steam cycle, is employed.

If Additional information can be found in CBO, "The Energy Research

and Development Budget: An Overview," unpublished Staff Draft

Analysis (March 16, 1979).

51
Among breeder reactors, the best known—the Liquid Metal Fast

Breeder Reactor—was selected as a leading breeder technology long before

the associated proliferation problems were sufficiently appreciated, and it

has been successfully developed elsewhere. But there are several other

kinds of breeder reactors, particularly the thorium-cycle breeder reactor,

that may have superior nonproliferation characteristics. Exploration of this

or an alternative breeder reactor, which is impossible at current funding

levels, might be undertaken with Energy Security Fund financing.

MASS TRANSIT

While full details on the Energy Security Fund are not yet available, it

does call for federal grants for mass transit capital improvements. These

funds would be used primarily for the purchase of new buses and rehabilitation of existing rail systems. The thrust of the program would be to

reduce automobile gasoline consumption by providing additional urban

transport capacity.

Background

Transportation for people in urban areas consumes about one-fourth of

the nation's petroleum, or about 10 percent of all energy. Except for travel

in the central parts of older cities, such as Boston or New York, most of this

energy is consumed by the automobile. There are significant differences

among the energy efficiencies of the different modes of urban transportation. A previous CBO study found that, on a door-to-door basis, after

adjusting for the energy used in vehicle manufacture, in route construction,

and for round-about journeys, the most energy-efficient modes were vanpools and buses, while the average automobile was among the least

efficient. 2/ Vanpools and buses are about three times as efficient as the

typical auto and twice as efficient as new rail transit systems, such as those

in San Francisco and Washington, B.C. Because of their reliance on greater

speed and amenities such as air conditioning and escalators, newer rail

transit systems are significantly less energy-efficient than are older rail

systems, such as those in Boston, Chicago, New York, and Philadelphia.

2/ CBO, Urban Transportation and Energy; The Potential Savings of

Different Modes, Committee Print by the Senate Committee on

Environment and Public Works (September 1977).

52
The amount of energy that can be saved by a particular mode of

transportation depends on its ability to attract riders from less efficient

modes. For example, new carpools result in very large energy savings

because they typically attract riders from single-occupant automobiles—a

very inefficient mode. In contrast, although new rail transit is usually

thought of as very energy efficient, CBO's analysis shows that the typical

new rail system increases energy consumption since it attracts many of its

riders from even more efficient buses. Depending on the energy source for

electric generation, however, rail transit systems still might result in some

petroleum energy savings. Thus, the proposals to concentrate efforts on

buses and older rail systems to conserve energy in mass transit appear

reasonable. Certainly, additional grants for new mass transit rail systems

would be counter-productive in terms of energy savings.

Potential Energy Savings

The expanded funding for mass transit would probably influence energy

consumption in two ways: increased bus patronage and increased ridership on

new rail systems. The increased bus grants should encourage a modest

expansion in bus patronage. Although energy savings from this expanded

usage would be negligible in the early years, by 1985 savings could be

between 5,000 and 10,000 barrels of oil per day. The estimated energy

savings are based on the assumption that an additional 8,000 buses, a 15

percent expansion in the fleet size, would be purchased. Such an expansion

is likely, however, to add to current operating deficits and thus to greater

pressure for increased federal operating aid.

These calculations assumed that most of the funds earmarked for

buses were used to purchase new buses, as apparently is assumed by the

Administration. It might be possible to increase the investments that

improve bus productivity. Examples include exclusive bus lanes and contraflow lanes that permit buses, carpools, and vanpools to bypass regular

highway traffic; park and ride facilities; ramp metering to improve the flow

of traffic on freeways; and coordinated traffic lights, including signals that

can be activated by buses. 3_/ Such a program would have the advantage of

increasing the productivity of the more than 50,000 transit buses in the fleet

instead of merely increasing the size of the fleet.

3/ Some of these options are discussed in more detail in CBO, Urban Mass

Transportation; Options for Federal Assistance (February 1977), pp.

40-50.

53
The added money for buses and older transit systems should allow a

reallocation of existing federal mass transit funds to permit the starts of

two new rail transit systems between now and 1985. But, as discussed

above, these new rail systems are likely to be less energy-efficient than

older ones. Because of the normal planning and construction delays,

however, new rail systems would probably not be operating much before

1985.

Alternative Mass Transit Proposal

Since vanpools and carpools show even greater energy savings than do

buses, a program to encourage their use could result in substantially greater

energy savings than the mass transit program proposed by the President.

Currently, both vanpools and carpools are operated almost entirely on a

voluntary basis without government aid or involvement. Lack of funds does

not appear to be the most important factor in their success or failure, so

that a new program of federal financial aid is unlikely to have a large effect

on the use of vanpools and carpools. Rather, institutional problems, such as

concerns over liability insurance and lack of information, appear to be the

major constraints.

SPENDING ALTERNATIVES

There are several alternatives for spending the additional tax revenues

that would be generated by decontrol through the excess profits and

corporate income taxes. Three options are addressed in this analysis:

o Do not earmark funds—that is, allow the budget and appropriations

committees of the Congress to decide on the use of the funds.

o Establish a fund to expedite development of petroleum in nonOPEC countries.

o Roll back payroll taxes.

No Earmarked Funds. Since spending decisions are usually made

independently of revenue decisions, a major alternative would be not to

establish a fund to spend the tax revenues. Instead the budget and

appropriations committees—the committees traditionally concerned with

such decisions—would decide how to use the funds. These committees could

recommend spending on projects similar to those of the President or other

54
programs, or they could decide to decrease the size of the deficit. Such an

option would have distinct advantages over the President's proposed Energy

Security Fund in terms of budget efficiency and overall planning and policy

coordination.

Fund to Expedite Development of Petroleum in Non-OPEC Countries.

An alternative use for the President's proposed energy fund is to use the

fund to finance exploration and development of oil resources in countries

that have potential resources and do not belong to OPEC. 4/ In theory,

there is little reason to believe that such a fund is necessary because private

entrepreneurs have been exploring for oil in virtually all countries since the

turn of the century. As a practical matter, however, a fund might be

beneficial for several reasons:

o Recent price increases have increased the probability that many

"semi-explored" provinces have economically attractive deposits of

oil.

o Private firms may not have sufficient access to risk capital to

invest in exploration as fast as is socially desirable.

o Some countries have restricted private oil companies from the

development of the countries' oil resources.

The need for this kind of fund or for this type of exploration is,

however, very controversial. One side argues that exploration has been

inadequate in many nations because of political restrictions, instability, or

availability of nearby, inexpensive fuels. As evidence, one study claims that

95.7 percent of the world's exploratory drilling has been accomplished on

only half of the prospective areas. 5_/

The other side contends that patterns of exploration have been more

thorough than is apparent. About half of the non-North American exploratory wells drilled between 1967 and 1976 were in the developing and non47 See CBO, A Strategy for Oil Proliferation; Expediting Petroleum

Exploration and Production in Non-OPEC Developing Countries, Staff

Working Paper (February 23, 1979).

5/ Congressional Research Service, Project Interdependence; U.S. and

World Energy Outlook Through 1990 (November 1977), Chapter XX.

55
OPEC countries, and 71 of the 113 developing countries had exploratory

wells drilled in that decade. 6/ Furthermore, 68 percent of the potential

basins in the world (almost all of the basins that are not under polar ice or in

deep ocean areas) have been explored to a degree that seems sufficient to

find "giant" fields. Fields of this size now account for about 75 percent of

the world's known reserves. According to this view, exploration of the

"neglected" areas would not provide an important contribution to world

reserves. 7/

On balance, it appears that there are potential benefits in using public

funds to finance exploratory drilling investments in neglected areas in

return for some assurances of future supplies if discoveries are made. But it

is unlikely that such discoveries would be substantial.

Reduction in Payroll Taxes. Since the inflationary effects and the

increased burden on low-income households are two of the most critical

costs of decontrol, it is important to consider alternatives that might offset

them. One such option would be to use the additional tax revenues from

decontrol to reduce other taxes. While a personal tax cut might be

considered, this has the critical disadvantage of stimulating demand and,

hence, inflationary pressures. An alternative would be to reduce equally the

employer and employee shares of payroll taxes. Although such a proposal

would have the effect of breaking the link to direct financing of the social

security system, it is estimated that such tax reductions would, on balance,

lead to a lower rate of price increases by reducing the cost of labor

compensation to employers.

A reduction in social security taxes would be relatively easy to

implement. And, if the tax rate was reduced rather than the taxable wage

base, after-tax wages would rise quickly and would reduce the adverse

impact of higher energy prices almost immediately. In addition, the timing

of the reduction could be closely phased with the increases in federal tax

revenues resulting from decontrol. This would be an important advantage

over spending programs that often do not "spend out" as quickly as intended.

Finally, as discussed in Chapter VE, the coverage of payroll taxes is such

6/ Exxon Corp., Exploration in Developing Countries (New York: Exxon,

June 1978).

7/ Richard Nehring, Giant Oil Fields and World Oil Resources (Santa

Monica, Calif.: Rand Corporation, 1978).

56
that, in conjunction with existing government transfer programs, most of

the population affected by higher energy prices would receive additional

funds.

The tax cut proposal considered here assumes that the size of these

social security payroll tax reductions just equals the increase in tax receipts

from decontrol, as shown in the first column of Table 9, and that 50 percent

of this reduction accrues to employers and 50 percent to employees. For

comparative purposes, the last column of Table 9 shows the currently

legislated increases in social security taxes.

TABLE 9. ADDITIONAL TAX RECEIPTS RESULTING FROM DECONTROL AND LEGISLATED INCREASES IN SOCIAL SECURITY

TAXES: IN BILLIONS OF CURRENT DOLLARS

Calendar

Year

1980

1981

1982

1983

1984

Additional

Tax Receipts

from Decontrol a/

1.6

4.6

4.9

5.6

5.7

Legislated

Increases in Social

Security Taxes b/

0.5

15.1

20.7

23.7

27.2

a/ Estimates for the President's plan as described in Chapter IV.

b/ Base estimates assume wage base grows with the rate of inflation.

The employee portion of the tax cut would be indistinguishable from a

reduction in federal personal income taxes, except for distributional considerations which are believed to be very small. The employer share,

57
however, would be expected to lead to a reduction in prices as firms pass on

these savings to consumers in lower prices. 8/ Because there is little

historical experience with such tax cuts, the empirical evidence to confirm

such behavior by firms is modest. Consequently, these estimates must be

treated as highly uncertain. The substitution of the payroll tax reduction

for the proposed expenditures would have virtually no effect on the real

economic growth. The improvement in the price level, however, is

estimated to be roughly 0.3 percentage point by 1984. This deflation benefit

results from the net impact of the payroll tax reduction and also from the

reduction in federal spending. Consequently, such an option could reduce

the cumulative inflationary impacts of the President's proposals by nearly

half.

8/ For a discussion of these taxes, see CBO, Aggregate Economic Effects

of Changes in Social Security Taxes, Technical Analysis Paper (August

1978). The estimates presented here assume two-thirds of the

employers, tax reductions are passed forward.

58
CHAPTER Vn. DISTRIBUTIONAL IMPACT AND ASSISTANCE TO LOWINCOME FAMILIES

Under the President's plan, part of the incremental revenues resulting

from oil price decontrol would be redistributed to low-income families.

These families pay a disproportionate share of their income for energyrelated goods and services and would, therefore, bear a disproportionate

burden of any fuel price increase passed on to consumers. The Administration anticipates that this assistance would average $100 a year for the

"typical" low-income household.

To assess the potential burden of oil price decontrol and the need for

assistance to low-income families, this chapter first reviews the current

distribution of oil expenditures by income class and region of residence.

Second, future family expenditures on oil and the impact of decontrol are

examined. Because of the uncertainty about future OPEC pricing policies,

the distributional effects of decontrol are analyzed under two alternative

assumptions: constant real OPEC prices, and a 3 percent per year increase

in real OPEC prices. As in all other sections of this report, it is assumed

that all added crude oil costs attributable to decontrol are inevitably passed

through to consumers. Finally, alternative mechanisms to distribute revenues for low-income assistance are analyzed.

CURRENT FAMILY EXPENDITURES ON OIL

In 1978, gasoline and home heating oil consumption by households

accounted for 39 percent of total U.S. oil consumption. !_/ The remainder

was used for utilities and commercial, industrial, and governmental purposes. Consumers bear the burden of rising oil prices both directly through

the purchase of petroleum products such as gasoline for their cars or fuel oil

to heat their homes and indirectly through the purchase of goods and

services that use oil in their production. These burdens vary considerably

for families at different income levels and in different geographic regions.

The remaining part of this section draws upon earlier CBO findings and

I/ Includes 5.9 million barrels per day of gasoline and 1.3 million barrels

per day of heating oil and kerosene.

59
focuses on direct expenditures by families on gasoline and fuel oil for home

heating, and indirect expenditures by families on oil through purchases of

other goods and services. 2_/

Gasoline

A number of factors such as location of employment, availability of

alternative modes of transportation, and auto efficiency affect the level of

family gasoline consumption. On average, the absolute amount a family

spends on gasoline rises with its income (see Table 10). The reason for this

is that as incomes rise families tend to drive more, have more cars, utilize

autos for commuting purposes, locate outside of core cities in areas where

public transportation is inadequate or unavailable, and drive automobiles

that are less fuel efficient. Expressed as a proportion of income, however,

the percentage of income spent on gasoline falls as income rises; that is, the

relative burden of family gasoline expenditures is regressive. For example,

in 1973-1974, the lowest fifth of families as ranked by money income (those

with less than $3,700 a year in money income) spent, on average, 6.5 percent

of their cash income on direct expenditures for gasoline, as compared with

3.2 percent for the highest fifth of the income distribution. 3/

Since not all families own automobiles and families differ in their

driving habits and needs, expenditures for families with similar incomes may

vary considerably. Moreover, the way car ownership and gasoline expenditures vary among families, in relation to their incomes, causes the

distribution of the percent of income spent on gasoline within income

classes to vary considerably according to the level of income. For example,

more than half the families in the lowest income quintile do not own

vehicles and therefore cannot be expected to incur significant gasoline

expenses. In fact, many of these low-income families, which are predomi2/ Congressional Budget Office, President Carter's Energy Proposals; A

Perspective, Staff Working Paper, 2nd ed. (June 1977).

3_/ Throughout this analysis, income is used as a measure of ability to pay.

In fact, at the low end of the income distribution, consumption

expenditures for some families exceed income, indicating that these

families have available other resources such as savings, loans, and

some income transfers that are not included in money income. The

income ranges in 1973-1974 for each fifth are noted in Table 10.

60
TABLE 10. AVERAGE ANNUAL GASOLINE EXPENDITURES a/ PER FAMILY FOR

FAMILIES RANKED BY MONEY INCOME AND FOR FAMILIES BY REGION

AND AREA OF RESIDENCE, 1973-1974

Families

Average Annual

Gasoline

Expenditures,

AU Families

Percent of

Dollars Income

Average

Annual Gasoline

Expenditures,

Families

with Vehicles Only

Percent of

Dollars Income

Percent

of Families Owning One

or More

Vehicles

Ranked by Money

Income b/

Lowest fifth

Second fifth

Third fifth

Fourth fifth

Highest fifth

By Region and Area

161

338

493

589

718

6.5

6.2

5.3

4.4

3.2

340

430

538

615

731

13.7

7.8

5.8

4.5

3.3

43.5

75.9

90.1

94.7

97.7

Northeast

North Central

South

West

SMSA c/

Other urban

Other rural

All Families

418

476

462

488

458

420

501

461

4.2

5.0

5.8

5.3

4.8

5.0

6.7

5.1

554

559

566

564

568

509

573

561

5.5

5.8

6.9

6.1

5.8

6.0

7.5

6.1

73.8

83.3

80.0

85.0

79.0

81.5

85.5

80.5

SOURCE: Calculated by CBO, based on data from the Consumer Expenditure Survey

Series; Diary Survey, July 1973-June 1974, U.S. Department of Labor,

Bureau of Labor Statistics. Survey figures are adjusted to be consistent with

aggregate estimates of family gasoline consumption.

a/ Retail market value. In addition to crude oil, includes all refining and marketing

costs.

b/ In 1973-1974, the income ranges for each fifth were: lowest fifth, under $3,700;

second fifth, $3,701 to $7,300; third fifth, $7,301 to $11,200; fourth fifth, $11,201 to

$16,450; highest fifth, $16,451 and over. Unrelated individuals are counted as oneperson families.

£/ Standard Metropolitan Statistical Areas.

61
nantly older, retired people or single-parent families, do not typically work

and therefore do not use a car for commuting purposes. For those who do

commute, however, gasoline expenditures may be considerable and particularly burdensome. For example, average annual gasoline expenditures in

1973-1974 for families with vehicles in the lowest income fifth were $340,

or 13.7 percent of income for these families, as compared with $161 or 6.5

percent when averaged across all low-income families. One study of 1975

gasoline expenditures which examined variation within income classes found

that, among those in the lowest tenth of the income distribution, 56 percent

incurred no gasoline expenditures at all, while 11 percent incurred gasoline

expenditures that exceeded one-fifth of their family income. At the highest

tenth of the income distribution, virtually all families owned one or more

vehicles and about fourfifths spent less than 5 percent of family income on

gasoline for driving purposes. 4/

Gasoline expenditures differ not only by level of income but also by

region of residence. For example, in 1973-1974, gasoline expenditures for

families ranged from an average of $488 a year in the West to $418 a year in

the Northeast. Because incomes are, on average, higher in the Northeast

than in other regions, the disparity in relative burdens between the

Northeast and the other regions is even greater; for example, 4.2 percent of

income was spent on gasoline by families in the Northeast, as compared with

5.8 percent by families in the South. These differences reflect, in part, the

rural nature of the South with its long travel distances and dependence on

automobiles as the primary mode of transportation. Similarly, there is

greater dependence on automobiles in the West and North Central regions

than in the Northeast, which has more concentration of population in

metropolitan areas together with alternative modes of transportation and

shorter commuting distances. For example, average gasoline expenditures

were roughly 10 percent higher in rural areas thaji in metropolitan areas;

gasoline expenditures were 6.7 percent of family income in rural areas, as

compared with 4.8 percent for families living in metropolitan areas.

Heating Oil

Families also use petroleum products in the form of various fuel oils to

heat their homes and indirectly as inputs to produce other home energy

4/ James N. Morgan, "Trends in Driving and Commuting," in Five

Thousand American Families, vol. VI (Ann Arbor: University of

Michigan, Survey Research Center, 1978), p. 414.

62
sources such as electricity. 5/ Factors that affect household use of energy

include income as reflected in the types and sizes of residential housing

units (small apartments versus large detached homes), conservation habits,

and regional differences in climate and relative abundance of various energy

sources. Thus, expenditures for heating fuel and other home energy sources

vary according to family income and areas of residence. 6/

Direct family expenditures on fuel oil rise with income, though the

burden of these expenditures is regressive. In 1973-1974, the lowest fifth of

families spent an average of $49 a year on home fuel oil, as compared with

$101 for the top fifth of families (see Table 11). Since large numbers of

families do not heat with fuel oil and use, for example, natural gas or

electricity, expenditures for those who use fuel oil are much higher; for

example, the average annual expenditure for fuel oil users was $36Z, as

compared with $72 when averaged across all families. The increase in home

fuel oil expenditures as income rises reflects the greater incidence of home

ownership and larger homes among higher-income families. Nevertheless, as

was the case with gasoline consumption, home fuel oil expenditures impose a

greater relative burden on those with lower incomes; families in the lowest

fifth spent 2.0 percent of their income on heating oil, as compared with 0.5

percent for the highest quintile.

Though fuel oil represents only about 15 percent of home energy

expenditures (excluding gasoline) and thus oil price increases may have, on

average, a small direct impact on families, variations in the consumption

and availability of home energy sources may impose relatively larger

burdens on families in regions that rely primarily on fuel oil for home

heating. Fuel oil accounts for about 27 percent of home energy expenditures for families in the Northeast, as compared with about 10 percent of

home energy expenditures for those in other regions. Given the severe

winters in the North, use of fuel oil for heating purposes exacerbates the

disparity between fuel oil usage in the Northeast and that in warmer regions

of the country which depend primarily on energy sources such as electricity

or natural gas. Moreover, though incomes are generally higher in the Northeast, the relative burden of fuel oil expenditures for families in the

5/ This analysis includes distillate (number 2 home heating oil) and

kerosene, but excludes propane.

6_/ For a comprehensive evaluation of home energy expenditures see

Wayne L. Hoffman,, The Distribution of Home Energy Expenditures by

American Households in 1977-1978, Working Paper (Washington, B.C.:

The Urban Institute, May 1979).

63
TABLE 11. AVERAGE ANNUAL HEATING OIL AND KEROSENE EXPENDITURES a/

PER FAMILY FOR FAMILIES RANKED BY MONEY INCOME AND BY REGION

AND AREA OF RESIDENCE, 1973-1974

Families

Average Annual

Heating Oil and Kerosene Expenditures

Percent of Percent with

Dollars Income Expenditures b/

Heating Oil and

"Kerosene as

Percent of

Home Energy

Expenditures c/

Ranked by Money

Income d/

Lowest fifth

Second fifth

Third fifth

Fourth fifth

Highest fifth

By Region and Area

Northeast

North Central

South

West

SMS A e/

Other urban

Other rural

All Families

49

66

53

89

101

160

52

45

39

61

81

108

72

2.0

1.2

0.6

0.7

0.5

1.6

0.6

0.6

0.4

0.6

1.0

1.4

0.8

16.1

18.1

19.9

22.5

23.1

33.

17.

18.

9.

16.5

17.8

36.4

19.9

15.1

16.3

12.0

15.4

14.5

27.3

10.0

9.6

10.8

12.

17.

19.9

14.6

SOURCE: Calculated by CBO, based on data from the Consumer Expenditure Survey

Series; Diary Survey, July 1973-June 1974, U.S. Department of Labor,

Bureau of Labor Statistics. Survey figures are adjusted to be consistent with

aggregate estimates of household heating oil and kerosene consumption.

a/ Retail market value. In addition to crude oil, includes all refining and marketing

costs.

b/ Calculated from Consumer Expenditure Interview Survey, 1972-73; Annual Expenditures and Sources of Income Cross-Classified by Family Characteristics, 1972-73

Combined, U.S. Department of Labor, Bureau of Labor Statistics.

£/ Home energy includes heating oil and kerosene, propane, natural gas, electricity,

coal, and wood.

d/ See Table 10 for income boundaries of each fifth,

e/ Standard Metropolitan Statistical .Areas.

64
Northeast is greater than for those in other regions; fuel oil expenditures

were 1.6 percent of income in the Northeast, as compared with about 0.5

percent elsewhere.

Indirect Expenditures on Oil

Families pay for oil indirectly through their purchases of goods and

services that use oil as an input in their production. Industries such as steel,

agriculture, food processing, and transportation rely on oil as a major source

of energy and pass these oil costs on to consumers through higher prices. In

1973-1974, these and other indirect oil expenditures cost families, on

average, $415 a year—only about 20 percent less than family expenditures

on gasoline and heating oil (at their retail cost)—and were 4.6 percent of

money income (see Table 12). These indirect expenditures are assumed to

include crude oil used in the production of consumer goods and oil used in

the production of investment goods that would actually result in costs to

consumers only at some time in the future. Indirect expenditures also

include oil used by governments and a small amount of input oil costs that

would fall on consumers of U.S. export goods.

Indirect family expenditures on oil depend on family consumption

expenditures. Family consumption expenditures generally rise with income;

however, these expenditures as a proportion of income decline as income

rises. Assuming that indirect family expenditures on oil are proportional to

consumption patterns (excluding gasoline and home heating oil) across the

income distribution, the lowest fifth of families in 1973-1974 spent an

average of $193 a year for crude oil through indirect purchases, as compared

with $684 a year for the highest fifth of families. Relative to income,

however, these expenditures were regressive; that is, the lowest fifth of

families spent 7.8 percent of their income on indirect crude oil expenditures, as compared with 3.1 percent for the highest quintile.

FUTURE EXPENDITURES ON OIL AND IMPACT OF DECONTROL

In the future, family expenditures on oil will depend upon family

consumption of gasoline for automobiles, use of fuel oil for home heating

purposes, and indirect purchases of oil through general consumption expenditures. Future consumption of petroleum products will depend upon several

factors that are difficult to predict, such as changes in the price of oil, in

the demand for oil as family incomes rise, in family consumption patterns,

in the availability and price of alternative energy sources and modes of

transportation, in the ability to conserve, and in technological advances

toward the more efficient use of resources.

65
TABLE 12. AVERAGE ANNUAL INDIRECT EXPENDITURES ON OIL a/

PER FAMILY FOR FAMILIES RANKED BY MONEY

INCOME, 1973-1974

Families Ranked

by Money Percent of

Income b/ Dollars Income

Lowest Fifth 193 7.8

Second Fifth 294 5.4

Third Fifth 397 4.3

Fourth Fifth 464 3.4

Highest Fifth 684 3.1

All Families 415 4.6

SOURCE: Calculated by CBO, based on the Consumer Expenditure Interview Survey, 1972-73: Annual Expenditures and Sources of

Income Cross-Classified by Family Characteristics, 1972-73

Combined, U.S. Department of Labor, Bureau of Labor Statistics; and Consumer Expenditure Series; Diary Survey, July

1973-June 1974, U.S. Department of Labor, Bureau of Labor

Statistics. Adjusted to aggregate levels of U.S. domestic

crude oil expenditures.

a/ Crude oil costs only.

b/ See Table 10 for income boundaries of each fifth.

Extension of Price Controls

In 1982, under a continuation of domestic oil price controls (the base

case) and no increase in real OPEC oil prices, U.S. families would spend both

directly and indirectly $136.1 billion on crude oil or, on average, 8.7 percent

of family income (see Table 13). The lowest fifth of families would spend

14.7 percent of their income on oil, whereas those in the top quintile would

devote only 5.7 percent of their income to oil expenditures.

Under a continuation of controls—assuming that real OPEC prices are

not increased and that EPCA auto efficiency standards are met—direct

66
TABLE 13. DOMESTIC OIL EXPENDITURES UNDER CONTINUATION OF PRICE CONTROLS AND INCREASES IN EXPENDITURES FROM THE PRESIDENT'S

DECONTROL DECISION, TOTAL AND PER FAMILY, UNDER ALTERNATIVE OPEC PRICE INCREASES, 1982: IN DOLLARS

Domestic Oil

Gasoline

Families Ranked

by Money

Income a/

Constant Real

OPEC Prices

Lowest fifth

Second fifth

Third fifth

Fourth fifth

Highest fifth

All families

Total expenditures

for all families (in

millions)

Three Percent per

Year Increase in

Real OPEC Prices

Lowest fifth

Second fifth

Third fifth

Fourth fifth

Highest fifth

All families

Total expenditures

for all families (in

millions)

With

Refining

Costs c/

314

660

962

1,148

1,400

898

81,068

324

681

994

1,186

1,447

928

83,746

Crude

Cost

Only

147

308

449

536

654

419

37,856

161

339

494

590

720

462

41,670

Expenditures Under Continuation of Price Controls Increase Induced by Decontrol

Heating Oil

and

Kerosene

With

Refining

Costs c/

105

142

113

191

216

154

13,854

110

150

119

201

228

162

14,589

Crude

Cost

Only

65

89

70

119

135

96

8,650

71

96

76

130

147

104

9,385

Total b/

Indirect

Expenditures

492

703

950

1,169

1,637

992

89,544

506

759

1,025

1,261

1,766

1,070

96,581

Dollars

704

1,100

1,469

1,824

2,426

1,507

136,050

738

1,190

1,595

1,980

2,63Z

1,636

147,636

Percent of

Income

14,7

10.5

8.3

7.0

5.7

8.7

—

15.5

11.3

9.0

7.6

6.2

9.4

Gasoline

12

26

38

45

55

35

3,176

16

33

48

57

70

45

4,038

Heating Oil

and

Kerosene

7

9

7

12

14

10

873

8

11

9

15

17

12

1,119

Indirect

Expenditures

45

64

87

107

149

91

8,170

55

84

113

139

195

118

10,651

Total

Percent of

Dollars

64

99

132

164

218

135

12,219

79

128

170

212

282

175

15,808

Income

1.3

0.9

0.7

0.6

0.5

0.8

—

1.7

1.2

1.0

0.8

0.7

1.0

~~

SOURCE: Congressional Budget Office.

a/ See Table 10 for income boundaries of each fifth. These boundaries are increased by 92 percent to reflect projected growth in family money income from 1973-1974 to

1982.

b_/ Does not include refining and marketing costs for gasoline and heating oil.

£/ Retail market value of gasoline and heating oil. In addition to crude oil, includes all refining and marketing costs.
expenditures by families on gasoline and home heating oil at their market

value would be $94.9 billion by 1982, a 6 percent increase over 1978

expenditures after inflation is taken into account. This increase reflects oil

price inflation and moderate increases in aggregate consumption as a result

of growth in the number of families and greater automobile usage. On a per

family basis, however, real expenditures on gasoline are projected to rise by

less than 5 percent from an average of $461 a year in 1973-1974 to $483 in

1982 in 1973-1974 dollars ($898 in 1982 dollars). Thus, with family income

growing on average only slightly faster than the rate of inflation, the future

burden of these expenditures is projected to be virtually unchanged; that is,

5.1 percent of family income in 1973-1974 and 5.2 percent in 1982. Some

families, however, such as those unable to conserve and alter their level of

consumption, those living in areas without alternative sources of energy for

home heating purposes, and those whose incomes are fixed or have not kept

pace with inflation, would experience greater burdens from rising oil

prices. 7/

The President's Plan

CBO estimates that, with constant real OPEC prices, oil price

decontrol would increase the nation's oil bill by $12.2 billion in 1982. These

additional expenditures would ultimately come from families either through

their direct purchase of petroleum products at higher prices or indirectly

through their consumption of other goods and services that use oil in their

7_/ It is difficult to estimate with any certainty the distributional

outcomes of current and future energy expenditures. For example,

part of the expected reduction in family gasoline consumption comes

from future fuel efficiencies. Low-income families will be less likely

to purchase the new, presumably more fuel-efficient automobiles of

the future. The used cars that low-income families typically buy are

likely to be less fuel-efficient models from the mid-1970s. The poor

may, however, choose from the more economical of the current stock

of automobiles, while those higher up the income distribution who are

capable of purchasing more fuel-efficient automobiles may still prefer

to buy the less economical cars to be produced under EPCA standards.

On balance, it is assumed these factors are offsetting, so that changes

in expenditures across the income distribution from 1973-1974 to 1982

are considered to be proportional.

68
production. &J Direct expenditures by families on gasoline and heating oil

would increase by $4.0 billion, while indirect family expenditures on oil

would increase by $8.2 billion. 9/ With an increase in real OPEC prices of 3

percent per year, the nation's oil bill would rise by $15.8 billion over a

continuation of price controls; about one-third of this increase would be for

family expenditures on gasoline and heating oil, and the other two-thirds for

indirect oil expenditures.

Families at different income levels would be affected differently by

decontrol and additional expenditures may result in relatively greater

burdens for families in the lower-income classes. For example, under the

assumption of constant real OPEC prices, $3.0 billion of additional family

expenditures would be by families in the lowest two-fifths of the income

distribution—that is, families with incomes of less than $11,400 a year in

today's dollars (first quarter, 1979). For the lowest fifth (those with less

than $5,800 a year in family income), average family consumption expenditures would increase $64 a year, with more than 70 percent of this increase

coming from indirect oil expenditures. Those higher up the income

distribution would see their consumption expenditures rise much more; for

example, the top fifth of families would spend, on average, an additional

$218 a year. But higher-income families also have a greater ability to pay;

additional expenditures resulting from decontrol would represent 1.3 percent

of income for families in the lowest fifth and only 0.5 percent for families

in the highest quintile. 1CI/

!3/ Additional expenditures resulting from higher prices on oil used in the

production of investment goods, goods purchased by governments, and

export goods are included in the burden on households, inasmuch as

domestic consumers will eventually bear most of the burden of these

higher costs.

9_/ The CBO estimates of decontrol on household gasoline consumption

assume a 0.16 price elasticity of demand for gasoline; that is, with a 1

percent rise in the price of gasoline the quantity of gasoline demanded

would fall by 0.16 percent.

10/ Profits from decontrol are not reflected in money income of families

who hold oil company stock. Since many of these households are in the

higher income categories, figures in Table 13 understate the difference in relative burdens of decontrol on the rich and poor. At the

other end of the income distribution, however, incomes that rise with

inflation such as social security and some welfare benefits have not

been adjusted to reflect growth in these benefits from oil price rises.

69
ASSISTANCE FOR LOW-INCOME FAMILIES

The President has suggested setting aside through the Energy Security

Fund up to $800 million (in 1982) in revenues from a windfall profits tax and

the normal corporate income tax to assist low-income families. According

to the President, increases in real OPEC prices would not affect this level of

assistance. The President would provide $100 a year to the "typical"

low-income household, though who would be considered low-income has yet

to be specified, ll/ If low-income families are considered to be those in the

lowest fifth, $1.2 billion in assistance would have to be provided to offset

fully the effects of decontrol on this population. If the second-lowest fifth

of families were also included, an additional $1.8 billion would be needed for

low-income assistance. This assumes, of course, constant OPEC prices in

real terms. With a 3 percent yearly increase in real OPEC prices, CBO

estimates $1.4 billion and $2.3 billion in assistance would have to be

provided to the bottom two fifths of families, respectively. 12/

Not all low-income families would be affected in the same way by

rising oil prices. While most families in the lowest fifth would generally

feel the indirect effects of decontrol through their general expenditures on

goods and services, incomes for many of these low-income families will rise

automatically with the price level (that is, indexed social security, Supplemental Security Income, and food stamp benefits) and thus offset some of

the costs of decontrol. Low-income families not receiving indexed transfer

benefits would feel the full indirect burden of oil price increases. Nongasoline expenditures for families in the lowest fifth would rise by $930

million or, on average, $52 a year per family. On top of increases in

indirect oil expenditures, low-income families with significant gasoline

expenditures would feel the direct effect of decontrol; for example, gasoline

expenditures for the lowest fifth would rise by $220 million, and the average

increase for those with some gasoline expenditures would be $28 a year.

Mechanisms for Assisting Low-Income Families

There are several possible ways to provide assistance to low-income

families affected by decontrol. The Administration has yet to propose a

ll/ See Office of the White House Press Secretary, Fact Sheet on the

President's Proposals for the Windfall Profits Tax and the Energy

Security Trust Fund (April 5, 1979).

12/ These estimates do not include possible offsets resulting from increases in federal transfer payments that are indexed to keep pace

with inflation.
specific method for distributing low-income assistance, but it is considering

several options, including the following:

o Increasing benefits in current cash or in-kind welfare programs;

o Providing block grants to states to distribute to their low-income

populations as a form of emergency assistance;

o Using an expanded tax credit under the federal income tax; and

o Rolling back payroll taxes.

Increasing Welfare. Additional support could be provided through

several current cash welfare programs such as Aid to Families with

Dependent Children (AFDC) or the Supplemental Security Income (SSI)

program for the needy aged, blind, or disabled—though SSI benefits are

already adjusted automatically for price rises—and through the food stamp

program, which also adjusts benefits for food price inflation. Gasoline and

other oil-related expenditures could be treated as deductions in computing

benefits, or basic benefits could be increased by a fixed amount.

Use of current welfare programs would have several advantages.

First, administrative structures are already in place. Benefits could be

conditioned on a test of need, and administrators of such programs are

experienced in dealing with low-income households. Utilizing current

structures would minimize additional administrative costs. Second, some

programs are administered by the states, and benefits could be adjusted to

deal with localized needs. Third, with the provision of benefits on a monthly

basis, these programs could be responsive to current needs in offsetting

higher gasoline and other energy expenditures as they occur. Fourth, in the

case where benefits are increased by a fixed amount, benefits are based on

income as a measure of need and are not related directly to a particular oil

expenditure. Such a benefit encourages substitution of less costly energy

sources and would be consistent with policies to encourage conservation.

Fifth, roughly one-quarter of all low-income families (that is, the bottom

two fifths of the income distribution) are currently receiving benefits from

cash welfare programs or food stamps and, thus, a significant number of

low-income households could receive immediate relief. Sixth, increasing

benefits under the food stamp program would have the advantage of

providing benefits for all low-income families and would thus benefit the

working poor, many of whom incur direct expenditures on gasoline.

On the other hand, use of some welfare programs would have a number

of disadvantages. First, since traditional cash welfare programs are

categorical—that is, restricted to specific groups—it could be difficult to

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use them to assist some of the low-income population hurt by rising oil

prices. Welfare programs such as AFDC and SSI generally assist those in

single-parent families (mostly women) or those who are elderly or disabled.

The working poor, and especially intact families, are not generally assisted

by welfare programs, except for the food stamp program. Yet, the working

poor would be precisely those families who would feel the direct effects of

oil price increases through increased gasoline expenditures. Second, since

AFDC is a federal/state program, administered by states under federal

guidelines with some federal financial participation, the federal government

may have limited control over how benefits are adjusted and may be unable

to assure equitable treatment of individuals from state to state. Third,

options that allow deductions of actual oil expenditures would not encourage

conservation. Furthermore, there could be increased administrative costs

associated with recomputing benefits based on expenses as they occur.

Providing Block Grants to States. Attempting to provide assistance to

low-income households through the mechanism of a block grant for emergency assistance may have many of the disadvantages associated with

improving cash welfare benefits and few of the advantages. The Community

Services Administration currently distributes benefits at the state and local

levels through its Emergency Energy Assistance Programs (EEAP). These

programs have assisted the poor in a number of ways, including payment of

back energy bills. EEAP could be one way to provide the block grants to

states, though it is unclear how effective the program has been to date.

Although block grants can be categorical—that is, earmarked for specific

purposes—the federal government would have little control over how funds

would be distributed. If traditional welfare mechanisms such as AFDC were

utilized, benefits would not be targeted on the working poor.

On the other hand, one advantage of a block grant from the federal

perspective is that the grant could be adjusted to reflect regional differences in dependence on petroleum products, such as higher fuel oil expenditures in the Northeast. Furthermore, from a budgetary perspective, a block

grant affords greater control over the commitment of federal dollars to this

type of low-income assistance.

Using an Income Tax Credit. Another way to offset rising oil

expenditures for low-income households is to establish a refundable tax

credit for low-income households or to expand the current earned income

credit. The refundable tax credit could be based on income and, in order not

to support the rich, could be phased out as earnings rise. It would not

subsidize a particular energy expenditure but rather would meet the general

income needs of low-income households, encourage substitution, and remain

consistent with conservation goals. The earned income credit, which rises

with earnings for low-income families, would have the advantage of

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directing benefits at those who would most likely bear the burden of rising

gasoline expenditures—namely, the working poor. Both the general tax

credit and the earned income credit would have the advantage of building on

the current tax system and would have a relatively marginal impact on

administrative costs.

One disadvantage of the uniform credit approach is that benefits are

not related to actual expenditures so that some poor may realize a windfall

while others with sizable out-of-pocket expenditures, who may already be

conserving and unable to reduce oil expenditures further, would receive

insufficient support. Also, an approach providing credits to the entire lowincome population based on income as a measure of need, not just to those

who incur additional oil expenses, would be less well targeted than an actual

expenditure approach. A disadvantage of a credit based on actual gasoline

expenditures is that, unless households adjust their withholding (which seems

unlikely given uncertainty regarding future gasoline expenditures), the

credit would not be responsive to current needs. Finally, the federal

government has relatively little control over the costs of any of these tax

credits.

Rolling Back Payroll Taxes. The working population hurt by oil price

decontrol could also be helped by a reduction in payroll taxes. This option is

discussed in Chapter VI of this report.

o

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