Ohio’s Severance Tax Policy Should Look Beyond 17th Century Economics

In his 2015 State of the State Address, Governor Kasich argued that Ohio needed to increase the tax on oil and gas extraction—the severance tax—because removing oil and gas from the ground makes Ohio poorer.  Is this true?  Is Ohio poorer because of oil and gas extraction?  This debate isn’t new.  In fact, there was once a school of thought, the mercantilists, who made similar arguments in the 16th and 17th centuries. Fortunately, the work of great economists such as Adam Smith soundly proved the error of this thinking. What was true in the days of Adam Smith is true today.  Ohio benefits from the economic growth induced by the shale boom.  Increasing the severance tax will discourage shale-drilling activity, which will be the true culprit in making Ohio poorer.

Mercantilists did not see free trade as mutually beneficial because they thought one party could gain only at the other’s expense.  They were strong nationalists who wanted to maximize the national wealth by tightly controlling the economy.  These ideas and motives led them to implement misguided policies that restricted trade in order to hoard gold and silver.

But this was a flawed doctrine that only hindered its adherents in their stated goal of maximizing national wealth.  Adam Smith correctly explained that when producers and consumers freely trade, both parties win.  This leads to economic growth and true prosperity, regardless of how much gold is in the king’s vault.

Governor Kasich argued that, “Ohio’s being made poorer as a result of the depletion of our resources… Much of the wealth the shale boom is generating is being shipped out of our state, being shipped out of Ohio.”

His proposed remedy is to dramatically increase the state severance tax on horizontal drillers so that, like the mercantilist philosophers in days of old, the state can build up its savings with the tax revenue.  He views the shale oil and gas deposits sitting in the ground as part of Ohio’s wealth.  Because of this view, Kasich hopes to maintain this wealth by taxing shale production and saving the revenues.

But as Adam Smith ably proved, this economic view is erroneous.  Oil and gas deposits do not create wealth for Ohio by merely sitting in the ground beneath thousands of feet of rock. It’s the extraction of the deposits, thanks to new horizontal drilling technology, that makes them profitable.  Horizontal drillers add value to those oil and gas deposits by using advanced machinery, skilled labor, and technical know-how to bring them to the surface and make them usable.  In the process, these drillers generate business for Ohio-based companies and create high-paying jobs for Ohio citizens.  In turn, the state government, local governments, and local schools receive higher tax revenues as well.

Increasing the severance tax discourages shale-drilling activity, which consequently discourages growth.  Moreover, any surplus to the state from this tax increase will be more than offset by the loss of jobs, investment, and spending that would have been created by keeping those resources in the private economy.  Those who benefit directly from the shale boom re-invest some of their proceeds, resulting in even more wealth and job creation.  Their income also becomes their spending, which becomes income for people who then benefit indirectly from shale production.  In this way, all Ohioans share in the benefits of the shale boom without the need for state intervention.

The Kasich administration has repeatedly overestimated the level of oil and gas production in Ohio, and consequently, has repeatedly overestimated the amount of severance tax revenue the state would receive.  Significantly increasing the tax will surely maintain this pattern.  The Governor further argued for his proposal by emphasizing that, “If you don’t drill, you don’t pay.”  But the last thing that Ohio should want is for companies not to drill, and to instead take their valuable economic contribution elsewhere.

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Takeaway from State of State: Ohio Needs to Adhere to Sound Tax Principles

When DHL Express pulled out of Wilmington during the throes of the Great Recession in 2008, the Mayor said the city took a “gut punch.” That story is one of the big reasons Governor Kasich decided to take his annual State of the State speech to Wilmington. He wanted to highlight the difference his policies are making for Ohio and why the General Assembly should follow through on his latest biennial budget proposal. The Governor is right that many Ohio policies, specifically its troublesome tax code, hurt economic growth and prosperity.

While The Buckeye Institute did find some promising policy recommendations in the budget, there are numerous areas where improvement is definitely needed in order to turbo-charge Ohio’s recovery. Nothing that the Governor said in last night’s State of the State alters the following observations that we made in our overview of the budget when it was released earlier this month:

• “Efforts to continue reducing the personal income tax (PIT) and shift to consumption-based taxation should also be applauded from a long-term perspective. However, several of the mechanisms chosen to offset revenue losses will counter-act some of the positive impacts from the PIT reduction and violate the principle of tax equity. Among these are increases to the Commercial Activities Tax and the Ohio severance tax. Both will be harmful for businesses and should not move forward. The proposed tobacco tax increases will also lead to smuggling and evasion, thus not yielding the revenues projected by the Administration while also singling out a single class of taxpayers and violating the principle of tax equity. Further government spending restraint should form the basis of eliminating the income tax prior to any other increases.
• Education spending continues to grow rapidly despite little academic evidence that increased budgets benefiting bureaucracy yield significant academic gains.
• Medicaid continues to be what former Governor George Voinovich called the “Pac-Man” of the state budget, especially after the expansion. However, the Governor is wisely seeking to impose limited personal responsibility requirements on those over 100% of the Federal Poverty Level (FPL).
• The state is wisely continuing a reduction in revenue sharing by further reducing reimbursements to local governments for tangible personal property and kilowatt-hour taxes.
• Overall state spending is increasing faster than can be justified through either inflation or population growth. The largest increase comes from moving the Medicaid expansion costs back onto the General Revenue Fund (GRF) books. However, state-only GRF spending also eclipses inflation.”

Adhering to good tax policy of the kind we outlined in our Tax Principles report will move Ohio into a continuously improving economic condition. All reforms should be simple, transparent, pro-growth, and fair and equitable. Unwise tax shifting undermines some of the salutary effects of things like the large reductions in the personal income tax, including the elimination of that tax for many small businesses.

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The Buckeye Institute on State of Ohio Talking Taxes and Spending

Our Greg R. Lawson was on The State of Ohio news program opposite Policy Matters Ohio’s Amy Hanauer on February 20.  The video is below.


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Medicaid Expansion Relies on Uncertain Funding

Ohio stands to lose up to $1.3 billion in expected revenue by 2022 after a likely rule change by the Center for Medicare & Medicaid Services (CMS) that would close a Medicaid funding loophole. Buckeye Institute President Robert Alt cautioned policymakers against relying on these expected revenues to make Medicaid expansion feasible. Unfortunately, his initial success was thwarted when Governor Kasich bypassed the legislature to expand Medicaid through the Controlling Board.

Ohio exploits the loophole to game the federal Medicaid matching grant system. Here’s how it works:

The state pays per-member per-month or “capitated” premiums to private insurance firms called Managed Care Organizations (MCOs) that coordinate healthcare for Medicaid recipients. By increasing the capitated premium and subjecting it to the state sales tax, Ohio inflates spending and boosts federal matching dollars. Consider the following hypothetical example:

In one year Ohio determines that MCOs need a $475 capitated premium and there are 1 million Medicaid recipients. Total Medicaid managed care spending equals $5.7 billion per year, with $2.28 billion coming from the state’s coffers and—at a 60 percent matching rate—$3.42 billion from the federal government.

The next year, Ohio exploits the loophole by setting the premium to $500 and assessing a 5 percent sales tax. Total spending is now $6 billion per year, with $2.4 billion coming from the state and $3.6 billion from federal matching grants. The state spends $120 million more out of pocket but receives $300 million in new revenue from the sales tax. In effect, Ohio fleeces the federal government for a yearly $180 million bonus, and the MCOs still get the money they need.

A federal Inspector General recently investigated Pennsylvania for playing the same game and found the practice unlawful. The Center for Medicare & Medicaid Services responded by declaring its intent to bring the states back in line. This most likely means pulling the plug on Ohio’s own MCO premium tax scheme.

A report by the Urban Institute and The Ohio State University projected that Medicaid expansion would net a $1.85 billion gain to the state budget through 2022. However, if Ohio loses MCO premium tax revenue, their estimates imply that the program would run a $169 million annual deficit in 2022 and lose a cumulative total of $1.18 billion by 2032.

With a potentially adverse decision from CMS looming on the horizon, Ohio may soon learn that disregarding The Buckeye Institute’s warning was an expensive mistake. Fortunately, the coming biennial budget debate will afford state leaders the opportunity to reverse course before it’s too late.

To read more about this issue, please see our policy brief.



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Containing State Spending is Key for Tax Reform

Governor Kasich’s proposed budget for FY 2016-2017 contains some positive features, but overall it continues the trend of unchecked growth in state spending. The Governor’s proposal expends an additional $912 million of the state-funded portion of the General Revenue Fund. While an increase of this magnitude is hard to justify from an economic perspective, it is not unusual from a historic perspective.  GRF expenditures grew by over $1.6 billion in real dollars from 1996 to 2014, averaging 3.2% growth per year. For the last six years this growth has been closer to 5%, a trend that continues in this proposal.

It is hard to imagine a compelling reason for such a dramatic increase. From 1996 to 2014 Ohio experienced a very low rate of population growth, averaging  .18% per year. Inflation averaged a moderate 2.3% per year. If GRF spending per capita were confined to 1996 levels, and merely kept pace with historic inflation and population growth rates, state GRF expenditures would have totaled less than $19.4 billion in 2016. Unfortunately, though perhaps not unexpectedly, spending did not merely keep pace with inflation and population growth. With Kasich’s proposed $912 million increase, state GRF expenditures will total more than $22.7 billion. This is $3.3 billion above what inflation and population growth require, and continues the recent trend of raising state GRF spending by 4-5%.

Increasing spending by $3.3 billion forces Ohio taxpayers to pay $3.3 billion in additional taxes. While the governor’s commitment to cutting individual income taxes is laudable, claims of true tax reform ring hollow in the face of spending growth. Merely shifting the tax burden to businesses is not “reform” in any sense of the term, particularly given the systemic problems with how Ohio taxes businesses. Once spending growth is contained the tax burden can be lifted rather than shifted.

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Why Ending the Renewable Energy Mandate is Good for Ohio Families and the Economy

The Pew Charitable Trusts recently reported, with regret, that investment in Ohio’s renewable energy industry fell from $750 million in 2012 to $100 million in 2013. But as The Buckeye Institute’s new report explains, ending the renewable energy mandates will only prove to help Ohio’s families and strengthen the economy.

Pew fears that so much lost investment could cost the state thousands of jobs and even wipe out the fledgling Ohio renewable energy sector, spelling disaster for the Buckeye State’s economic future. Their report points the finger for these woes at Senate Bill 310, a state law that temporarily suspended previous government mandates that forced utilities and electricity retailers to use renewable energy and implement energy efficiency measures.

Pew’s comparison of 2012 to 2013 investment is fundamentally unsound. 2012 investment was likely driven to artificially high levels by federal renewable electricity production tax credit policy, which incentivized renewable energy companies to begin projects before December 31, 2012. Pew is wrong to conflate the effects of federal tax policy and state energy policy.

But regardless of where the blame lies, SB 310 is a smart policy move for four reasons.

  1. It reduces crony capitalism that favors the owners and employees of renewable energy companies at the expense of other Ohioans.
  2. Any conspicuous harm to the jobs and renewable energy investment with which Pew is concerned masks other unseen benefits for the rest of Ohio’s economy.
  3. Eliminating the renewable energy standards will help the bottom line for all Ohioans by lowering energy bills.
  4. Forcing renewable energy companies to compete without subsidies will make them stronger in the long run.

Testimony by Peggy Claytor of The Timken Company illustrates the significant harm of these mandates on Ohio companies:

Consumers don’t need costly portfolio mandates to do what makes good business sense. Make no mistake about it: Ohio’s current mandates are costly. They are particularly costly for large energy users…Together, the portfolio mandates will cost Timken in excess of $2 million this year alone.

Such exorbitant compliance costs prevent such companies from focusing on growing their businesses, giving existing employees better pay and benefits, and creating new jobs. Scrapping these ill-conceived mandates, along with the unnecessary costs they impose on businesses and consumers, is a vital step forward for all Ohioans.

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New U.S. EPA Rules Will Crush Ohio Recovery

The U.S. EPA recently proposed two crushing sets of regulations—the Clean Power Plan aims to reduce CO2 emissions, while the other is a plan for ozone reduction. There are four major issues with these plans that should concern all Ohioans: (1) the costs imposed are extraordinary and will damage the economy; (2) compliance will make Ohio’s energy grid less reliable; (3) the centralization of power to the EPA will erode the free market forces which have slowed the growth of energy costs and improved services; and (4) the federal agency’s power grab will strip much of Ohio’s authority to make her own energy policy.

First, studies by NERA Economic Consulting found that the Clean Power Plan and the ozone proposal would cost the nation up to $73 billion and $360 billion per year, respectively. The worst-case scenario has the total cost of these two regulations nearly equaling the 2014 federal deficit of $486 billion.

In the Buckeye State specifically, NERA estimates the ozone regulations alone could impose compliance costs of more than $20.8 billion per year. Both regulations will also increase electricity costs—the Clean Power Plan by an average of 12 percent per year by 2031 after adjusting for inflation, and ozone regulations by about 15 percent through 2040.

Second, these regulations would impair electric reliability by reducing the use of coal to generate electricity. Less coal usage forces our state to rely more on natural gas, for which there is insufficient pipeline infrastructure, and renewables such as solar and wind, which are inherently unstable. This increases the likelihood of “widespread rotating blackouts,” according to Commissioner Philip Moeller of the Federal Energy Regulatory Commission, and could be catastrophic during severe weather events like the recent polar vortex.

Third, centralizing command over Ohio’s energy sector under the U.S. EPA also diminishes market freedom and consumer choice. The ability of most Ohio consumers to choose the best electricity provider among a variety of competitors would be restricted, leading to worse service at higher prices.

Finally, as the Buckeye Institute’s comments to the EPA explain, the Clean Power Plan is fundamentally a “national energy and resource planning policy.” It gives the EPA unprecedented authority over rightful state jurisdiction, and Ohio officials would often need permission from the EPA to change the state’s energy policies.

Ohio citizens have power to hold their state legislators accountable through the democratic process; however, they cannot hold bureaucrats at the EPA accountable for wrongheaded policies. Thus, the Clean Power Plan would severely curtail Ohioans’ political power over their own energy system.

Piling on $20.8 billion per year in regulatory costs is an economic growth killer that will also endanger the reliability of Ohio’s power grid. Worse, the rules leave Ohio vulnerable to future changes because increased EPA power strips Ohioans of control over their own energy system. These plans ignore economic prudence and disregard federalist principles. For these reasons the Ohio General Assembly should do everything in its power to mitigate both proposals.

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