Russia: A Taxing Dilemma

Interesting story about the Russian oil industry:

Russia’s government may make it illegal for oil companies to reduce crude output and oil-product sales when “there’s demand” and sales won’t be loss-making, Vedomosti reported.

The measure is included in the latest version of a new law on oil extraction, refining and transporation that is being debated in the government, the Moscow-based newspaper said, citing a copy of the drafted dated March 1.

Here’s what I think is really going on.  Russia taxes oil extraction very heavily, and relies heavily on oil taxes to fund the government.  When taxes become too onerous, companies rationally respond by cutting output (and by not investing in new productive capacity).  This puts a crimp in government revenues.  So the state is proposing to eliminate the ability of firms to respond to high (and potentially higher) taxes on oil by reducing output.

This is essentially another way of extracting rents from “private” oil producers in order to fund the state.  It suggests acute near-term fiscal pressures.

There is always “demand” at some price.  Who determines what is “loss-making” is key here.  Presumably this will be interpreted to mean that price (net of taxes) exceeds lifting costs.  But lifting costs are not the true opportunity cost of producing oil.  The primary opportunity cost is the “shadow price” of extraction: the revenue foregone on a barrel of oil that could be produced in the future, but is produced today instead.  The ukase to produce today indicates a divergence between the government’s estimate of this shadow price and the estimate of the owners of the wells.

In other words, this proposed law signals that the Russian government discounts the future more heavily than ostensibly private resource owners.  (I say “ostensibly private” because the rights of ownership are highly circumscribed if the state controls both price–through taxes–and output and extraction decisions.)  The Russian government wants revenue now, and plans to get a lot of it through resource taxes.  It wants to limit the ability of firms to reduce their tax burden by reducing output today (in order to produce more in the future, perhaps when fiscal strains are less acute).  Hence the law.

In brief, the significance of the law is primarily what it says about the fiscal situation in Russia, and the dependence of the government on resource taxes.

Russia is trying to push output to the max today to maximize current tax revenues.  But there is a recognition that producing resources–many dating from Soviet times–must be replaced, and the more that is produced today, the more rapidly these resources need to be replaced.  The problem is that the tax regime creates a severe disincentive to invest in new fields.  Hence the heavy lobbying by Sechin and other elements in the Russian oil industry to get tax breaks on new fields.

One problem is the inability of an autocratic state like Russia to make credible commitments on such a tax regime.  The proposed law is an example of the time-inconsistency problem.  Future changes in the law can effectively take away tax breaks granted today.

Thus, in the coming years Russia will face an increasingly complex dilemma.  There is an increasingly pressing need to replace the legacy fields developed by the USSR.  But there is chronic and increasingly acute fiscal pressure: an aging population and the regime’s use of increased social benefits to tamp down popular opposition mean increasing demands on the state budget.  The major source of revenue to fund these demands is resource taxation.  But there is a fundamental contradiction between a tax regime that would encourage investments to replace depleted legacy resources and a tax regime that will meet these fiscal demands.

Just how Putin et al can square that circle is not immediately apparent, to say the least.

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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