Running the Royalty Numbers

Ever since Art Laffer stalked the halls of the Reagan White House, it’s been an article of faith among Republican politicians and policy wonks that if you want to raise tax revenue, you ought to cut tax rates. And on the flip side, if you want to slash revenue, the surest way to get there is to raise tax rates - which Laffer, to be clear, would never, ever, recommend.

That might sound a little paradoxical, but unless you’ve been living in splendid isolation for the last 35 years, you’ve probably heard how this is all supposed to work. When a tax rate is cut, the folks providing the taxed item – labor, natural resources, financial investment, luxury goods, or what have you -  will be so unburdened that they will want to provide more of it - so much more, in fact, that the tax base will grow faster than the rate is cut and, voilà, revenue will increase. On the other hand, if government is foolish enough to raise rates, the opposite will happen: people providing whatever it is that’s being taxed will pick up their marbles and go home and all that nice revenue will disappear.

Now there’s nothing wrong with the logic here – everybody can agree that when you tax something you usually tend to discourage, to some degree, its production and use.* But when it comes to figuring out the impact of tax rates on tax revenue, more than just logic matters; you also have to look at the actual numbers.

Take, for example, the case of Federal coal royalties.

This past summer, the Department of the Interior asked for public comment on whether or not mining companies pay the public reasonable royalties when they dig up and sell Federal coal. Needless to say, the companies think they are paying plenty and resent the question even being asked. As far as they’re concerned, it’s just one more salvo in the “Obama administration’s war on coal.” On the other side are folks (full disclosure, I’m one of them) who maintain that the companies have contrived to price Federal coal at well less than its true market value, in order to short the public on royalty payments. Indeed, according to an analysis by Headwaters Economics, pricing coal at true market value could produce over $100 million in new Federal revenue.**

But John Ostlund are Bob Story are having none of it.

Ostlund, who’s a Yellowstone county commissioner, opined in the Gazette in August that the best way to raise more royalty revenue would be to mine more Federal coal, and the best way to make that happen, of course, would be to reduce royalty payments and bonus bids***. And Story, who’s the executive director of the Montana Taxpayers Association and a former president of the Montana Senate, predicted in the Missoulian that if the Federal government increased per ton royalty payments, the “best-case scenario” would be that companies would priced out of the market and stop mining Federal coal entirely, meaning royalty revenue would be zilch.

Well, maybe, but look at the numbers. According to the Headwaters study, Montana and Wyoming, the states that produce the lion’s share of Federal coal, deliver that coal to their customers at a little more than $30 a ton, and pay per-ton royalties of $1.79 (Montana) and $1.56 (Wyoming). Now imagine we cut those royalty payments in half, hoping, with Commissioner Ostlund, that we would get enough additional production for total royalty revenue to actually increase. For that to happen, since we’d be collecting half as much on each ton, we’d have to more than double the number of tons sold; stated otherwise, sales would have to increase by more than 100%. Let’s assume that the whole royalty reduction would be passed on to the buyers in the form of lower prices – none of it would be kept by the companies - so prices would fall by $.85, or roughly 3% in Montana, and by $.70, or again roughly 3%, in Wyoming.

So there you have it: for royalty revenue to increase in this scenario, a 3% decrease in price would have to induce customers to increase their purchases of Federal coal by over 100%. And that just isn’t going to happen. In the short run, in particular, power producers are locked in; a small price reduction is not going to drive them to switch in droves from natural gas or solar or wind to coal, and it certainly isn’t going to allow them to sell twice as much electricity to their customers. Of course they might switch from non-Federal to Federal coal, but in that case, Commissioner Ostlund should be careful what he wishes for. Yes, there would be more Federal coal produced – and royalties paid – but it would be taken out of the hide of the companies and workers who mine state or private coal leases. The net effect on total coal production would be very, very small.

The same objection applies in reverse, but more so, to Story’s “best-case scenario.” According to Story, any increase in royalty payments would price Federal coal out of the market. Any increase in the price of Federal coal, no matter how small, would reduce purchases to zero. But there’s simply no reason to believe any such thing. Just as buyers are not going to flock to Federal coal when the price goes down a little, they are not going to abandon it when the price goes up. If they did, it would be because they were buying state or private coal instead. And if that happened, unlike Story, the folks producing that coal would probably think that raising Federal royalties was really  a pretty darn good idea!

* A noteworthy exception to this rule is labor. Taxing wages can induce people to work more, rather than less.

** One of the pricing reforms that Headwaters proposes would increase revenue by over $500 million, but it doesn’t look likely that that proposal will get very far.

*** Bonus bids are what companies pay to get access to Federal coal in the first place; royalties are what they pay as and when the actually dig the coal up and sell it.