CALIFORNIA GENERAL ELECTION October 2006

Chasing the Rainbow:

Economist’s Analysis of California’s Proposition 87 Oil Tax

By Adrian T. Moore, Ph.D., Benjamin Powell, Ph.D., and Samuel R. Staley, Ph.D.

POLICY
BRIEF
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Reason Foundation

Chasing the Rainbow:

Economist’s Analysis of California’s Proposition 87 Oil Tax

By Adrian T. Moore, Ph.D., Benjamin Powell, Ph.D., and

Samuel R. Staley, Ph.D.
R e a s o n F o u n d a t i o n

Table of Contents
Introduction................................................................................................................ 1
Why Proposition 87 is Wrong For California................................................................ 2
Higher Prices, More Volatility ................................................................................................... 2
A Blow to State and Local Government .................................................................................... 3
Long on Hope, Short on Accountability .................................................................................... 3

How Proposition 87 Will Lead to Higher Prices and More Bureaucracy ....................... 5
Impact on Gas Prices................................................................................................................ 5
Creation of Alternative Fuels..................................................................................................... 6
Conclusion ............................................................................................................................... 7
Proposition 87 is Ideology Not Reality ......................................................................... 8
 PROPOSITION 87 1

Part 1

Introduction

P roposition 87 would create a new tax on the production of oil in California to fund $4 billion in
alternative energy programs over a 10-year period. The measure contains a complex and
imprecise tax-rate structuring with increasing tax rates as the price of oil increases. Consequently,
there is no way of knowing how long this tax will be in place to fund the $4 billion program.

Three of Reason’s economists analyzed Proposition 87 and prepared brief discussions of its likely
effects.

This measure would have the ironic impact of increasing California’s dependence on foreign oil.
California already has among the highest taxes on oil in the nation. Raising state taxes on oil
production to the highest in the nation will cause many marginal wells to become too expensive to
operate and they will be shut down, forcing us to import more oil. Though the initiative forbids oil
producers from passing the costs of the tax on to consumers, the independent Legislative Analyst’s
Office points out that there is no way to enforce the ban.

Oil production in California is a significant source of income to the state, both in the form of
salaries paid to its employees, and taxes/royalties paid to the state. Increasing the regulatory and
tax burdens on the industry will discourage expansion and new investment in the industry,
resulting in a loss of jobs and state and local and school district revenues. The measure also
authorizes the state to issue bonds to fund the alternative energy program, adding to our prodigious
state debt and costing nearly $8 billion at the end of the day. The tax will continue until that debt
is paid off.

While the goals of alternative energy are admirable, attempting to promote it through $8 billion in
new taxes that go to create a new bureaucracy to give out grants that are not even required to
produce actual alternative energies would be far less effective than encouraging the already
substantial private investment in alternative energy research.

Proponents claim that the proposition would prevent the tax from being passed on to consumers,
but the laws of economics cannot be repealed, and this kind of tax will decrease production and
increase prices for consumers.
2 Reason Foundation

Part 2

Why Proposition 87 is Wrong For

California

Analysis by Adrian T. Moore, Ph.D., Vice President of Reason Foundation

Alternative energy is an important issue, but the proposed tax on oil production is
the wrong way to address it. Rather than improving California’s energy situation,
it would drive up prices for everyone while creating a new bureaucracy with no
accountability for results, and likely would not result in any major breakthroughs
in alternative energy.

Higher Prices, More Volatility

For those who think gasoline prices are too low and don’t change often enough, this tax proposal is
a wonderful thing. I can’t think of a better way to drive up gasoline prices in California, and make
them change more often, than by taxing oil production. Though the initiative forbids oil producers
from passing the costs of the tax on to consumers, the independent Legislative Analyst’s Office
points out that there is no way to enforce the ban. And all economists know that with products like
oil and gasoline, where our demand does not change easily, new taxes are always passed on to
consumers.

Just as bad, the tax will reduce production of oil in California and require us to import more oil
from overseas, where prices change more often. So the oil tax will cause our gasoline prices at the
pump to be higher and to change more often. By raising the costs of production at each oil well in
California, the tax would lead oil companies to close some high-cost/low production wells, and
avoid drilling for new oil where it is more difficult or expensive to do so. The result will likely be
a reduction of nearly 10 percent of oil production in California over the next 10 years.

Higher gas prices, thanks to the proposed tax, would not only hit all Californians in the wallet
when they fill their tank, it will have broad negative effects on the state’s economy and jobs.
Adding this new tax to the many taxes oil producers in California already pay will make California
one of the highest tax states for oil production. That not only will shrink the oil industry in
 PROPOSITION 87 3

California, but the higher prices will reduce the productivity of every business in California where
fuel costs are important—agriculture, manufacturing, and many services. The oil industry will
directly lose hundreds of jobs, and job cuts will follow in other industries as well thanks to higher
fuel costs.

A Blow to State and Local Government

Don’t be fooled by the initiative’s double talk on the price tag. It authorizes a new bureaucracy to
spend $4 billion on alternative energy programs funded by the new tax. But the bureaucrats can
float a bond and borrow that $4 billion up front, without a public vote. With interest added, the oil
tax will have to raise about $5.8 billion to pay off the loan over the life of the program.

This is another case of creating a new state program by stealing funding from local governments.
The new oil tax will reduce other state and local tax revenues, effectively shifting money from
state, county, and city budgets to pay for this alternative energy project. Because the oil tax would
cause oil producers in California to reduce production, they would pay less property tax to county
governments, less income tax to the state, and less sales tax to the state and local governments.
The budget impacts in Kern, Los Angeles, Ventura, and Santa Barbara counties would be
substantial.

The new alternative energy bureaucracy created by this initiative operates with no oversight, but
puts substantial risks on California taxpayers. Once they borrow the $4 billion, state taxpayers are
on the hook to pay it back, with interest, even if the oil tax does not raise enough money to cover
the full nearly $5.8 billion obligation. That could easily happen if oil production falls thanks to the
higher tax. Or what if the plan succeeds too well and alternative energy projects begin to rapidly
reduce our need for oil, and thus for oil production and falling oil tax revenues leave us holding the
bag to pay for the program out of general revenue?

At the same time the new alternative energy bureaucracy can run up billions in debt, as the
initiative allows them to hire as many full time staff as they see fit. Those staff will vest in the
state pension system and health care plans, creating obligations for taxpayers long after the
alternative energy efforts have run their course. All spending must be completed in just 10 years,
but the bureaucracy it creates is authorized for 20 years, meaning we will be paying overhead
costs, salaries and benefits long after the alternative energy program has ended.

Long on Hope, Short on Accountability

Figuring out where to invest the $4 billion the new oil tax would create is a tricky and risky
business, and the initiative has no plan for how the funds will be used to improve alternative
energy.
4 Reason Foundation

The accountability section of the initiative provides for nothing but a financial audit, which will
ensure that the money is not being embezzled. There is no requirement that the new bureaucracy
and the $4 billion in spending be used for viable alternative energy programs, deliver any actual
positive results, or provide any benefit at all to California citizens. The only sure outcome is
substantial corporate welfare for the alternative energy industry. The new alternative energy
bureaucracy will consist of up to 50 political appointees who would be exempt from normal
procurement rules and oversight, so they would not have to use a competitive process to determine
to whom they dole out billions in oil tax dollars, and they don’t have to submit to legislative
oversight hearings to ensure the money is being spent to actually accomplish the program’s goals.

The initiative sets the goal of reducing petroleum use in California by 25 percent over the next 10
years, but provides no plan for accomplishing that goal. Instead, the idea appears to be: Let’s
throw $4 billion at the problem and see what sticks. It is ridiculous to think that starting now to
invest in research in alternative energy will result in new technologies that will be fully developed
and in the market and knocking our petroleum use down by 25 percent in just 10 years. We have
been investing much larger sums in solar and wind power for decades and have not got anywhere
near that kind of result.

In fact the government has a horrible track record at picking winners with investments in new
technologies. Back in 1979 President Carter launched a five-year, $500 million program of
research in solar power that did not result in any new commercial technologies. The history of
alternative energy policy is full of such boondoggles. Enough so that when someone suggests
throwing piles of taxpayer dollars at alternative energy programs, we should be asking: Are we
picking the right solution? How do you know? And if you are so sure, then why isn’t someone
already doing it?

Technological change is incremental and evolutionary, and the most important changes are the
ones that catch us by surprise, that we don’t predict. It is very unlikely that 50 political appointees
in Sacramento will know what alternative energy efforts will succeed and which will be a dead
end, and we should expect most of their choices will be a waste of our money and some may even
do more harm than good by diverting effort away from viable alternative energy projects toward
politically chosen ones.
 PROPOSITION 87 5

Part 3

How Proposition 87 Will Lead to

Higher Prices and More Bureaucracy

Analysis by Benjamin Powell, Ph.D., Assistant Professor of Economics, San Jose

State University, Director of the Center on Entrepreneurial Innovation, The
Independent Institute, Oakland, California

Proposition 87, the Clean Alternative Energy Act (CAEA) is one of the worst
ways Californians could encourage the development of alternative fuels. The
initiative would discourage oil production, increase fuel costs, and the
government bureaucracy it creates would not likely improve on the competitive
market’s development of alternative fuel vehicles. These points are elaborated
on in greater detail below.

Impact on Gas Prices

Proposition 87 attempts to mislead the public. It claims to be a tax on oil companies’ excess
profits. But really it is a tax on oil production that will raise consumer prices. Taxing profits
discourages the activity that generates those profits, in this case, oil production. California oil
production is already trending downward. Taxing the production of oil will accelerate this trend
by discouraging new oil exploration and by encouraging the premature closure of existing oil
fields. Fields become more costly to extract oil from as they age. Eventually they are no longer
profitable and are closed. Since this tax is on the profits of the oil production, it will encourage
wells to close prematurely.

With less oil produced in California we will have to import more oil from other states and foreign
countries. Though the Act is intended to decrease our dependence on foreign oil, at least in the
short run, CAEA will make us more dependent on foreign oil.

Less oil produced inside of California will mean higher prices at the pump. There is a well-
established world market for oil but that oil has to make it to California. A barrel purchased at the
6 Reason Foundation

world market price in the Middle East still needs to be transported here. That cost doesn’t exist for
Californian oil so taxing oil production here will lead to higher prices.

Proposition 87 attempts to eliminate the laws of economics by fiat. The Act reads, ”the assessment
imposed by this Part shall not be passed on to consumers through higher prices for oil, gasoline, or
diesel fuel.” This provision claims to prevent the tax from being passed on to consumers, but is
economic nonsense. Proposition 87 cannot eliminate the laws of economics any more than it could
eliminate the law of gravity. This tax will decrease production and increase the price of gasoline
for consumers.

The enforcement of the provision that attempts to prohibit the tax from being passed on would
have further negative consequences. There is no objective way the regulators would be able to
distinguish between price increases due to increased production costs, the tax, or market
conditions. Enforcement would be arbitrary. Since arbitrary enforcement of this provision would
be a risk to anyone involved in the oil business, it would further contract California’s oil
production and ultimately drive consumer costs higher.

Taxes decrease the activity being taxed and drive up prices. Proposition 87 is no exception. It’s a
bad deal for both oil producers and consumers.

Creation of Alternative Fuels

Private businesses are already in the process of creating alternative fuel vehicles. As oil reserves
shrink, and prices rise, even more investment will be naturally funneled into alternative fuel
vehicles. Private venture capital and corporate investment are very efficient at developing
technology when it is profitable to do so. Private business is better than government agencies in
identifying how best to serve consumer needs. Picking the appropriate alternative fuel vehicles to
develop is no exception.

Proposition 87 attempts to speed this development by injecting more than four billion dollars into
the development of alternative fuel products. Unfortunately the Act will likely divert the market
away from developing the most efficient means of advancing alternative energy—research and
development in the market.

Proposition 87 would create a new bureaucracy led by political appointees to dispense the money
to research institutes, businesses, universities and individuals. The Act mandates that this
bureaucracy must last for 20 years whether it achieves any results or not. There are financial audits
to try to limit corruption but there is nothing in the Act to eliminate the bureaucracy or stop the
flow of funds if it fails to achieve any advances in alternative fuels. This Act gives bureaucrats
billions to spend without any accountability. That’s a recipe for waste.
 PROPOSITION 87 7

In the private market when people make unprofitable investments they lose their money and thus
the ability to direct future investment flows. This bureaucracy would guarantee billions of dollars
to political appointees to be continually dispersed no matter how bad the decision-making is.

The Act reeks of a centrally planned bureaucracy already. The Act mandates the exact proportion
of funds that will annually go to the Gasoline and Diesel Reduction Account, the Research and
Innovation Acceleration Account, the Commercialization Acceleration Account, the Vocational
Training Account, and the Public Education and Administrative Account. Do the authors of this
Act really think they know in advance that precisely 26.75 percent of funds should go to research
and innovation? Some of these programs may prove ineffective, yet the Act locks funding into
place so that even when it’s obviously being wasted it must still be funneled into the same
accounts.

The planning bureaucracy that Proposition 87 would establish would influence the path the private
market takes in developing alternative fuels. Unfortunately it will influence that path for the
worse. Government planners do not face the same incentives nor have access to the same
information as private participants in a market economy. The bureaucracy would not have the
required information, flexibility, or incentives to pick winners in the development of alternative
fuels.

Conclusion

Proposition 87 is not a desirable way to encourage alternative fuel vehicle innovation. When you
think of government bureaucracies, innovation, creativity, and adaptability are not words that jump
into your head. Yet that is what the development of alternative fuel technology requires. It’s an
activity best left to the private market. The bureaucracy created by this Act would not lead the
market but would instead blindly interfere with its entrepreneurial process.

While the Act would not likely succeed in the development of alternative fuels, it would achieve
something it specifically states it would not: higher prices at the pump for Californians. The tax is
on the production of oil, not profits. The effect will be less oil produced in California and higher
prices for consumers.
8 Reason Foundation

Part 4

Proposition 87 is Ideology Not Reality

Analysis by Samuel R. Staley, Ph.D., Reason Foundation and

Adjunct Lecturer in Economics the at University of Dayton

The California Alternative Energy Act is a classic example of ideology

trumping reality. The special interests pushing this bill envision a smooth-
running government bureaucracy efficiently managing California’s
transition from oil-based fuels to an as yet unspecified alternative. It
couldn’t be done in the centrally planned economies of Russia, Cuba, and
Eastern Europe, and it can’t be done in California. The Clean Alternative
Energy Act is little more than a goosed up attempt to centrally plan
California’s energy industry. State-sponsored industrial policy didn’t work
in the 20th century, and it won’t work in the 21st.

This tax is so poorly conceived it kills the goose laying the golden egg. The California Alternative
Energy Act shows that environmentalists know a lot about kitschy slogans and virtually nothing
about economics. Sixty-five percent of California’s oil production requires costly recovery
techniques to extract. A severance tax is a recipe for killing oil industry profitability in California,
and exporting jobs to other states. Oil production has fallen 40 percent since 1985 and all
indications are it’s still in decline. Since California oil is already expensive to extract, a tax will
hasten killing it. By taxing a declining industry, it encourages its destruction. And a dead industry
can’t generate tax revenues for schools, let alone subsidies for privileged, state-anointed alternative
energy businesses. A tax on oil production is yet another idea that forsakes the economic future of
California’s rural citizens and workers. The oil industry provides high-paying jobs in many very
poor counties. Raising the cost of doing businesses simply helps empty out these counties faster.
In a state with the nation’s highest housing costs, highest cost of living, and mediocre job growth,
an initiative that elevates the tax burden on business is stunningly short-sighted.

The California Alternative Energy Act is a naïve, simplistic proposal that does more harm than
good. Supporters of the oil tax misleadingly claim it will rein in excess oil profits. In fact, it’s a tax
on production, not profits. So the effect will be seen in lower output and higher taxes paid at the
pump by average Californians. It reduces oil production, lowers employment, while increasing gas
 PROPOSITION 87 9

prices. The inevitable result will be Californians paying higher gas prices to out-of-state
multinationals that employ high-wage workers in other parts of the world. The technology simply
doesn’t exist for a fast, efficient transition away from automobiles. Perhaps the authors of this
initiative are counting on that to fund their pet alternative energy projects.

And the bad economics underlying the California Alternative Energy Act is rivaled only by its
naïve faith in the so-called California Energy Alternatives Program Authority. Proposition 87 is
ripe for abuse, with a guaranteed source of income and no meaningful accountability. The
Authority could continue forever without ever having to show it accomplished anything. In fact,
the initiative requires it to be in existence for at least 20 years!

The California Energy Alternatives Program Authority is supposed to manage California’s

transition to non-oil based fuels. But what evidence is there a state bureaucracy is better at picking
technology than private investors? There isn’t any. The Authority will be nothing more than a $4
billion black hole of ineffective and wasteful spending just like the other industrial policy
programs. Federal and state governments have been doing this for decades to no avail. What
evidence do the Act’s supporters have that they will be successful now? The California Energy
Alternatives Act puts its faith in a new government bureaucracy to manage innovation in the
energy field. In truth, it will dampen incentives for research and development into real innovation
by letting the government pick the winners and losers rather than letting the marketplace sort out
the best ideas with the most potential.

Even if the California Alternative Energy Act has the implausible effect of keeping gas prices
stable at near-market rates, this works against the Act’s larger goal of oil independence. In fact,
supporters of the Act need gas prices to go up to justify speculative private investment in these
unprofitable and unproven alternative technologies!

As a nation, we’ve been grappling with the problems of imported oil since the early 1970s. We’ve
failed miserably in every attempt to wean us off oil. And we’re wealthier and more economically
stable because of it. The truth alternative energy advocates don’t want the public to realize is that
their pet projects are highly speculative and have a dismal track record of providing energy
efficiently and cost-effectively to a broad base of consumers. That’s why there isn’t an existing
market for these products.

If the California Alternative Energy Act is successful, Californians can look forward to paying 20
to 40 cents more per gallon simply to satisfy the quirky interests of alternative energy special
interests. It’s ironic that a policy intended to increase California’s oil independence will actually
put more money into the hands of foreign oil importers. By limiting production here, prices will go
up and fuel the coffers of foreign governments in Venezuela, Iran, and Saudi Arabia. The dirty
little back-room secret behind the California Alternative Energy Act is that no one really knows
how much revenue it will generate or what the money will pay for. Higher gas prices and lower oil
production in California will mean much lower revenue. Undoubtedly, alternative fuel interests
will be going to the general fund trough to make up the shortfalls.
CALIFORNIA GENERAL ELECTION

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