GOVERNMENT WOULD LOSE REVENUE IF PRODUCER'S ROYALTY PAYMENT IS BACKED OUT FROM COAL PRICE, CRS SAYS

88-250 E

CRS REPORT FOR CONGRESS

This report examines the appropriate price for the Federal Government to use for determining a developer's royalty payment on federally owned coal. Should the actual royalty payment, State severance taxes, the abandoned mineland tax, and the black lung benefits tax be deducted from the price of coal before calculating the royalty? Estimates are made of the difference in royalty payment per ton depending on whether or not these items are "backed out" of the coal price. The report also discusses the benefit received by Federal taxpayers after adjustments are made for the effects of the corporate income tax and the earmarking of 90 percent of the royalty revenue.

                                   by Salvatore Lazzari

SUMMARY AND CONCLUSIONS

THE CONCEPT OF A ROYALTY

LEGISLATIVE AND RECULATORY HISTORY OF COAL VALUATION

Determining the appropriate product value against which to assess royalties on the extraction of coal from Federal lands is a relatively recent issue for the Federal Government. At first, Federal coal lands were sold outright rather than leased. When in the 1920s Federal authorities did implement a coal leasing policy, royalties were set at a fixed amount per ton of coal rather that as an ad valorem amount (a percentage of coal value).

The energy crisis of the 1970s focused more attention on the United States's coal reserves, and particularly on the Federal Government leasing policy for the vast amounts of coal it owned in the western States. Many of these leasing problems were addressed by the Federal Coal Leasing Amendments Act of 1975 and subsequent regulations. ¹ One aspect of leasing policy not resolved was the method for determining the appropriate coal value against which to levy an ad valorem, as opposed to a fixed, royalty payment. This issue is critical to the determination of producers' royalty payments and the Federal Government's royalty income from its coal leasing program.

Numerous terms have been proposed for coal value: value of coal in the mine, the value for royalty purposes, the mine-mouth value, the gross value at the point of sale, gross proceeds, and gross income as defined by the Internal Revenue Service (IRS) when calculating the percentage depletion allowance. With the exception of the IRS definition, these terms are not precisely defined. In addition, all of the terms require the authorities to grapple with the issue of whether the royalty payment should be deducted from coal value and whether coal value should include certain Federal and State externality-related taxes.

Under current regulations, abandoned mine land, black lung, and State severance taxes as well as the royalty itself are included in coal value. Under proposed regulations, the royalty itself and State severance taxes would be included in coal value. Reimbursements for black lung and abandoned mineland fees would be excluded from coal price. In contrast, the coal industry proposes that all of four of these charges be excluded from coal value when calculating royalty payments.

For the reader he does not wish to work through the technical discussions upon which the results are based, the report begins with a summary of the conclusions. The remainder of the report is divided into five sections. The first section discusses the concept of a royalty. The second section traces the evolution of the Mineral Leasing Act's royalty provisions and regulations up to the present as they relate to coal valuation. The third section analyzes whether or not the royalty payment and externality-related taxes (State severance taxes, the abandoned mineland tax, and the black lung tax) should be "backed out" of coal value when determining the coal producer's royalty payment to the Federal Government. A numerical example is provided using hypothetical coal prices and taxes to help the reader understand the contrasting results.

The fourth section discusses the implications of backing out externality-related taxes when the taxes are not an accurate reflection of the external costs that result from coal production. All three types of taxes considered in the earlier analysis -- abandoned mineland, black lung, and severance -- are discussed in some detail.

Some have suggested the Federal taxpayer receives so little benefit per dollar of royalty collected that the Federal Government's financial position might be improved by giving the coal away. The last section calculates the budgetary implications for the Federal government when the interaction of royalty payments, Federal income taxes, and disposition of royalty revenues are considered.

SUMMARY AND CONCLUSIONS

The report emphasizes several points and reaches several conclusions:

o As a starting point for the analysis, coal price is defined as the present value of all the resources which willing buyers (usually utilities) agree to give to willing coal producers, in an arms length transaction, to induce the coal producers to give up one ton of coal.

o Given this coal price, there is no economic justification for backing out the royalty from the coal price when determining the producer's royalty payment. This is consistent with both current and proposed regulations, but inconsistent with the coal industry proposal. Should the royalty be backed out of coal value, Federal royalty receipts would be too low, and the underpayment would benefit either the electric utilities and railroads or the coal companies.

o In the presence of State severance taxes and Federal taxes for abandoned minelands and black lung disease which, in theory, correct for the external costs associated with the production of coal, there is economic justification for backing out these taxes from the price of coal when determining the producer's royalty payment. This is consistent with the coal industry's proposed treatment of these taxes and charges, and consistent with Interior's proposed regulations concerning abandoned mineland and black lung charges. It is not consistent with current or proposed regulations concerning severance taxes. Should these taxes not be backed out of coal price, coal development would be inhibited as producers are forced to pay one factor of production, the landowner, more than a fair return.

o Based on hypothetical values for the price of coal of $15.15 per ton and for externality-related taxes of $3.90 per ton, removing the royalty from coal price would reduce the royalty payment by $0.16, while leaving the taxes in the coal price would raise the royalty by $0.48.

o Some information suggests the actual externality-related taxes imposed may exceed the true external costs of producing coal. If all these taxes are backed out of coal value, the Government receives too low a royalty payment and has an incentive to reduce its leasing of coal lands below the desirable rate. If only those taxes representing true social costs are backed out of coal value, the producer pays too high a royalty and has an incentive to reduce its production below the desirable rate. Either policy results in an inefficient solution.

o Assuming the FEDERAL taxpayer receives no benefit from the share of royalty receipts returned to the States, the net benefit to Federal taxpayers from each dollar of coal royalty collected is relatively small, probably ranging between -$0.24 and +$0.16. This suggests that the revenue consequences of the product valuation issue is of limited importance to the Federal taxpayer, although it may be very important to those States with substantial Federal coal reserves.

THE CONCEPT OF A ROYALTY

The original concept of a royalty signified the monarch's share of the production, in kind, of natural resources situated on the monarch's land. One deer out of five bagged in the king's forest or one bushel of corn grown on the king's land constituted payment to the king for the privilege of hunting in his forest or farming his land.

Likewise in mineral production, a royalty signifies a sharing of the mineral output with the landowner. It is a factor payment: a payment from producers of mineral resources to landowners for the services of land which contains a mineral deposit. It entitles the landowner to a specified fraction (conventionally, 12.5 percent) of the value (paid in cash or in kind) of the total production of the mineral, free of expenses, for the life of the property.

Landowners usually receive compensation in the form of a constant annual rental payment that reflects the fact that the supply of land is fixed. There is, however, uncertainty as to the amount and quality of a mineral deposit, the cost of its production, and the price of the final output. Thus, ad valorem royalty payments are based not on the number of acres of land which the producer uses but on the gross value of the output, free of production costs. The function of the royalty is to protect the landowner against underestimation of economic rents and the producer against overestimation of those rents. Together with the lease bonus and the delay rental, the royalty serves as a proxy for the payment of economic rent. ²

Both the original and the economic concept of a royalty as a factor payment imply that the payment should be based on the market value of the producer's output, in this case coal. It simply does not make sense to pay a royalty on any basis other than market value (price). For example, if instead of payments in kind (deer or crops) the king were to be paid in money, one would expect him to receive the monetary equivalent of the value of the output. A rational king would not settle for less than what the deer or crop is worth because he could always have the deer or the crop taken to market and sold for at least market value. If he wanted less, then presumably that would have been negotiated as a smaller share (instead of 1 deer out of 5, it would perhaps be 1 out of 6). Likewise it would not be rational for a hunter or farmer to pay to the king a royalty based on more than market value. It is inconsistent with the concept of sharing and with the concept of a factor payment in a competitive market.

LEGISLATIVE AND REGULATORY HISTORY OF COAL VALUATION

This section of the report traces the evolution of the Federal legislative and regulatory treatment of coal valuation as it relates to royalties.

LEGISLATIVE HISTORY OF COAL VALUATION

Coal royalties were not an issue prior to 1920. With the exception of coal-bearing lands in Alaska, Federal lands containing coal were sold rather than leased, thereby eliminating any need for production royalties. ³ Following the enactment of the Minerals Leasing Act (MLA) of 1920 (Title 30, United States Code, Subchapter II), coal and a number of other minerals were disposed under a new system. Instead of transferring ownership of its coal-bearing land to the private sector, the Government retained title to its lands and allowed resources to be developed under a leasing system. Each lease was negotiated on a case-by-case basis. Royalties were fixed at so many cents per ton of coal produced. The leases also provided for a minimal annual rental per acre leased.

This system of leasing with fixed royalties continued until the early 1970s, when the oil embargo and shortages of domestic petroleum reserves focused attention on the vast Federal coal deposits in the western States. In 1971 the Interior Department established a moratorium on all new long-term leasing. The moratorium continued for approximately 10 years and spanned a period of intense public and congressional debate, punctuated by a number of lawsuits by environmental groups and other affected parties.

During the moratorium, Congress responded to leasing criticisms with the enactment in 1976 of the Federal Coal Leasing Amendments Act (P.L. 94-377). Among other important changes, the legislation switched the royalty from a fixed amount per ton to an ad valorem basis: "A lease shall require payment of a royalty in such amount as the Secretary shall determine of not less than 12.5 percentum of the value of coal AS DEFINED BY REGULATION, . . . " [emphasis provided]. ⁴

REGULATORY HISTORY OF COAL VALUATION

With the impendings switch to ad valorem royalties, it be came necessary to address the issue of the appropriate price against which to levy the royalty. The Federal Register of January 30, 1975, began the official discussion of product valuation for coal. ⁵ Paragraph 211.61 of the proposed rules stated that, "The value basis for determination of the amount of royalty due shall not be less than the best obtainable market price." The proposed rules also recommended that, in arriving at a market price, the appropriate authority should take into consideration (given applicable contracts) ". . . the highest and best obtainable market price for coal of similar quality at the usual and customary place of disposal,. . . ." No mention was made of potential adjustments for State or Federal charges that were likely be included in the "best obtainable market price."

The final rules and regulations were published on May 17, 1976. By then, the Interior Department had issued a final environmental impact statement (EIS) for its new long-term leasing program. Interior indicated that many of these final regulations were based on the comments received on both the 1975 proposed rulemaking and this final EIS. In fact, the product valuation language in the final regulations departed significantly from the language in the regulations proposed in 1975.

Paragraph 211.63 of the final regulations stated that ". . . the value of the coal for royalty purposes shall be the gross value at the point of sale." ⁶ This use of the phrase "gross value" suggests the royalty base should include not only the "price" agreed to by the buyer (such as a utility) and the seller (lessee), but also any items not included in the "price" for which the buyer has agreed to provide "reimbursement" to the seller. In fact, these regulations require that calculation of the royalty payment take ". . . into account any consideration received by the lessee in other related transactions."

Although the final regulations remained silent on specific taxes and charges that should be included in the gross value, it appears that the term is consistent with the inclusion of abandoned mineland, black lung, and State severance taxes as well as the royalty itself. In fact, all of these taxes and charges are currently included in the definition of gross value for purposes of calculating the royalty payment. ⁷

On January 15, 1987, further rules for coal lease valuation were proposed and published in the Federal Register. ⁹ The purpose of these regulations was to update and consolidate the existing rules concerning coal valuation for determining coal royalty payments. The proposed regulations were to clarify whether specific items such as transportation cost, washing allowances, black lung benefit taxes, abandoned mineland reclamation fees, and state severance taxes should be included or excluded from the coal value in determining royalties. ⁹

Under these proposed regulations, the royalty itself and State severance taxes would be included in the coal price. Reimbursements for black lung and abandoned mine land fees would be excluded from coal price. Interior argues that these two fees should be excluded since it would be inappropriate for the Government to enhance its royalties through its powers to tax. ¹⁰

The coal industry argues that the Government is trying to unfairly increase its revenues by including in the royalty base items that do not represent coal value. They argue that the proposed regulations are costly for the coal industry (making it less competitive), and for the electric utilities and the Government as well. The industry proposes that valuation should be based not on gross proceeds, but rather "upon the concepts contained in Internal Revenue Code Section 613 (and related regulations) dealing with percentage depletion for coal mining." ¹¹ Under this proposal, the abandoned mineland, black lung, and State severance taxes would all be excluded from product value when calculating royalty payments.

Some may wonder why the industry is now challenging proposed regulations that are less onerous than the current regulations. The absence of industry concern about the potential of current regulations (combined with a percentage royalty) to generate higher royalty payments may have been due to the high percentage of leases that were grandfathered under the pre-FCLAA fixed-royalty provisions. These leases would not have been adjusted until reaching the end of their then-current terms of 20 years, well after the enactment of the law. The absence of industry concern may also have been due to the perception that rapidly increasing demand for Federal coal and consequent price increases would sustain both a comfortable return on investment to the lessees as well as royalties to the Government.

COAL VALUATION AND FEDERAL ROYALTIES FROM COAL

This section addresses two questions. First, should the royalty payment be part of the coal value to which the ad valorem royalty is applied, or should the royalty be subtracted from the coal value? Second, should black lung, abandoned mineland, and State severance taxes be subtracted from the coal value before calculating Federal coal royalties?

Before proceeding to these issues, it is important to clarify what is meant by coal value or coal price. Coal value per ton means the present value of ALL THE RESOURCES (both monetary or in kind) that a willing buyer (typically a utility) is willing to give to a willing seller (the coal producer), in an arms-length transaction, in order to induce the coal producer to sell one ton of coal. It should not matter whether the resources that the coal buyer is willing to give up are labelled "reimbursements," "considerations," or some other creative euphemism devised to avoid using the word "price." It also should not matter whether the resources that are given up for the coal are all traded at one time or in stages. What matters is agreement on the precise value of ALL the resources given by the buyer to the seller in a competitive market. In this report it is assumed that the gross value of coal is the sum of these resources. This sum is equivalent to the market price of coal at the first stage of marketability. ¹² This is the market price that determines the gross revenue to the seller (the coal producer) discussed in this report. This price is represented in the discussion below by the letter P.

SHOULD THE ROYALTY BE PART OF GROSS VALUE?

Should the royalty payment be subtracted or "backed out" from the coal price when calculating the coal producer's Federal royalty payment? This can be stated in arithmetic terms. If the price of coal is P, and if the ad valorem royalty rate is 1/8 or 12.5%, then the Federal royalty per ton of coal is equal either to the amount 1/8 P if the royalty is not subtracted or to the amount 1/8(P - 1/8 P) if the royalty is subtracted. In the former case, the Government would receive 1/8 or 12.5% of the coal price, which is the rate prescribed by regulation for surface-mined coal. In the latter case, the Government would receive 7/64 or 10.9% of the coal price.

The solution depends upon what determines payments (incomes) to factors of production in the extractive industries. As a general rule, income paid to a factor of production by a profit-maximizing producer in a competitive free-market economy, without external costs and benefits, would be based on the market price of the product. More specifically, the per-unit payment to a factor of production (such as the wage rate per hour of labor) would be the price of the output times the marginal product attributable to the factor. This is called the value of the factor's marginal product. The factor's total income would be price times marginal product times units of the factor.

For example, assume the factor is labor, the marginal product of the unit hired is 10 units of output per hour, and the price of the output is $1 per unit. The value of the worker's marginal product is $10 per hour; so a competitive firm in equilibrium would pay each worker $10 per hour. Each worker's income would be price per unit of output times marginal product per hour times total hours worked. The output price used in this calculation would be the price at which market supply and market demand are equal in the product market. This market price is the price which buyers pay, which, in turn, is the price which producers receive. This general rule is true for land, labor, capital, or any other factor of production.

In the case of coal, the Federal royalty is a factor payment from producers of mineral resources to the Federal Government, as landowner, for the services from lands which contain a mineral deposit. Assuming competition in the coal market and no external costs or benefits, then royalty payments to the Federal Government as well as to private landowners would, in theory, be based on the market value of the coal (for example, 1/8 of market price times quantity). ¹³

Concerning the competitiveness of coal markets, the key ingredient of competition is not the structure of the coal industry per se -- which is somewhat concentrated -- but the fact that interfuel substitution precludes the price of coal in the long run being significantly affected either by any one coal producer or by the entire coal industry. ¹⁴ The market price of coal and other energy resources is closely tied to the market price of oil, although with a lag. Because the price of oil is determined in the world market (i.e., oil prices are exogenous to the United States), domestic oil producers are price takers. If the market price of coal is a function of the market price of oil, then it follows that, in the long run, coal prices are also exogenous to United States coal producers -- they take coal prices as given.

This suggests that the basis of coal royalties should be the market price of coal, as defined above. More specifically, the royalty paid by coal producers per acre of land would be equal to the market price of coal times the marginal product of land (in tons per acre). The total royalty income accruing to the Federal Government should be equal to the royalty rate times the price of coal times the marginal product of land times the total number of acres.

These conclusions are illustrated graphically in figure 1. In part (a) of figure 1, S represents the aggregate industry supply curve for coal, and D represents the aggregate market demand for coal. ¹⁵ In equilibrium, the coal product market would establish a price of Po (per ton) and a quantity of coal output of Qo (per year). Part (b) shows the demand and supply of mining land as a factor of production. The supply of mining land is assumed fixed at Lo. ¹⁶ The demand for mining land by the coal producer (under the assumptions of profit maximization, competition, and no externalities) is the value of land's marginal product, Po (the price of coal), times MP (land's marginal product of land). This in turn establishes Ro, the royalty the producer is willing to pay. It is important to emphasize that the output price which determines the coal producer's demand for mining land (and which determines the Federal royalty income) is Po, the equilibrium price in the market for coal (as shown in part (a)).

The implication of this discussion is that the royalty payment to the Federal Government should NOT be backed out of the price of coal. As long as the convention is established that royalties are to be a certain fraction of revenues, then the theoretically correct price to use is Po, not (Po - 1/8 Po).

Consider the implications of backing out the royalty from product value, such that the royalty payment is not 1/8 of Po but 1/8 of the royalty-adjusted market price, [1/8(Po - 1/8 Po)] = 7/64 Po. What price is the coal buyer to be charged? Is he to be charged the price determined by the intersection of the market demand and supply curves, Po? Or is he to be charged a price determined by adding the royalty payment (7/64 Po) to the adjusted royalty base (Po - 1/8 Po), the sum of which is 63/64 Po? If the price charged to buyers is 63/64 Po, then the price is underestimated and would lead to overconsumption of coal. In this case, coal buyers (electric utilities) or the transportation industry (railroads) would be the primary beneficiaries of coal producers' underpayment of royalties. If, on the other hand, the price charged to buyers is Po, the full market price, then the coal producers would be earning extra profits above the competitively determined rate of return. In this case the coal-producing industry would be the primary beneficiary from the underpayment of royalties. In either of these cases, there is no economic justification for "backing out" the royalty payment and creating a dual price structure for coal.

FIGURE 1. FEDERAL ROYALTIES WITHOUT EXTERNAL COSTS

[Figure omitted]

Should Externality-Related Taxes Be Subtracted from Gross Value?

It is important to underscore that the principle that the Federal Government should be paid on the basis of coal market price depends critically on the assumption that all costs by producers and benefits to consumers are internalized (accounted for) in market price. This assumption is not met. In the absence of Government intervention, the production of coal generates a variety of external costs which would not be accounted for by coal producers and would not be reflected in the market price of coal.

Several types of external costs have been attributed to coal production, depending upon whether coal is produced from an underground mine or from a surface mine. In the case of the underground mine, some analysts have argued that black lung disease is an external cost of coal production. This is the rationale for the black lung benefits excise tax (BLB). In the case of surface mining and some underground mining, coal production can result in destruction of the landscape. Without land reclamation, there is damage to the environment which is a social cost to society. This is the rationale for the abandoned mineland tax or fee. Likewise, State severance taxes are, in theory, often imposed to attempt to internalize these external costs that coal production imposes on regional populations.

In the presence of taxes which attempt to internalize these external costs, the market price of coal -- the price paid by coal buyers -- is not equal to the net price received by coal producers. In particular, the market coal price is greater than the net price received by producers after payment of externality-related taxes to the Federal and State governments. And it is the producer's net price which determines the producer's demand for factor inputs and therefore the base against which the Federal Government's royalty should be levied.

Figure 2 is a duplicate of figure l adjusted for the presence of external costs in coal production. Part (a) represents the product market for coal. D represents the aggregate demand for coal and So represents the supply of the product in the absence of external costs (equivalent to S in figure 1). The market price with no effort to internalize social costs would be Po, as in figure 1. The demand schedule for factor inputs such as land would be PoMP (part (b)), reflecting the market price Po.

Now assume that the production of coal generates external costs whose damages are valued at $T per ton. Assume that the government imposes a tax of $T per ton and that the revenue is used to compensate those who bear the cost of the environmental damage. The marginal cost to society of every unit of output would be measured by S1 (social marginal cost equals private marginal cost, So, plus $T). Such a tax would not raise the market price of the product due to the assumption that coal prices are exogenous. The price paid by coal buyers, Po, however, would be higher than the net revenue per ton received by coal producers, P1. Net of externality-related taxes, producers would receive P1, equal to Po - $T. Without external costs, producers would receive Po, which is what coal buyers would pay. With external costs there is a wedge between what buyers would pay, Po, and what producers would receive, P1. ¹⁷

This reduced net price received by producers causes their demand schedule for factor inputs to decline from DO to D1. In this case demand for the services of the land would decline from PoMP to P1MP in part (b). Thus, under conditions in which taxes are levied to correct for external costs, factor payments (including royalty payments to landowners) should, for efficiency reasons, be based on the lower net price, P1. Thus, coal producers should subtract black lung and abandoned mineland taxes, and State severance taxes from the market price of coal.

What would be the economic costs if Po, the price of coal inclusive of externality-related taxes, is used to calculate Federal royalties instead of P1? In general, this implies that Po would determine how much land the producer is willing to use in the production of coal. In figure 2, given that the true demand curve for mining land by the producer is P1MP, then the amount of mining land demanded at price P1 would be L1 instead of Lo. The available supply of mining land would be Lo, however. Thus, there would be an excess supply of mining land.

FIGURE 2. FEDERAL ROYALTIES WITH EXTERNAL COSTS

[Figure omitted]

Moreover, given that the Federal Government owns such a large proportion of coal land in the United States, it is uncertain that competitive forces would ultimately force the royalty rate down to R1. Thus the disequilibrium could be a permanent one, leading to a permanent inefficient use of resources. This suggests that externality-related taxes should be backed out of coal value when calculating royalty payments.

The logical necessity of backing out externality-related taxes from coal price can also be rationalized in a more intuitive way. Suppose the Government insisted on levying the royalty on Po rather than on P1. The logical response by the producer would be to refuse monetary payment and give all production to the Government. The Government would find itself in the position of having to pay all non-royalty factor incomes, including a normal return on the producer's capital. What it would have left over would be just enough revenue to pay the externality-related taxes and a royalty payment of 1/8 P1. It would soon discover that paying itself a royalty based on Po would be possible only if the payment to some other factor of production was reduced below its market-determined rate.

In conclusion, this discussion suggests that externality-related excise taxes imposed on the production of coal should be deducted from the market price in determining the base for calculating the royalty payment. This conclusion is consistent with the coal industry's proposed treatment of these taxes and charges, and consistent with Interior's proposed regulations concerning abandoned mineland and black lung charges. It is not consistent with current regulations concerning severance taxes.

Numerical Example

The above economic principles, and the conclusions drawn from them, are illustrated here with a numerical example based on hypothetical prices and taxes. Assume:

                       Price of coal = $15.15 per ton

                         $15.15 Price of Coal

1/8 of $11.25 = $1.41.

Subtracting or "backing out" from the net price the corresponding royalty would lead to a Federal royalty of $1.23 instead of $1.41:

              1/8 (P - 1/8 P) = 1/8($11.25 - 1/8 $11.25)

Turning to the treatment of externality-related taxes, suppose the royalty calculation does not back out these taxes from the externality-adjusted market price of $15.15. The royalty would be:

1/8 of $15.15 = $1.89

In contrast, if the royalty calculation uses the producer's net price of $11.25 per ton arrived at by backing out the $3.90 of externality- related taxes (but not backing out the royalty payment itself), then the royalty would be:

1/8 of $11.25 = $1.41

In effect, the producer's rental costs per ton per acre would be increased by $0.48 because the royalty calculation uses Po = $15.15 rather than P1 = $11.25.

EXTERNALITY-RELATED TAXES AND SOCIAL COSTS

The previous two sections suggest that taxes designed to internalize social costs in the coal production decision should not be included in the base for calculating royalty payments. Does this conclusion hold if these taxes are not an accurate reflection of the social costs?

Suppose the charges for social costs levied on the extraction of coal exceed the actual social costs incurred. The market adjusts to these charges whether or not they are an accurate reflection of costs. This means that the Po determined by the intersection of D and S1 in figure 2(a) exceeds the sum of private production costs plus true social costs, such that the difference between P0 and P1 is greater than the social costs of coal extraction.

This puts the Federal Government in a difficult situation whereby either possible decision will result in an inefficient allocation of resources. Assume the Government uses P1 as the royalty base, allowing all externality-related taxes to be deducted. This means the base upon which the royalty is calculated UNDERSTATES the net price that would accrue to producers if the charges for social costs were accurately measured. The royalty revenue received by the Federal Government would be too low and its response would be to curtail its leasing activity.

Now assume the Federal Government allows only those taxes to be deducted that reflect social cost. This means the base upon which the royalty is calculated OVERSTATES the net price the producer receives from coal production because the producer is paying taxes in excess of the deductible taxes. The royalty revenue received by the Federal Government would be too high. This causes producers to reduce their demand for land and extraction rate.

The problem here is not with the Federal Government's product valuation policy or the producers, but rather with the externality- related tax policies of the Federal Government and States. These charges are absorbing more of the value of the output than is necessary to compensate for social costs. The result, no matter what the Federal Government's treatment of externality-related taxes, is in theory an inefficiently low rate of coal production.

Some evidence exists to suggest that the level of externality- related taxes on extraction from Federal coal lands in the West may fit this description. The following sections discuss this possibility for each of the charges.

Abandoned Mineland Tax

The AML tax is designed to provide funds to clean up the environmental damage caused by mining on lands abandoned prior to the enactment of the Surface Mine Control and Reclamation Act (SMCRA). Very little of this damage occurred on Federal lands in the West that are currently being mined. Furthermore, SMCRA requires lessees to be financially responsible (over and above their AML contribution) for correcting the environmental damage they cause on lands currently being mined. Thus, the AML tax does not represent a charge for the social cost being generated by extraction on these lands. The market nonetheless adjusts to the tax and creates a difference between the gross price and the net price received by the producer.

Black Lung Benefits Tax

The black lung tax causes similar problem, for western coal producers. The tax is designed to internalize the cost of black lung disease incurred primarily by underground miners. Since the only underground mines on Federal lands in the West are in Utah, most of these charges are being imposed on surface coal production that is not generating the social costs. Adjusting for these charges would understate the appropriate base for Federal royalties.

State Severance Taxes

Evaluating the accuracy of severance taxes as a charge for social costs is much more difficult. Table 1 lists the coal severance tax revenue received by the major coal-producing States in 1986. This table shows that all the major western coal-producing States earmark their severance taxes, a characteristic that is probably a prerequisite for these revenues to be used for correcting social costs. Although it is conceivable that a non-earmarked tax could be used primarily to correct for social costs, it is far more likely that the revenue from such a tax would be used for other governmental purposes (including possibly relief from other types of taxation). ¹⁸

Table 2 provides some insight into the purposes for which coal severance taxes are earmarked. All three of the States listed in this table allocate a substantial share of their severance tax revenue to activities that are not clearly related to the social costs of coal production. North Dakota allocates 30 percent of its revenues to the general fund. In addition, although the remaining funds are targeted to coal-impacted jurisdictions, it is not clear that their spending is targeted on environmental damage or other social costs from coal development. Montana's story is somewhat similar -- much of its spending is likely to be on activities that do not compensate for social costs.

This is not, of course, conclusive evidence that the existing severance taxes overstate the social costs of coal development. It is possible that social costs are as high as the severance tax revenue, but that the States' political decision-making processes have chosen to leave some citizens uncompensated for the social costs they bear while providing other citizens with a windfall in terms of higher public spending or tax relief. It is also possible that a State's 50 percent share of the Federal Government's royalty revenue compensates the State for the social costs of coal production, thereby freeing State severance tax revenue for other purposes.

      TABLE 1. COAL SEVERANCE TAX REVENUE, PERCENT EARMARKED, AND

/b/ Ten States not included in this tabulation levy charges generally based on a unit of production to defray regulatory costs under the U.S. and State laws on surface mining and reclamation. These States are Alaska, Illinois, Iowa, Maryland, Missouri, Oklahoma, Pennsylvania, Texas, Utah, and Virginia. Revenues from this source for fiscal year 1986 were above $1.0 million in three of the States -- Illinois, Pennsylvania, and Utah.

/c/ Colorado is currently revising the disposition of its severance tax revenue.

/e/ Estimated from production data.

NA -- No allotment

Sources: Lillian Rymarowicz of the Congressional Research Service provided these data from several sources. Revenue data from Bureau of the Census except as indicated in the footnotes. Earmarking information from various State statutes and tax codes.

          TABLE 2. DISPOSITION OF COAL SEVERANCE TAX REVENUE

/b/ North Dakota Century Code, 57-62. Distribution of county allocation to the sub-county units of local government is governed by very detailed statutory requirements.

/c/ Chapter 464 Kentucky Acts, section 8.

Source: The data in this table were provided by Lillian Rymarowicz of the Congressional Research Service based on the State laws listed below.

To summarize, this discussion indicates that an efficient solution does not exist if externality-related taxes exceed the true level of social costs. If all these taxes are backed out of coal value, the Government receives too low a royalty payment and has an incentive to reduce its leasing of coal lands below the desirable rate. If only those taxes representing true social costs are backed out of coal value, the producer pays too high a royalty and has an incentive to reduce its production below the desirable rate. The preliminary data presented in this section suggest existing taxes and charges may indeed overstate social costs.

FEDERAL ROYALTIES: ARE THEY WORTH THE TROUBLE?

Some have suggested that the Federal taxpayer receives so little benefit per dollar of royalty collected that the Federal Government's financial position might be improved by giving the coal away. The payment of royalties reduces a firm's corporate income tax, and a mere one-tenth going to the States or earmarked for other Federal spending. This section of the royalty revenue is placed in the General Fund, with the remainder discusses the revenue and budgetary implications for the Federal treasury when the interaction of royalty payments, Federal income taxes, and disposition of royalty revenues are considered. State corporation income taxes are excluded from the discussion.

Royalties and the Corporation Income Tax

First consider the interaction of the royalty payment and the Federal corporation income tax. The Federal royalty is 12.5 percent of the value of the coal. A royalty payment is an expense of doing business for the coal producer, and as such is fully deductible in the calculation of corporate income tax liability. The taxable income of the producer is reduced by one dollar for every dollar of royalty payment, and the income tax revenue of the Federal Government is reduced by $0.34, the corporate income tax rate. Thus, every dollar of royalty yields the Federal Government $0.66 net of income tax revenue [$0.66 = $1(1- 0.34)].

Royalties and Their Disposition

The effect on the Federal budget is more complicated. Current law (FCLAA) dictates the use of the royalty payment. Fifty percent of the royalty is earmarked for use by the States that generated the revenue, 40 percent is earmarked for the Reclamation Fund for irrigation and other water-related projects authorized under the Reclamation Act of 1902 as amended, and 10 percent is placed in the General Fund of the Treasury. Given this disposition of the royalty receipts, whether Federal taxpayers actually receive $0.66 of benefit for every dollar of royalty payment depends upon one's view concerning the desirability of this earmarking.

Royalties and the General Fund

Consider the most restrictive interpretation. Suppose the payment to the General Fund is the only portion of the royalty payment available to provide public services to Federal taxpayers. In this case, the Government loses $0.24 on every dollar of royalty. This is calculated by subtracting from the $0.10 General Fund payment the $0.34 reduction in corporate income tax revenue on every dollar of royalty [-$0.24 = ($1 x .10) - ($1 x .34)]. Such an interpretation suggests the monies paid into the Reclamation Fund and to the States generate no benefits for Federal taxpayers. This proposition seems rather extreme, but serves to establish a lower bound for Federal benefits.

Royalties and the Reclamation Fund

The Reclamation Fund payment provides monies to fund a program passed by the Congress. Assuming our governmental process does produce a budget that represents citizens' spending preferences, this suggests the program does generate benefits to taxpayers. Based on this reasoning, the Reclamation Fund share should be included when calculating Federal royalty benefits net of income tax. Thus, the Federal Government receives $0.50 per dollar of royalty receipt (the 10 percent for the General Fund plus the 40 percent for the Reclamation Fund) rather than $0.10, and earns $0.16 on every dollar of royalty [$0.16 = ($1 x .50) ($1 x .34)], rather than losing $0.24.

Including the entire 40 percent Reclamation Fund share may be an overstatement of taxpayer benefits from Reclamation Fund projects. Earmarking is a device that generally is used to finance a public service whose users are the primary consumers of the taxed product. Such is the case, for example, with the Federal excise tax on gasoline. These excise tax revenues are earmarked for highway construction. Since the users of the public service and the payers of the tax are essentially the same people, the political system is forced to keep the benefits of the service and the cost of the tax in rough balance. In contrast, the public services being provided with royalty revenues earmarked for the Reclamation Fund, irrigation and other water-related projects, may provide benefits to a set of people who are likely to be very different from the set of people who use the coal (or the electricity generated by the coal). This type of situation, where the "price" of the public service is set too low, often results in overproduction of the "subsidized" public service, such that costs exceed benefits. The use of some of the royalty revenue to provide other public (or private) goods would probably provide more benefit to taxpayers.

This discussion suggests that only a portion of the 40 percent share of royalty revenue devoted to the Reclamation Fund should be included when calculating Federal taxpayers' benefits from royalty receipts net of income tax revenue. When considering the combined portions of the royalty payment going to the General Fund and the Reclamation Fund, net benefits probably lie somewhere between the extremes of -$0.24 and $0.16 per dollar of royalty revenue. This suggests that the revenue consequences of the product valuation issue is of limited importance to the Federal taxpayer, although it may be very important to those States with substantial Federal coal reserves.

Royalties and the State Share

The proper treatment of the 50 percent State share presents a more difficult problem. Its resolution depends on whether Federal taxpayers receive benefits from the public services the States provide with this 50 percent share. The issue is addressed here in two steps: first, the conditions under which the Federal Government should subsidize State and local provision of public services are explained; and second, the actual use of the monies the States receive from their 50 percent share is evaluated for consistency with these conditions.

The economic justification for public goods provision suggests the State and local sector should provide goods and services when external benefits or costs (benefits or costs not considered by the buyer and seller to be of value or to be costs) preclude the private sector from providing the socially desirable amount. In other words, goods provided publicly should have a substantial element of collective consumption.

It follows, then, that if the Federal Government is going to subsidize State and local provision of goods and services and economic efficiency is the criterion of choice, it should subsidize only those State and local goods with a strong element of collective consumption. Considerations of intergovernmental efficiency, however, suggest that not all collectively consumed goods provided by the State and local sector merit Federal subsidy. This more restrictive view would confine the Federal subsidy to those collective consumption goods that are likely to be underprovided by State and local governments. The spillover of benefits among jurisdictions precipitates such under provision.

The sheer number of State and local political jurisdictions implies that any one jurisdiction is likely to have a geographic reach that fails to encompass all individuals and businesses who benefit from its public goods. Thus, some of the collective consumption benefits spill over the border of a taxing jurisdiction, such as in the case of redistributive welfare programs, some educational services, or environmental projects. Collective consumption benefits from providing such goods exceed the benefits to taxpayers in the providing jurisdiction. Since many taxpayers are unlikely to be willing to pay for services received by others, it may be desirable for a higher level of government (which does receive tax payments from the spillover beneficiaries) to subsidize their consumption in order to induce State and local governments to provide the proper (socially optimal) amount.

The task of identifying those goods possessing externalities sufficiently numerous to merit State and local provision, but not provided in the proper quantities by the State and local sector, is akin to untying the Gordian knot. One's perception of externalities and the State and local and Federal roles in their accommodation is undoubtedly influenced by all those non-economic and non-quantifiable factors which determine our preferences, such as politics, religion, culture, and ethics. Economic theory is quite useful in explaining the conditions under which Federal subsidy is desirable. But it is not easy to quantify these conditions in a manner which the Congress can use to determine public purpose. The definition of public purpose is necessarily elastic and subject to continuous reexamination.

How well does the Federal provision of its royalty revenue to the States satisfy the economic criteria for providing benefits to Federal taxpayers? The share of royalty payments earmarked for the States by the Mineral Lands Leasing Act of 1920 was originally restricted to use for roads and schools. The Federal Coal Leasing Amendments Act of 1977 increased this share from 37.5 percent to 50 percent, and allowed the additional 12.5 percent to be used for planning, public facilities, and public services, giving priority to those communities impacted by the mineral development. State use of these funds was further liberalized by eliminating the roads and schools restriction on the use of the original 37.5 percent State share.

Ultimately, the decision about whether these funds provide benefits to Federal taxpayers depends upon judgments concerning the degree to which the funds are spent to deal with spillovers. It is not sufficient that the funds are spent on public services such as schools and roads within the impacted community, for the community can deal with these through its borrowing and taxing powers if most of the benefits accrue to their own citizens. The funds must be spent on public goods and services that provide benefits to residents of other jurisdictions as well as its own citizens, for it is these services that will be underprovided unless the Federal Government assumes some of the cost burden.

It is useful to note in this regard that the spillovers most likely to occur from mineral exploitation, environmental costs, are supposedly dealt with in most States by severance taxes. This suggests that the royalty revenue given to States might be going to provide public services that primarily benefit the residents of the impacted communities. This seems to be the implication of the legislation that establishes the current cost-sharing arrangement. If this is the case, then the 50 percent share currently going to the States should not be counted as part of Federal taxpayers' net benefits, leaving the Federal taxpayer with net benefits somewhere between the extremes of -$0.24 and $0.16 per dollar of royalty receipt.

² The economics literature contains several definitions of rent, and is unclear whether the royalty is a component of rent. We adopt McDonald's definitions of a royalty as a component of economic rent and economic rent as a surplus paid to a productive factor above its opportunity cost. See McDonald, Steven L. The Leasing of Federal Lands for Fossil Fuel Production. The John Hopkins University Press. 1979. pp. 25-46.

³ The Alaska Coal Leasing Act provided for minimum royalty of 2 cents per ton as early as October 20, 1914.

⁴ 30 United States Code sec. 207(a). The law applies a lower rate for coal produced by underground mining. There is evidence that the Department of the Interior had already begun to apply the ad valorem concept some years earlier. One key report during the leasing debate stated that as early as February 1971, the conservation division of the United States Geological Survey (USGS) began shifting to ad valorem royalties whenever leases came up for readjustment at the end of their initial term (Leased and Lost: A Study of Public and Indian Coal Leasing in the West, Council on Economic Priorities, New York, N.Y., 1974, p. 27.). The USGS changed the royalty rate on some Utah leases from an initial 15 cents/ton (applied initially in 1930 and renewed in 1950) to 5 percent of the coal's value when the lease was renewed in 1970. The agency did not file any proposed regulation changes in the Federal Register and the change was not noted in the CFRs until after the enactment of the FCLAA.

⁵ Federal Register, v. 40, no. 21, Thursday, January 30, 1975, p. 4437.

⁶ Federal Register, Vol. 41, No. 96 -- Monday, May 17, 1976, p. 20271.

⁷ In addition, the regulations specified that if the United States Geological Survey (USGS) determined the transaction was based upon consideration other than the value of the coal, or that the transaction was not arms-length but involved the transfer of the coal between subsidiaries of the same company, the agency was authorized to attach a value for royalty purposes. To aid in arriving at an appropriate value, comparable sales could be used. These regulations did, however, allow deductions from the gross value for royalty calculation purposes of processing costs above the cost of primary crushing, storing, and loading.

⁸ Federal Register, v. 52, no. 10, Thursday, January 15, 1987, p. 1840, et seq.

⁹ The proposed regulations would also alter the definition of value to be "gross proceeds under an arms length transaction." Gross proceeds would be defined as the "total monies or consideration paid to a coal lessee to which such lessee is entitled, for the disposition of the coal."

¹⁰ Federal Register, Jan. 15, 1987. see note 8.

¹¹ Letter from AMAX Coal Company to Minerals & Management Service, April 13, 1987. p. 7.

¹² It is important to underscore the point that coal may undergo additional processing (liquefaction, thermal drying, gasification) beyond the first stage of marketability referred to here. Another market exists for such coal, and it would have a higher market price due to this additional processing. Whether the royalty base should include these costs or be based on the price of coal earlier in the production process is also the subject of some dispute in the proposed coal regulations, although not a subject of this report.

¹³ In theory, the demand schedule for factors of production by a producer of an exhaustible resource such as coal is based upon an amount somewhat less than the value of the marginal product, a difference that reflects the sacrifice of future profit due to present production. This causes the extractive firm to produce at an output level consistent with minimum average cost rather than an output level consistent with price equal to marginal cost.

In practice, the supply of coal is so large relative to current production that the present value of sacrificed future profit due to present production is nearly zero. Factors would be paid the value of their marginal product. Regardless of which solution actually applies, the MARKET PRICE OF THE PRODUCT -- coal in this case -- governs the demand for land and other factors. See Sweeney, James L. The Economics of Depletable Resources. Review of Economic Studies. Vol. 44, No. 136. February 1977. pp. 125-141.

¹⁴ The extent of this interfuel substitution is discussed in: Pindyck, Robert S. The Structure of World Energy Demand. MIT Press. Cambridge, Mass. 1979; Halvorsen, Robert. Econometric Models of U.S. Energy Demand. Lexington Books. Lexington, Mass. 1978; and Mittelstadt, Axel. Use of Demand Elasticities in Estimating Energy Demand. Organization for Economic Co-Operation and Development. 1983.

¹⁵ The upward sloping supply curve reflects the assumption of increasing marginal cost of coal production. The horizontal market demand curve reflects the assumption that coal producers take the coal price as exogenous.

¹⁶ In reality the supply of Federal mining lands would have an upward slope (this means that it would be affected by the royalty rate and the rate of other rental payments per acre of land). The simplifying assumption in the text does not affect the main conclusions.

¹⁷ If the domestic coal industry was not a price taker and faced a downward sloping demand curve, consumers and producers would both be willng to bear part of the burden of the tax. The extent to which this is so depends upon the price elasticity of demand for coal relative to the price elasticity of supply of coal. The basic conclusion of the analysis developed here would not be changed by this different market structure.

¹⁸ State governments can exercise market power in setting severance rates. The end result is even higher severance taxes than could be justified as internalizing social costs. This point strengthens our conclusion that State severance taxes should be excluded in determining the Federal royalty. See Kolstad, Charles D. and Frank A. Wolak, Jr. Competition in Interregional Taxation: The Case of Western Coal. Journal of Political Economy, v. 19, no. 3. p. 443-460.