Menu
Tax Notes logo

Tax History: When Reforms Go Bad: The Origins of Percentage Depletion

Posted on Aug. 12, 2019

When drafting tax laws, what should lawmakers emphasize: ideals or practicality?

Sometimes that dichotomy is a false one, dissolved by reasonable and thoughtful compromise. Other times, the quest for administrative simplicity can lead to the evisceration of sound tax policy.

Such was the case with percentage depletion, a reform enacted in 1926 to help remedy problems with earlier forms of the depletion allowance. Percentage depletion was framed as a victory for simplicity and certainty, according to historian Peter A. Shulman, and was “widely seen as a remedy to past tax abuses, not a path to a future tax shelter.”

Of course, percentage depletion did become a notorious tax shelter. So notorious, in fact, that it became something of a poster child for bad policy. In 1951, Shulman points out, The New Republic called percentage depletion “perhaps the most scandalous single grab by Big Business extant.” Around the same time, tax scholar and Harvard Law School Dean Erwin Griswold wondered aloud “why anyone should think that it has a proper place in a fair and equitable tax system.”

And at least some policymakers were listening. President Harry Truman offered a particularly scathing indictment. “I know of no loophole in the tax laws so inequitable as the excessive depletion exemptions now enjoyed by oil and mining interests,” he wrote in a 1950 message to Congress.

Shulman quotes these and other critics in his 2011 article, “The Making of a Tax Break: The Oil Depletion Allowance, Scientific Taxation, and Natural Resources Policy in the Early Twentieth Century.” Others have written more recently about the history of depletion allowances, including George K. Yin, Jay Starkman, and Calvin H. Johnson. But Shulman’s article remains the most comprehensive, as well as the most ambitious attempt to connect the history of depletion allowances to broader trends in Progressive Era political reform.

Ideals and Practicalities

“The depletion question reflected the challenge facing all architects of modern taxation,” Shulman notes at the start of his article. “Could seemingly straightforward economic principles be practically administered?”

It’s a reasonable question, which Shulman answers by citing Edwin R.A. Seligman, the most influential tax economist of the early 20th century and a champion of the modern income tax. “An ideal principle which is administratively unworkable is not for an instant to be compared with a less elevated ideal which can be actually carried out in practice,” Seligman wrote in 1914.

Seligman’s elevation of practicality over idealism might seem incongruous, given his intellectual bent and academic reputation. He was deeply committed to abstract notions of tax fairness and fiscal equity, and throughout the 1890s and 1900s he used both to argue for new state and federal income taxes.

But advocating legislative tax reform is necessarily an exercise in practical politics, not just abstract reasoning. And practical politics puts a premium on administrative workability. Which is probably why, when faced with a choice between ideals and practicality, Seligman chose the latter.

In any case, Seligman’s comment goes a long way toward explaining the early history of depletion allowances generally and percentage depletion particularly.

In the Beginning

Like most dichotomies, the trade-off between fairness and practicality is problematic, because practicality is sometimes hard to measure. “In the early twentieth century,” Shulman notes, “the boundary between workable and unworkable principles was often rather murky.”

When lawmakers set out to develop a system of depletion allowances, the ink was not yet dry on the income tax law itself. Determining which provisions were likely to work and which would fail involved some careful reasoning — and more than a little trial and error. As a result, simplicity and practicality tended to rule the day.

When Congress enacted the first corporate income tax in 1909 (technically an excise tax but structured to function as an income tax), lawmakers provided a depreciation deduction but made no allowance for resource depletion. Two years later, Treasury corrected the oversight with an administrative ruling, and two years after that, Congress added a depletion provision to the Revenue Act of 1913. Under the new corporate income tax, mining and drilling companies were allowed a depletion deduction equal to 5 percent of the gross value of their annual output.

“The figure was arbitrary, but it was defensible as an economic principle (accounting for the capital losses of wasting assets) and offering administrative simplicity in its application,” Shulman notes.

Then things got complicated.

War and Oil

World War I transformed the depletion allowance (along with the rest of the nascent income tax). As the United States edged closer to entering the war, lawmakers felt compelled to encourage the production of petroleum products. Those same lawmakers, however, were also enacting various tax increases to help pay for the war, including both higher levies on corporate income and a new tax on excess profits.

The conflict between these goals — higher oil production on one hand, higher revenues on the other — was obvious. But that didn’t stop oil industry executives from harping on it constantly. The existing allowance was inadequate, they complained, and high wartime taxes were severely hampering production. Congress responded in 1916 by removing the 5 percent cap and providing for a “reasonable allowance for actual reduction in flow and production.” The new provision was more generous than the one it replaced, but it still included a limit: The depletion allowance permitted to a well could not exceed the capital originally invested in that well.

Oil industry leaders were unsatisfied, and they warned lawmakers that without a more generous allowance, the industry might fail to meet the nation’s wartime demand for petroleum products. And they had a solution in mind. The depletion allowance should not be limited to the amount of capital invested in a well (including the cost of land and equipment). Instead, it should be based on the value of the oil likely to be produced by that well.

This idea, known as discovery depletion, was extremely generous. In practice, Shulman notes, it meant that “the wealth of nature gained from an oil discovery under discovery depletion would be tax free.” Champions of discovery depletion, however, framed it as a triumph for science over politics. It would be up to experts — chiefly geologists and engineers — to determine the value of a well. Their judgments would be objective and unbiased — just like science itself.

Discovery depletion became law in 1918. According to Shulman, it represented a triumph of “the technocratic wish” (a term borrowed from science historian Gary S. Belkin). This impulse suffused Progressive Era politics, extending beyond tax policy to a wide array of policy domains. At its heart, the movement was rooted in a secular faith — a confidence that expert-driven policy would be objective, neutral, and (ultimately) fair.

False Hope

Discovery depletion was a disappointment. “Like many other Progressive Era attempts to depoliticize public policy by grounding it in the authority of seemingly objective experts, this approach ultimately proved a failure,” Shulman notes. The experts charged with valuing oil discoveries confronted a dearth of data, especially because many oil companies did not keep careful records. Even more problematic, the science of geology was not up to the task of accurately estimating the size (and value) of a particular oil well. Many valuations amounted to little more than guesswork.

Also problematic was the administrative complexity inherent in the new depletion regime. Making it work required a vast army of federal tax officials, all of them schooled in geology and familiar with the specific conditions of oil fields around the nation. During the war, such a bureaucratic behemoth was sustainable, but in the 1920s, it was a tough political sell. Both Congress and the White House were eager to shrink the war-swollen government, and federal tax officials soon found themselves without the resources necessary to maintain the discovery depletion regime.

Meanwhile, these same tax officials were struggling with an epidemic of depletion-based tax avoidance. New companies began to diversify into oil production, Shulman notes, claiming huge depletion allowances that far exceeded a particular well’s income and served to shelter income from other, non-extractive operations. Congress responded by limiting the depletion allowance, first to 100 percent of net income from a given well, and later to 50 percent.

In the mid-1920s, a Senate panel charged with investigating the Bureau of Internal Revenue (BIR) found many problems with the discovery depletion regime, including what Yin has called “tremendous valuation problems.” As he recounts in a 2016 article for Tax Notes:

The congressional investigation reported numerous cases in which BIR valuations of a given property provided to different taxpayers (such as the lessor and lessee of the property) varied by more than 100 percent. Those results reflected not just bureaucratic incompetence but also the essential difficulties of the task. (Prior analysis: Tax Notes, Sept. 19, 2016, p. 1695.)

So much for scientific objectivity. Clearly, the BIR’s depletion experts were not delivering on the technocratic promises made in 1918. Scientists, it turned out, were not quite as neutral, objective, and fair as many had hoped.

Alarmed by the results of the Senate investigation, Congress sought to abandon discovery depletion. Lawmakers might reasonably have opted for a return to cost depletion. “Indeed, Ways and Means Committee Chair William Green of Iowa asked Treasury to recommend exactly that result,” Yin notes. “As Green explained, discovery depletion ‘seems to me to be entirely illogical; it seems to have no foundation of right or justice in it.’” Treasury, however, declined the invitation.

Congress eventually chose to take a different route. Disillusioned by the technocratic approach, lawmakers opted instead for simplicity and administrative convenience. L.C. Manson, chief counsel for the BIR investigation, suggested to the Senate Finance Committee that it “replace discovery depletion with an allowance calculated as a flat percentage of operating income,” Yin writes. “His purpose was to simplify administration.”

Oil industry lobbyists, for their part, were content with a flat percentage, which had been a feature of the very first depletion allowance. But they urged lawmakers to pick a generous number for the new allowance. Legislators agreed. The Revenue Act of 1926 gave drillers a depletion allowance equal to 27.5 percent of a well’s gross income.

The Limits of Science

The enactment of percentage depletion represented a defeat for idealized notions of science and expertise. Although arguments for advancing discovery depletion in 1918 may have been flawed, they were rooted in a genuine conviction that science-based valuations would provide an objective basis for the taxation of extractive industries. In that respect, discovery depletion was broadly consistent with the Progressive Era impulse to put experts in charge of complex policy decisions. As Shulman notes, that impetus often failed to deliver on its promises.

Percentage depletion, on the other hand, served its goal of simplicity quite well. It remained on the books for decades, largely immune to the scathing attacks mounted by tax experts and even many politicians. Few considered it fair, but many acknowledged its relative simplicity.

In retrospect, the rise of percentage depletion is a case study in the political appeal of simplicity over precision, and of practicality over idealism. That allure extends well beyond the issue of depletion to encompass a range of other tax-related topics.

No one has ever described the appeal of simplicity more succinctly than Daniel Roper, commissioner of internal revenue from 1917 to 1920. “Certainty and simplicity,” he observed in 1921, “are far more important in a tax measure than an abstract element of equity.”

Copy RID