Economic analysis from the European Commission’s Directorate-General for Economic and Financial Affairs Volume VI, Issue 8 11/9/2009 ECFIN COUNTRY FOCUS Highlights in this issue: • Oil price increases have been associated with a tax UK public finances and oil prices: tax bonanza bonanza for from black gold? the UK Exchequer By Karl Scerri and Adriana Reut* • Changes in oil prices feed through into Summary tax revenues from oil The UK's self-sufficiency in fossil fuels shields public finances from the negative production and effects of higher oil prices on general economic activity. Changes in the international price of oil affect government revenues from the corporate and household sectors. sales of fuel Taxes on oil production are estimated to increase by around 0.1% of GDP for every $10 increase in the oil price. The increase in tax revenue on profits from oil • But a number production is partly mitigated by the fall in profits of the oil-consuming industries. of offsets limit Nevertheless, even if the non-oil corporate sector were to absorb the entire increase the overall in production costs through a reduction in profit margins, the net impact on corporate budgetary taxation would remain non-negligible, at 0.05% of GDP. On the demand side, we impact estimate a weaker effect of changes in oil prices on taxation revenues in the UK, as the reduction in fuel duty revenues following an increase in the crude oil price would offset higher revenues from VAT. The estimates on the budgetary impact of changes in oil prices underline the role of taxation regimes on oil production and energy demand, as well as the effect of changes in oil prices on the distribution of profits across industrial sectors and on the composition of household spending. Tax bonanza with higher oil prices? Over the past 18 months, the international price of crude oil has been subject to unprecedented volatility. The Brent price of oil fell to $35 at end-2008 from $140 at the beginning of July 2008, before rising back to around $70 in September 2009. The United Kingdom's status as the largest oil producer in the EU suggests the country's public finances could be exposed to asymmetric shocks from oil price changes. In the UK, past large oil price increases have often been associated with a tax bonanza for the Exchequer, sometimes triggering calls for compensatory cuts in other taxes. Higher oil prices boost profits from oil production, thereby raising corporate tax revenue. At the same time, revenue from value added taxation (VAT) on fuel sales also increases in response to higher crude oil prices. But a number of offsets could limit the overall impact on public finances. Higher energy and fuel costs depress profit margins for the non-oil producing segment of the economy, while the downward demand for fuel reduces intakes from fuel sales. Similarly, higher expenditure on domestic fuel and power, which is subject to a reduced VAT rate of 5%, could crowd out expenditure on other goods and services that are subject to the * Directorate for the Economies of the Member States. The views expressed in the ECFIN Country Focus are those of the authors only and do not necessarily correspond to those of the Directorate-General for Economic and Financial Affairs or the European Commission. standard VAT rate, thereby exerting downward pressure on VAT receipts. This Country Focus examines the impact of changes in oil prices on public finances. Top-down approach One approach to assess the indirect impact of changes in oil prices on public finances that is consistent with the European Commission's method of estimating the cyclically-adjusted budget balance (CAB) involves identifying the effect of changes in oil prices on GDP and, subsequently, measuring the impact on public finances using the budgetary sensitivity parameters that are presently used for calculating the CAB. Barrell and Kirby (2008), using NIESR's global econometric model, find that a temporary two-year $20 increase in oil prices would, assuming a policy reaction that stabilises the price level, reduce UK GDP by 0.06% after one year and by 0.14% after two years. The increase in inflation reduces real household income and in the NiGEM simulation leads to a policy response in the form of higher interest rates. With UK exports depending overwhelmingly on demand in oil- consuming countries, the increase in the price of oil also cuts UK exports1. The UK's net self- In Table 1, the budgetary sensitivity parameters, representing the change in the sufficiency in fossil budget balance-to-GDP ratio associated with a unit change in the output gap, are fuels shields its used to estimate the impact of oil-induced changes in GDP on public finances. The public finances from results imply that significant variations in oil prices, such as those experienced since the negative effect of the second half of 2007, have non-negligible effects on public finances. A doubling higher oil prices on in the international price of oil from an average annual price of $70 to $140 would economic activity increase the UK budget deficit by 0.2% of GDP, around half the increase in the euro area, reflecting a smaller fall in output as a result of the UK being almost self- sufficient in fossil fuel. Table 1: "Top-down" approach to estimating the budgetary impact of oil prices UK DE FR IT ES Euro area Output effect of a temporary two-year $10 increase in oil prices (% difference from year t -0.03 -0.07 -0.05 -0.01 -0.04 -0.04 year t+1 -0.07 -0.15 -0.10 -0.10 -0.13 -0.11 Sensitivity of budget balance (% of GDP) to 2 one unit change in output gap 0.42 0.51 0.49 0.50 0.43 0.48 Effect on budget balance (% of GDP)3: fall in oil price from $70 to $35 year t 0.02 0.06 0.04 0.01 0.03 0.03 year t+1 0.05 0.13 0.09 0.09 0.10 0.09 increase in oil price from $70 to $140 year t -0.04 -0.12 -0.09 -0.02 -0.06 -0.07 year t+1 -0.10 -0.27 -0.17 -0.18 -0.20 -0.18 SOURCE: 1 Barrell and Kirby (2008), National Institute for Economic and Social Research; 2 Girouard and Andre (2005), OECD; 3 Own calculations. Corporate tax on oil and natural gas production The United Kingdom is the European Union's major oil producer, accounting for around two-thirds of total EU production. Compared to the other EU Member States, the UK has the highest share of oil production in GDP after Denmark; the latter being the only net oil-producing country in the EU. This notwithstanding, oil production in the UK has been on a steep downward trend, with production volumes between 2000 and 2008 falling at an annual average of 6.9%. In 2005 the UK became a net importer of crude oil for the first time in decades, while in 2008 crude oil consumption net of oil production UK was equivalent to 0.2% of GDP. ECFIN Country Focus Volume VI, Issue 8 Page 2 Chart 1. Oil production and consumption in Chart 2. Revenues on oil and gas production selected countries, 2008 Oil production USD per barrel 6 % of GDP 1.0 % of GDP 90 (average oil price: Oil consumption Net oil production/ consumption 5 97.23 US 0.9 80 dollars/barrel) Total government revenues 4 0.8 from oil production 70 3 0.7 Oil prices 60 2 0.6 50 1 0.5 0 40 0.4 -1 30 0.3 -2 0.2 20 -3 10 -4 0.1 UK EU 0.0 0 Italy Spain World France Romania Denmark Germany 1997/98 1998/99 1999/00 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 2009/10 Source: International Monetary Fund, World Economic Source: HM Revenue and Customs Outlook Database, April 2009; BP, Statistical Review of World Energy, 2009 Taxation on oil- Companies which earn profits from extracting UK oil and natural gas, almost entirely production higher from the North Sea, are liable to three forms of taxation. First, like all major than for oil- consuming industrial companies in the UK, oil and gas extraction firms are liable to the main corporate tax activity rate on profits, which as from April 2008 stood at 28%. Second, profits from oil and gas extraction and from rights on such resources are subject to a supplementary charge of 20%. Third, gross profits2 on extraction from oil fields approved before March 1993 are subject to a petroleum revenue tax (PRT) at a rate of 50%. This PRT liability is allowed as a deduction against profits subject to the main corporate tax rate and the supplementary charge. North Sea companies, most of which have calendar year accounting periods, pay their corporate tax liability through three instalment payments, with the final payment typically being made in January after the end of the accounting period. Given the instalment payments system, and with corporation tax receipts (including the supplementary charge) and the petroleum revenue tax being recorded in government accounts on a cash basis, government tax revenues during financial-year t/t+13 predominantly reflect profits made by North Sea companies during the calendar-year t4. In turn, the level of North Sea profits depends on production levels, the international price of crude oil, the sterling exchange rate with respect to the US dollar, and operating and capital costs.