What is a Severance Tax?

A severance tax is a tax charged on the basis of removal of natural resources. The tax is not based on profit realized by producers and partners, but rather on the total amount of resources removed. In some regions, the taxes are levied on a graduated scale, so small-scale producers are not taxed at the same rate as producers who extract high volumes of natural resources. Severance taxes vary from region to region, with some areas charging no taxes at all, while others may charge an array of taxes related to natural resource removal, including oil and gas taxes, coal taxes, fisheries taxes, and timber taxes.

For regions where exploitation of natural resources represents a large share of the economy, severance taxes are one important way to support government operations, including payment to regulatory agencies monitoring natural resource removal. This tax may be charged in addition to other taxes related to the use of natural resources. A company drilling for oil, for example, can pay a severance tax on all the oil removed, in addition to paying income taxes on the profits from the oil production.

Critics of severance taxes argue that they have a chilling effect on business in a region by making the costs of business higher than in other areas. Studies seem to suggest this is not the case, as the existence of a severance tax is not linked with lower levels of production or reluctance to do business. Companies taking advantage of natural resources cannot simply relocate their operations, as they need to work in an area where those resources are available. In a region with ample supplies of resources, severance taxes do not create a disincentive for business, as they are typically set very low and do not eat into profits.

Regions without severance taxes can experience significant losses in potential revenues. Commissioned studies in regions where such taxes are nonexistent or restricted to only a few resources show that implementing a severance tax could generate large government revenues and these revenues could help pay costs associated with resource extraction industries, as well as general government expenses.

In some regions, rather than being paid by the producers, severance taxes may be paid by the initial consumer of the resources instead. The severance tax is structured into the pricing for raw resources. This can result in passing on the price to end consumers, raising overall costs slightly, and may be a concern in areas with high pricing for commodities like oil and gas.