The relative ability to tax coal in the western states.

• Author: Fain, James R.

1. Introduction

   Over the past decade, state governments have begun to acknowledge an implicit relationship between states in the tax-setting process. The recent taxation literature suggests that differences in tax burdens do affect economic decisions and that states do compete with each other when designing tax policy [2; 1; 13; 14; 15]. Moreover, there has been a growing interest in the theoretical models of strategic interactions between regions as they compete for tax revenues [3; 9; 16; 17].

   Natural resource-laden states enjoy an advantage in the collection of own-source revenues. Reserves of coal, oil, copper, or other natural resources with a national market provide states with an opportunity to exploit their advantage through the imposition of severance taxes.

   The purpose of this study is to examine the relationship between the western states in their relative power to tax the extraction of coal. In section II of this paper we examine earlier work on the taxation of western coal. Section III contains the details of the coal model we use. In section IV we determine the composition of the western coal market and the strategic tax-setting behavior of the state governments involved. In section V we discuss our empirical results.

2. Interstate Competition for Tax Revenue

   Previous work that focuses on the relative ability of western states to tax the extraction of coal includes Alt, Baumann, and Zimmerman [1] and Kolstad and Wolak [7; 8]. The increase in oil and gas prices and the decline of nuclear power throughout the 1970s and early 1980s increased the competitiveness of coal as an alternative source of energy. The demand for coal became less elastic. State legislatures found themselves in a position to take advantage of coal's less elastic demand by increasing their tax rates. The research conducted by Alt, Baumann, and Zimmerman [1] and Kolstad and Wolak [7; 8] focuses on the ability of state legislatures to increase severance tax rates on coal in this favorable market environment.

   Alt, Baumann, and Zimmerman consider the taxation of western coal with primary emphasis on Wyoming and Montana. These two states are the dominant coal producers in the western region. Because of the low sulfur content and cheap production costs associated with their coal, these two states can compete very successfully in the midwestern and southern U.S. markets.

   The states' objective is to maximize the present discounted value of revenue from the imposition of severance taxes on coal. The strategic decision variable is the state tax rate on coal extraction. The authors use a linear model to determine regional coal output, sulfur content, the flows of coal from supply regions to demand regions, and the delivered price of coal to each region. The linear model is solved annually under two different assumptions with respect to the nature of the relationship between Wyoming and Montana.

   First, Wyoming and Montana compete with each other in terms of setting tax rates in a Bertrand-type equilibrium. Wyoming's tax rate is held constant while solving for Montana's revenue maximizing rate. Then Montana's tax rate is held constant at that level, and the authors find the tax rate that maximizes the present value of Wyoming's tax revenue. The resulting reaction functions intersect at a tax rate of 7.5 percent for both states. The authors suggest that competition between the two states and their substitutable coal types keep the tax rates low. However, they find that the resulting tax rates are very sensitive to the real discount rate used in their model. If the real discount rate falls from 11.5 percent to 4.5 percent, the revenue maximizing tax rates increase from 7.5 percent for both states to 25 percent for Wyoming and 27.5 percent for Montana.

   The second behavioral setting posited for Wyoming and Montana is that of cooperation. The two states set their severance tax rates jointly to maximize the present value of combined revenues, assuming all other tax rates are held constant. The resulting optimal tax rate in this instance is 62.5 percent, and it is insensitive to the discount rate chosen. Both Wyoming and Montana tax revenues are considerably higher in this case than when they compete with each other.

   The results from Alt, Baumann, and Zimmerman (ABZ) [1] suggest that there is an incentive for Wyoming and Montana to form a mini-cartel. Limits to their taxing power primarily come from Utah and Colorado. Both Utah and Colorado produce high quality coal, but it is at a much higher cost than in Wyoming or Montana. The authors find that when tax rates increase in Wyoming and Montana, coal demand shifts to Utah and Colorado. Arizona and New Mexico also gain, but low coal reserves seem to limit this gain to the short run. Arizona and New Mexico appear to be too small to limit Wyoming's and Montana's power to tax in the long run. Therefore, ABZ conclude that most of the interregional competition for Wyoming and Montana seems to come from Utah and Colorado.

   Kolstad and Wolak (KW) [7; 8] consider the taxation of western coal in a variety of settings. In their 1983 paper KW focus exclusively on two states for their simulations - Wyoming and Montana. The states' objective is to maximize revenue from the imposition of severance taxes on coal. The strategic decision variable is the state tax rate on coal extraction. To conduct the analysis, the authors use a model of the U.S. coal market to generate ten pseudodata, points, which they use to estimate a static partial equilibrium model of coal demand, supply, and transport links. They simulate the market's response to a variety of tax rates for Montana and Wyoming, while taxes in other states remain constant at their 1979 levels. The results are then used to estimate aggregate demand and supply relationships. These relationships are used to determine the revenue maximizing tax rates under different assumptions about the interaction between Montana and Wyoming in the tax-setting process.

   The authors first consider the optimal strategy if Montana and Wyoming cooperate with each other when choosing tax rates. One option is for the states to set a common tax rate that maximizes their joint revenue. This cartel revenue maximizing tax rate is 87 percent. Alternatively, Montana and Wyoming may choose their tax rates separately to maximize their joint tax revenues. A Montana tax rate of 83 percent and a Wyoming tax rate of 96 percent are optimal under this cartel strategy. Joint tax revenues are highest under this latter solution, but only 2 percent higher.

   If the states do not cooperate, then a Nash equilibrium exists. Montana chooses its tax rate to maximize its own tax revenue, taking into account that Wyoming is behaving in the same manner. The simple Nash equilibrium solution is a tax rate of 27 percent for Montana and 33 percent for Wyoming. The sum of total tax revenues in the noncooperative setting declines to 62 percent of the maximum revenue cartel solution.

   KW [8] build on their earlier work by broadening the western coal market to include Arizona, Colorado, Montana, New Mexico, Utah, and Wyoming. The state government objective function is expanded to include the maximization of tax revenues and other positive benefits associated with coal extraction. Severance taxes in the western states vary uniformly, while tax rates in states outside the region are held constant at their current levels. Again, these simulation points are then used to estimate aggregate demand and supply relationships in order to determine optimal tax rates under different behavioral settings.

   The simplest case is to treat all western states as a unit, with maximum market power. The regional cartel acts in concert, increasing its tax rates from 0 percent to 120 percent. As a...