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Severance Tax: What Businesses Should Know

Severance Tax: What Businesses Should Know

Severance taxes are a form of tax imposed on the extraction of natural resources such as oil, gas, coal, or timber. These taxes are levied on businesses that extract natural resources from state-owned or privately-owned lands, and the revenues generated from these taxes are often used to fund state and local government programs. Severance taxes are particularly important for states that rely on natural resources as a significant part of their economy. 

In this article, we will discuss what severance taxes are, how they work, and what businesses should know about them. 

What is Severance Tax? 

A severance tax is a tax imposed on the extraction of natural resources from state-owned or privately-owned lands. The tax is typically levied as a percentage of the value of the extracted natural resource. The revenue from severance taxes is often used to fund state and local government programs such as education, infrastructure, and environmental conservation. 

Severance taxes can be imposed on a wide range of natural resources, including oil, gas, coal, timber, and minerals. The rate at which severance taxes are levied can vary widely depending on the state and the type of natural resource being extracted. In some cases, the rate can be as high as 25% or more. 

How Does Severance Tax Work? 

A severance tax is typically paid by the business that extracts the natural resource. The tax is calculated based on the resource's value at the extraction point. For example, if a business extracts oil from a well, the severance tax would be calculated based on the value of the oil at the wellhead. 

The revenue from severance taxes is often distributed to state and local governments to fund various programs. Some states use the revenue to fund education or infrastructure projects, while others use the revenue to support environmental conservation or public safety initiatives. 

What Businesses Should Know About Severance Tax

If your business is involved in extracting natural resources, it is important to understand how severance taxes work and how they may impact your business. Here are some key considerations to keep in mind: 

  • Compliance with State Laws: Severance tax laws vary widely from state to state, and it is important to comply with all applicable laws and regulations. Failure to do so can result in significant fines and penalties. 

  • Impact on Profit Margins: Severance taxes can significantly impact the profitability of businesses involved in natural resource extraction. It is important to factor in the cost of severance taxes when determining the profitability of a project. 

  • Planning for Severance Taxes: Businesses in natural resource extraction should plan for severance taxes as part of their overall financial planning. This may include setting aside funds to pay the tax or adjusting business plans to account for the cost of the tax. 

Understanding Tax Credits

Some states offer tax credits to businesses that engage in natural resource extraction. These tax credits can help offset the cost of severance taxes and make certain projects more financially feasible. 

Working with Tax Professionals

Given the complexity of severance tax laws, working with a tax professional with experience in this area is often advisable. A tax professional can help ensure compliance with all applicable laws and regulations, identify opportunities for tax credits, and help with overall financial planning.


Pros and Cons of Severance Tax

Like any tax, severance tax has both pros and cons. Here are some of the key advantages and disadvantages:


Revenue Generation: Severance taxes can generate significant revenue for state and local governments. This revenue can fund a wide range of programs, including education, infrastructure, and environmental conservation. 

Promotes Conversation: Another advantage of severance taxes is that they promote conversation and negotiation between businesses and the state government. The taxes act as a tool to encourage businesses to work closely with the government in determining the appropriate amount of resources that should be extracted from the earth. By promoting conversation, the government can better understand the industry and its environmental impact, while businesses can work to minimize their tax obligations by demonstrating good environmental stewardship practices. 

Revenue Generation: Severance taxes can generate significant revenue for state governments. The revenue can be used to fund various public projects, including infrastructure development, education, healthcare, and other critical public services. In some states, severance taxes are the primary funding source for these essential services. As a result, the tax can significantly impact the economy and overall quality of life for residents. 

Encourages Environmental Protection: Severance taxes can also encourage environmental protection by incentivizing businesses to adopt environmentally friendly practices. Since the tax is based on the number of natural resources extracted, businesses are encouraged to find ways to reduce their overall resource consumption. By adopting sustainable practices, businesses can reduce their tax obligations and, in doing so, help to protect the environment. This creates a win-win situation: the business benefits from reduced tax obligations, and the environment benefits from reduced resource consumption. 

Cons of Severance Tax: 

The burden on Businesses: One of the most significant disadvantages of severance taxes is that they can burden businesses significantly. Since the tax is based on the amount of resources extracted, businesses have to pay the tax regardless of whether they are profitable or not. This can be particularly challenging for smaller businesses that are already struggling to stay afloat. In some cases, the tax can even make it impossible for businesses to remain viable. 

Competitive Disadvantage: Severance taxes can put businesses at a competitive disadvantage compared to businesses operating in other states or countries that do not have a similar tax. This can lead to businesses relocating to areas where taxes are lower, resulting in a loss of jobs and revenue for the state. It can also discourage businesses from investing in new projects or expanding their operations, which can stifle economic growth. 

Unpredictable Revenue: Severance taxes can also be unpredictable, making it difficult for businesses to plan for the future. Since the tax is based on the price and quantity of resources extracted, businesses need to predict their tax obligations from year to year accurately. Planning for future projects, hiring new employees, or investing in new technologies can make it challenging. It can also make it difficult for state governments to plan their budgets and allocate resources. 

Regressive Taxation: Severance taxes can also be regressive, meaning they disproportionately affect low-income households. Since the tax is based on the value of the natural resources extracted, it does not consider the income level of the individuals affected by the tax. This can make it more challenging for low-income households to afford essential goods and services, such as heating and electricity, which can hurt their quality of life. 


Severance taxes can be a powerful tool for state governments to generate revenue, encourage environmental protection, and promote conversation between businesses and the government. However, they can also burden businesses, putting them at a competitive disadvantage, being unpredictable, and regressive. It is essential for state governments to carefully consider the advantages and disadvantages of severance taxes before implementing them. Additionally, businesses should understand the impact of severance taxes on their operations and take steps to minimize their tax obligations while promoting environmental protection.



Dennis Jao
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