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Oil Depletion Allowance

In what some Texans view as the Good Old Days, the federal government allowed owners of oil wells to take a tax savings for selling their oil. Specifically, a firm could reduce its corporate income tax by an oil depletion allowance equal to roughly 27.5 percent of the value of the crude oil sold. The Revenue Act of 1924 limited the depletion allowance to no more than 50 percent of a property's taxable income before depletion but after deduction of expenses directly associated with the producing property. As amazing as it seems, firms were actually recompensated for using up their own reserves.

The oil depletion allowance gave oil companies a strong incentive to vertically integrate. If a company owned the wells, processed the crude oil, and sold gasoline and other products to final consumers, it could control the price it charged its own units for the oil. The law gave firms an incentive to charge a very high internal transfer price for the oil so that the firm could earn a large allowance, which depended on the value of the crude oil sold.

Needless to say, oil companies took advantage of this tax loophole with enthusiasm by vertically integrating. With the end of this opportunity in 1974, there was large-scale divestiture of firms' downstream retailers.

SOURCE:

Bolch, Ben, and William W. Damon. 1978. "The Depletion Allowance and Vertical Integration in the Petroleum Industry." Southern Economic Journal 45:241-9.

© 2000 Dennis W. Carlton and Jeffrey M. Perloff. Reprinted by permission.





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