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Tax Policy Review for the Electric and Natural Gas Utility Industries in Washington, DC
Rodney D. Green and Daniel Muhammad
January 1998

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TAX POLICY REVIEW FOR THE ELECTRIC AND NATURAL GAS UTILITY INDUSTRIES IN WASHINGTON, DC:

A REPORT TO THE WASHINGTON, D.C. TAX REVISION COMMISSION

RODNEY D. GREEN, PH.D. PROFESSOR OF ECONOMICS
DANIEL MUHAMMAD
GRADUATE FELLOW HOWARD UNIVERSITY WASHINGTON, DC

JANUARY 1998

TABLE OF CONTENTS

I. INTRODUCTION AND SUMMARY OF TAX ISSUES
II. REGULATED UTILITIES
III. CHANGING STRUCTURE AND TAX IMPLICATIONS
IV. THE TAXATION OF ELECTRICITY AND NATURAL GAS IN THE DISTRICT OF COLUMBIA
V. DISCUSSION OF THE TAX ISSUES
VI. ELECTRIC POWER AND NATURAL GAS IN THE DISTRICT OF COLUMBIA, 
MARYLAND AND VIRGINIA - A COMPARISON
VII. ELECTRICITY PRICES IN DC UNDER COMPETITION
VIII. IMPLICATIONS FOR TAXES AND REVENUES
IX. ADMINISTRATION AND COMPLIANCE
X. BIBLIOGRAPHY 

 

TABLE 1 Importance of Electric Utility Tax Payments
TABLE 2 Share of Electric Utitlity's Total Tax Payment by Category of Tax
TABLE 3 Aggregate Tax Burden on Electric Utilities
TABLE 4 Pepco's Taxes in Two Jurisdictions
TABLE 5 Tax Rates for Electric Utilities by Jurisdiction
TABLE 6 Pepco Taxes, 1996, By Category and Jurisdiction
TABLE 7 Washington Gas Taxes by Category and Jurisdiction
TABLE 8 Washington Gas Taxes, Sales, and Tax Rate, By Jurisdiction
TABLE 9 Washington Gas Revenues per Therm, By Customer Category and Jurisdiction, 1996
TABLE 10 Cents/kwh Sold (1995)

I. INTRODUCTION AND SUMMARY OF TAX ISSUES(1)

As the Tax Revision Commission considers medium to long-run changes in tax policy for the District of Columbia, several challenges in the electric and natural gas utility industries must be met. These challenges arise from the ongoing transition from fully regulated to restructured and deregulated industries, and from the prominent role of the federal government and the non-profit sector in purchasing energy in the District of Columbia.

The Commission's goals include (1) assuring adequate revenues for the city, in particular achieving tax revenue neutrality through the set of tax policy changes which emerge from the Commission's deliberations; (2) maintaining a level playing field (horizontal equity) for firms in their respective markets; and (3) stimulating economic development in the District of Columbia by creating an attractive business environment.

This paper begins with a summary of the key tax issues in electricity and natural gas. It then provides a discussion of the history and current developments in these industries which are important to tax policy, especially the restructuring currently underway in electricity and natural gas. The complex array and level of taxation in these industries are reviewed for the District and then for surrounding jurisdictions, followed by a fuller discussion of tax policy and administration issues in these industries. 

The Key Tax Issues in Electricity and Natural Gas

The key challenges and associated options in the energy industries may be summarized as follows.

1. What should be done about the gross receipts tax for energy utilities?

Options

If the gross receipts tax is left unchanged, and deregulation continues, unregulated energy firms may enter the market and gain a cost advantage of up to 11.1% over the regulated industries by not having to pay the gross receipts tax. Such firms may have no legal nexus in the District, in which case the city may not be able to tax their receipts.(2) This prospective competitive advantage of these unregulated firms would, in all likelihood, lead to a flow of energy sales to lower cost firms outside the District, leading to a decline in tax receipts from DC-based firms as well as a reduction in the business of these firms. Accordingly, the employment base of the utilities in the District would decline, weakening their economic development impact.(3)

If the gross receipts tax is abolished and replaced with a special energy sales tax or other consumption tax, horizontal equity would be maintained among competing energy-providing firms, but the federal government and non-profit organizations would escape this levy due to their tax-exempt status.(4) Tax revenues would decline unless a much higher sales tax than would otherwise be needed to maintain revenue neutrality is imposed on non-exempt customers. Such a tax would reduce the incentives for economic development in the District.

If the gross receipts tax is abolished and the personal property tax exemption rescinded, horizontal equity would be facilitated to the extent that competing companies would face similar personal property tax rates in their home jurisdictions; tax revenues would be substantially reduced, both from DC companies (the net tax would be lower) and from a possible inability to tax non-DC-based companies (unless an allocation negotiation could be concluded with the jurisdiction of origin); and economic development would be modestly stimulated.

If special legislation is passed by the City Council to extend the gross receipts tax to non-DC-based energy companies (as it has already done for the natural gas industry), a level playing field (horizontal equity) would be maintained; tax revenues would be maintained, including those currently received from the federal government's payment of its energy bills; and the energy utility industries' impact on economic development would be unchanged. However, the nexus issue is non-trivial, court challenges from non-DC-based energy firms are inevitable, and such litigation may prove successful.(5)

If the gross receipts tax is abolished and replaced by a tax on city rights-of-way is implemented(6), horizontal equity could be maintained only insofar the new tax could be applied via access charge adjustments to non-DC based firms which use DC rights of way; tax revenue neutrality could be maintained by a careful calculation of the tradeoffs of reduced gross receipts tax and the new right-of-way tax; and there would be no significant effect on economic development.

If the gross receipts tax is abolished and no specific energy utility tax is put in its place, the effect would be: horizontal equity for the deregulated industries, except insofar as the taxes on DC-based firms might become less, in the aggregate, than taxes on energy firms in other jurisdictions; substantially decreased tax revenues; and a modest positive effect on economic development.(7)

If the gross receipts tax is maintained for regulated utilities and a tax on sales of electric power and/or gas to the District of Columbia from outside jurisdictions is added, a careful setting of such a "foreign" energy sales tax rate could establish horizontal economic equity; keep tax revenues constant; and leave unchanged the impact of the power utilities on economic development. However, the interstate commerce clause of the U.S. Constitution may be invoked in court challenges; litigants may make the argument that such a levy is discriminatory from a legal standpoint in that it would not be applied to energy sold by DC-based businesses.

2. If deregulation leads to lower energy prices and thus lower tax revenues, can the tax revenue shortfall be offset within the energy sector?

Options

To maintain tax revenue neutrality within the energy sector(8), the gross receipts tax and franchise tax rates could be increased, a right-of-way tax could be implemented, or a BTU tax (revenues from which would be insensitive to the expected price reductions) could be legislated. Any decreases in energy prices in the District of Columbia brought about through competition are not likely to be as great as those in such high-cost areas as California and the Northeastern states, however, reducing the importance of this challenge.

3. With competition evolving in the energy industries, tax administration and collection becomes more complex and costly. Moving from a single provider in each of the energy utility industries to multiple providers may create added administrative burdens for the Office of Tax and Revenue.

Options

The local energy distributors (PEPCO and Washington Gas) could be made legally responsible for collecting all revenues from all customers in the District in a consolidated billing system, for delivering all tax revenues from such collections to the District government, and for dispersing the remaining revenues to the appropriate providers. The challenge which could emerge is that the unbundling process in both electricity and natural may lead to the separation of, among other functions, metering, billing, and customer service from the regulated entity. Outside firms could compete for these functions, and the local distributor may not retain them as part of their regulated functions. It would be inequitable to make the local regulated distributor legally responsible for paying all taxes if a separate corporate entity were to carry out the billing and collection function.

In addition, to the extent that existing energy companies create marketing subsidiaries, as Washington Gas has done with its Washington Gas Energy Services (WGES) unit, it may be undesirable for the distribution company to be required to collect taxes for all energy marketers using the distribution system. Customers may have a negative reaction to Washington Gas, for example, insofar as that company collects the tax on gas purchases from all gas customers, they might be less inclined to purchase their gas from WGES, which has a name very similar to the tax collecting distributor company. Thus, such a policy could devalue the corporate name and reduce company assets accordingly.

Treating each energy provider as a separate firm responsible for paying its own taxes would involve increased administrative costs for the District, such as the expense and uncertainty of sending tax auditors and administrators to many distant corporate offices instead of to one local company. Moreover, the opportunities for tax evasion in an industry with a non-trivial turnover rate among many relatively small firms, many of which would be physically located well beyond the borders of the District of Columbia, are qualitatively greater than those associated with a single, local, large, stable firm.(9)

4. Paying for Energy-Related Social Programs

A deregulated, competitive energy industry will in all likelihood be driven to reduce its commitment to such social programs as low-income assistance and economic development support which are currently conducted at modest levels by the regulated energy utilities.(10) If the same level of support for these activities is desired by the city, new District programs are likely to be required; tax revenues to pay for them will need to be raised accordingly, although there is no specific reason why such tax revenues should be drawn from any particular dedicated source.


II. REGULATED UTILITIES

Most U.S. business firms operate in a relatively competitive market and realize profits as the ex post excess of revenues over costs. Regulated utilities, on the other hand, incorporate a reasonable rate of return into their cost projections which are reviewed and ultimately approved on an ex ante basis by a Public Service Commission (PSC) or other comparable regulatory body. Thus, regulated utilities are assured of economic health: the compact legally assures vertically integrated utility monopolies full cost-of-service recovery plus a fair rate of return on invested capital.(11) In return, utilities accept the rate-setting decisions of the PSC. This arrangement, usually called rate-of-return regulation, has governed many public utilities in the United States since the early 1900's. This form of regulation has pleased state and local tax collection agencies because it provides an excellent and efficient avenue for substantial tax collections, since taxes are usually passed through to consumers as part of the regulatory arrangement.

Vertical Integration in Electricity and Natural Gas

The traditional vertically integrated electric monopoly consists of three primary components: generation, transmission, and distribution. However, the electric utility industry is now in transition from a vertically integrated monopoly structure to a deverticalized, relatively competitive, market structure in which each utility's generation component, which accounts for 74% of the cost of electric power, could be functionally separated from its transmission and distribution components. The generation sector of the industry will be thrown open to retail competition through deregulation, while high-voltage transmission (generally interstate) will remain federally regulated by the Federal Energy Regulatory Commission (FERC) and distribution will continue to be locally regulated. In this new structure, consumers of electricity will be able to choose their power source from competing generating companies and marketers.

In natural gas, deverticalization has already followed a similar path. The industry is divided into wellhead providers, interstate transmission pipelines, and local distribution companies (LDCs). Costs are more evenly spread over the components of this industry than in the electric utility industry, with wellhead production accounting for 39%, citygate (cost of acquisition via pipelines), 31%, and distribution, 30%, of total costs. There is currently unregulated competition among wellhead providers, while FERC continues to regulate pipelines and the local Public Service Commission regulates LDCs. Large retail customers are able to choose their gas supplier, which in the District of Columbia includes the marketing arm of Washington Gas, Washington Gas Energy Services (WGES), as well as independent gas marketing companies.

The desired outcome of a restructured, competitive, industry is a more efficient market for the provision of electricity and natural gas, ultimately resulting in lower costs to customers and a socially improved allocation of resources. The transformation of these industries will require major changes in the regulatory compact with significant implications for the manner in which these utilities are taxed.

The electric and gas utilities are among the most heavily taxed industries in the country. State and local governments have relied heavily on electric and gas utilities for tax revenues since large taxes are embedded in the cost of service of utilities, making the taxes invisible to customers and hence politically palatable.


III. CHANGING STRUCTURE AND TAX IMPLICATIONS

One of the policy hurdles that states involved in deregulating their electric utilities must clear is that of taxation.

Retail competition in the District of Columbia (assuming no change in the present tax structure) would result in out-of-state electric suppliers being subject to fewer taxes than PEPCO, the current sole supplier of electricity. Such an imbalance would present the locality with two major problems. First, given their lighter tax requirement, new suppliers would be able, in all likelihood, to sell electricity at lower prices than the local utility, eroding the utility's customer base. Every dollar which went to the new suppliers would reduce tax revenues by 11.1 cents from the gross receipts tax revenues alone. Second, out-of-state competitors might be able to capture market share in the District without reducing their prices as low as full competition would otherwise require, since the higher tax would still remain in place in the District. Any price they charged within the range between their internal marginal cost and PEPCO's marginal cost (including all taxes)(12) would induce substantial numbers of retail customers to change services. Thus, the disproportion in tax rates between jurisdictions would not only drain tax revenues from the District, but deprive District customers of the full benefits which might otherwise emerge as a result of deregulation and competition.


IV. THE TAXATION OF ELECTRICITY AND NATURAL GAS IN THE DISTRICT OF COLUMBIA

Today, energy utilities constitute one of the most heavily taxed sectors in the country. In 1996, taxes paid by PEPCO, the sole supplier of electricity in the city, accounted for 3.5% of all taxes collected by the city, while those paid by Washington Gas accounted for more than 1%.

In 1996, PEPCO paid $74.4 million in gross receipts taxes, which accounted for 85% of all taxes and fees paid by PEPCO to the District of Columbia(13). In the same year, Washington Gas paid $22.4 million in gross receipts taxes, which accounted for over 87% of its payment of taxes and fees to the District. PEPCO's gross receipts tax payment accounted for 31.4% of all gross receipts paid by public utilities, which in turn accounted for 60% of all gross receipts taxes paid to the city.(14)

PEPCO's franchise tax payment was relatively modest at $6.2 million, accounting for 0.77% of all franchise/income taxes paid by District businesses. Its property tax payment was trivial due to the District's personal property tax exemption for utilities(15), while its real estate tax payment was fairly modest at $2.1 million (amounting to only 0.29% of all property taxes collected in the District) due to the fact that the company's generation assets are located in Maryland, except for a relatively small peaking plant on Benning Road, and an inactive facility at Buzzards Point, while the company leases its headquarter offices from tax-exempt George Washington University(16). The allocation formula therefore weights these tax payments towards Maryland.

In the District of Columbia, the gross receipts tax is the most substantial tax levied on the local energy utilities. In the District, the official tax rate is 10% of gross revenues, with an effective gross receipts tax rate of 11.1%(17). Gross receipts taxes apply only to sales to customers within a taxing jurisdiction; sales to out-of-state customers are exempt. The franchise tax rate levied against energy utilities is 9.975% of net income. All real property, unless expressly exempted, is subject to the real property tax and is assessed annually at 100% of estimated market value.(18) Energy utilities also collect the use tax of 5.75%. Two other fees were paid by the local electric utility, the PSC fee and the filing fee. Both fees are based on revenue. In 1996, the fees amounted to $3.8 million and $8,440 respectively.


V. DISCUSSION OF THE TAX ISSUES

The Gross Receipts Tax

There is some debate about the appropriateness of a gross receipts tax being applied to out-of-state suppliers. The most problematic issue (potentially) involves the minimum connection a taxing jurisdiction must have with the corporation or the activity being taxed, or nexus. Sufficient nexus is commonly understood to require a physical presence (property or company agents) in the taxing jurisdiction. Retail competition allows electricity to be imported from out-of state suppliers to end-users without physically being in the jurisdiction of the end-user, making local customers the only nexus of the out-of state suppliers. This limited nexus has been challenged in the courts as insufficient to justify taxation under the commerce and due process clauses of the Constitution. If this issue results in the courts declaring such taxation unconstitutional, these jurisdictions could be required to make massive tax refunds.

Apart from the legal question, there is an economic issue about the appropriateness of a gross receipts tax for unregulated businesses. The incidence of such a tax is heaviest on high volume sales industries, such as wholesale and retail trade, even if business net income as a share of total value of goods sold is very small or even negative. Energy suppliers generally fall into this category. The net income tax (or profit tax) is, on its face, more equitable and less discouraging to prospective energy competitors, yet given the accounting complexities which business owners can invoke in preparing their tax returns (only a minority of business owners pay any net income tax at all), the size and stability of this stream of tax revenues would most likely be quite volatile and uncertain.

These characteristics of the gross receipts tax makes it most appropriate as a levy on regulated monopolies, since such firms are assured of recovering their complete cost of service (including taxes) while earning a reasonable and consistent return on investment. Deregulation will greatly reduce the propriety of such a tax.

Alternatives to the Gross Receipts Tax: Sales/Consumption Taxes

The District could follow the example of several states which are considering replacing the gross receipts tax with a consumption tax.(19) A consumption tax could be set as a percentage of selling price (ad valorem) or a fixed amount on kwh or BTUs (unit tax) at a rate to recover all tax revenues lost due to either the repeal of the gross receipts tax or because of not extending the gross receipts to out-of-state suppliers.(20) The consumption tax would eliminate unbalanced taxation for all providers, could be adjusted to be revenue neutral, and would replace the hidden tax. However, the very visibility of this tax might make it politically undesirable.

If the tax were designed as an ad valorem tax, revenue would vary in proportion to changes in the dollar amount spent on electricity, which would be the net change in total revenues from the increased amount spent per unit due to the higher tax and the reduction in the amount of energy purchased in response to the higher price confronting the consumer.(21) Such a tax might also shift consumers modestly away from electricity and gas to other fuels.

One disadvantage of the sales tax (levied based on the price of electricity or gas) is that it would require the disclosure of potentially sensitive pricing information if remitted by a supplier. Also, a tax on price would make the stream of tax revenues to the local government more volatile. An alternative form of consumption tax on quantity of power, i.e., a tax on the kilowatthours, therms, or BTUs, has the advantages of protecting proprietary pricing information, making estimated tax revenues less volatile, and promoting conservation. However, such a quantity-based consumption tax would shift the tax burden to the users of less expensive electricity, and it would not automatically adjust for general inflation or deflation of the overall price level. The former issue could be important to the emerging energy marketing companies which are "demand aggregators" and negotiate price based on consolidating large numbers of users to receive reduced prices.

Alternatives to the Gross Receipts Tax: the Net Income Tax

The District could rely on the net income tax for tax revenues in place of the gross receipts tax. But the net income tax would yield a much smaller amount of tax revenues if the current rate were to be extended to the electricity industry. Increasing the overall net income tax rate, while necessary to maintain revenue neutrality, would have a discouraging impact on economic development and would, in essence, shift the burden of taxation from energy sector to other sectors.

Additionally, many District businesses report net operating losses. In fact, only about a third of DC businesses pay any net income taxes at all. While PEPCO and Washington Gas are likely to continue to have net income in a deregulated environment, other energy providers may operate more marginally, and even PEPCO and Washington Gas would face incentives to reduce its tax exposure if a substantial net income tax were applied to it.


VI. ELECTRIC POWER AND NATURAL GAS IN THE DISTRICT OF COLUMBIA, MARYLAND AND VIRGINIA - A COMPARISON

The District of Columbia is a relatively small jurisdiction nestled between Maryland to the north and east and Virginia to the south and west. PEPCO is presently the sole supplier of electricity to the District while Washington Gas is both the local distributor of gas and one of the major suppliers (through WGES). To assess the effects on competition and economic development of various taxation scenarios, it is important to compare existing tax structures for the utilities in the three jurisdictions.

Gross receipts taxes, and utility taxes in general, are quite important in all jurisdiction, with the District relying most heavily of the three jurisdictions on the gross receipts tax (see Tables 1 and 2). Fifteen (15) cents of every dollar of PEPCO's electricity sales in the District go to taxes. This level is lower than Maryland's main supplier (Baltimore Gas and Electric) but 50% higher than Virginia Electric Power Company (VEPCO), Virginia's main electricity supplier (see Table 3).

TABLE 1 IMPORTANCE OF ELECTRIC UTILITY TAX PAYMENTS
1996 Electric Utilities' Gross Receipts Tax as Percentage 
of Total Gross Receipts Tax Revenues 
Collected by Jurisdiction
Electric Utilities' Total Taxes as Percentage 
of Jurisdiction's Tax Revenues
BG&E (MD) 37% 2.9%
PEPCO (DC Only) 31% 3.7%
VEPCO (VA) 61% 2.7%
Sources: FERC Form No.1: Annual Report of Major Electric Utilities, Licensees And Others, Baltimore Gas and Electric Company. December 31, 1996 (FERC F1, BGE, 1996); FERC Form No.1: Annual Report of Major Electric Utilities, Licensees And Others, Potomac Electric Power Company, December 31, 1996 (FERC F1, PEPCO, 1996); FERC Form No.1: Annual Report of Major Electric Utilities, Licensees And Others, Virginia Electric And Power Company, December 31, 1996 (FERC F1, VEPCO, 1996); District of Columbia Office of Tax and Revenue; State of Maryland Comptroller of the Treasury; State of Virginia Department of Taxation.

 

TABLE 2 
SHARE OF ELECTRIC UTILITY'S TOTAL TAX PAYMENT 
BY CATEGORY OF TAX
1996 Gross Receipts & 
Franchise Taxes 
Property and Real Estate Taxes  Other
BG&E (MD) 0.275 0.268 0.456
PEPCO (DC) 0.930 0.024 0.045 
VEPCO (VA) 0.475  0.491 0.034
Sources: FERC F1, BGE, PEPCO, VEPCO, 1996.

 

TABLE 3 
AGGREGATE TAX BURDEN ON ELECTRIC UTILITIES
  Taxes Charged* Sales of Electricity Tax per Dollar of Sales 
BG&E $361,822,365 $2,209,027,253 0.164
PEPCO $263,523,342 $1,702,592,052 0.150
VEPCO $459,043,022 $4,365,434,580 0.105
Sources: FERC F1, BGE, PEPCO, VEPCO, 1996; District of Columbia Office of Tax and Revenue; State of Maryland Comptroller of the Treasury; State of Virginia Department of Taxation

*Total taxes charged includes all PSC fees, environmental fees, income, and unemployment taxes paid to all applicable state and local governments and the federal government.

Only 40.8% of PEPCO's electricity sales were attributed to the District in 1996, the remainder were attributed to the company's Maryland customers. When examining PEPCO's District and Maryland markets, the company's District customers pay slightly more in taxes than its Maryland Customers. The District still has a heavier tax burden than Virginia customers but still lower than Maryland customers.

TABLE 4  PEPCO'S TAXES IN TWO JURISDICTIONS
  Taxes Charged Sales of Electricity* Effective Tax Rate per Dollar of Sales
District of Columbia $86,694,700 $744,568,408 11.6 %
Maryland $107,508,601 $958,023,644 11.2 %
Source: District of Columbia Public Service Commission. 

* PEPCO had $744,568,408 in KW sales in the District. PEPCO's Maryland sales was calculated by subtracting DC sales from the total sales recorded in FERC F1, PEPCO, 1996.

The electricity market in the District is relatively small when compared to the major suppliers in Maryland (Baltimore Gas & Electric) and Virginia (Virginia Electric Power Company). However, both the gross receipts and the franchise taxes are about five times as much as the same taxes levied in the bordering states, and the amount of taxes per kwh of sales is still less than Virginia.

TABLE 5 TAX RATES FOR ELECTRIC UTILITIES BY JURISDICTION
  Gross Receipts Franchise Real and Personal Property* Sales/Use
DC 11.10% 9.975% 3.40% 5.75%
Maryland 2.00% 2.00% 2.43% 5.00%
Virginia 2.00% 2.00% 1.24% 4.50%
Sources: District of Columbia Department of Finance and Revenue; State of Maryland Comptroller of the Treasury; State of Virginia Department of Taxation 

*Property tax rates are levied and vary by county and local jurisdiction. This tax rate is the combined effective real and personal property tax rates calculated by Washington Gas for its property. The rates are assumed identical for other utilities.

Each jurisdiction's respective tax rate as it corresponds to the amount of customers serviced produced the following tax revenues:

TABLE 6 PEPCO TAXES, 1996, BY CATEGORY 
AND JURISDICTION
Tax Amount

District of Columbia

Gross Receipts $74,456,319
Franchise 6,220,886
Real Estate 2,111,336
Use 96,610
Filing Fee 8,440
Personal Property 1,440
PSC Fee 3,799,709
DC Total $86,694,740

Maryland

Gross Receipts $21,669,325.00
Montgomery County Fuel Tax 15,447,679
Use 1,695,375
Filing Fees 1,507,499
Environmental Surcharge 2,581,445
Co. Local St Property 64,484,322
Income Tax 59,956
Maryland Total $107,445,601

Virginia

Gross Receipts $21,283
Co. Local St. Property 2,618,052
Use Tax 17,583
Registration 850
Valuation 301
Arlington Co. Bus. Priv 1,308
Virginia Total $2,659,377
PEPCO's Total Non-Federal Taxes Paid $194,140,368
Source: FERC F1, PEPCO, 1996.

This section has demonstrated that PEPCO pays more taxes per kwh than do electric utilities in Virginia but less than such companies do in Maryland.

When considered in an interjurisdictional comparison, the taxes paid by Washington Gas in the District compared to the levies in the other jurisdictions are quite high, approximately twice the rate of Maryland and more than that compared to Virginia (see Table 8). Some gas intensive customers, such as Linens of the Week, already have limited their presence in the District because of such differentially high tax rates. Moreover, in an increasingly deregulated industry, it may turn out that gas marketers themselves will find net tax advantages from locating outside the District, unless the District changes its tax policies to guarantee that location will not affect tax payments to the District of Columbia.

TABLE 7 
WASHINGTON GAS TAXES BY CATEGORY AND JURISDICTION, 1996
District of Columbia 
Gross Receipts $22,399,987
Income 1,131,464
Real Est. & Personal Prop 660,230
Use 22,078
Public Safety Fee 16,800
Reimbursement Fee 1,110,090
Annual Report Fee 100
Unemployment 83,687
DC Total $25,424,436
Maryland 
Gross Receipts $7,069,851
Montgomery County Fuel 4,341,644
Use 275,592
PSC Fund 567,488
Real &Personal Property 522,839
Income Tax (49,126)
Unemployment 71,124
Miscellaneous Taxes 741
Franchise 70,295
Real & Personal Property 8,861,071
Maryland Total $14,661,668
Virginia
Gross Receipts $6,398,269
Miscellaneous taxes 850
Use Tax 320,123
Annual license 888,150
Valuation 263,125
Unemployment 14,829
Real & Property Tax 5,781,387
Virginia Total $13,666,733
WG Total Non-Federal Taxes Paid $60,822,688
Source: FERC Form No.2: Annual Report of Major Natural Gas Companies, Washington Gas Light Company, December 31, 1996 (FERC F2, WG, 1996)

 

TABLE 8 WASHINGTON GAS TAXES, SALES, AND TAX RATE, BY JURISDICTION
  Taxes Charged* Sales of Natural Gas Tax Rate per 
Dollar Sales of Gas
DISTRICT OF COLUMBIA $25,340,749 $243,766,024 11%
MARYLAND $21,709,521 $398,579,717 5.4%
VIRGINIA $13,651,904 $327,418,514 4.2%
TOTAL** $109,535,037 $969,764,255 11.3%
Source: FERC F2, WG, 1996 

*Total taxes charged includes all PSC fees, environmental fees, income, and unemployment taxes paid to all applicable state and local governments and the federal government. 
 
** This total amount includes property and franchise taxes paid to West Virginia and Pennsylvania. 

This significantly higher overall tax rate accounts for much of the differential in gas revenues (including tax collections) received by Washington Gas from differing jurisdictions, as shown in Tables 8 and 9.

TABLE 9 WASHINGTON GAS REVENUES PER THERM, BY CUSTOMER CATEGORY AND JURISDICTION, 1996

 

  Residential Commercial Total
DC 0.93 0.76 0.84
Maryland 0.77 0.59 0.69
Virginia 0.81 0.59 0.72
Total 0.81 0.64 0.73
Source: FERC F2, WG, 1996

VII. ELECTRICITY AND NATURAL GAS PRICES IN DC UNDER COMPETITION

Having considered the issue of tax rates in absolute and comparative perspectives, it is now reasonable to address the issue of the effect of deregulation on energy prices and the derived impact on tax revenue collections. If the District is already a relatively low cost state in terms of electricity and gas production and sales, then deregulation may have little impact on tax collections from these industries. Is the District of Columbia a low-cost or high cost environment? What will be the likely effect of retail competition on energy prices in this jurisdiction?

As the momentum for deregulation increases, many policy makers are stating their support for deregulation in terms of prospectively lower energy prices to be had by consumers. However, the consumers most likely to benefit the most from competition will be industrial and large commercial customers rather than residential and small business consumers. Industries in the District of Columbia's economy are rather low in electricity intensity(22) and its electricity prices by customer class are already below the national average in each of three major categories (see Table 10), so the benefits from competition in electricity will be rather slight at best in the District.(23) A similar point could be made for natural gas. From the standpoint of tax policy impact, the most important issue is whether electricity and gas prices, electricity and gas revenues, and hence electricity and gas tax payments will fall substantially as a result of deregulation and competition.

Some areas of the United States have been burdened by high electricity prices while their competitors in other areas pay far less for a kilowatt hour of electricity. Thus, electricity price differentials among utilities provide an advantage to the competitors who are situated in areas with lower electricity prices. Large industrial users of electricity in high cost areas are making the argument that all consumers should have access to cheap electricity. Some industrial consumers have threatened to purchase power from lower-priced providers by moving their companies or by generating their own electricity, and have thereby succeeded in obtaining lower prices from their traditional electric utility suppliers.

Based on revenue per kilowatt hour sold, which is defined as the cost per unit of electricity sold, the following table indicates the price of a kilowatthour by customer class. On the national level, when the District of Columbia is compared to states like Pennsylvania, Maine, New York, and California, the District is not a high cost state for electric power. Within each customer class the District is well below the corresponding national average.(24)

TABLE 10 CENTS/KWH SOLD (1995)
  Residential Commercial Industrial  Total
Oregon 5.49 5.06 3.47 4.67
Virginia 7.84 6.07 4.16 6.26
National Average 8.40 7.69 4.66 6.89
Maryland 8.43 6.91 4.23 7.06
DC 7.62 7.15 4.36 7.12
Maine 12.51 10.28 6.65 9.49
California 11.61 10.49 7.37 9.91
New York 13.90 11.92 5.79 11.06
Source: Energy Information Administration, Electric Sales and Revenue 1995, DOE/EIA-0540(95), Washington DC, December 1996.

Natural gas prices in the District of Columbia tend to be somewhat over the national average, so there could be slightly greater improvements in gas prices for District consumers in this industry. However, mitigating against this prospect is the fact that much of the higher price for natural gas can be traced to the high tax burden on natural gas in the District compared, at least, to the parallel tax burden in surrounding jurisdictions, a cause which competition does not, in and of itself, affect.

The overall implication of these statistics is that the District is a relatively low cost power supplier even with the present tax structure, and that deregulation will not greatly reduce energy prices.

Prices and Taxes under Deregulation in DC

PEPCO officials feel that there would be little reduction in electricity prices due solely to deregulation and competition because the District already has very low rates.(25) If rates (1) tend toward uniformity across the nation because of competition and (2) District rates are currently below or near the national mean, then there may be very small changes in the District electric prices compared to states where there are currently relatively high prices. Prospective declines in natural gas prices are also not likely to be great. What would be the tax revenue consequences of such relatively small declines?

If prices decline and the quantity consumed remains absolutely constant, then a hypothetical 10% decline in the price of electricity would lead to a 10% decline in gross receipts tax revenue from PEPCO, or a reduction of approximately $7.4 million in tax receipts. However, price reductions usually induce increases in consumption of most products. PEPCO officials believe that there is very little price elasticity in the demand for electricity in the District, however, and the Energy Information Administration agrees that the short-run price elasticity of the demand for electric power tends to be quite low, on the order of -0.15(26). Thus, for every 10% reduction in price, there would be only an increase of 1.5% in consumption, for a net reduction in tax revenues due to such a hypothetical price reduction of approximately 8.5% or $5.4 million.(27)


VIII. IMPLICATIONS FOR TAXES AND REVENUES

Restructuring of the energy utilities creates a problem for tax revenue collection for the District of Columbia. The current tax structure was designed to collect taxes from the local energy companies that operated as regulated monopolies in the city. Under this regime, tax officials needed not to concern themselves with the dynamics of taxing out-of-state electricity and natural gas suppliers.

Today, the rules of the industry is changing. DC is considering opening the city up to retail electricity competition, and has already done so with regard to natural gas. Without structural changes to the tax code that applies the energy utilities, negative effects could occur, e.g.,

  • DC could see a shortfall in utility revenue because the gross receipts tax may not be applicable to out-of-state-suppliers, who may obtain a tax-related cost advantage and thus improve their market share at the expense of D.C. based utilities; and
  • PEPCO and Washington Gas could be subject to gross receipts tax that would work to competitively disadvantage them relative to competing suppliers.

With this in mind and assuming deregulation occurs, there appears to be several options to be considered.

  • The District can keep the its present tax structure as it relates to electricity. This option would mean that the District would accept the losses in tax revenues and tax the local supplier in a manner that could impede it from potentially competing fairly in a national restructured market.
  • The District can do for the local electric power market what it did for the local natural gas market which is to extend the gross receipts tax, through a change in legislation, to out-of-state suppliers. While this approach seems relatively simple, there are some repercussions that must be considered. The U.S. Constitution states that in order for a state or local taxing authority to exercise the power any type of tax on a taxpayer, it is necessary to establish nexus (i.e. that the business to be taxed have a presence in the state). This condition calls into question the validity of the position of the D.C. City Council in the case of natural gas. The District is not alone is making this attempt; Pennsylvania has required all who sell electricity to Pennsylvania customers in a pilot retail wheeling program to register with the state, and as part of that registration the seller must agree to pay the state gross receipts tax on revenues.
  • The District could establish a tax on imported electricity and gas based on the kilowatt hour, therms, or BTUs, set at a level that would replace lost tax revenues and fees. In this option, the nexus issue remains, and in addition, the District might face a court challenge based on the interstate commerce commission clause of the Constitution, which might make such a tax illegally discriminatory because it restrains interstate trade.
  • The District could implement its recently-enacted tax on the use of the public rights-of-way by companies which market energy since electricity and gas both use such rights-of-way to reach customers through distribution companies. Such a tax would in all likelihood be best collected by the local distribution companies from either directly handling all billing and collections in the system, or by assessing companies which supply energy an additional access fee proportional to their use of the public rights-of-way, collecting such taxes, and delivering them to city authorities.
  • The District could institute a BTU sales/BTU use tax, and/or a tax on the public right of way, and reduce but not eliminate the gross receipts tax to take a middle position and maintain revenue neutrality. The BTU sales/BTU use tax (or other consumption tax on energy) could be levied on power purchased from any provider, within or outside the District of Columbia, since it is levied in principle on the consumer, even if it is collected by one or more company(ies). As in the case of the sales tax, however, the federal government and non-profit organizations in the District may be able to avoid payment as a result of their tax exemption. They would have more difficulty obtaining exemption if the tax is placed on the use of the public right-of-way by companies, which would then pass on the bulk of the tax to consumers, including those exempt from sales taxes. By maintaining the gross receipts tax at a lower level, some indirect tax collection from the federal government and non-profits could be maintained. Any gross receipts tax which could not be levied against out-of-state suppliers would tilt the playing field against DC based providers.

IX. ADMINISTRATION AND COMPLIANCE

With competition evolving in the energy industries, tax administration and collection becomes more complex and costly. Moving from a single provider in each of the energy utility industries to multiple providers may create added administrative burdens for the Office of Tax and Revenue.

The first option is that the local energy distributors (PEPCO and Washington Gas) could be made legally responsible for collecting all revenues from all customers in the District in a consolidated billing system, for delivering all tax revenues from such collections to the District government, and for dispersing the remaining revenues to the appropriate providers. The challenge which could emerge is that the unbundling process in both electricity and natural may lead to the separation of, among other functions, metering, billing, and customer service from the regulated entity. Outside firms could compete for these functions, and the local distributor may not retain them as part of their regulated functions. It would be inequitable to make the local regulated distributor legally responsible for paying all taxes if a separate corporate entity were to carry out the billing and collection function.

In addition, to the extent that existing energy companies create marketing subsidiaries, as Washington Gas has done with WGES, it may be undesirable for the distribution company to be required to collect taxes for all energy marketers using the distribution system. Customers may have a negative reaction to Washington Gas, for example, insofar as that company collects the tax on gas purchases from all gas customers, they might be less inclined to purchase their gas from WGES, which has a name very similar to the tax collecting distributor company. Thus, such a policy could devalue the corporate name and reduce company assets accordingly.

The second option is to treat each energy provider as a separate firm responsible for paying its own taxes. This option would involve increased administrative costs for the District government, such as the expense and uncertainty of sending tax auditors and administrators to many distant corporate offices instead of to one local company. Moreover, the opportunities for tax evasion in an industry with a non-trivial turnover rate among many relatively small firms, many of which would be physically located well beyond the borders of the District of Columbia, are qualitatively greater than those associated with a single, local, large, stable firm.


1. In preparing this report, many sources have been consulted, including senior officials of the regulated gas and electric industries in the District of Columbia. All recommendations and analysis remain the responsibility of the authors and should not be construed to represent the position of any other party.

2. The City Council extended the gross receipts tax to natural gas providers which are not DC-based approximately a year ago, however, and has been collecting these revenues.

3. A concrete version of this problem is now confronting the State of Maryland, which has undertaken a pilot retail wheeling program for electricity for up to 1/3 of the state's customers without having undertaken any tax reform. If the customers in the pilot program choose out-of state electricity suppliers, tax revenues from Maryland's 2% gross receipts tax will fall precipitously. Tax reformers are recommending that a consumption tax be put in place to prevent a tax revenue shortfall and to maintain horizontal equity among electricity providers.

4. They currently pay their share of the gross receipts tax indirectly since the levy is considered part of the costs of the utilities and is embodied in the rate base paid by all customers.

5. The State of Pennsylvania, in a pilot project, has required that out-of-state providers of electricity who wish to market their electricity in Pennsylvania register with the state authorities and sign an agreement to pay gross receipts taxes. Additionally, such companies are required to open an office in the State, thus providing legal nexus. Thus far several companies have agreed to these terms and are paying taxes to the state.

6. Such a tax has been approved in the District, and is awaiting administrative implementation. As it currently stands, such a tax would be in addition to the gross receipts taxes, increasing tax revenues but exerting negative competitive effects on DC-based energy companies.

7. Interestingly, New Jersey plans such a tax transition in electricity, with a 5 year special transitional tax which would be reduced to zero at the end of the period. State authorities expect to make up the tax revenue shortfall through economic growth, and have no plans for new taxes to replace the tax on electricity.

8. There is no theoretical reason that tax revenue neutrality should be observed within the industries constituting the energy sector, especially to the extent that such industries become more similar to other industries through deregulation.

9. It is likely that, for a few years, there will be large numbers of entrepreneurial energy marketers entering the gas and electric industries. As in most industries, there will also likely be a subsequent shakeout and consolidation of the industry. In the interim, compliance issues may be quite significant.

10. Both PEPCO and Washington Gas executives state that their companies remain fully committed to their existing programs as part of their role as good corporate citizens of the District regardless of the possible effects of deregulation and restructuring. The point here is that significant new economic pressures on the companies associated with restructuring will make it more difficult for them to maintain these commitments.

11. There is a perennial regulatory debate over whether the rate of return approved by the regulatory body is guaranteed to the company or merely a ceiling on their earnings. As a practical matter, the companies generally obtain the approved rate of return. As part of the transition to competition, many utilities are calling for incentive regulation to replace existing rate of return regulation.

12. Whether PEPCO would continue to use average cost pricing for rate setting or marginal cost pricing in a new competitive environment would depend greatly on the restructured regulatory environment. In any case, for present discussion, the higher taxes would still keep PEPCO's prices higher than its lesser-taxed competitors.

13. The total includes unemployment and PSC fees as well as other taxes.

14. Washington Gas pays much less of its tax bill to Maryland and Virginia in the form of gross receipts tax, which account for approximately 33% of the taxes it pays to the State of Maryland and 47% to the State of Virginia. PEPCO similarly pays much less to Maryland. This differential is accounted for, in part, by the personal property tax exemption in the District and the higher gross receipts tax rate charged in the District compared to the two surrounding states. An important implication of such tax policy differentials between jurisdictions is that, with increasingly competitive industries, energy companies (especially marketers) will locate their offices where the net tax advantages are the greatest.

15. This exemption is the formal rationale for the gross receipts tax.

16. The lease expires in 2002 and will not be renewed. PEPCO had planned to build a new $80 million office building in the District which would have been taxable as part of the merger proposal with BGE. Such plans are now in abeyance due to the withdrawal of the merger proposal.

17. Because the legislation requires that the utilities pay a tax on all revenues it collects, there is in effect a tax on a tax, leading to the higher effective rate.

18. Utility property falls under class IV property which is assessed at $2.15 per $100 of value.

19. The disadvantage to such a change in the District of Columbia is the fact that, unlike the situation in other states, the federal government and non-profit organizations make up a considerable share of the electricity market and are exempt from consumption taxes. Since the gross receipts tax is levied on the supplier, not the consumer, utilities pass on these tax costs to the federal government and non-profit entities, thus circumventing this exemption.

20. But if the gross receipts tax on regulated utilities were retained as well, the NUGs would gain a significant cost advantage over regulated utilities, leading to a loss of market share by the regulated entity and hence a fall in revenues collected from the gross receipts tax. A leveling approach might be to impose a tax on sales of electricity to District residents from outside the District, but significant legal difficulties would confront efforts to impose any such tax due to the interstate commerce clause, even though such an "import tax" would create an economically level playing field by offsetting the tax advantage held by non-regulated firms not subject to the gross receipts tax.

21. The short run elasticity, or responsiveness, to such price changes is very small, so the net effect of a higher tax would in all likelihood be substantial increases in tax revenues.

22. Office of the People's Counsel, Initial Comments, Formal Case No. 945, Public Service Commission of the District of Columbia, In the Matter of the Investigation into Electric Services, Market Competition, and Regulatory Policies, January 24, 1997.

23. In fact, the District may lose in terms of economic development as a result of competition nationally, as the price of electricity in other areas will fall relative to that in the District, tending to reduce even further the District's relative attractiveness to energy intensive economic activities such as manufacturing. See Office of the People's Counsel, op.cit.

24. This apparently counter-intuitive fact is due to the large share of residential and commercial customers compare to industrial customers in the District of Columbia compared to other parts of the country.

25. The State Assembly in the State of California is so confident that there will be reduced costs of electric power in a competitive electricity market in their high-cost state, especially for industrial consumers, that it included in its electricity restructuring legislation a requirement for a 10% rate reduction for residential users and small businesses effective January 1, 1998 to ensure that those customers receive some immediate benefit from utility restructuring. The goal of the legislation is to further reduce residential rates by an additional 10 percent at the close of a five year transition period in 2002. It is unlikely, however, that such substantial price reductions would occur in the District of Columbia, and so there is less danger of a major fall in tax revenues from this source alone.

26. Energy Information Administration, Electricity Prices in a Competitive Environment: Marginal Cost Pricing of Generation Services and Financial Status of Electric Utilities -- A Preliminary Analysis Through 2015, DOE/EIA-0614, Washington, DC, August 1997, p. 24 uses this value for its "Moderate Consumer Response Case" forecast. Studies on this issue over the years support a generally low value. See, for example, New Jersey Board of Public Utilities, Joint Task Force Report on Energy Tax Policy, Attachment C, November 1996, and Rodney D. Green et al., "The Demand for Heating Fuels: A Disaggregated Modeling Approach", Atlantic Economic Journal 14 (December 1986): 4, pp.1-14.

27. These findings are consistent with the U.S. Department of Energy's (DOE's) forecast for electricity prices in a competitive environment. DOE's projections were made using the National Energy Modeling System (NEMS) and a prototype version of the Value of Capacity (VALCAP) model, given certain assumptions. Their findings under various different scenarios (all of which exclude recovery of stranded cost through prices) suggested that electricity prices in all cases would be lowered. The price reductions described in the competitive cases are in addition to the price reductions that are already occurring due to the current level of limited competition in the wholesale market for electric power and the expectation of a higher level of competition in the future. See Energy Information Administration, Electricity Prices in a Competitive Environment, pp. 101-103   


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