FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman, Senator Baucus, and distinguished Members of the Subcommittee:

I appreciate the opportunity to discuss with you today the Federal income tax issues relating to proposals to encourage the creation of public open spaces in urban areas and the preservation of farm and other rural lands for conservation purposes as well as Federal income tax issues relating to proposals to lower U.S. dependency on foreign oil used in transportation fuels (including tax incentives to promote the use of alternative fuel vehicles and to increase domestic oil production). The first part of my testimony will focus on the Administration's proposed tax incentives to help build livable communities. I will then discuss the Administration's proposals for lowering U.S. dependency on foreign oil. I would like to begin by thanking the Chairman and Senator Baucus for their leadership on these issues.

Earlier this year, in the Administration's budget for FY 2001, the President proposed initiatives to help build livable communities for the 21^st century. These initiatives aim to provide communities with tools, information, and resources they can use to enhance the quality of life of their residents, enhance their economic competitiveness, and build a stronger sense of community. For example, the Administration proposed a new financing tool -- Better America Bonds -- to help preserve green space, improve water quality, and revitalize communities for future generations. The Administration proposal would make available a total of $10.75 billion in bond authority over 5 years for investments by State, local, and tribal governments to preserve green space, create or restore urban parks, protect water quality, and clean up abandoned industrial sites. The revenue cost of the Better America Bonds proposal is estimated to be $690 million over 5 years. The Administration also proposed to make permanent the tax incentive to clean up brownfields in low-income communities and other targeted areas, which is scheduled to expire on December 31, 2000. The revenue cost of the brownfields proposal is estimated to be $600 million over five years.

The Administration's budget also included a $4 billion package of tax incentives over 5 years to encourage energy efficiency, reduce greenhouse gas emissions, and develop renewable energy sources. The tax incentives are part of a larger package of complementary initiatives.

In addition to the tax incentives, the Administration's budget includes a $337 million increase in funding for research and development in energy-efficient technology and renewable energy, a new $85 million Clean Air Partnership Fund to boost State and local efforts to reduce air pollution and greenhouse gases, almost $500 million to accelerate efforts to develop clean energy sources both here and abroad, and $1.7 billion in funding for global climate change research. The President's package of research and development funding and tax incentives to address the challenge of climate change totals over $4.1 billion for fiscal year 2001.

In addition to calling for steps to decrease our demand for oil through increased efficiency and increased development of renewable energy resources, the Administration is proposing new steps to support domestic exploration and production, and to lower the business costs of producers when oil prices are low. The Administration's proposals include favorable tax treatment for geological and geophysical costs and delay rental payments. The revenue cost of these tax proposals is estimated to be $750 million over 5 years.

My comments today will focus on an explanation of the Administration's tax initiatives for improving the environment and reducing our dependence on foreign oil.

Americans are concerned that the quality of the environment surrounding their communities is threatened by sprawl, that scenic vistas are being lost, that watersheds are eroding and contaminated, and that public access to outdoor recreation is diminishing.

To address these concerns, the Administration proposed the creation of a new financial tool -- referred to as "Better America Bonds" -- for use by State, local, and tribal governments, often in partnership with nonprofit organizations, to make their communities more livable. Better America Bonds are a tax-credit bond program, similar to the current-law provision for Qualified Zone Academy Bonds. Through the provision of tax credits, the Federal government would, in effect, pay all the interest on Better America Bonds for fifteen years, thereby significantly lowering the cost of financing below that attainable by State, local, and tribal governments issuing traditional tax-exempt bonds. S. 1558, introduced by the Chairman and ranking member of this subcommittee, contains many significant aspects of the Better America Bonds proposal. In fact, the bonds proposed by S. 1558 would be very similar to Better America Bonds, except that under S. 1558 the authority to issue bonds would be allocated by a newly created board, whereas the authority to issue Better America Bonds would be allocated by the Environmental Protection Agency (EPA), as described below. In addition, Mr. Matsui and others have introduced a proposal for Better America Bonds in H.R. 2446. The Administration looks forward to working with Congress to resolve the differences between these bills and the Administration's proposal.

Interest would effectively be paid to holders of Better America Bonds in the form of a credit that could be claimed by the bondholder against Federal income taxes otherwise due. The credit rate would be set by the Treasury Department on a daily basis based on aa corporate yields of comparable maturity. The credit rate set for the day on which the bonds were sold would apply for the life of the bonds. (This method of setting credit rates was established by Treasury regulations for Qualified Zone Academy Bonds sold on or after July 1, 1999.) Issuers of Better America Bonds would pay no interest for the 15-year term of the bonds; their only obligation would be for repayment of principal after 15 years.

The Administration's proposal is designed to enhance the marketability of Better America Bonds by allowing buyers of the bonds to strip the "coupons," in the form of the tax credits, from the obligation to repay principal and sell the two pieces separately, much the same way that Treasury obligations are stripped. This would permit non-taxable entities, such as pension funds and endowments, to benefit from the difference between the current value of the stripped principal and the repayment of principal at par upon redemption, while a taxable investor claims the tax credit.

The proceeds of Better America Bonds could be used for the following purposes:

1. Acquisition of land by State, local, or tribal governments for open space, wetlands, parks, or greenways. Acquired land would be owned by a government or a tax-exempt entity whose exempt purposes include environmental protection.
2. Construction of public access facilities such as campgrounds and hiking or biking trails on publicly owned land or land owned by a tax-exempt entity whose exempt purposes include environmental protection.
3. Improvement of water quality by planting trees or other vegetation, creating settling ponds to control runoff, or remediating conditions caused by the prior disposal of toxic or other waste.
4. Acquisition of permanent easements on privately owned open land that prevent commercial development and any substantial change in the character or use of the land. Such easements could be held by governments or tax-exempt entities.
5. Environmental assessment and remediation of brownfields owned by State or local governments under certain circumstances.
6. Environmental assessment and remediation of property damaged by anthracite coal mining and owned by a State, local, or tribal government or qualifying tax-exempt entity under certain circumstances.

For example, the City of Lewistown, Montana could use Better America Bonds to acquire land for parks, open space, and trail systems. Other Montana municipalities could issue Better America Bonds to acquire land along rivers, such as the Missouri and the Yellowstone, in order to preserve the natural structure, reduce erosion, and protect the water quality. In Utah, Better America Bonds could be used to preserve the Bonneville Shoreline Trail in the Wasatch Mountains. In addition, Salt Lake City could use Better America Bonds in its Park Blocks development, in furtherance of its plan to create green space, pathways and park facilities to support significant economic development.

In general, property acquired with the proceeds of Better America Bonds would be available only for public use and use by tax-exempt entities, but not private use. The one exception is with respect to remediated brownfields and certain property damaged by coal mining, which could be sold to a private entity for private development, with the sale proceeds made available to repay principal.

Owners of property financed with Better America Bond proceeds generally would be required to covenant not to convert the property to a nonqualifying use without first offering the property for sale to tax-exempt entities at a price that does not exceed the original value of the property. A tax-exempt purchaser would be required to hold the property in its qualifying use in perpetuity.

The Administration proposes $2.15 billion of authority to issue Better America Bonds each year for 5 years beginning in 2001 (i.e., a total of $10.75 billion of bond authority). Of the total authorization, $50 million per year would be available with respect to property damaged by anthracite coal mining under special allocation rules. The EPA would administer an annual, open competition among State, local, and tribal governments for authority to issue these bonds, subject to published EPA guidelines.

Projects qualifying for Better America Bonds, with the exception of remediated brownfields and damaged coal property converted to private use, could be financed by tax-exempt bonds under current Federal tax law. Indeed, States and localities occasionally use tax-exempt bonds for these purposes. But more needs to be done. Benefits from environmental projects are often so diffused over time and distance that taxpayers within particular local jurisdictions are reluctant to finance such projects with conventional tax-exempt bonds. Better America Bonds would provide a deeper subsidy than tax-exempt bonds in order to induce State and local governments to undertake beneficial environmental infrastructure projects. The revenue cost of the proposal is estimated to be $690 million for FY 2001 - 2005.

Compared to traditional tax-exempt bonds, Better America Bonds would significantly reduce the financing costs to local taxpayers of environmental projects. For example, annual payments of principal and interest on a traditional 30-year, 6-percent, $10 million tax-exempt bond issue would be about $726,000. In comparison, the annual payments into a sinking fund earning 6.5 percent that would repay after 15 years the $10 million principal of an issue of Better America Bonds would be about $414,000. A State or local government issuing the bonds would thus save about $312,000 per year over the initial 15 years, and $726,000 per year over the remaining 15 years of a 30-year issue's term. Better America Bonds would cost state and local governments only about half of what a tax-exempt bond would (in present value terms). This is a powerful tool for financing investments to make our communities better.

Better America Bonds not only would provide a deeper subsidy to State and local governments than tax-exempt bonds, they also would be more efficient. With Better America Bonds, the Federal government would pay the issuer's interest costs in the form of a tax credit to the bondholders. The issuer would receive the full benefit of the Federal subsidy.

By contrast, the revenue loss to the Federal government from tax-exempt bonds exceeds the amount of the subsidy to State and local governments. The subsidy from a tax-exempt bond depends on market factors, and is equal to the debt service savings a State or local government realizes by borrowing at a tax-exempt, rather than a taxable, interest rate. The large volume of outstanding tax-exempt bonds has increased tax-exempt interest rates generally, which has reduced the subsidy provided by tax-exempt bonds to amounts significantly below the cost to the Federal government.

Brownfields are abandoned or underutilized properties where redevelopment is complicated by known or suspected contamination. Because lenders, investors, and developers fear the high and uncertain costs of cleanup, they avoid developing contaminated sites. Blighted areas of brownfields hinder the redevelopment of affected communities and create safety and health risks for residents. The obstacles in cleaning these sites, such as regulatory barriers, lack of private investment, and contamination and remediation issues, are being addressed through a wide range of Federal programs that includes the tax incentive for brownfields remediation.

To encourage the cleanup of contaminated sites, the Administration proposed, and the Congress enacted in the Taxpayer Relief Act of 1997, a brownfields tax incentive that permits the current deduction of certain environmental remediation costs. Environmental remediation expenditures qualify for current deduction if the expenditures would otherwise be capitalized and are paid or incurred in connection with the abatement or control of hazardous substances at a qualified contaminated site. A qualified contaminated site must be located within a targeted area, i.e., census tracts with at least 20-percent poverty rates (and certain contiguous industrial or commercial tracts), designated Empowerment Zones and Enterprise Communities, and the 76 EPA brownfields pilot projects designated before February 1997. In order to claim a current deduction, the taxpayer must obtain a statement from a designated State environmental agency that the qualified contaminated site satisfies the statutory geographic and contamination criteria of a brownfield. The provision applies to qualified environmental remediation expenditures paid or incurred in taxable years ending after August 5, 1997, and before January 1, 2002.

Many taxpayers are unable or unwilling to undertake long-term remediation projects based on the current-law, temporary incentive because environmental remediation often extends over a number of years. For that reason, the Administration's budget proposed a permanent extension of the brownfields tax incentive. That proposal was introduced by Mr. Coyne and several cosponsors as H.R. 1630.

Reclaiming brownfields would encourage the redevelopment of targeted communities by making unused or underutilized land productive again. Extending the special current-law rule on a permanent basis would eliminate uncertainty regarding the future availability of the incentive and encourage long-range investment in the targeted areas. The revenue cost of the proposal is estimated to be approximately $536 million for FY 2001 - 2005. Treasury estimates that the tax incentive would induce an additional $7 billion in private investment to return 18,000 brownfields to productive use over the next ten years.

Oil is an internationally traded commodity with its domestic price set by world supply and demand. Domestic exploration and production activity is affected by the world price of crude oil. Historically, world oil prices have fluctuated substantially. From 1970 to the early 1980s, there was a fivefold increase in real oil prices. World oil prices were relatively more stable from 1986 through 1997. During that period, average annual refiner acquisition cost (composite) ranged from $14.83 to $23.74 per barrel in real 1992 dollars. In 1998, however, oil prices declined to about $11.15 per barrel at the refiner in real 1992 dollars, their lowest level in 25 years in real terms. Since 1998, the decline has reversed with refiner acquisition costs (in nominal dollars) rising to about $17.50 per barrel in 1999 and to over $28 per barrel in March 2000. Although March is the latest month for which composite figures are available, the price of West Texas intermediate crude on the spot market was nearly $31 per barrel on July 20, 2000.

Domestic oil production has been on the decline since the mid-1980s. From the late 1970s to the mid 1980s, oil consumption in the United States also declined, but in the last decade oil consumption has risen by nearly 12 percent. The decline in oil production and increase in consumption have led to an increase in oil imports. Net petroleum imports have risen from approximately 42 percent of petroleum products supplied in 1989 to 51 percent in 1999. The volatility of crude oil prices over the past year has focused attention on the economic condition of the oil and gas industry, the increasing U.S. dependence on foreign oil supplies, and the prospects for reducing reliance on oil imports.

The strong performance of our economy over the past year, despite oil price rises, underscores the dramatic improvements in energy efficiency we have achieved over the past quarter century. While past oil shortages have taken a significant toll on the U.S. economy, the recent increases in oil prices have yet to have a major impact on the economy. Increased energy efficiency in cars, homes, and manufacturing has helped insulate the economy from these short-term market fluctuations. In 1974, we consumed 15 barrels of oil for every $10,000 of gross domestic product. Today, we consume only 8 barrels of oil for the same amount of economic output.

We can, however, do more to minimize the effect of future energy price increases and reduce our dependence on foreign oil. One essential element of national energy security is a comprehensive and balanced program of tax incentives. These must include both support for domestic oil producers to reduce our reliance on oil imports and incentives for energy efficiency and renewable and alternative energy sources. While current law provides substantial tax incentives for domestic oil and gas production and some incentives for energy efficiency and renewable and alternative energy, the Administration proposes to do more in both areas.

Individuals and businesses do not invest enough in energy-saving technologies that produce benefits to society in excess of their private returns. If a new technology reduces pollution or emissions of greenhouse gases, those "external benefits" should be included in the decision about whether to undertake the investment. But potential investors have an incentive to consider only the private benefits in making decisions. Thus, they avoid technologies that are not profitable even though their benefits to society exceed their costs. Tax incentives can offset the failure of market prices to signal the desirable level of investment in energy-saving technologies because they increase the private return from the investment by reducing its after-tax cost. The increase in private return encourages additional investment in energy-saving technologies.

Tax incentives currently provide a limited amount of support for energy-efficiency improvements and increased use of renewable and alternative fuels. Current incentives in the form of tax expenditures are estimated to total $5.8 billion for fiscal years 2001 through 2005. They include a tax credit for electric vehicles and expensing for clean-fuel vehicles and clean-fuel refueling property ($460 million), a tax credit for the production of electricity produced from wind or biomass and a tax credit for certain solar energy property ($625 million), an exclusion from gross income for certain energy conservation subsidies provided by public utilities to their customers ($560 million), and an income tax credit or partial excise tax exemption for ethanol and renewable source methanol used as automobile fuel ($4.2 billion).

A 10-percent tax credit is provided for the cost of a qualified electric vehicle, up to a maximum credit of $4,000. A qualified electric vehicle is a motor vehicle that is powered primarily by an electric motor drawing current from rechargeable batteries, fuel cells, or other portable sources of electric current, the original use of which commences with the taxpayer, and that is acquired for use by the taxpayer and not for resale. The full amount of the credit is available for purchases prior to 2002. The credit begins to phase down in 2002 and does not apply to vehicles placed in service after 2004.

Certain costs of qualified clean-fuel vehicles and clean-fuel vehicle refueling property may be deducted when such property is placed in service. Qualified electric vehicles do not qualify for the clean-fuel vehicle deduction. The deduction begins to phase down in 2002 and does not apply to property placed in service after 2004.

A 1.5-cent-per-kilowatt-hour tax credit is provided for electricity produced from wind, "closed-loop" biomass (organic material from a plant that is planted exclusively for purposes of being used at a qualified facility to produce electricity), and poultry waste. The electricity must be sold to an unrelated third party and the credit is limited to the first 10 years of production. The credit applies only to facilities placed in service before January 1, 2002. The credit amount is indexed for inflation after 1992.

A 10-percent investment tax credit is provided to businesses for qualifying equipment that uses solar energy to generate electricity, to heat or cool or provide hot water for use in a structure, or to provide solar process heat.

Subsidies provided by public utilities to their customers for the purchase or installation of energy conservation measures are excluded from the customers' gross income. An energy conservation measure is any installation or modification primarily designed to reduce consumption of electricity or natural gas or to improve the management of energy demand with respect to a dwelling unit.

Ethanol and renewable source methanol used as a highway fuel may qualify for either an income tax credit or a partial exemption from the excise tax on highway fuel. The income tax credit is generally 54 cents per gallon for ethanol and 60 cents per gallon for renewable source methanol. As an alternative to the income tax credit, gasohol blenders may claim a gasoline tax exemption of 54 cents for each gallon of ethanol and 60 cents for each gallon of renewable source methanol that is blended into qualifying gasohol. Slightly lower credits and exemptions apply in years after 2000 and both the credit and the exemption are scheduled to expire in 2005. The favorable tax treatment of ethanol increases national energy security by reducing the demand for imported oil and U.S. dependence on foreign oil sources.

In addition to the tax incentives described above, a tax ranging from $1,000 to $7,700 per vehicle is imposed on gas-guzzling automobiles (automobile models with a fuel economy of less than 22.5 miles per gallon).

The Administration has proposed tax incentives designed to reduce energy consumption and greenhouse gas emissions by encouraging the deployment of technologies that are highly energy efficient and that use renewable and alternative energy sources. The proposed incentives also are designed to minimize windfalls for investments that would have been made even absent the incentives and to facilitate tax administration. The design of the tax incentives incorporates the following considerations:

The tax incentives the Administration has proposed cover vehicles, buildings and homes, renewable energy, and industrial equipment. The proposed incentives will encourage businesses and consumers to increase their investment in energy-efficient items, new technologies, and renewable and alternative energy sources. The investments induced by the credits would be long-lived and, therefore, would produce energy savings and greenhouse gas reductions for many years after the investment is undertaken. The induced increase in the market penetration of energy-efficient technologies, new technologies, and renewable energy sources may lead to lower cost production and increased awareness of the benefits of such technologies that could have lasting effects.

Reductions in greenhouse gas emissions, however, are not the only benefits that will be realized from these incentives. The incentives will also reduce local air pollution. In addition, the proposals will produce private benefits, such as energy savings for consumers and businesses.

Vehicles

Cars and light trucks (including minivans, sport utility vehicles, and pickups) currently account for 20 percent of greenhouse gas emissions. Those vehicles also account for about 20 to 40 percent of urban smog-forming emissions and 40 percent of total U.S. petroleum consumption. Almost all cars and light trucks use a single gasoline-fueled engine.

Hybrid vehicles, which have more than one source of power on board, and electric vehicles have the potential to reduce greenhouse gas emissions, air pollution, and petroleum consumption. The proposed credits will encourage the purchase of vehicles that incorporate advanced automotive technologies and will help to move advanced hybrid vehicles currently under development from the laboratory to the highway. These vehicles can significantly reduce emissions of carbon dioxide, the most prevalent greenhouse gas.

The proposal would extend the present tax credit for electric vehicles and fuel cell vehicles. Under current law, a 10-percent credit is provided for the cost of qualified electric vehicles and fuel cell vehicles up to a maximum credit of $4,000. The maximum amount of the credit is scheduled to phase down in 2002 and be phased out in 2005. The President's proposal would extend the tax credit at its $4,000 maximum level through 2006.

The proposal also would provide new tax credits of $500 to $3,000 for certain hybrid vehicles, depending upon requirements for the vehicle's design and performance. A qualifying hybrid vehicle is a road vehicle that can draw propulsion energy from both of the following on-board sources of stored energy: (1) a consumable fuel, and (2) a rechargeable energy storage system. The tax credits would be available for vehicles purchased during the period 2003 through 2006. The credit amounts -- available for all qualifying vehicles, including cars, minivans, sport utility vehicles, and pickup trucks -- would be:

• $500 if the rechargeable energy storage system provides at least 5 percent but less than 10 percent of the maximum available power;
• $1,000 if the rechargeable energy storage system provides at least 10 percent but less than 20 percent of the maximum available power;
• $1,500 if the rechargeable energy storage system provides at least 20 percent but less than 30 percent of the maximum available power; and
• $2,000 if the rechargeable energy storage system provides 30 percent or more of the maximum available power.

If the vehicle actively employs a regenerative braking system, the amount of the credit shown above would be increased by:

• $250 if the regenerative braking system supplies to the rechargeable energy storage system at least 20 percent but less than 40 percent of the energy available from braking in a typical 60 miles per hour (mph) to 0 mph braking event;
• $500 if the regenerative braking system supplies at least 40 percent but less than 60 percent of such energy to the storage system; and
• $1,000 if the regenerative braking system supplies 60 percent or more of such energy to the storage system.

Hybrid vehicles eligible for the largest credit would be 50 percent to 100 percent more fuel efficient than a conventional vehicle of the same size and power. Doubling a car's fuel economy reduces its emissions of carbon dioxide by about 50 percent. The revenue cost of this initiative is estimated to be about $2.1 billion for FY 2001 - 2005. These credits are estimated to result in purchases of 17 million electric and hybrid vehicles through 2010.

This sector currently accounts for about one-third of energy consumption and the related greenhouse gases. The proposed tax incentives would encourage investment in highly energy-efficient building equipment and new homes, and solar energy systems.

A tax credit of 20 percent would be provided for energy-efficient equipment that will improve the energy efficiency of both residential and commercial buildings. The items covered are electric heat pump water heaters, natural gas heat pumps, and fuel cells. The credit would be 20 percent of the cost of the equipment, subject to a cap. It would be available for the period 2001 through 2004.

Items eligible for the credit are top-tier technologies that are much more energy efficient than conventional equipment. For example, compared to typical units on the market, the eligible electric heat pump water heaters and natural gas heat pumps are about twice as efficient. Items eligible for this credit embody new, cutting-edge technologies that have substantial purchase prices and that are limited in their cost effectiveness. They generally account for less than one percent of market sales. Therefore, the credits would benefit very few purchases that would have been made absent the credit. Some makes and models of qualifying items are currently available. Existing energy efficiency standards for the designated heat pump water heaters and natural gas heat pumps have been used to define eligible items precisely enough for IRS to administer the credit.

The revenue cost of this incentive is estimated to be $201 million for FY 2001 - 2005. The credit is estimated to result in purchases of nearly 2 million items of highly energy-efficient building equipment through 2010.

Residences account for about one-sixth of U.S. greenhouse gases and offer one of the largest sources of energy saving potential. Over one million new homes and manufactured homes are built and sold each year. Some States and certain Federal programs require new houses to meet certain energy code standards for insulation and related construction standards, and for heating, cooling and hot water equipment. However, the energy efficiency of new homes could be improved significantly through the use of more energy-efficient building practices and more efficient heating and cooling equipment that exceed current efficiency standards.

A tax credit equal to $1,000 to $2,000 (depending upon the home's energy efficiency) would be provided to encourage consumers to purchase energy-efficient new homes. The tax credit would be: (1) $1,000 for homes that use at least 30 percent less energy than the standard under the 1998 International Energy Conservation Code (IECC) -- this credit would be available for homes purchased during the period 2001 through 2003; and (2) $2,000 for homes that use 50 percent less energy than the IECC standard -- this credit would be available for homes purchased during the period 2001 through 2005.

Homes qualifying for the credit would use 75 percent to 85 percent less energy than existing housing and as much as 50 percent less energy than typical new housing. The revenue cost is estimated to be $633 million for FY 2001 - 2005. The credit is estimated to result in purchases of over 400 thousand new energy-efficient homes through 2010.

Solar energy systems accounted for 0.025 percent of electricity generation in 1998. These systems produce no greenhouse gas emissions. To encourage use of these systems, a tax credit would be provided for the purchase of rooftop photovoltaic (PV) systems and solar water heating systems equal to 15 percent of the cost up to a maximum credit of $2,000 for PV systems and $1,000 for solar water heating systems. The tax credit for PV systems would be available for the period 2001 through 2007 and the tax credit for solar water heating systems would be available for the period 2001 through 2005.

The revenue cost of this incentive is estimated to be $132 million for FY 2001 - 2005. This incentive will help to achieve the President's goal of one million solar energy roofs by 2010. The credit is estimated to reduce electricity demand from nonsolar sources by 3 billion kilowatt hours through 2010.

Wind and biomass currently account for about 2 percent of electricity generation from renewable sources. These renewable energy sources produce virtually no greenhouse gas emissions. Methane gas, which has approximately 21 times the greenhouse gas effect as carbon dioxide, accounts for about 10 percent of the warming caused by U.S. emissions. Methane from landfills, the single largest source of methane emissions, accounted for 37 percent of total U.S. methane emissions in 1997. To make electricity produced from wind and biomass price competitive with other forms of electricity generation, the proposal would extend the current-law tax credit for wind and biomass, expand eligible biomass sources and facilities, and allow a credit for electricity produced from cofiring biomass with coal. The proposal also would provide a tax credit for electricity produced from methane from landfills.

The proposal would extend and expand the tax credit for electricity produced from wind and biomass. It would:

• Extend the current wind and biomass credit for 2.5 years to cover facilities placed in service before July 1, 2004.
• Expand the definition of eligible biomass for the present credit beyond closed-loop biomass to include certain forest-related resources and agricultural and certain other sources. This change would apply to facilities placed in service after December 31, 2000, and before January 1, 2006.
• Expand eligible biomass for existing facilities. The proposal adds a 1-cent-per-kilowatt-hour credit for electricity produced from the newly eligible sources for biomass facilities that were placed in service before January 1, 2001. The credit would be available for electricity produced from biomass after December 31, 2000, and before January 1, 2003.
• Allow cofiring biomass with coal. This proposal adds a 0.5-cent-per-kilowatt-hour tax credit for electricity produced by cofiring biomass in coal plants after the date of enactment and before July 1, 2004. This credit would be adjusted for inflation after 2000. Only the portion of electricity associated with biomass would be eligible for the credit.
• Allow methane from landfills. The proposal adds a tax credit for electricity produced from landfill methane for the first ten years of production if the facility is placed in service after December 31, 2000, and before January 1, 2006. The credit would equal 1.5 cents per kilowatt hour for facilities at landfills that are not subject to EPA's 1996 New Source Performance Standards/Emissions Guidelines (NSPS/EG) and 1 cent per kilowatt hour for facilities at landfills that are subject to NSPS/EG. These credits would be adjusted for inflation after 2000.

The revenue cost of this incentive is estimated to be $976 million over FY 2001 - 2005.

This incentive is estimated to increase electricity production from renewable energy sources and methane by 80 billion kilowatt hours through 2010.

Distributed power technologies have made it possible to place electrical generation assets in or adjacent to commercial establishments and residential rental properties, as well as in industrial establishments. These technologies can be more energy efficient and generate fewer greenhouse gases than conventional electrical generation methods. Under current law, distributed power assets used in a commercial or residential building are likely to be depreciated over much longer lives than are similar assets used to produce process energy in an industrial setting. Also, because the current asset classification system predates the development of these technologies and the era of electricity deregulation, there are ambiguities regarding the proper classification of distributed power property. The proposal would simplify current law by clarifying and rationalizing the assignment of recovery periods to distributed power property, including property used to produce both electricity and useful heat and mechanical power. It would reduce taxpayer uncertainty and controversy in this area, and would promote the use of these more efficient technologies.

Distributed power property placed in service after the date of enactment would be assigned a 15-year depreciation recovery period and a 22-year class life. For this purpose, distributed power property would include only (1) property used in the generation of electricity for primary use in nonresidential real property or residential rental property used in the taxpayer's trade or business, and (2) property with a rated total capacity in excess of 500 kilowatts that is used in the generation of electricity for primary use in a taxpayer's industrial manufacturing process or plant activity. It must be reasonably expected that no more than 50 percent of the electricity produced from distributed power assets would be sold to, or used by, unrelated persons. Distributed power property may also be used to produce usable thermal energy or mechanical power for use in a heating or cooling application, subject to certain restrictions.

The revenue cost of this provision is estimated to be $10 million for FY 2001 - 2005.

The importance of maintaining a strong domestic energy industry has been long recognized and the Internal Revenue Code includes a variety of measures to stimulate domestic exploration and production. The tax incentives contained in present law address the drop in domestic exploratory drilling that has occurred since the mid-1950s and the continuing loss of production from mature fields and marginal properties.

The current tax incentives for oil and gas are intended to encourage exploration and production. They are generally justified on the ground that they reduce vulnerability to an oil supply disruption through increases in production, reserves, and exploration and production capacity. U.S. vulnerability to oil supply disruptions also has been reduced by the growth of oil production outside the Middle East, the establishment of the Strategic Petroleum Reserve, and measures that promote energy conservation and alternative energy sources. In addition, major technological advances in oil exploration, such as three- and four-dimensional seismic drilling, are helping domestic producers find more oil, at greater depths, on and off-shore. At the same time, these technologies have reduced the environmental footprint left by exploration and production to 1/10th the size it was 25 years ago.

Preferential tax treatment is an important source of assistance provided by the Federal government to the domestic oil and gas industry. Incentives for oil and gas production in the form of tax expenditures are estimated to total $8.3 billion for fiscal years 2000 through 2005. They include the nonconventional fuels (i.e., oil produced from shale and tar sands, gas produced from geopressured brine, Devonian shale, coal seams, tight formations, or biomass, and synthetic fuel produced from coal) production credit ($3.7 billion), the enhanced oil recovery credit ($2.8 billion), the allowance of percentage depletion for independent producers and royalty owners, including increased percentage depletion for stripper wells ($1.7 billion), the exception from the passive loss limitation for working interests in oil and gas properties ($125 million), and the expensing of intangible drilling and development costs ($5 million). In addition to those tax expenditures, oil and gas activities have largely been eliminated from the alternative minimum tax. These provisions are described in detail below.

Certain costs incurred prior to drilling an oil- or gas-producing property are recovered through the depletion deduction. These include costs of acquiring the lease or other interest in the property, and geological and geophysical costs (in advance of actual drilling). Any taxpayer having an economic interest in a producing property may use the cost depletion method. Under this method, the basis recovery for a taxable year is proportional to the exhaustion of the property during the year. The cost depletion method does not permit cost recovery deductions that exceed the taxpayer's basis in the property or that are allowable on an accelerated basis. Thus, the deduction for cost depletion is not generally viewed as a tax incentive.

Independent producers and royalty owners (as contrasted to integrated oil companies) may qualify for percentage depletion. A qualifying taxpayer determines the depletion deduction for each oil or gas property under both the percentage depletion method and the cost depletion method and deducts the larger of the two amounts. Under the percentage depletion method, generally 15 percent of the taxpayer's gross income from an oil- or gas-producing property is allowed as a deduction in each taxable year. The amount deducted may not exceed 100 percent of the net income from that property in any year (the "net-income limitation"). Additionally, the percentage depletion deduction for all oil and gas properties may not exceed 65 percent of the taxpayer's overall taxable income (determined before such deduction and adjusted for certain loss carrybacks and trust distributions).

A taxpayer may claim percentage depletion with respect to up to 1,000 barrels of average daily production of domestic crude oil or an equivalent amount of domestic natural gas. For producers of both oil and natural gas, this limitation applies on a combined basis. All production owned by businesses under common control and members of the same family must be aggregated; each group is then treated as one producer for application of the 1,000-barrel limitation.

Special percentage depletion provisions apply to oil and gas production from marginal properties. The statutory percentage depletion rate is increased (from the general rate of 15 percent) by one percentage point for each whole dollar that the average price of crude oil (as determined under the provisions of the nonconventional fuels production credit of section 29) for the immediately preceding calendar year is less than $20 per barrel. In no event may the rate of percentage depletion under this provision exceed 25 percent for any taxable year. The increased rate applies for the taxpayer's taxable year which immediately follows a calendar year for which the average crude oil price falls below the $20 floor. To illustrate the application of this provision, the average price of a barrel of crude oil for calendar year 1997 was $17.24; thus, the percentage depletion rate for production from marginal wells was increased by two percent (to 17 percent) for taxable years beginning in 1998. In addition, the 100-percent-of-net-income limitation has been suspended for marginal wells for taxable years beginning after December 31, 1997, and before December 31, 2000.

Marginal production is defined for this purpose as domestic crude oil or domestic natural gas which is produced during any taxable year from a property which (1) is a stripper well property for the calendar year in which the taxable year begins, or (2) is a property substantially all of the production from which during such calendar year is heavy oil (i.e., oil that has a weighted average gravity of 20 degrees API or less corrected to 60 degrees Fahrenheit). A stripper well property is any oil or gas property for which daily average production per producing oil or gas well is not more than 15 barrel equivalents in the calendar year during which the taxpayer's taxable year begins. A property qualifies as a stripper well property for a calendar year only if the wells on such property were producing during that period at their maximum efficient rate of flow.

If a taxpayer's property consists of a partial interest in one or more oil- or gas-producing wells, the determination of whether the property is a stripper well property or a heavy oil property is made with respect to total production from such wells, including the portion of total production attributable to ownership interests other than the taxpayer's. If the property satisfies the requirements of a stripper well property, then that person receives the benefits of this provision with respect to its allocable share of the production from the property for its taxable year that begins during the calendar year in which the property so qualifies.

The allowance for percentage depletion on production from marginal oil and gas properties is subject to the 1,000-barrel-per-day limitation discussed above. Unless a taxpayer elects otherwise, marginal production is given priority over other production for purposes of utilization of that limitation.

Because percentage depletion, unlike cost depletion, is computed without regard to the taxpayer's basis in the depletable property, cumulative depletion deductions may be greater than the amount expended by the taxpayer to acquire or develop the property. The excess of the percentage depletion deduction over the deduction for cost depletion is generally viewed as a tax expenditure.

In general, costs that benefit future periods must be capitalized and recovered over such periods for income tax purposes, rather than being expensed in the period the costs are incurred. In addition, the uniform capitalization rules require certain direct and indirect costs allocable to property to be included in inventory or capitalized as part of the basis of such property. In general, the uniform capitalization rules apply to real and tangible personal property produced by the taxpayer or acquired for resale.

Special rules apply to intangible drilling and development costs ("IDCs"). Under these special rules, an operator (i.e., a person who holds a working or operating interest in any tract or parcel of land either as a fee owner or under a lease or any other form of contract granting working or operating rights) who pays or incurs IDCs in the development of an oil or gas property located in the United States may elect either to expense or capitalize those costs. The uniform capitalization rules do not apply to otherwise deductible IDCs.

If a taxpayer elects to expense IDCs, the amount of the IDCs is deductible as an expense in the taxable year the cost is paid or incurred. Generally, IDCs that a taxpayer elects to capitalize may be recovered through depletion or depreciation, as appropriate; or in the case of a nonproductive well ("dry hole"), the operator may elect to deduct the costs. In the case of an integrated oil company (i.e., a company that engages, either directly or though a related enterprise, in substantial retailing or refining activities) that has elected to expense IDCs, 30 percent of the IDCs on productive wells must be capitalized and amortized over a 60-month period.

A taxpayer that has elected to deduct IDCs may, nevertheless, elect to capitalize and amortize certain IDCs over a 60-month period beginning with the month the expenditure was paid or incurred. This rule applies on an expenditure-by-expenditure basis; that is, for any particular taxable year, a taxpayer may deduct some portion of its IDCs and capitalize the rest under this provision. This allows the taxpayer to reduce or eliminate IDC adjustments or preferences under the alternative minimum tax.

The election to deduct IDCs applies only to those IDCs associated with domestic properties. For this purpose, the United States includes certain wells drilled offshore.

Intangible drilling costs are a major portion of the costs necessary to locate and develop oil and gas reserves. Because the benefits obtained from these expenditures are of value throughout the life of the project, these costs would be capitalized and recovered over the period of production under generally applicable accounting principles. The acceleration of the deduction for IDCs is viewed as a tax expenditure.

Nonconventional fuels production credit

Taxpayers that produce certain qualifying fuels from nonconventional sources are eligible for a tax credit ("the section 29 credit") equal to $3 per barrel or barrel-of-oil equivalent. Fuels qualifying for the credit must be produced domestically from a well drilled, or a facility treated as placed in service, before January 1, 1993. The section 29 credit generally is available for qualified fuels sold to unrelated persons before January 1, 2003.

For purposes of the credit, qualified fuels include: (1) oil produced from shale and tar sands; (2) gas produced from geopressured brine, Devonian shale, coal seams, a tight formation, or biomass (i.e., any organic material other than oil, natural gas, or coal (or any product thereof)); and (3) liquid, gaseous, or solid synthetic fuels produced from coal (including lignite), including such fuels when used as feedstocks. The amount of the credit is determined without regard to any production attributable to a property from which gas from Devonian shale, coal seams, geopressured brine, or a tight formation was produced in marketable quantities before 1980.

The amount of the section 29 credit generally is adjusted by an inflation adjustment factor for the calendar year in which the sale occurs. There is no adjustment for inflation in the case of the credit for sales of natural gas produced from a tight formation. The credit begins to phase out if the annual average unregulated wellhead price per barrel of domestic crude oil exceeds $23.50 multiplied by the inflation adjustment factor.

The amount of the section 29 credit allowable with respect to a project is reduced by any unrecaptured business energy tax credit or enhanced oil recovery credit claimed with respect to such project.

As with most other credits, the section 29 credit may not be used to offset alternative minimum tax liability. Any unused section 29 credit generally may not be carried back or forward to another taxable year; however, a taxpayer receives a credit for prior year minimum tax liability to the extent that a section 29 credit is disallowed as a result of the operation of the alternative minimum tax. The credit is limited to what would have been the regular tax liability but for the alternative minimum tax.

This provision provides a significant tax incentive (currently about $6 per barrel of oil equivalent or $1 per thousand cubic feet of natural gas, or roughly half the wellhead price of gas) for production of nonconventional fuels. Coalbed methane and gas from tight formations currently account for most of the credit.

Taxpayers are permitted to claim a general business credit, which consists of several different components. One component of the general business credit is the enhanced oil recovery credit. The general business credit for a taxable year may not exceed the excess (if any) of the taxpayer's net income over the greater of (1) the tentative minimum tax, or (2) 25 percent of so much of the taxpayer's net regular tax liability as exceeds $25,000. Any unused general business credit generally may be carried back three taxable years and carried forward 15 taxable years.

The enhanced oil recovery credit for a taxable year is equal to 15 percent of certain costs attributable to qualified enhanced oil recovery ("EOR") projects undertaken by the taxpayer in the United States during the taxable year. To the extent that a credit is allowed for such costs, the taxpayer must reduce the amount otherwise deductible or required to be capitalized and recovered through depreciation, depletion, or amortization, as appropriate, with respect to the costs. A taxpayer may elect not to have the enhanced oil recovery credit apply for a taxable year.

The amount of the enhanced oil recovery credit is reduced in a taxable year following a calendar year during which the annual average unregulated wellhead price per barrel of domestic crude oil exceeds $28 (adjusted for inflation since 1990). In such a case, the credit would be reduced ratably over a $6 phaseout range.

For purposes of the credit, qualified enhanced oil recovery costs include the following costs which are paid or incurred with respect to a qualified EOR project: (1) the cost of tangible property which is an integral part of the project and with respect to which depreciation or amortization is allowable; (2) IDCs that the taxpayer may elect to deduct; and (3) the cost of tertiary injectants with respect to which a deduction is allowable, whether or not chargeable to capital account.

A qualified EOR project means any project that is located within the United States and involves the application (in accordance with sound engineering principles) of one or more qualifying tertiary recovery methods which can reasonably be expected to result in more than an insignificant increase in the amount of crude oil which ultimately will be recovered. The qualifying tertiary recovery methods generally include the following nine methods: miscible fluid displacement, steam-drive injection, microemulsion flooding, in situ combustion, polymer-augmented water flooding, cyclic-steam injection, alkaline flooding, carbonated water flooding, and immiscible non-hydrocarbon gas displacement, or any other method approved by the IRS. In addition, for purposes of the enhanced oil recovery credit, immiscible non-hydrocarbon gas displacement generally is considered a qualifying tertiary recovery method, even if the gas injected is not carbon dioxide.

A project is not considered a qualified EOR project unless the project's operator submits to the IRS a certification from a petroleum engineer that the project meets the requirements set forth in the preceding paragraph.

The enhanced oil recovery credit is effective for taxable years beginning after December 31, 1990, with respect to costs paid or incurred in EOR projects begun or significantly expanded after that date.

Conventional oil recovery methods do not recover all of a well's oil. Some of the remaining oil can be extracted by unconventional methods, but these methods are generally more costly and uneconomic at current world oil prices. In this environment, the EOR credit can increase recoverable reserves. Although recovering oil using EOR methods is more expensive than recovering it using conventional methods, it may be less expensive than producing oil from new reservoirs. Although the credit could phase out at higher oil prices, it is fully effective at present world oil prices.

A taxpayer is subject to an alternative minimum tax ("AMT") to the extent that its tentative minimum tax exceeds its regular income tax liability. A corporate taxpayer's tentative minimum tax generally equals 20 percent of its alternative minimum taxable income in excess of an exemption amount. (The marginal AMT rate for a noncorporate taxpayer is 26 or 28 percent, depending on the amount of its alternative minimum taxable income above an exemption amount.) Alternative minimum taxable income ("AMTI") is the taxpayer's taxable income increased by certain tax preferences and adjusted by determining the tax treatment of certain items in a manner which negates the deferral of income resulting from the regular tax treatment of those items.

As a general rule, percentage depletion deductions claimed in excess of the basis of the depletable property constitute an item of tax preference in determining the AMT. In addition, the AMTI of a corporation is increased by an amount equal to 75 percent of the amount by which adjusted current earnings ("ACE") of the corporation exceed AMTI (as determined before this adjustment). In general, ACE means AMTI with additional adjustments that generally follow the rules presently applicable to corporations in computing their earnings and profits. As a general rule a corporation must use the cost depletion method in computing its ACE adjustment. Thus, the difference between a corporation's percentage depletion deduction (if any) claimed for regular tax purposes and its allowable deduction determined under the cost depletion method is factored into its overall ACE adjustment.

Excess percentage depletion deductions related to crude oil and natural gas production are not items of tax preference for AMT purposes. In addition, corporations that are independent oil and gas producers and royalty owners may determine depletion deductions using the percentage depletion method in computing their ACE adjustments.

The difference between the amount of a taxpayer's IDC deductions and the amount which would have been currently deductible had IDCs been capitalized and recovered over a 10-year period may constitute an item of tax preference for the AMT to the extent that this amount exceeds 65 percent of the taxpayer's net income from oil and gas properties for the taxable year (the "excess IDC preference"). In addition, for purposes of computing a corporation's ACE adjustment to the AMT, IDCs are capitalized and amortized over the 60-month period beginning with the month in which they are paid or incurred. The preference does not apply if the taxpayer elects to capitalize and amortize IDCs over a 60-month period for regular tax purposes.

IDCs related to oil and gas wells are generally not taken into account in computing the excess IDC preference of taxpayers that are not integrated oil companies. This treatment does not apply, however, to the extent it would reduce the amount of the taxpayer's AMTI by more than 40 percent of the amount that the taxpayer's AMTI would have been if those IDCs had been taken into account.

In addition, for corporations other than integrated oil companies, there is no ACE adjustment for IDCs with respect to oil and gas wells. That is, such a taxpayer is permitted to use its regular tax method of writing off those IDCs for purposes of computing its adjusted current earnings.

Absent these rules, the incentive effect of the special provisions for oil and gas would be reduced for firms subject to the AMT. These rules, however, effectively eliminate AMT concerns for independent producers.

A taxpayer's deductions from passive trade or business activities, to the extent they exceed income from all such passive activities of the taxpayer (exclusive of portfolio income), generally may not be deducted against other income. Thus, for example, an individual taxpayer may not deduct losses from a passive activity against income from wages. Losses suspended under this "passive activity loss" limitation are carried forward and treated as deductions from passive activities in the following year, and thus may offset any income from passive activities generated in that later year. Losses from a passive activity may be deducted in full when the taxpayer disposes of its entire interest in that activity to an unrelated party in a transaction in which all realized gain or loss is recognized.

An activity generally is treated as passive if the taxpayer does not materially participate in it. A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is regular, continuous, and substantial.

A working interest in an oil or gas property generally is not treated as a passive activity, whether or not the taxpayer materially participates in the activities related to that property. This exception from the passive activity rules does not apply if the taxpayer holds the working interest through an entity which limits the liability of the taxpayer with respect to the interest. In addition, if a taxpayer has any loss for any taxable year from a working interest in an oil or gas property which is treated pursuant to this working interest exception as a loss which is not from a passive activity, then any net income from such property (or any property the basis of which is determined in whole or in part by reference to the basis of such property) for any succeeding taxable year is treated as income of the taxpayer which is not from a passive activity.

Similar limitations apply to the utilization of tax credits attributable to passive activities. Thus, for example, the passive activity rules (and, consequently, the oil and gas working interest exception to those rules) apply to the nonconventional fuels production credit and the enhanced oil recovery credit. However, if a taxpayer has net income from a working interest in an oil and gas property which is treated as not arising from a passive activity, then any tax credits attributable to the interest in that property would be treated as credits not from a passive activity (and, thus, not subject to the passive activity credit limitation) to the extent that the amount of the credits does not exceed the regular tax liability which is allocable to such net income.

As a result of this exception from the passive loss limitations, owners of working interests in oil and gas properties may use losses from such interests to offset income from other sources.

Taxpayers are allowed to deduct the cost of qualified tertiary injectant expenses for the taxable year. Qualified tertiary injectant expenses are amounts paid or incurred for any tertiary injectant (other than recoverable hydrocarbon injectants) which is used as a part of a tertiary recovery method.

The provision allowing the deduction for qualified tertiary injectant expenses resolves a disagreement between taxpayers (who considered such costs to be IDCs or operating expenses) and the IRS (which considered such costs to be subject to capitalization).

In order to insulate the economy from the effects of future energy price increases, the President announced, on March 18, 2000, a comprehensive and balanced energy strategy that included tax incentives. This comprehensive approach includes, in addition to tax incentives for energy efficiency and renewable and alternative energy sources, support for domestic oil producers to reduce our reliance on oil imports.

Expensing of Geological and Geophysical Costs. The Administration is proposing to support domestic exploration and production by adjusting the tax treatment of the costs of exploration and development -- geological and geophysical (G&G) costs. Under current law, geological and geophysical costs may be deducted in the year in which they are paid or incurred if exploration activity was unsuccessful, but must be capitalized if the exploration activity was successful. By allowing the industry to expense these costs, we will be encouraging the discovery of new reserves. The Department of Energy estimates that this G&G provision will add 230 million barrels of oil to domestic reserves. The revenue cost of expensing G&G costs is estimated to be $380 million over FY 2001 - 2005.

Allowing Expensing of Delay Rental Payments. A delay rental payment is an amount paid by a lessee to the lessor of a petroleum resource when the lessee does not begin producing commercial quantities of oil or natural gas as soon as was agreed to. The delay rental payment is intended to compensate the lessor for the royalties he does not receive while production is delayed. Currently, the uniform capitalization rules of section 263A would appear to require delay rental expenses to be capitalized to the depletable basis of the property to which they relate if the property is being held for development. Allowing producers to expense delay rental payments will lower the cost of doing business on Federal lands. The revenue cost of expensing delay rental payments is estimated to be $370 million over FY 2001 - 2005.

The Administration strongly supports the proposed tax credits for holders of Better America Bonds, a permanent extension of the current deduction of brownfields remediation expenses, the proposed tax incentives to improve energy efficiency and the environment, and the proposed tax incentives to support domestic oil and gas production.

The proposed Better America Bonds provide a new financing tool that will enable State, local, and tribal governments to preserve green spaces, create and restore urban parks, protect water quality and clean up brownfields. Those governments would be authorized to issue a total of $10.75 billion of Better America Bonds to finance environmental and conservation projects. The proposed permanent extension of the current deduction of brownfields remediation costs will help return industrial and commercial sites in targeted areas to productive use. The proposal is estimated to induce an additional $7 billion in private investment and return an additional 18,000 brownfields to productive use over the next ten years. Together, these initiatives will help to preserve our environmental heritage and make our communities more livable in the 21^st century.

The Administration's proposed package of tax incentives for energy efficiency and the environment is designed to improve energy efficiency by encouraging purchases of items that offer superior energy efficiency or that use renewable or alternative energy sources. The investments induced by the tax incentives would produce energy savings for many years after the investments are undertaken. The benefits of the proposal should increase significantly in the years beyond the ten-year budget window, through the transformation of markets after the credits are no longer in effect. Moreover, the proposed incentives also may generate other benefits to society, such as cleaner air.

The proposed tax incentives to support domestic oil and gas production will reduce tax burdens on domestic producers and encourage the discovery and exploitation of additional domestic oil and gas reserves.

In conclusion, Mr. Chairman, we believe that the Administration's proposed tax initiatives represent sound policy that can produce significant environmental and energy security benefits over the next ten years and for decades to come. The proposals represent investments that will generate long-term benefits for the Nation. We look forward to working with the Congress on these initiatives.

Mr. Chairman, this concludes my prepared testimony. I will be pleased to answer any questions you or other members of the Subcommittee may have.