Why West Virginia’s reliance on volatile severance taxes is problematic

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For months, West Virginia lawmakers have said one thing repeatedly: the state has more than $1 billion in budget surplus. And when you look at the numbers, that’s largely thanks to the severance tax. 

That trend continued last week, as Gov. Jim Justice announced that the state had collected close to $800 million in severance taxes since July, far outpacing the roughly $250 million it estimated it would take in. This growth has fueled increased optimism about the state economy, and Justice and others have used it to help justify recent policy decisions like income tax cuts. 

But severance taxes — which are collected on natural resources extracted in the state — are extremely complicated and can fluctuate wildly. And as West Virginia touts its increased surplus achieved largely through this volatile tax, some policy experts are urging caution on how the state spends its money, particularly as it makes long-term decisions with what could turn out to be short-term gains. 

Here’s what to know about the biggest driver of the current revenue surplus — and how its role in state finances could change in the future.

What is the severance tax?

Around 34 states apply severance taxes to the extraction, production, value, and sale of finite natural resources that have been extracted — or “severed” — from the ground. That includes oil, coal, natural gas, limestone and sandstone, but in West Virginia coal and natural gas account for the bulk of severance tax revenue. In recent years, money from natural gas operations have made up an increasingly large share of severance tax collections. The state currently applies a 5% tax on natural gas and a smaller amount on various types of coal. 

Why are collections up right now?

West Virginia has made significantly more money from severance taxes since 2021, and experts say that the reasons behind this are complex. But one of the biggest factors is the ongoing war in Ukraine: Russia has long been one of the world’s top exporters of natural gas, but after the country’s 2022 invasion, many of Europe’s main consumers of natural gas have sought to find new sources. Because of this, demand for non-Russian natural gas has risen, contributing to a surge in natural gas prices in the U.S. 

That’s helped West Virginia bring in more money from natural gas in recent years.

“The high prices translate into higher severance tax collections almost immediately,” John Deskins, director of WVU’s Bureau of Business and Economic Research, said in a recent interview.   

In the 2020 fiscal year, West Virginia’s state and local governments collected roughly $343 million in severance taxes. Two years later, they collected $840 million. And for the current fiscal year, West Virginia has already collected $787 million in severance taxes, putting it on track to collect more than a billion dollars before the end of June.

How has the severance tax affected the state budget?

Severance taxes are applied at varying rates at both the local and state level and counties do receive some of the money collected under the tax. But a significant portion of the money, like other taxes collected by West Virginia, lands in the state’s general revenue fund, where it is then able to be used towards anything. And those collections have had a huge impact on West Virginia’s state budget in recent years, particularly when it comes to its surplus revenue, the amount of extra money compared to what the state estimated it would take in. 

Severance taxes as a whole have accounted for about half of the state’s budget surplus in the past few years.

With so much money on hand, the severance tax is playing a big role in the financial decisions being made by the state, including on the state Legislature’s recent move to cut the state personal income tax rate. That cut, which along with several new refundable tax credits is expected to reduce state revenue by more than $750 million in the coming years, has largely been justified by the state’s high surplus, with the argument being that with the extra money, the state can afford to return money to taxpayers.

Experts say the severance tax is volatile; what does that actually mean? 

As it has had an increasing impact on state budget revenue, particularly when it comes to the surplus, some policy experts have cautioned against West Virginia becoming too reliant on the severance tax as a source of consistent, long-term revenue. That’s largely because the taxes are highly volatile, and often go through boom and bust cycles.

This has been the case historically. In 2014 for example, West Virginia experienced a significant boom in the severance tax, with it accounting for 13% of the state’s overall tax revenue. But a year later as coal production declined and natural gas prices fell, the state soon found itself in a deficit that forced budget cuts to state agencies. 

That sort of shift is always possible with the severance tax, which is why some policy experts have criticized the state for some of its decisions when it comes to the budget surplus, especially the recent income tax cut.

“We are using the severance tax to build up this big surplus, this big surplus is being used to cut the income tax, which is the most stable source of revenue and the biggest source of revenue,” said Sean O’Leary, the senior policy analyst at the West Virginia Center on Budget and Policy. “So now we’re going to become more reliant on the severance tax.” 

“You’re really counting on this volatile, up-and-down source of revenue to become much more stable and stable at a higher level than it ever has been in the past,” he added. 

The volatility of this tax has been a concern in some other states that collect significant amounts in severance tax collections as well. In some of those states, like Alaska and Wyoming, there has been an effort to address the issue by moving part or all of the revenue into permanent severance tax trust funds that are then used to help fund certain state goals like infrastructure changes, economic development projects, or investments in education. West Virginia did have one such account, the West Virginia Future Fund, but no money was ever placed into it. Lawmakers passed a bill officially closing the account during the recent legislative session. 

What happens if severance tax revenue falls?

Because of how unstable the severance tax is, it is likely that the amount of money the state is collecting in severance taxes will begin to fall in the near future. And the state has little say in when that will happen. 

“Energy prices as a whole are really tied to global market forces,” O’Leary said. “There’s not really anything West Virginia can do to control natural gas prices.”

These prices are already beginning to decline, with forecasters predicting the price of natural gas will drop by at least 50% in 2023 when compared to last year. The West Virginia Center on Budget and Policy also notes that this year’s severance tax revenue is starting to trend downward from the highs of last year. While the state does have the extra money, the Center has argued that the current surplus would be better used providing additional support to address a number of ongoing state crises, and also backs giving additional surplus money to the counties that produce the highest amount of natural resources, some of which face significant financial difficulties.

“This extractive industry has not fulfilled its promises of economic prosperity in the areas where the actual extraction is taking place,” O’Leary said.

As of now, if severance tax revenue does decline, that combined with the recently-implemented tax cuts means the state will have less money to work with. Though it’s unclear exactly how that will play out, it could cause officials to have to make significant shifts in the future. 

And more broadly, as West Virginia continues to enjoy the boom of the current severance tax collections, there’s still no indication from state leaders how they are preparing to handle the inevitable bust.

Reach P.R. Lockhart at [email protected]