Suppose an oil company is considering whether to develop production facilities for a newly discovered oil field on lands owned by a state government. If the firm spends $2 billion in present value in capital costs, it could install facilities capable of producing 80,000 barrels per day. Annual operating costs for the oil field are anticipated to be $30 per barrel produced. The company expects production from the field to start at 80,000 barrels per day but then decline at 9 percent annually indefinitely. The firm has to pay its investors a 10 percent annual return.
The state government is facing a budget deficit due to low oil prices. The legislature is considering changing its tax regime by replacing the production tax based on 35 percent of profits with a tax based on 5 percent of the company's share of gross revenues, i.e., 5 percent of 7/8 of gross revenues. Which tax would be likely to yield more revenues? Show your calculations and explain your reasoning. Sale price is $60 per barrel.