Oil Industry Financial Performance and the Windfall Profits Tax

Summary: Over the past 13 years, surging crude oil and petroleum product prices have increased oil and gas industry revenues and generated record profits, particularly for the top five major integrated companies, ExxonMobil, Royal Dutch Shell, BP, Chevron, and ConocoPhillips. These companies, which reported a predominant share of those profits, generated more than $104 billion in profit on nearly $1.8 trillion of revenues in 2008, before declining as a result of the recession and other factors. From 2003 to 2008, revenues increased by 86%; net income (profits) increased by 66%. Oil output by the five major companies over this time period declined by more than 7%, from 9.85 million to 9.12 million barrels per day. In 2010 the companies' oil production was 9.4 million barrels per day. Being largely price-driven, with no accompanying increase in output resulting from increased investment in exploration and production, some believe that a portion of the increased oil industry income over this period represents a windfall and unearned gain. A windfall income is not earned as a result of additional production effort on the part of the firms, but due primarily to record crude oil prices, which are set in the world oil marketplace.

Summary: Since the 109th Congress, numerous bills have been introduced seeking to impose a windfall profits tax (WPT) on oil. An excise-tax based WPT would tax only domestic production and, like the one in effect from 1980-1988, would increase marginal oil production costs. Theoretically, such a policy could reduce domestic oil supply, which could raise petroleum imports, making the United States more dependent on foreign oil, undermining goals of energy independence and energy security. By contrast, an income-tax based WPT would likely be more economically neutral (less economic distortion) in the short-run. Sizeable tax revenues could potentially be raised without reducing domestic oil supplies. Neither the excise-tax based nor income-tax based WPT are expected to have significant price effects. Neither tax would increase the price of crude oil, which means that refined petroleum product prices, such as pump prices for gasoline, would likely not increase.

Summary: In lieu of these two types of WPT, an administratively simple way of increasing the tax burden on the oil industry, and therefore recouping some of any excess or windfall profits, particularly from major integrated producers, would be to raise the effective corporate tax rate. One option would be repealing or reducing the domestic manufacturing activities deduction under IRC § 199. The 112th Congress voted on this measure as part of the Close Big Oil Tax Loopholes Act (S. 940). Going forward, in the context of deficit reduction, the 112th Congress may continue evaluating various methods for increasing taxes on the oil and gas industry to address concerns surrounding possible windfall profits.

Over the past 13 years, the price of crude oil has generally been increasing and volatile. High crude oil prices, which have led to high gasoline prices, have contributed to a weakening of the U.S. economy. Further, high gasoline prices put increased pressure on household budgets, during a time when households continue to struggle with persistently high levels of unemployment and a flagging housing market. While much of the American economy has suffered as a result of high oil prices, those prices generated record profit levels for the oil industry. Five companies—ExxonMobil, Royal Dutch Shell, BP, Chevron, and ConocoPhillips—earned a predominant share of those profits.

Record oil and gas industry profits have raised the concern of many public policy experts and federal policymakers, including many in Congress, who have questioned whether these profits were justified, or whether they constituted a "windfall" to the industry: an excessive, unearned, and unfair gain. Important factors in considering this issue might include the ultimate source, or reason, for the price increases, and what the industry's role was in generating them, i.e., whether it was through the direct result of the industry's efforts, in terms of employing its resources, decision-making, or risk-taking, or whether it was the result of fortuitous factors and events. Also important to the public policy question might be the actual size of the profits and what the industry did with them. If an industry invests profits into increased production capacity, the increased supply may ultimately cause prices to fall and the profits to dissipate. As the analysis in this report shows, the experience between 2003 and the first quarter of 2011 suggests that investments in oil exploration and development have not managed to keep company oil output from declining from the peak attained in 2006.

Numerous bills have been introduced in the Congress over this period to tax the oil and gas industry's record profits. Broadly, there are two ways that tax policy can be used to increase taxes on oil and gas profits. First, Congress could scale back or eliminate various tax incentives and preferences currently available to the industry. Second, Congress could directly increase taxes on the industry, through some form of an excess profits tax or windfall profits tax.

During the 1 st session of the 112 th Congress, the Senate considered a measure that would have eliminated various tax preferences for major integrated oil companies. A motion to proceed to consideration of the Close Big Oil Tax Loopholes Act ( S. 940 ) was rejected in May 2011. S. 940 sought to eliminate industry-specific incentives, such as the ability to partially expense intangible drilling costs (IDCs). Further, the legislation would have prevented major integrated oil companies from taking advantage of tax incentives available to firms operating in other industries, such as the domestic production activity deduction (the § 199 deduction).

High crude oil prices and the associated profits may lead policymakers to look at the tax burden on the oil and gas industry broadly, shifting the focus beyond the major integrated oil companies. Since the inception of the federal income tax system in the early 20 th Century, the oil and gas industry has accrued sizable benefits (in excess of $190 billion, according to one estimate). While some of the traditional tax incentives, notably percentage depletion for integrated producers, have been significantly pared back over the years, some have argued that no tax incentives should be available to the industry at a time of high profits.

As was noted above, a second option for increasing taxes on oil and gas industry profits is to take a more direct approach. Congress could choose to impose a windfall or "excess" profits tax-a supplemental or additional tax on the oil industry-one based on windfall or excess profits in addition to other income or other taxes that the industry might pay. While some might envision this as a totally new type of tax on windfall gains, an alternative would be to model it after the windfall profits tax on oil that existed from 1980 to 1988. A windfall profit tax would be in addition to the current tax on corporate and business income that applies to the oil and gas industry, whose profits are taxed at rates as high as 35%.

This report contains information useful in evaluating the windfall profits tax policy option. The first section analyzes the major oil companies profit performance, particularly from 2003 to 2010, both in terms of earnings and how those earnings have been used. The second section is a brief legislative history of windfall profit tax proposals and legislation in the 109 th through 112 th Congresses. The third section analyzes the concept of a windfall profits tax, including experiences with the tax of the 1980s, its viability, and potential role in the tax system and economy.

During the 2000s, oil prices have been volatile, and generally rising. Rising oil prices have been associated with increased revenues and net incomes amongst major integrated oil producers. While prices, revenues, and incomes have risen, production levels have remained relatively constant. The following sections review trends in oil prices as well as the revenues, income, and production levels of major integrated oil companies. This information, combined with information on the use of profits, is helpful when evaluating whether the industry has benefitted from windfall profits in the face of high oil prices.

Since the late 1990s, crude oil prices have been volatile, but also trending upward (see Figure 1 ). During the fall/winter of 1998/1999, the spot market price of West Texas Intermediate (WTI) crude oil was between $11 and $12 per barrel. By July 2003, it had risen to $30.75 per barrel. Five years later, in July 2008, the spot market price of WTI was $133.37, an increase of 334% in five years, and more than 1,000% over the 1998 price. In June 2008, the spot market price reached the all-time high of $147 per barrel. With the onset of the effects of the financial crisis and the recession, as well as a reaction to higher consumer gasoline prices, the price of WTI fell to $39 per barrel in February 2009. By the end of 2009 the price of WTI was almost $75 per barrel. During 2010, the price of WTI ranged between $73 and $90 per barrel. Unrest in the Middle East and North Africa brought the price of WTI back over $100 per barrel in April 2011.

This 13-year period of generally increasing oil prices, punctuated by a major decline in 2008/2009, began after a poor year for profitability in the oil industry, 1998, and included another poor year, 2002, along with record profit years. The oil price increases that began in late 2003 seemed to be largely unanticipated by the industry. They have since been attributed primarily to (1) a growing world economy, particularly the emerging economies of China and India; (2) declining excess production capacity, particularly within OPEC (Organization of the Petroleum Exporting Countries) producers; and (3) a number of financial factors, including futures market speculation, exchange rate, and inflation hedges. As the price of oil rose, company revenues, net incomes, and income taxes paid also rose, with ExxonMobil eventually becoming the most profitable corporation in the history of American industry.

The oil industry is composed of thousands of companies, ranging from the major integrated oil companies with operations around the globe, to independent producers (which range in size from small to very large), to relatively small oil service and equipment companies. The increase in oil prices over the past 13 years—particularly over the past five years—has enhanced the profitability of virtually all sectors of the industry, directly or indirectly. This report highlights the financial performance of the industry's largest players, the major integrated oil companies.

While the oil and gas industry's high profitability has been widespread, it has also been concentrated among the industry's largest firms. Financial data show that the performance of the industry is dominated by the five largest firms: ExxonMobil, Royal Dutch Shell, BP, Chevron, and ConocoPhillips. Generally, the net income of these five firms constituted 90% of the total net income of the nine firms considered to be integrated oil companies, at various times over the period, operating in the United States.

With the exception of 2009, revenues of the five major firms have increased annually since 2003 (see Table 1 ). Total revenue is measured as price times the quantity of goods and services sold. In the case of the five major oil companies over this period, the increase in revenues was largely price-driven, with quantities of oil produced largely stagnant. For example, in 2003, ExxonMobil produced 2.59 million barrels per day (b/d) of crude oil, and in 2010, ExxonMobil produced 2.42 million b/d, a decrease of about 3%. In general, the five major oil firms did not produce more crude oil and petroleum products in response to the incentive of higher prices. As illustrated in Table 2 , production of crude oil during the period was relatively stable. Only Chevron and BP produced more crude over this period, and, for the five firms as a whole, output declined by 4.5% from 2003-2010.

Revenue data for the first half of 2011 reflects the sharp increases in the price of oil observed during the first four months of the year, with the price of WTI reaching $112 per barrel in April. For the first quarter of 2011, the five firms earned total revenues of $422 billion and net incomes of $32.3 billion. These values could result in yearly values approaching the results of 2008, assuming the price of oil remains near its peak.

In recent years, trends in net income have also tended to follow trends in revenues and crude oil prices (see Table 3 ). While revenues increased by 86% from 2003 to 2008, net income increased by a greater percentage, on average 108%, except for ConocoPhillips, which can be considered as a special case in 2008. These percentages suggest that price increases for crude oil, which can be both a revenue and a cost for these firms, increased at a higher rate than other costs and taxes, yielding net income growth for the five major firms. Analogously to the observed increase in revenues, the increase in net income experienced by the five firms was largely price-driven.

The measures of financial performance shown in Table 1 and Table 3 focus on absolute levels: absolute levels of revenue, and absolute net income. An additional measure of financial performance is the profit rate, which may also be measured in variety of ways. One measure of the profit rate is the profit margin, essentially net income divided by revenue. As a result of the increasing price of oil driving up both total revenues and net incomes, the return on revenue, or the profit rate performance, has been mixed for the major integrated oil companies, as shown in Table 4 . This indicator of industry performance does not appear excessive when compared to the profit rate in the manufacturing sector as a whole, which in 2007 had a profit rate of 8.9%. However, an additional measure of the relative profit rate is the rate of return on equity (ROE). Using this measure of profit rate, the oil and gas industry's ROE was, on average, greater than the ROE for the manufacturing sector generally. According to the Energy Information Administration (EIA), the oil and gas industry earned a 27% ROE in 2006, down slightly from 2005, but more than 9 percentage points higher than the average ROE for all manufacturing companies.

For the entire 2000-2008 period, the oil and gas industry's ROE averaged 7 percentage points higher than manufacturing's ROE, while for the 1985-1999 period, the oil and gas industry's ROE was only 2 percentage points higher. However, in 2009 the oil and gas companies' ROE fell to 4%, below the manufacturing industry average. By these measures, the industry's recent high profits, measured both in absolute terms, and relative to ROE, suggest that high oil price volatility is a key factor in explaining profits in the oil industry.

There are multiple ways to interpret the price, income, and production data presented above. The data on net income and oil production could be viewed as a characterization of a set of firms that were unable to respond to the market signal of higher price by increasing output as predicted by economic theory. As a result, their revenues and net incomes increased proportionately, possibly supporting the conclusion that those profits constituted a "windfall," at least in the sense that they were not earned through output expansion or improvement, risk-taking, or investments leading to cost reductions in production. However, the data could also be taken to suggest that the major oil companies did not earn more net income relative to the value of their product than many other industries, and the value of their product was determined on a world market, beyond their control. From this point of view, oil was attaining only its fair market value.

The net income data presented in Table 2 and Table 3 was earned across three sectors of the industry. Namely, these three sectors are upstream operations (the exploration and production of oil and natural gas), downstream operations (the refining, transportation, distribution, and marketing of petroleum products, including motor gasoline, diesel, jet fuel, and other petroleum products), and chemicals and all other "non-oil" activities. Over time, the relative importance of these sectors may shift in terms of their potential to generate net income. For example, while downstream activities were strong in 2005 and 2006, they weakened from 2007 to 2009. In terms of general corporate income taxation, this cyclical pattern of change is likely to have little effect, since it is over-all corporate net revenues that form the tax base. In terms of possible windfall profit taxation, however, this cyclical pattern might be important, as it is net-income from crude oil ownership and production that is likely to have a windfall gain, or "unearned" income component.

Firms that earn returns in excess of the market rate of return tend to reinvest these returns. Reinvestment can mean expanding business through increasing output or investing in technological improvements to meet the challenge of new firms entering the industry (i.e., remain competitive). Firms that seek to maximize shareholder value use profits to invest in business projects that offer a higher potential rate of return than the average return currently earned by the firm.

Capital expenditures for the five major oil companies were $48.6 billion in 2003, $48.7 billion in 2004, $57.2 billion in 2005, and more than $80 billion in 2006 and 2007, for a total increase of 77% over the five-year period. This increase is proportionately less than the increase in net income over the period. From 2008 to 2010, capital expenditures were over $115 billion in 2008, fell to $99.8 billion in 2009 and recovered to $101 billion in 2010. Part of capital investment funding is directed to environmental compliance for both facilities and products, and does not increase capacity to bring petroleum products to the market. The five companies have not committed to the construction of a new refinery in the United States since the 1970s, though existing refineries have been expanded and upgraded. When the demand for gasoline exceeds the ability of the U.S. refineries to produce, the gap has been filled with imported product.

Although the oil industry, including the five major firms, has invested in exploration, development, and production, those investments, to date, have not led to increased output. Table 2 shows that the companies have failed to expand, or even maintain, their oil production rates.

Cash Reserves, Dividend Payouts, Stock Buybacks13

Between 2003 and 2010, cash reserves held by the major integrated oil companies increased from $19.4 billion to $63 billion. Cash reserves increased from $19.4 billion in 2003 to $52.7 billion in 2007, an increase of nearly 170%. While cash holdings declined in 2007, compared to 2006, this was the result of reduced balances at only one company, Chevron. The other four major oil companies continued to build their cash balances. Cash holdings for the five major companies rose to almost $65 billion in 2008 before falling to $38 billion in 2009. Higher revenues and net incomes in 2010 resulted in cash reserves rising to over $63 billion in 2010.

Accumulating cash balances gives firms flexibility and positions them to take advantage of investment and other opportunities quickly. It is also likely that the rapid increase in the price of oil and profits from 2003 to 2010 exceeded corporate plans and strategies on how to use it, resulting in accumulating cash holdings.

Cash dividend payouts by the five major oil companies were over $36 billion in 2008 and $38 billion in 2009, increasing even though 2009 saw declining revenues and profits for the firms. Although dividends fell to about $31 billion in 2010, this reduction was largely due to a 73% fall in dividend payments by BP associated with the expense of the Macondo oil spill. The firms also paid out funds to investors in the form of stock buybacks. Although this activity diminished in light of the financial crisis of 2008, it was an important source of investor returns over the 2000s.

The theory of corporate finance, under the rule of maximizing shareholder value, suggests that extraordinary cash returns to shareholders are appropriate only when the management feels that individual shareholders are likely to have access to higher return investment alternatives than management can identify for the firm. The oil companies' large cash balances, dividend payments, and stock buybacks could be considered to be key factors in judging whether excess, or windfall, profits were earned.

As crude oil prices rose in the mid-2000s, Congress began to explore the option of imposing a windfall profits tax on the oil and gas companies. The rising price of crude oil and petroleum products led many in Congress to become concerned over the level of oil industry profits. Various legislative proposals that would have raised taxes on the oil and gas industry were considered during the 109 th , 110 th , and 111 th Congresses. Early in the 112 th Congress, the spot market price of West Texas Intermediate (WTI) crude oil surpassed the $100/barrel mark. Should high crude oil prices be associated with increased industry profits, Congress may once again choose to consider windfall profits tax proposals.

A windfall profits tax can be viewed as a way to allow the government to share in financial gains, particularly when the financial gains are not the direct result of industry activities. Some proposals have suggested that the additional tax revenues be used to fund subsidies for low-income persons to offset the burden of high petroleum prices. Additional revenues could also be used for energy conservation programs, alternative and renewable fuels, or deficit reduction. Additional revenues generated through a windfall profits tax need not be dedicated to a specific purpose.

The concept of a windfall profits tax is not new; a tax on windfall, or excess, business profits has been one the instruments of fiscal policy, used by both state and federal governments, whenever business profits either rise too fast or rise to levels that are considered too high—above "normal" or fair rates of return. At the federal level, however, such taxes have been used sparingly—being viewed as extraordinary measures, their use limited to wartime or other periods characterized by economic emergencies and instabilities such as hyper-inflations. Such was the case with the surtax on business profits imposed as a temporary measure to control large profits earned during World Wars I and II, and the Korean War. A windfall profits tax on health insurers was also discussed, though ultimately not adopted, during the healthcare reform debate in 2009.

A type of windfall profits tax on domestic crude oil production was in effect from April 1980 to August 1988. This tax, which was actually an excise tax, not a profits or income tax, was part of a compromise between the Carter Administration and the Congress over the decontrol of crude oil prices. , Some have proposed reinstating this tax, although it should be underscored that the current situation giving rise to possible windfall profits—the current reasons for the high price of petroleum products and record profits—is different from the conditions and rationale which existed at the time that tax was imposed.

Reinstating the oil windfall profits tax was also discussed during the 1990s, when crude oil prices doubled in just two months due to the crisis in the Middle East (Iraq invaded Kuwait on August 2, 1990).

Windfall Profits Tax Legislation in the 109th–111th Congresses

After the enactment of the Energy Policy Act of 2005 (EPACT05; P.L. 109-58 ), congressional interest in a windfall or excess profits tax on the oil and gas industry intensified. More than a dozen windfall profits tax bills were introduced in the 109 th Congress. Many of these bills proposed to use the revenues from the WPT to offset the burden of higher gasoline prices for consumers. There were two types of windfall profits tax bills in the 109 th Congress: those that would have imposed an excise tax on windfall profits based on the price of crude oil, and those that would have imposed an income tax on windfall profits based on either the existing tax law's definition of corporate taxable income or excessive rates of return.

WPT legislation introduced during the 110 th Congress tended to be of the income tax type, rather than the excise tax type. In addition to imposing WPT, legislation in the 110 th Congress sought to repeal the IRC § 199 deduction for domestic manufacturing activities. Repeal of the § 199 deduction would effectively increase the marginal tax rate of affected entities. Repealing § 199 would increase the tax rate on all profits, not just those considered to be windfall profits. As discussed in more detail below, the corporate income tax system could be used as an administratively simple way to increase the tax burden on the oil and gas industry, approximating a WPT, while likely limiting the risk of adverse economic and energy market effects.

There were fewer legislative efforts to impose a windfall profits tax on oil and gas companies during the 111 th Congress. Oil prices declined late in 2008, with WTI spot prices falling to $41 per barrel by the end of the year. During 2009, WTI spot prices averaged $62 per barrel. WTI spot prices averaged $79 per barrel during 2010, climbing to $89 per barrel toward the end of the year. Crude oil prices below the levels reached in late 2007 and throughout 2008 may have muted legislative efforts to impose a crude oil WPT.

As noted above, the WPT that was in effect from 1980 through 1988 was an excise tax rather than an income tax. In other words, it was not a type of tax that most economists would consider a true tax on "windfall gains or income." The tax was imposed on the difference between the market price of oil, which was technically referred to as the removal price, and a statutory 1979 base price that was adjusted quarterly for inflation and state severance taxes. Almost every barrel of domestically produced crude oil—i.e., every barrel of domestic production that was not specifically tax-exempt—was subject to this excise tax.

The excise tax type of WPT was the type proposed in most of the WPT bills in the 109 th Congress. These bills would have generally imposed an excise tax equal to 50% of the windfall profits not reinvested in (1) oil and/or gas exploration and drilling, (2) increased refinery capacity, (3) renewable electricity property, or (4) facilities for producing alcohol fuels or biodiesel. These bills would have defined a windfall profit as the difference between the market price of oil (at the wellhead) and an inflation-adjusted base price of $40/barrel.

During the 110 th Congress, legislation was introduced that would have imposed a 50% excise tax on major integrated oil companies, based on the difference between the market price of oil and $50/barrel (the $50 would be adjusted annually for inflation).

Some of the WPT proposals in the 109 th Congress were of the income tax type, using the existing corporate income tax system to assess the tax, or defining the tax base in terms of taxable income under the existing corporate income tax. Typical of the income tax type of WPT were those that would have imposed a 50% tax on the excess of the adjusted taxable income for a taxable year over the average taxable income during the 2000-2004 period. The 50% tax would have applied to crude producers and integrated oil companies with sales in 2005 or 2006 above $100 million. The tax would have been temporary and would have applied to petroleum products as well as crude oil.

An alternative income tax based WPT would tax profits above a legislatively determined rate of return. One proposal made during the 109 th Congress would have taxed profit from the sale of crude oil, natural gas, or products of crude oil and natural gas above a 15% rate of return at 100%.

Income tax type WPT legislation was also introduced in the 110 th Congress. Similar to previous legislation, this legislation sought to tax the windfall profits of major integrated oil producers or oil producers with gross revenues in excess of $100 million per year, averaged over a base period. Generally, excess profits were defined as taxable income above 110% of taxable income during the base period. Income tax type WPT proposals made during the 110 th Congress would generally have taxed 50% of what was deemed to be excess profits. Various proposals differed in the rate that would be levied on the taxable portion of excess profits, with some proposing a tax rate of 50%, while others proposed a lower rate of 25%.

Other types of WPT proposals are not easily categorized as being excise tax type or income tax type. Some WPT proposals in the 109 th Congress would have imposed a WPT with graduated rates, ranging from 50% to 100%, depending on the extent to which profits exceeded a "reasonable level."

Similar to legislation introduced in the 109 th Congress, legislation introduced in the 110 th Congress proposed taxing excess profits above a "reasonable" amount. A Reasonable Profits Board would be created to determine reasonable profits levels. Taxable profits would be taxed at some rate ranging from 50% to 100%.

One House bill introduced during the 111 th Congress ( H.R. 1482 ) would have taxed profits in excess of reasonable profits, where reasonable profits were determined by a Reasonable Profits Board. The tax would have ranged from 50% to 100%, increasing as profits exceeded reasonable profits by a larger margin. Revenues from this tax would be used to fund the Low-Income Home Energy Assistance Program (LIHEAP).

High crude oil and petroleum product prices are one factor that may contribute to oil industry profits. Not all profits, even with high oil prices, are windfall profits or unearned income. Oil industry income and profits also reflect a return on investment from capital stock or a return on the firm's decision-making and risk-taking.

Governments share in the profits of companies through tax collections. Table 5 presents income taxes reported on the financial statements of major integrated oil companies between 2005 and 2010. These include income taxes paid to the U.S. federal government, as well as income tax payments to state and local governments and foreign governments. Tax payments by these five companies increased 32% between 2005 and 2007, before decreasing in recent years. Total tax payments by the major integrated oil companies in 2009 and 2010 were substantially lower than tax payments during the previous four years. Any windfall profits tax that might be adopted would add to these tax revenues.

While tax payments of the major integrated oil companies did increase during the 2005 through 2007 period, the presence of or change in tax payments does not directly indicate whether oil and gas companies have experienced windfall gains or unearned income. A well-designed WPT would tax only the true windfall component of oil industry incomes. Moreover, such a tax would be simple to administer and easy to comply with, and would avoid or minimize any adverse economic and energy market effects. As the discussion below suggests, while in theory the concept of a windfall profit seems simple and intuitive, in practice it can be difficult to accurately measure. The actual implementation of a WPT involves a compromise over differing fiscal policy objectives: (1) administerability—collecting the excess revenues (or windfall gains) in the least costly manner in terms of tax administration and compliance, and (2) economic efficiency—devising and structuring the tax in a way that minimizes economic distortions, including adverse output and price effects, and adverse impacts on petroleum imports, energy independence, and energy security.

The remaining sections of this report discuss some of the more important economic issues surrounding proposed legislation, and draw relevant policy implications. The final section discusses alternative policy options.

One challenge in designing a WPT is how to define a true windfall gain, i.e., the tax base. In theory, windfall gains and excess profits are distinct concepts. A windfall gain applies to income or wealth that is unexpected. This type of gain is often due to factors outside of the control of the benefitting institution. Excess profits, on the other hand, are based on defining an acceptable profit, and attributing everything above that level as excessive. Defining the level of profits that constitute excess profits can be subjective. This difference might be illustrated with a hypothetical example. A firm might be so efficient that its above-average profitability (or returns) might be considered excessive, but not a windfall. However, if its production waste, which formerly was costly to dispose of, became valuable, that gain might be considered a windfall.

One goal of a WPT could be to tax profits that are price driven, or those that are not the result of additional output or investment. From this perspective, it may not necessarily be appropriate to compare rates of return in the oil and gas sector to rates of return in other industries, for the purpose of defining excess returns. Higher rates of return in the oil and gas sector do not necessarily indicate the presence of windfall profits. If, however, the profits are price-driven and a windfall, and there is little or no output or investment effect, an excise tax type or an income tax type WPT could be used to collect the tax revenues related to the windfall.

Excise tax type and income tax type WPTs may elicit different responses from oil producers, and may have different administrative and compliance costs. The following sections examine the possible output and price effects of the different types of WPT, and explore which type of WPT is more likely to minimize economic distortions.

Economic Effects of the Excise Tax Type of WPT

An excise tax on domestically produced crude oil is one option for approximating a WPT. As discussed in more detail below, an excise tax on domestically produced crude oil may only approximate a windfall profit tax, and may have certain adverse energy market and economic effects. In other words, depending on how a WPT was structured, an excise tax type of WPT—for instance, by reinstating the WPT of the 1980s—might make the United States more dependent upon foreign oil, which in turn might have implications for energy security.

A WPT in the form of an excise tax could affect domestic oil production. In economic terms, oil producers would likely view the tax as an increase in the marginal, or incremental, cost of domestic oil production—the marginal cost of producing every barrel of taxable crude oil would be higher by the amount of the excise tax. An increase in the marginal cost of production might reduce domestic oil production. However, this effect is likely to be mitigated in the U.S. oil market by other factors.

For the tax to effectively reduce domestic oil production, the difference between price and marginal cost would have to be relatively small. If the difference between price and marginal cost were small, the imposition of a tax could reduce or eliminate profits. In the current oil market, oil prices are typically far above the marginal cost of production, implying that even after paying a tax, profitability could remain high, continuing to provide an economic incentive for production.

Additionally, marginal production adjustments are unlikely to be made to existing oil wells. Once an oil well goes into production, the maximum sustainable flow rate is likely to simultaneously be the maximum economic flow rate. In other words, once a well goes into production, operating the well at maximum capacity tends to maximize economic returns. From this perspective, oil field management tends to be based on physical factors related to output.

If the domestic supply of oil was reduced in response to an excise tax on domestically produced oil, the demand for imported oil and petroleum products would likely increase, unless some other policy would concomitantly reduce the demand for petroleum to offset a tax-induced reduced supply. This is because oil imports to the United States are a residual, adjusting to reflect the difference between aggregate demand for oil and aggregate domestic oil supply.

One concern is that a WPT on crude oil would be passed forward to consumers in the form of higher prices. Given that oil prices are determined in the worldwide oil market, however, it seems more likely that a WPT would reduce the price received by oil producers, rather than increase the price for petroleum consumers.

As discussed above, an excise tax only on domestically produced oil would increase marginal production costs. In theory, a profit maximizing firm would respond to this type of tax by reducing output and attempting to raise prices to offset the higher marginal production costs. However, in the case of domestic crude oil, the higher marginal cost cannot be shifted forward as a higher oil price, because oil is priced in the international (world) oil market. Oil producers would not be able to shift the tax forward as a higher oil selling price because the first purchaser (generally, the refiner) could merely substitute imported crude, which would be tax-exempt. Instead, this type of WPT would reduce the net selling price paid to producers. As a result, the first purchaser would subtract the tax from the price paid to the producer (supplier)—the producer's net selling price of each barrel of oil would be reduced by the amount of the WPT.

In the short-run, an income tax based WPT—such as those that use the existing corporate tax system to define excess or windfall taxable income—may be less likely than an excise tax type WPT to distort output decisions of oil producers. The reason for this is that firms maximize profit at the point at which market prices are equal to marginal production costs, and neither are affected in the short-run by an increase in the corporate tax burden. In other words, the profit maximizing level of output is unaffected by the tax. Thus, to the extent that a surtax on the corporate income of crude oil producers on their upstream operations could approximate a WPT, this would not raise crude oil prices and domestic production in the short-run .

In the long-run, however, all taxes tend to distort resource allocation. A corporate profit tax (either of the pure type or the surtax on the existing rates) would raise average long-term production costs, reduce the rate of return and reduce the flow of capital into the industry relative to other industries, and move resources away from the corporate form of business organization. All these effects could adversely affect domestic production, possibly resulting in increased petroleum imports.

Because the income tax type of WPT does not create incentives to reduce domestic production in the short-run, there is no increase in the demand for imports under such a tax in the short-run, although it could if the tax were still in effect in the long-run.

Economic theory suggests that increasing marginal tax rates would have little effect on petroleum product prices, at least in the short-run. Profit maximizing firms choose production levels by producing up to the point where the marginal cost of production equals market prices. Since marginal changes in income taxes do not affect marginal production costs or market prices, profit maximizing levels of production, theoretically, would be unaffected by an income tax type of WPT. Over time, as the long-run average cost of production rises, firms may reduce output, thereby driving up prices.

A number of policy options are available should Congress decide to increase taxes on the oil and gas industry. President Obama's FY2012 budget proposes to eliminate a number of tax incentives available for oil and gas as well as coal producers. Eliminating existing tax subsidies is one option for increasing taxes paid by the oil and gas sector. Rather than review all options related to oil and gas tax incentives, the remaining sections of this report address alternatives that are variations on the two WPT options discussed above.

Marginal tax rates for oil and gas companies could be increased by repealing the IRC § 199 deduction for domestic manufacturing activities. This option does not actually attempt to measure or tax windfall profits, but uses the existing corporate income tax system to effectively increase the marginal corporate tax rate on domestic oil and gas producers. A repeal of the § 199 deduction could apply to all oil and gas producers, as proposed in the President's FY2012 budget, or apply only to major integrated oil companies, as proposed in the Close Big Oil Tax Loopholes Act ( S. 940 ).

Enacted in 2004 as an export tax incentive, IRC § 199 allows a deduction for a specified percentage of the qualified production activity's income (or profit). The deduction was originally established as a substitute for the repeal of the export tax benefits under the extra-territorial income tax exclusion, which was ruled to be in violation of trade laws. The deduction is subject to a limit of 50% of the wages paid that are allocated to the domestic production during the taxable year. The deduction was phased-in over time, starting at 3% in 2005, increasing to 6% in 2007, and increasing again to the full rate of 9% in 2010. Oil extraction is permanently limited to a 6% deduction.

For the domestic oil and gas industry, which qualifies for this deduction (i.e., it is not excluded from claiming it), the deduction applies to oil and gas or any primary product thereof, provided that such product was "manufactured, produced, or extracted in whole or in significant part in the United States." Note that extraction is considered to be manufacturing for purposes of this deduction, which means that domestic firms in the business of extracting oil and gas from underground reservoirs or deposits qualify for the deduction. Oil-related production activities such as refining, processing, and transportation are also limited to a 6% deduction.

Repealing or cutting back this deduction would be effectively equivalent to an increase in the marginal income tax rate. As was discussed above, a change in the corporate tax burden in the short-run is relatively neutral. Repealing the § 199 deduction would increase the top effective federal marginal tax rate for affected oil and gas producers from 32.9% to 35% (the statutory rate). All other large corporations would continue to face a top effective marginal tax rate of 32.9%, with the exception of non-manufacturing enterprises (services, for example), which do not qualify for the § 199 deduction. As was noted above, repealing the § 199 deduction does not attempt to measure and tax the oil industry's windfall profits. Instead, the repeal can be viewed as a way of using the existing corporate income tax system to increase the tax burden on the oil industry, and recoup some of any potential windfall or excess profits in the form of corporate income taxes.

As before, eliminating the deduction—that is to say, raising the corporate tax rate—would increase total (or average) business costs and therefore reduce profitability among the major oil and gas producers. As long as marginal production costs are unaffected, there would be no price effects in the short-run . Similarly, the demand for imports is likely to remain the same in the short-run. Thus, this type of corporate income tax increase would arguably be an administratively simple way to capture at least some of the oil industry's windfalls in the short-run. However, at a current deduction of 6%, and a marginal corporate tax rate of 35%, removing the deduction might only capture a small portion of the industry's potential windfalls.

The market price of crude oil and natural gas, or even of refined petroleum products, such as gasoline, would not be expected to increase very much, if at all, by such a change in the short-run. In general, also, the income tax increases are not expected to have real output effects in the short-run, although they could cause resources to flow to other industries in the long-run as long as these other industries are allowed the manufacturing deduction, which is equivalent to a lower marginal tax rate.

Researchers have attempted to quantify the effects of repealing various energy tax incentives on oil and gas markets. In 2009 testimony before the Senate Committee on Finance, Subcommittee on Energy, Natural Resources, and Infrastructure, Alan B. Krueger presented analysis from the Treasury Department on the economic impact of removing various tax incentives for oil and gas producers. The tax incentives under consideration were those presented in the President's FY2010 Budget Proposal, which included a repeal of the § 199 deduction, among other provisions. Similar proposals appear in the FY2011 and FY2012 budget proposals. Overall, Kruger's testimony suggested that the effect of removing existing tax incentives for oil and gas would have small market impacts. Treasury officials estimate that eliminating the § 199 deduction and other tax incentives for oil and gas would have little or no effect on the world supply of oil and world oil prices. Removing tax incentives for the oil and gas industry would be unlikely to result in significantly higher prices for consumers of refined petroleum products. Treasury officials also estimate the long-run effects on domestic production to be small. According to Kruger, removing the § 199 deduction along with other oil and gas tax incentives might result in a long-run reduction in domestic production of roughly 0.5%.

A WPT proposal could be combined with a repeal or reduction in the § 199 manufacturing activities deduction. This effectively uses two instruments to raise the corporate tax rate on domestic oil and gas producers. As noted above, repealing the § 199 deduction does not target windfall profits. Legislation could be designed that would attempt to tax windfall profits, or profits attributable to high petroleum prices, while also increasing marginal tax rates on oil and gas producers by eliminating the § 199 deduction.

A Tax on Imported and Domestically Produced Crude Oil

Another option would be to impose an excise tax on both imported and domestically produced oil. This tax would tend to have upward price effects—the price of crude oil in the United States would tend to be higher than under the WPT on domestic oil alone. This is because the tax would be imposed on imports, which are the residual source of oil supplies and therefore the benchmark for crude oil prices. The effect on domestic production and the level of imports—dependence on foreign imports—would depend on the size of the tax and the responsiveness of domestic supply and import demand to price changes.

A gas tax suspension could be enacted alongside an excise tax type WPT. The goal of this option might be to use the excise tax holiday—the suspension of the 18.4¢/gallon tax on gasoline—to offset any price increases associated with the excise tax type WPT. A suspension in the federal gas tax could have revenue consequences for the highway trust fund (HTF), if lost revenue are not offset from the general fund or some other source.

The statutory or legal incidence of the federal gas tax falls on the refiners. Depending on how responsive consumers of gasoline are to changes in price, some of the reduction in tax liability may be shifted forward to consumers, resulting in lower gas prices for consumers. In the short-run, consumers are not very responsive to changes in prices (e.g., the short-run price elasticity of demand for gasoline is low). Given that consumer demand is not responsive to changes in gas prices in the short-run, refiners would be unlikely to reduce prices with a gas tax holiday. In the long-run, as consumers are better able to change their behavior to adapt to higher gas prices, refiners may use the savings associated with a gas tax holiday to reduce gas prices for consumers. Thus, over a longer period of time, it is possible that a gas tax suspension could be used as a tool to offset potential price increases resulting from a WPT on crude oil.

A WPT on crude oil could generate sizeable revenues depending on the tax rate and the tax base. As discussed above, the tax base for a WPT would depend on which type of WPT was implemented: an excise tax type or income tax type. Revenues might also depend on crude oil prices at the time the tax were imposed. Providing estimated revenues associated with a WPT is beyond the scope of this report.

The excise tax type WPT probably has the greatest revenue potential when crude oil prices are high, partially because the tax base is not adjusted for operating costs. With an excise tax type WPT, the tax base is the difference between the market price and a legislatively determined base price. The tax rate applied to this base would also be determined by Congress. For example, an excise tax type WPT could be structured to impose a 50% tax on the difference between the market price of oil and $50/barrel. If oil prices remain high, this tax could generate substantial revenues.

The income tax type of WPT generally has a smaller revenue potential, as the tax base is likely to be smaller. In an income-tax-type WPT, taxable income is used as the tax base. Taxable income is generally smaller than book income (which is the net income measure reported in Table 3 ). Also, the income tax based proposal typically uses the average of taxable income over a lagged five-year period. Thus, in a period of generally rising prices, the base tends to vary proportionately with prices.

Eliminating existing tax preferences for oil and gas has the potential to generate substantial federal revenues. Repealing the IRC § 199 deduction would generate an estimated $18.3 billion in additional revenues over the 10-year, 2012 through 2021 budget window. As was noted above, the President's FY2012 budget proposes to eliminate a number of tax incentives for fossil fuels. Eliminating oil and gas tax preferences would generate an estimated $43.6 billion over the 10-year, 2012-through-2021 budget window.

High crude oil prices of the late 2000s have raised concerns that oil companies may be earning windfall profits, or profits that were excessive, unearned, or unfairly gained. As oil prices increased in the period leading to their 2008 peak, revenues and net income of the major integrated oil companies were also relatively high. When oil prices rose again in 2010, so did revenues and net incomes. During this period of high oil prices and price volatility, oil production by the major integrated oil companies remained relatively constant. The fact that revenues and income have risen without a corresponding increase in production has led to the observation that some of the gains enjoyed by the industry may be windfall profits.

Profit rates for major integrated oil companies, however, are in-line with profit rates in the broader manufacturing sector. Further, returns in the oil and gas sector are highly volatile. Over some periods, returns may exceed those earned in manufacturing broadly. Over other periods, profits earned by oil and gas producers may fall short of profits earned in other sectors. From this perspective, short periods of high profitability may represent volatility in the industry, rather than potentially sustained windfall profits.

Should a WPT—or other type of additional tax—be imposed on the oil and gas industry it is important to note that the potential economic consequences of different types of taxes differ. An excise tax type of WPT could lead to a reduction in domestic oil production, but would not likely lead to an increase in the price of petroleum for consumers. An income tax type WPT would be less likely to distort domestic production in the short-run. However, as resources are reallocated over time, and income tax type WPT could affect domestic production. In the short-run, an income tax type WPT would be unlikely to have much effect on prices. Over time, however, it is possible that an income tax type WPT could lead to price increases.

Another option for increasing taxes on the oil and gas industry, one that has been considered in the 112 th Congress, is scaling back existing tax benefits. Rescinding the § 199 domestic production deduction for oil and gas companies is another option for increasing taxes on the industry. This option, however, does not target windfall profits, but would instead effectively increase the marginal corporate tax rate for domestic oil and gas producers. Repeal of the § 199 deduction would be unlikely to reduce output or increase prices in the short-run. Further, any long-run market impacts on production and prices would likely be small.

Question: What would an excise-tax based WPT do?

Answer: An excise-tax based WPT would tax only domestic production and, like the one in effect from 1980-1988, would increase marginal oil production costs.

Question: What could be downsides to an excise-tax based WPT?

Answer: Theoretically, such a policy could reduce domestic oil supply, which could raise petroleum imports, making the United States more dependent on foreign oil, undermining goals of energy independence and energy security.

Question: What has changed about the number of these bills since the 109th Congress?

Answer: Since the 109th Congress, numerous bills have been introduced seeking to impose a windfall profits tax (WPT) on oil.

Question: What could be the benefits of an income-tax based WPT?

Answer: By contrast, an income-tax based WPT would likely be more economically neutral (less economic distortion) in the short-run.

Question: How would the possible taxes affect prices?

Answer: Neither the excise-tax based nor income-tax based WPT are expected to have significant price effects. Neither tax would increase the price of crude oil, which means that refined petroleum product prices, such as pump prices for gasoline, would likely not increase.

Windfall Profits Tax Legislation in the 109th–111th Congresses

Economic Effects of the Excise Tax Type of WPT

Analysis of Economic and Policy Issues
The Corporate Income Tax Type of WPT
Output Effects

Analysis of Economic and Policy Issues
The Corporate Income Tax Type of WPT
Oil Imports and Energy Independence

Analysis of Economic and Policy Issues
Alternative Policy Options
Rescinding the § 199 Deduction

A Tax on Imported and Domestically Produced Crude Oil

Question: What would be a simple way to recoup excess or windfall profits?

Answer: In lieu of these two types of WPT, an administratively simple way of increasing the tax burden on the oil industry, and therefore recouping some of any excess or windfall profits, particularly from major integrated producers, would be to raise the effective corporate tax rate.

Question: What action could be taken to implement this?

Answer: One option would be repealing or reducing the domestic manufacturing activities deduction under IRC § 199.

Question: Why might Congress continue evaluating various methods for increasing taxes on the oil and gas industry?

Answer: Going forward, in the context of deficit reduction, the 112th Congress may continue evaluating various methods for increasing taxes on the oil and gas industry to address concerns surrounding possible windfall profits.

Analysis of Economic and Policy Issues
Alternative Policy Options
An Income Type WPT Tax and § 199 Repeal


Teacher Quality Issues in the Elementary and Secondary Education Act

Summary: One of the major goals of the Elementary and Secondary Education Act of 1965 (ESEA), as amended by the No Child Left Behind Act of 2001 (NCLB, P.L. 107-110), is to raise the achievement of students who currently fail to meet grade-level proficiency standards. Because student achievement is widely believed to depend largely on the quality of instruction, the law also contains provisions designed to improve teacher quality. These provisions establish professional credentials for teachers and charge states and school districts with developing plans to improve teacher quality. According to the law, these plans must ensure that all core subject-matter courses are taught by a highly qualified teacher and that poor and minority students have equal access to quality instruction.

Summary: To be deemed highly qualified, NCLB requires that teachers possess a baccalaureate degree and a state teaching certificate, and that teachers also demonstrate subject-matter knowledge for their teaching level. Elementary school teachers must show knowledge of basic elementary school curricular areas. Middle and secondary school teachers must demonstrate a high level of competency in all subject areas taught. Demonstration of subject-matter knowledge and competency may be shown by passing a state certification exam or licensing test in the relevant subject(s).

Summary: This report examines implementation of the NCLB requirement and examines the extent to which schools achieved the law's goal of placing a highly qualified teacher in every classroom. After describing the highly qualified teacher requirement in detail, the report analyzes data from a national survey of schools conducted a year before NCLB became law. These data suggest that as many as four out of five teachers met the NCLB requirement prior to its enactment. Data reported throughout implementation of the law indicate that the proportion of highly qualified teachers increased each year, but that no state has reached 100%. In addition, analysis of these data also support concerns about the equitable distribution of teaching quality between poor and nonpoor schools.

Summary: This report concludes with a discussion of teacher quality issues that may be considered as the ESEA reauthorization process unfolds. Several of these issues have been the subject of waiver authority exercised by the Secretary of Education under both the current and previous Administrations. Congress has also taken up these issues along with reauthorization of the rest of the ESEA. This report will be updated as significant legislative developments occur.

It is widely believed that good teachers are critical to student learning. A large body of academic research has produced strong evidence that teacher quality is positively related to student performance. However, the strength of this research finding depends on the measure used to indicate "quality." Studies that use credentials such as degree attainment or teacher certification show weaker impacts on student performance than studies that use direct measures of teachers' pedagogical and subject-matter knowledge. Nevertheless, credentials are more readily available to local school administrators that hire teachers and more easily incorporated into state and federal policy. In recent years, education policy governing the attainment of teaching credentials has evolved to incorporate pedagogy and subject expertise. General state certification exams have been replaced or enhanced with testing for knowledge of subject matter. Some states have developed multi-tiered, knowledge-based certification systems. Teacher preparation programs in some states have begun requiring that candidates obtain a major or minor in a subject as a prerequisite for or in conjunction with an education degree.

Federal education policies have also aimed to enhance teaching credentials by placing added emphasis on subject expertise. Most recently, the Elementary and Secondary Education Act of 1965 (ESEA), as amended by the No Child Left Behind Act of 2001 (NCLB) ( P.L. 107-110 ), requires that all public school teachers, in states participating in the ESEA Title I-A program, be highly qualified by demonstrating subject knowledge for their teaching level. Elementary school teachers must show knowledge of basic elementary school curricular areas. Middle and secondary school teachers must demonstrate a high level of competency in all subject areas taught. Subject-matter knowledge and competency may be demonstrated by passing a state certification exam or licensing test in the relevant subject(s).

One of the major goals of NCLB is to raise the achievement of students who currently fail to meet grade-level proficiency standards. Since student achievement has been shown to be largely dependent on teacher quality, the law seeks to improve achievement by setting higher minimum teacher quality requirements. In complying with the law, schools are prevented from hiring teachers with emergency or provisional certification, those without a baccalaureate degree, or those with limited subject knowledge.

For some time, it was thought that schools hired teachers lacking full credentials because a shortage existed in the overall supply of qualified teachers. That idea has been challenged in recent years by research that revealed the shortage is in fact a distribution problem. Some so-called "hard-to-staff" schools find it difficult to maintain a staff of qualified teachers, while other schools have an adequate supply (and in some cases an oversupply) of quality teachers.

The reasons for the uneven distribution in the teacher supply are still a matter of debate. Some argue that rules providing priority in reassignment options to teachers with seniority and the late decision deadline given to resigning teachers relegates the least-qualified teachers to less desirable schools. Others point to working conditions and other factors that make these schools less desirable to quality teachers in the first place. Whatever the reasons for the uneven distribution of quality teachers, the persistence of hard-to-staff schools may undermine the impact of NCLB teacher quality standards in reducing the student achievement gap. To address this issue, Congress included in NCLB a requirement that poor and minority students have equal access to quality instruction.

This report examines implementation of the NCLB requirement of a highly qualified teacher in every public school classroom. The first section of the report describes the highly qualified teacher (HQT) requirement and how it was specified through regulation, guidance, and policy statements issued by the Education Department (ED). In the second section, the report analyzes data from a national survey of schools to assess teacher quality prior to enactment of NCLB and examines state reporting data to track how teacher quality may have improved throughout the law's implementation. Finally, the report discusses teacher quality issues that Congress may consider as the ESEA reauthorization process unfolds.

Teacher Quality and the No Child Left Behind Act

With regard to teacher quality, NCLB made three major amendments to the ESEA: (1) the law required that all teachers of core academic subjects be "highly qualified," (2) it mandated that the distribution of teacher quality be equal across poor and minority schools, and (3) it established accountability provisions to ensure that annual improvements in teacher quality are achieved.

A Highly Qualified Teacher in Every Classroom

NCLB requires that each state educational agency (SEA) receiving ESEA Title I, Part A funding (compensatory education of disadvantaged students) must have a plan to ensure that, by no later than the end of the 2005-2006 school year, all public school teachers teaching in core academic subjects within the state meet the definition of an HQT.

According to ESEA, Section 9101(23), the definition of an HQT has two basic components involving minimum credentials and subject-matter knowledge. First, to be deemed highly qualified, a teacher must possess a baccalaureate degree and full state teaching certification (i.e., must not have had any certification requirements waived on an emergency, temporary, or provisional basis). Second, a teacher must demonstrate subject-matter knowledge in the areas that she or he teaches. The manner in which teachers satisfy the second component depends on the extent of their teaching experience and the level at which they teach. These subject knowledge requirements are as follows:

New elementary school teachers must pass a rigorous state test demonstrating subject knowledge and teaching skills in reading, writing, math, and other basic elementary school curricular areas. New middle or secondary school teachers must demonstrate a high level of competency in all subjects taught by (1) passing rigorous state academic tests in those subjects, or (2) completing an academic major (or equivalent course work), graduate degree, or advanced certification in each subject taught. Experienced school teachers must meet (1) the requirements described above for new teachers (depending upon his or her level of instruction), or (2) demonstrate competency in all subjects taught using a "high objective uniform state standard of evaluation" (HOUSSE).

These provisions indicate that the tests used to demonstrate subject-matter knowledge may include state certification or licensing exams. Section 9101(23) states that a demonstration of subject-matter knowledge by an elementary school teacher "may consist of passing a State-required certification or licensing test or tests in reading, writing, mathematics, and other areas of the basic elementary school curriculum." For a middle or secondary school teacher, Section 9101(23) states that a demonstration of subject-matter knowledge "may consist of a passing level of performance on a State-required certification or licensing test or tests in each of the academic subjects in which the teacher teaches."

Equitable Distribution of Teacher Quality

Through passage of the NCLB amendments, lawmakers not only established minimum standards for teacher qualifications, they also sought to give all students equal access to good teachers. To this end, the law requires that each state desiring Title II, Part A funds submit a plan to the Secretary that, among other things, includes "steps that the State educational agency will take to ensure that poor and minority children are not taught at higher rates than other children by inexperienced, unqualified, or out-of-field teachers." The state's plan must further include the measures to be used to evaluate and publicly report on progress made in this area.

NCLB requires educational agencies to issue reports annually on the progress made toward meeting the HQT deadline. Each local education agency (LEA) is required to issue these reports publicly and report progress for the LEA as a whole and for each school within the LEA. Each SEA is required to submit reports annually to the Secretary on progress toward meeting the deadline.

Section 2141 of the law states that an LEA found to have failed to meet its annual HQT objectives for two consecutive years must submit an improvement plan to its SEA which must provide technical assistance in the development and implementation of the LEA's plan. An LEA found to have failed to meet its annual objectives for a third year that has also failed to make Adequate Yearly Progress for three consecutive years must enter into an agreement with its SEA and accept restrictions on its use of Title I and II funds. Specifically, such an LEA must agree to only use Title II funds for approved professional development activities that result in progress toward meeting the HQT deadline and may not use Title I funds to hire paraprofessionals.

Refining the Highly Qualified Teacher Definition

Following passage of NCLB, ED further specified the HQT definition through regulation, nonregulatory guidance, and other means. In general, these policy statements addressed concerns about the scope and application of the HQT requirements. Among a wide variety of implementation issues, ED sought to clarify what constitutes "core" subject matter, how states should develop and apply a HOUSSE, how the HQT requirements may be differentially applied to different types of teachers and in different types of educational settings, and when various aspects of the requirement must be completed.

Early in the implementation of these provisions, some asked whether they apply to all teachers, including vocational education teachers, special education teachers, or others not teaching core academic subjects. According to ESEA Section 9101(11), "The term 'core academic subjects' means English, reading or language arts, mathematics, science, foreign languages, civics and government, economics, arts, history, and geography." Final regulations for the Title I program published on December 2, 2002, in the Federal Register clarified that these requirements apply only to core academic subject teachers. ED noted that these requirements would apply to a vocational education teacher or a special education teacher providing instruction in a core academic subject.

ED addressed other subject matter issues in subsequent guidance and policy letters. A March 2004 policy announcement modified earlier nonregulatory guidance (issued in January 2004), which stated that science teachers teaching more than one field of science (e.g., biology and chemistry) would have to be highly qualified in each of the fields taught. Under the new flexibility, states determine whether science teachers need to be highly qualified in each science field they teach or highly qualified in science in general, based on how the state currently certifies teachers in these subject areas.

This new flexibility, along with other changes, was incorporated into the revised nonregulatory guidance issued on August 3, 2005. For example, the guidance clarifies that social studies is not considered a core subject and that certification in social studies or possession of a "composite social studies degree" does not necessarily indicate that a teacher is highly qualified to teach related subjects (e.g., economics and history). States are to determine whether a social studies teacher is qualified to teach the specific subject he or she is assigned to teach.

High Objective Uniform State Standard of Evaluation

According to NCLB, a teacher who is not new to the teaching profession may demonstrate subject matter knowledge through state-determined HOUSSE procedures. In defining its HOUSSE, the SEA must set standards for both grade appropriate academic subject knowledge and teaching skills that are aligned with challenging state academic and student achievement standards. The HOUSSE must provide objective information about teachers' content knowledge in all subjects taught and be applied uniformly statewide to all teachers in the same subjects and grade levels. Finally, the statute states that the HOUSSE may use multiple measures of teacher competency and may consider, but not be based primarily on, time teaching the relevant subjects.

Nonregulatory guidance, published on September 12, 2003, included suggestions on the development of HOUSSE procedures. According to the guidance, states should consider several factors when developing their HOUSSE procedures, including whether the proposed HOUSSE measures provide an "objective" way of determining whether a teacher has adequate subject-matter knowledge. The latest (August 2005) guidance defines new teachers as those with less than one year of teaching experience and teachers who are not new as those with more than one year of experience. However, the guidance indicates that states have the authority to determine who is new to the profession and who is not. States may also design their HOUSSE procedures to allow a teacher to go through the process a single time to demonstrate competency in multiple subjects.

Different Teachers in Different Settings

NCLB states that full certification includes "certification obtained through alternative routes to certification." The December 2002 final regulations indicated that teachers who were participating in an alternative certification program will be considered highly qualified on a provisional basis. Such teachers have a maximum of three years in which to become fully certified without being in violation of the highly qualified requirements regarding certification. This allowance is made only for a teacher in an alternative certification program who is receiving high-quality professional development, intensive supervision, and is making satisfactory progress toward full certification.

Concerns had been raised that the HQT requirements would limit participation in international teacher exchange programs. In a policy letter issued on March 24, 2003, the Secretary addressed these concerns by indicating how teachers from other countries could be considered highly qualified in the state in which they teach. The Secretary pointed out that each state has the full authority to define and enforce its own requirements for certification and licensure and make accommodations for foreign teachers. Accommodations could also be made in developing tests and other ways of demonstrating subject-matter expertise. In making this point, the Secretary clarified that one such demonstration provided in the law is coursework equivalent to an academic major.

These changes were included in the September 2003 updated guidance, along with clarification on the issue of middle school teachers. When determining whether teachers of core academic subjects in grades 6 through 8 should meet competency requirements for elementary or middle school teachers, the guidance advises states to "examine the degree of rigor and technicality of the subject matter that a teacher will need to know in relation to the state's content standards and academic achievement standards for the subjects in those grade levels." In addition, states may choose to consider teachers with middle school certification to be "highly qualified," and states may approve tests that are specifically developed for middle school teachers if the tests are "rigorous content-area assessments that are developed specifically for middle school teachers and aligned with middle school content and academic standards."

In a March 31, 2004, policy letter, the Secretary announced that additional flexibility could be applied in the implementation of the HQT requirements with regard to teachers in small rural school districts. In small rural districts, ED provided that teachers teaching core academic subjects who meet the highly qualified requirements in at least one of the subject areas they teach may have an additional three years to meet these requirements in the other subjects they might teach. For current teachers, this three-year grace period began with the 2004-2005 school year, meaning that rather than facing a deadline of the end of the 2005-2006 school year to be highly qualified in all core subjects taught, current rural teachers had until the end of the 2006-2007 school year. For newly hired teachers, a full three-year grace period can be provided from the date of hiring. But those newly hired teachers will have to be highly qualified in one of their core subject areas when hired. States decide whether to offer this flexibility to eligible rural districts.

Section 9101(23) states that charter school teachers must meet "the requirements set forth in the State's public charter school law." ED's guidance clarifies that this only refers to the requirements for certification and indicates that such teachers must meet all other HQT requirements. The guidance also states that teachers in juvenile and correctional institutions or "other alternative settings" must meet HQT standards only if such settings are considered LEAs under state law.

Each SEA was to submit its plan to meet the HQT deadline along with its Consolidated State Application for State Grants on July 12, 2002. The plan was to establish annual measurable objectives for each LEA and school that, at a minimum, included annual increases in the percentage of HQTs at each LEA and school to ensure that the 2005-2006 deadline was met. In turn, each LEA was also to have a plan to meet this deadline. In addition, beginning with the first day of the 2002-2003 school year, any LEA receiving ESEA Title I funding must ensure that all teachers hired after that date who are teaching in Title I-supported programs are highly qualified. States and LEAs must also submit annual reports to ED describing progress on the state-set annual objectives.

The Consolidated State Performance Reports (CSPR), for the 2003-2004 school year due in January 2005, were to contain the first data on the status of meeting the HQT requirement. However, ED reported widespread problems in state data systems and offered a series of regional data workshops to support states in collecting data. This includes the additional data on teachers who are not highly qualified that was required to be submitted in the January 2006 CSPR. ED announced these workshops in a policy letter to chief state school officers dated October 21, 2005.

The letter also announced additional flexibility in meeting the HQT deadline. The Secretary stated that the letter's purpose was "to assure you that States that do not quite reach the 100% goal by the end of the 2005-2006 school year will not lose federal funds if they are implementing the law and making a good-faith effort to reach the HQT goal in NCLB as soon as possible." Instead, states that "meet the law's requirements and the Department's expectations in these areas but fall short of having highly qualified teachers in every classroom" would be given an additional year to reach the 100% goal.

In a letter dated March 21, 2006, the Secretary requested that each state submit a revised plan to meet the 2006-2007 goal. The letter also established a schedule for reviewing these plans, monitoring their implementation, and assessing the state's progress. The Secretary's latest letter to chief state school officers on this policy (dated July 23, 2007) stated that all but one state had a plan approved. The letter also stated that data submitted in the 2005-2006 CSPR indicated that no state had reached 100% HQT (further examination of these data will be undertaken in the next section of this report). The Secretary reiterated ED's earlier position that no penalties would be imposed on states making a good-faith effort to reach the HQT goal.

Figure 1 provides a graphic diagram of the major HQT requirements as defined in NCLB and further specified in ED regulation and guidance.

This section examines progress made toward meeting the NCLB goal of placing a highly qualified teacher in every classroom. Data gathered prior to the law's passage will be compared to the most recent data available to see whether the nation's schools witnessed a measurable increase in the proportion of highly qualified teachers.

The only nationally representative source of pre-NCLB information on teacher quality is the Schools and Staffing Survey (SASS), which collects data on teachers' assignments, education, and certification. The SASS survey fielded during the 1999-2000 school year provides a snapshot of the teaching force prior to passage of NCLB. The only national source of post-NCLB data on teacher quality comes from the law's reporting requirements. Each year, states must submit to ED, as part of their CSPR, "the percentage of classes being taught by highly qualified teachers in the State."

It is important to note that the units of analysis for these two data sources are different. In the SASS data, the "objects" being measured in the survey are teachers; thus, these data are designed to address such questions as, "how many teachers are highly qualified?" Conversely, in the CSPR data the units of analysis are classes; thus, these data are designed to address such questions as, "how many classes are taught by highly qualified teachers?" Although the pre- and post-NCLB data come from different sources and use different units of analysis, these data do appear to show improvement in teacher quality over the years in which the law was implemented.

According to the 1999-2000 SASS survey, just under 3 million teachers were employed in the nation's public schools and, for about 6%, that year was their first year of teaching. Virtually all teachers (99.3%) held a baccalaureate degree at the time of the survey; the large majority (95.9%) also held some form of state teaching certification. Nearly one-third of all teachers did not teach a "core" academic subject during the 1999-2000 school year; these noncore teachers are not subject to the HQT requirement and are omitted from this analysis.

The SASS data suggest that prior to the passage of NCLB, more than eight out of ten teachers met the HQT requirement . Of the 2.1 million teachers who taught at least one core subject in 1999-2000, 1.73 million taught a single subject and 339,000 taught two subjects. Nine in ten single-subject teachers reported that they held full state certification in the subject they taught. Half of all two-subject teachers reported that they held full state certification in both of their subjects. Taken together, 84.5% of all single and two-subject teachers held a baccalaureate degree and reported being certified in the subject(s) they taught. Since NCLB considers state certification in all fields taught adequate demonstration of subject-matter knowledge, 84.5% of teachers met the HQT requirement. Table 1 presents the qualifications of core subject teachers for the 1999-2000 school year.

An additional 3.1% of all teachers were participating in an alternative certification program at the time of the survey. NCLB considers such teachers to be provisionally HQT and gave them three years to complete their program and become fully certified. Also qualifying for provisional HQT status (this time through regulation instead of statute) were another 0.4% of teachers who taught two subjects, held certification in only one, and were located in LEAs eligible for participation in the Small Rural School Achievement (SRSA) program (ESEA Title VI-B). According to ED's guidance, these teachers have additional time to demonstrate subject-matter knowledge in the field in which they are not highly qualified—one year in the case of veteran teachers and three years for new teachers. Thus, a total of 3.5% of all 1999-2000 teachers would have been temporarily deemed highly qualified teachers (combining those in alternative certification programs and those in SRSA schools who were uncertified in one of their two subjects).

NCLB reporting requirements (under the CSPR) ask states to tabulate the proportion of classes taught by highly qualified teachers, rather than the proportion of teachers who were highly qualified. Consequently, the CSPR data focus on a different unit of analysis and are not completely compatible with the estimates produced by the SASS survey. However, given that the SASS data show that a large majority of core subject teachers (83.6%) are also single-subject teachers, the proportion of core subject HQTs and the proportion of core subject classes taught by HQTs should not be greatly different.

The 1999-2000 SASS data show that prior to passage of NCLB, there was a very high proportion (84.5%) of core subject teachers who were highly qualified by the law's definition. Although they are not comparable to the SASS data, the CSPR data appear to show improvement in teacher quality over the years in which NCLB was implemented. Table 2 presents the percentage of core subject classes taught by highly qualified teachers. The 2003-2004 CSPR data show a higher proportion of HQT-led classes (86.5%) than was suggested by the SASS data, and the subsequent years show a steady increase over time—from 90.6% in 2004-2005 to 96.6% in 2012-2013.

The CSPR data also provide HQT information disaggregated by school level and poverty status. Although there was improvement each year and in all subgroups, the CSPR data show that classes taught by HQTs were not evenly distributed across school level or school poverty status. In each year, classes in elementary schools were more likely to be taught by HQTs than classes in secondary schools. Also in each year, classes in low-poverty schools were more likely to be taught by an HQT than classes in high-poverty schools.

The current funding authority for the ESEA expired after FY2007. Legislative action to reauthorize and amend the ESEA, along with the HQT requirements, has been previously undertaken by Congress. Legislative proposals have been forwarded and important action has taken place in the committees of jurisdiction in both chambers. Several reauthorization proposals would amend the HQT requirement to make accommodations for certain teachers or schools. Proposals address issues including multiple subject matter teachers, the definition of subject matter, middle school teachers, and rural, urban, and poor schools.

In addition to legislative action, Congress is concerned with issues raised by the Secretary's recent offer to waive certain NCLB requirements, including some associated with teacher quality. In exchange for these waivers, state and local educational agencies must commit to reforming their teacher evaluation systems, among other reforms. This may result in additional focus being placed on teacher performance as opposed to teacher qualifications. The remainder of this report will discuss issues raised by these waivers as well as other issues of interest to Congress as it considers reauthorizing the ESEA.

Although the analysis in this report indicates that less than one in five teachers cover more than one subject, those who did teach more than one subject were much less likely to be HQT. Among multiple subject teachers in this analysis, half did not meet the HQT standard. This small group—fewer than 6% of all teachers—may present a large problem for schools and states attempting to meet the 100% HQT requirement. Solutions have been proposed for certain kinds of schools (such as rural and hard-to-staff schools, discussed below); however, some proposals seek to address the problem for teachers in all schools generally. These amendments would allow teachers teaching multiple subjects to demonstrate knowledge in one subject area using the existing methods and provide a second method for other subject(s) taught. For example, multiple subject teachers who are HQT in one of their subjects could be given a certain amount of time to accumulate coursework equivalent to an academic minor in the subject(s) for which they lack sufficient knowledge.

The issue of multiple subject teachers is in part created by the definition of subject matter in NCLB. Specifically, Section 9101(11) of the statute states that, "The term 'core academic subjects' means, English, reading and language arts, mathematics, science, foreign languages, civics and government, economics, arts, history, and geography." As mentioned earlier, ED addressed issues related to science and social studies teachers in its nonregulatory guidance. States were given the authority to determine whether teachers qualified to teach in one field of science or social studies were qualified in other fields in those areas. Some have proposed legislative solutions that would recognize "generalist" certificates in these and other areas as proof of subject-matter knowledge.

Many of the teachers found not to meet the HQT standard are teaching middle school students. The problem posed by this group of teachers is that some have duties similar to elementary teachers, while others are more like secondary school teachers. That is, some middle school teachers work in so-called "self-contained" classroom settings where they are responsible for teaching multiple subjects to the same group of students. Meanwhile, other middle school teachers work in "departmental" settings, in which they teach the same subject to different groups of students over the course of a single day. According to NCLB, middle school teachers are to be treated like secondary school teachers with regard to demonstration of subject-matter expertise. Thus, those teaching multiple subjects in self-contained classrooms must be certified to teach in several subjects—or prove subject knowledge in each area by the other permitted means. The proposals to recognize "generalist" certification mentioned above would remedy this problem. Other proposals include expanding the allowable types of experience and forms of evaluation permitted in state HOUSSE methods for veteran middle school teachers.

The multi-subject issue just discussed is compounded in small, rural schools, which appear to have an especially difficult time meeting the 100% HQT requirement. This analysis revealed that only a small fraction (0.4%) of teachers benefit from the SRSA waiver. SRSA schools are largely defined as those located in areas classified as "rural" according to the U.S. Census Bureau locale codes. ED analysis has found the Census locale code classifications of rural areas to be at best crude and in some cases grossly inaccurate. Some proponents suggest that rural schools get extended time to meet the HQT deadline; however, others would provide this option only to SRSA schools. Still others propose giving the Secretary the authority to waive the HQT requirement for any rural school that could demonstrate that the requirement would impose an undue hardship on the school because of population and geographic constraints.

The data in Table 2 revealing higher HQT rates in non-poor schools compared to poor schools supports research that has shown that schools in poor neighborhoods and central city locations have higher rates of underqualified teachers. Although no legislative amendments have been proposed to address issues regarding urban or poor schools, some of the proposals presented here that concern "hard-to-staff" schools could be adopted to relieve the burden imposed by the HQT requirement. However, given the high turnover rates at these schools, short-term waivers and deadline extensions may not provide sufficient relief. At the same time, such flexibility would weaken NCLB's emphasis on securing highly qualified teachers in hopes of improving instructional quality—especially for disadvantaged students attending schools in high poverty areas.

On September 23, 2011, the Administration announced that states would have the opportunity to request, on behalf of school districts, flexibility regarding specific NCLB requirements, including elements of HQT. Under this flexibility, an LEA that does not meet its HQT targets would no longer have to develop an improvement plan and would retain flexibility in how it uses its Title I and Title II funds. Additionally, a state granted this flexibility would be exempt from the requirements regarding its role in the implementation of LEA improvement plans, including the requirement that the SEA enter into agreements with LEAs on the uses of funds and the requirement that it provide technical assistance to LEAs on their plans. States would not be exempt from the requirement that they ensure that poor and minority children are not taught at higher rates than other children by inexperienced, unqualified, or out-of-field teachers. This flexibility appears to extend the "good faith effort" waiver provided by the previous Administration. As with the accommodations made above, such actions would weaken minimal qualification requirements that teachers are now expected to meet. Although, waiver requirements pertaining to teacher evaluation systems are another approach toward promoting quality instruction.

Question: What is a major goal of the Elementary and Secondary Education Act of 1965 (ESEA)?

Answer: One of the major goals of the Elementary and Secondary Education Act of 1965 (ESEA), as amended by the No Child Left Behind Act of 2001 (NCLB, P.L. 107-110), is to raise the achievement of students who currently fail to meet grade-level proficiency standards.

Question: Why does the law cover teacher quality?

Answer: Because student achievement is widely believed to depend largely on the quality of instruction, the law also contains provisions designed to improve teacher quality.

Question: What do these laws establish?

Answer: These provisions establish professional credentials for teachers and charge states and school districts with developing plans to improve teacher quality.

Question: What does the law ensure regarding these plans?

Answer: According to the law, these plans must ensure that all core subject-matter courses are taught by a highly qualified teacher and that poor and minority students have equal access to quality instruction.

Equitable Distribution of Teacher Quality

Question: What does this report cover concerning qualified teachers?

Answer: This report examines implementation of the NCLB requirement and examines the extent to which schools achieved the law's goal of placing a highly qualified teacher in every classroom.

Question: What data does the report cover?

Answer: After describing the highly qualified teacher requirement in detail, the report analyzes data from a national survey of schools conducted a year before NCLB became law.

Question: What does the data show about teachers prior to NCLB enactment?

Answer: These data suggest that as many as four out of five teachers met the NCLB requirement prior to its enactment.

Question: How has newer data showed changes since the NCLB enactment?

Answer: Data reported throughout implementation of the law indicate that the proportion of highly qualified teachers increased each year, but that no state has reached 100%.

Question: What additional questions does this data raise?

Answer: In addition, analysis of these data also support concerns about the equitable distribution of teaching quality between poor and nonpoor schools.

A Highly Qualified Teacher in Every Classroom

Question: How does the report end?

Answer: This report concludes with a discussion of teacher quality issues that may be considered as the ESEA reauthorization process unfolds.

Question: How else have many of these issues been addressed?

Answer: Several of these issues have been the subject of waiver authority exercised by the Secretary of Education under both the current and previous Administrations.

Question: What other bodies have taken up these issues?

Answer: Congress has also taken up these issues along with reauthorization of the rest of the ESEA.

Question: How will the report be updated?

Answer: This report will be updated as significant legislative developments occur.