President Obama's budget proposal this week is likely to seek an end to federal tax breaks for oil and gas companies, attempting to revive a bid that died in Congress last year. Meanwhile, with much more rigor, Alaska is heading in the opposite direction.

Alaska's State House is working on a bill already passed by the Senate that would overturn the state's progressive oil tax structure, which increases the taxes oil companies pay as the price of oil rises. Supporters of the overhaul bill, which was written by Republican Governor Sean Parnell, say the tax break will help boost dwindling oil production in Alaska, which was overtaken by North Dakota last year as the number two oil-producing state. (See related: "Pictures: Bakken Shale Oil Boom Transforms North Dakota," and "The New Oil Landscape.") Texas produces by far the most oil in the United States.

Critics of the Alaska bill, however, say the move marks the end of a taxation scheme that has filled state coffers while much of the rest of the United States struggled through the recession. And they worry the break will do little to spur oil production.

"It's a grab by the oil industry," said state Senator Bill Wielechowski, an Anchorage Democrat. "This is billions of dollars that the state is turning over to the industry."

Progressive Pinch

Alaska currently taxes oil profits at 25 percent per barrel when oil prices are $30 per barrel, although crude has sold at far higher prices for the past decade, averaging $94 a barrel by the U.S. benchmark price last year. The sting for oil companies comes because the tax increases 0.4 percentage points for every $1 per barrel above $30, which causes taxes to rise as oil price increase. The tax and countervailing credits are complex, and estimates of how much companies actually pay range from 40 percent to 80 percent, depending on whose calculations you use—the advocates of keeping the current system or those calling for reform.

In contrast, North Dakota's production and extraction taxes add up to about 11.5 percent of the gross value of the oil produced, and there are reduced rates meant to incentivize certain types of drilling, including the horizontal wells that make up the majority of the booming shale oil business in the state. Texas' oil-production tax is 4.6 percent per barrel plus some other small fees.

The Alaska Senate's oil tax reform bill would create a flat 35 percent oil tax, with $5 per barrel exempted for all produced oil. The Republican-controlled House has been working on the legislation in late-night sessions, with a version expected to pass before the end of the legislative session this week.

Last year, Alaska brought in $8.9 billion in revenue from its oil tax, which accounted for 93 percent of the state's total tax haul. Although it's unclear how much would be lost under the reform plan, estimates are about $1 billion a year.

Parnell, a former partner at the Washington, D.C.-based law firm Patton Boggs, which counted ConocoPhillips and ExxonMobil as clients, has long pushed for lower taxes for oil companies. Parnell says the current system discourages exploration and production by oil companies, costing jobs and putting the state's huge Trans-Alaska Pipeline System (TAPS), one of the largest oil-conduit systems in the world, at risk as the amount of crude passing through it declines.

"The decline is not because Alaska is running out of oil," Parnell said in one of the weekly oil tax messages he has been publishing online since January. "It is because we are running behind the competition."

Pipeline Woes

There is little agreement between Alaska Democrats and Republicans on the tax issue, but the state's drop-off in oil production is inarguable. Production on Alaska's North Slope has declined to less than 560,000 barrels a day from its 1988 peak of 2 million barrels. That decline has created potential problems for TAPS, which runs 800 miles (1,287 kilometers) from the Prudhoe Bay oil fields in northern Alaska to the Valdez Marine Terminal, where crude is hauled to refineries by ship.

As the amount of oil moving through the pipeline falls, oil velocity slows and transit time increases, exposing the oil to frigid Alaskan winters in sections above the ground. Alyeska Pipeline Service Company, which operates the system, said diminished flow allows water and solids to settle out of the oil, which can lead to ice formation, corrosion, and ruptures as the pipe repeatedly freezes and thaws.

The three largest oil producers on the North Slope—BP, ConocoPhillips and ExxonMobil—have blamed part of the production decline on the tax structure known as "Alaska's Clear and Equitable Share" or ACES. The tax is the signature 2007 legislation of former Governor Sarah Palin, a Republican who pushed through the policy by harnessing populist resentment over federal corruption investigations that led to indictments of six Republican state senators, the late U.S. Senator Ted Stevens, and executives from the oilfield services contractor VECO Corp.

The tax increase has been a windfall for the state, despite declining oil production. While many other states face budget deficits due to years of economic decline, Alaska, among the least populous states, put away $17 billion in a rainy day fund with no state income or sales tax. With tax reform expected to become law this year, Democratic senators say those days are finished. "We will burn through those savings in the next few years," said Hollis French, an Anchorage Democrat.

The Palin-era tax flooded the state with cash, but oil industry representatives say ACES has discouraged investment in Alaska's so-called legacy oilfields. In March testimony to the state Senate, ExxonMobil's tax attorney Dan Seckers called ACES a "major disincentive" to investing in production of the more than 5 billion barrels of oil that remain in the North Slope. "Without meaningful tax reform . . . Alaska can expect production declines to continue," Seckers said.

Energy State

Alaska runs on oil money, and the oil industry has strong financial ties to state politics. In 2012, redistricting helped Republicans win a majority in the previously split Senate, which had rebuffed Parnell's previous efforts at tax reform. On its way to passage in the Senate of Alaska's part-time legislature in late March, Parnell's bill moved through committees with the help of senators who are also ConocoPhillips employees, according to reporting by AlaskaDispatch.

Senate Democrats say the oil industry and the governor have used the threat of job losses and declining oil production as scare tactics at a time when, ironically, the North Slope is experiencing record employment and the oil industry is posting strong profits in the state. And although they voice concern about diminished oil flow through the pipeline, they doubt the governor's tax cut will spur production.

"I hope he is right but I'm afraid he is wrong," French said. "We are taking the approach of slashing taxes and hoping for the best."

This story is part of a special series that explores energy issues. For more, visit The Great Energy Challenge.