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SLIMMING THE GOOSE: Less Foie Gras but More Golden Eggs?
Ben Smith
Visiting Fellow
College of Business and Economics
Australian National University
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of the key steel-making raw materials, iron ore and coal, and of being located close to
the world‟s fastest growing markets for those materials, first in Japan, Korea, and
Taiwan and subsequently in China and India.
Like the rent value of land, the rent value of in situ minerals is a residual – what is left
over after the other factors employed in production have been fully compensated. If
iron ore simply lay on the surface in known locations, needing only to be scraped up
and moved to a shipping point at which it could be sold for a known constant price of,
say, $100 per tonne of contained iron, and if the cost of hiring the necessary
equipment and labour (including the required managerial expertise) were also a
known constant amount of $60 for every tonne of contained iron, the residual (or rent)
value of the resource would be $40 per tonne. The owner of a deposit of this resource
could charge mining companies a “royalty” of $40 for every tonne removed without
deterring them from engaging in the activity. However, mining doesn‟t work like
that.
First, some tonnes of contained iron are more costly to extract than others, either
because mining conditions are themselves more difficult or because the concentration
of iron in the material being mined is lower. Thus, there will be some tonnes that cost
less than $60 to extract and others that cost more than this amount. If the resource
owner charges a $40 royalty in this situation the more costly ore will not be mined
and its rent value will be forgone. Moreover, for the material that is extracted the
resource owner will only have collected the full rent value of those tonnes that cost
exactly $60. If there are some tonnes that cost only $20 to extract (so their rent value
is actually $80), only half of that rent will go to the resource owner and the other half
will remain with the mining company.
Secondly, the price at which the contained iron can be sold is not constant or certain.
For example, it may vary between $50 and $150 per tonne. If the mining company
could hire equipment and personnel on a week-by-week basis, and if it faced a $40
per tonne royalty, it would extract little, if any, material when the price was very low
and a large amount when the price was high. But mining doesn‟t work like that
either. Mine development requires large initial investments and, to a significant
extent, the future pattern of extraction (how much ore and of what grades) is
conditioned by them. The variable cost per tonne extracted may be relatively low up
to the design capacity of the mine, but rise sharply as that capacity limit is
approached. Consequently, in the short to medium term, mine output is fairly
insensitive to price changes (with the consequence that minerals prices are highly
sensitive to demand changes). The mining company‟s problem is to decide in
advance what sort of mine to build, on the basis of its expectations about future prices
and costs. The higher the royalty per tonne, the more likely it is that the company will
decide either to forgo the project entirely or to “high grade” the deposit, taking only
the highest quality, lowest cost material and leaving lower grade ore in the ground.
One result in the latter case may be that mining the lower grade ore may never
subsequently be commercially viable, regardless of any future royalty regime.
Finally, of course, mineral resources are not just lying around in plain view waiting to
be picked up (though sometimes the situation is not very different from that).
Deposits have to be discovered and delineated by exploration before they can be
mined. For each highly profitable mining operation, there are many investments in
exploration that have either failed entirely or delivered resources that are only
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marginally worth mining and don‟t repay the cost of their discovery. Application of a
fixed royalty to successful outcomes reduces the incentive to engage in exploration.
The challenge, then, is to devise a means of identifying the rent value of resources
that, to a greater or lesser extent, are yet to be discovered – that is, identifying the
residual amount that remains after mining companies have been fully compensated for
the risky investments in exploration and mine development that are required - and a
mechanism whereby the owner of those resources can capture (at least a reasonable
share of) that value without reducing the incentives for their efficient exploitation.1
1. Or, more accurately, that do not distort those incentives more than they are already distorted
by the application to mining investments, as to all other investment, of the standard income
(corporate and personal) tax.
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debate. Among the main contributions to this were those of Swan (1976, 1978),
Garnaut and Clunies-Ross (1979), and Fane and Smith (1986). An important element
in that discussion was comparison of the effects of the RRT with those of a
mechanism suggested by Brown (1948).
The Brown (or Pure Rent) Tax is neutral in its effects on investment decisions
because, at least in its most transparent form, it is not a “tax” at all. The government
effectively purchases a silent equity share in the exploration/mining project equal to
the tax rate and, like any private joint venturer, receives a corresponding share of the
profits. Thus, if the tax rate were 40 per cent, the government would contribute that
share of all investment costs and the 40 per cent “tax” on future returns to the project
would simply be the means by which the government collected its equity share of the
profits. The mining company would have put up 60 per cent of the cost of the project
and would receive 60 per cent of the returns, subject to no charge, so its incentive to
undertake the project would be unaffected.
In the transparent form of the Brown Tax, the government contributes to investment
costs as they are incurred, financing this by general government borrowing.
Alternatively, however, the government may “borrow” from the mining company to
finance its share of costs, repaying this “loan” with interest from its share of the future
profits. To make this equivalent, the government would need to guarantee to meet
any outstanding balance of its “debt” by a direct payment to the company if, over the
life of the project, its share of the profits turned out to be insufficient to provide full
repayment. Given the certainty that the “debt” would be fully repaid by one means or
another (assuming the government‟s guarantee to be credible) the interest rate at
which it accumulated would not need to include any risk premium.
With some refinements, the case just described is exactly what the AFTS Report has
recommended and what the government has indicated it will introduce as the
Resource Super Profits Tax (RSPT). From the point of view of the mining company,
the difference from the transparent Brown Tax is that, in addition to meeting its 60 per
cent share of the investment costs, it is effectively obliged to purchase an unofficial
government bond of value equal to the other 40 per cent of those costs. If it can
borrow against the security of this “riskless” asset at the same interest rate that the
asset earns, then it should be indifferent between the two arrangements.
Fane and Smith (1986) showed that the RRT can similarly be characterised as a case
in which the government borrows from the company to finance a share of investment
costs equal to the tax rate, but only commits to repaying the loan to the extent that its
share of future profits provides sufficient funds. In that case, the company bears the
risk that the project will not be sufficiently profitable for the loan to be fully repaid
and needs to be compensated for this by being offered an interest rate (the uplift or
threshold rate in the RRT formula) that includes an appropriate risk premium.
In fact, the RRT can be thought of as the equivalent of a Brown Tax, to which has
been added a tax on investment whose rate is higher the greater the uncertainty
surrounding the investment outcome plus a subsidy to investment whose rate
increases as the uplift rate rises and as the degree of uncertainty surrounding the
investment decreases. For a given level of investment uncertainty (and time profile of
possible outcomes), there exists an uplift rate at which these tax and subsidy elements
exactly counteract one another, so that the RRT has the same neutral effect as the
Brown Tax, but that “neutral” uplift rate varies dramatically from project to project
and, within a project, between different kinds of investments (see Smith, 1999 for an
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extensive discussion of this). Any uniformly applied RRT formula will have
significant deterrent effects on some investments, while providing significant
incentives to over-investment elsewhere. Notably, although the balancing point at
which the taxing and subsidising elements of the RRT exactly counteract one another
is independent of the tax rate applied, the magnitude of the distorting tax or subsidy
that emerges when the uplift rate is set incorrectly increases with the tax rate. In order
to avoid substantial distortions to investment decisions when the uplift rate is too high
or too low, which it almost always will be, the taxing authority is obliged to keep the
tax rate at a relatively moderate level.
In a rough and ready attempt to deal with the fact that investment risk varies between
different kinds of investments, the Petroleum RRT was amended so that the uplift rate
applying to mine development expenditure was reduced below that for exploration
expenditure. The AFTS Report suggests that the uplift rate on development
expenditure (5 percentage points above the long term government bond rate) is still
overly generous, citing the corporate bond rate (about 2 percentage points above the
long term government bond rate) for comparative purposes. However, this would be
the relevant yardstick only if companies could finance projects subject to the PRRT
wholly by borrowing at the corporate bond rate, with the debt secured only against
those projects rather than against the assets of the company as a whole. The plain fact
is that the taxing authority does not, and cannot, know what the appropriate RRT
uplift rate for any given investment is (and hindsight is not a useful guide). All it can
do is to set a uniform rate across a broad class of similar investment types, knowing
that this rate will be either too high or too low in almost all cases, and to moderate the
distorting effects of this by keeping the tax rate applying to returns in excess of the
uplift rate at a relatively modest level.
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the nature of those charges. That is, by auctioning rights subject to the application of
a specified form of charge on mining activity. If that charging mechanism can be
seen to guarantee the community a significant share of any rents earned, regardless of
the quality of deposits discovered or future market conditions, the sovereign risk
concern that additional charges may be imposed will be abated and companies are
more likely to bid the full residual value of the rights. Independently of that issue,
Emerson and Lloyd (1983) argued that a combination of up-front auction payment
and conditional tax payment would generate efficiency gains by allowing risks
associated with resource development to be divided between the mining company and
the government in a manner that reflected their relative risk preferences.
A separate concern about auctioning has been fear that competition in the bidding
process would be limited, other than for areas of known high prospectivity. In the
absence of significant competition, companies will bid less than the expected value of
the resources independently of any sovereign risk concerns.
A company gains access to resources through the granting of an exploration licence
and, if a worthwhile deposit is discovered, a mining licence. Except where there is
evidence that more than one company is currently interested in the area, an
exploration licence is granted to the initial applicant for a limited period (e.g. 6 years)
on conditions that require bona fide exploration to be conducted and a progressive
surrendering of the area covered (together with disclosure of all information gained
about the surrendered land, which is then made available to any other interested
parties). This is commonly referred to as a “First Come, First Served” allocation
mechanism. In cases where there is wider interest, companies are most commonly
invited to submit work programs that detail their exploration plans, with the licence
being awarded to the company that submits the “best” program. Although there is no
explicit indication that “best” means “most expensive”, it is hard to imagine that this
is not the dominant criterion. Thus, companies are provided with incentives to
dissipate the expected rent value of resources by enlarging their exploration
expenditure beyond what would be efficient in order to win the auction.
Regardless of other considerations in the resource charging debate, there is a very
strong case for replacing work program bidding with straightforward cash bidding and
leaving the winners to decide for themselves how most efficiently to exploit the
resource rights they have acquired. No community advantage accrues from providing
incentives for companies to undertake a larger exploration program than they would
otherwise choose in areas that are already believed to be of prospective interest.
This is somewhat less clear in areas that are of limited current interest to explorers,
where the first come, first served arrangements apply. Exploration data from such
areas may provide information about the prospectivity of neighbouring areas, so that
there is an external benefit that the exploring company does not capture and does not
take into account in determining its exploration program. These “exploration
spillovers”, as the AFTS Review calls them, provide the only reasonable justification
for the work commitment and limited tenure conditions of exploration licences, whose
effect is to give companies incentives to explore more rapidly and intensively than
they otherwise might have chosen.
In its report on Mining and Mineral Processing in Australia, the Industry Commission
(1991) reviewed the arguments outlined above and concurred with the view that
existing royalties should be replaced by a more efficient mechanism, combined where
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possible with the auctioning of mineral rights. The problems of designing a RRT that
would not generate significant distortions to investment decisions led it to favour a
Brown Tax arrangement. Recognising that, by itself, this would capture resource
rents for the community only to the extent that the taxing authority also bore the risks
through its implicit equity stake, the Commission considered the possibility of
imposing the tax at a high rate, with the consequence that the authority‟s implicit
equity share would also be large. Its view was that this would create difficulties, both
because mining companies with only a small stake in each project would have
reduced incentives to operate efficiently and because it might expose the government
to a greater level of risk and revenue uncertainty than was acceptable. One could add
to this the problem of maintaining a non-managerial role as a silent partner in an
industry that was, effectively, a majority-owned public enterprise.
In keeping with the main thrust of the academic debate, the Commission concluded
that there were only two ways governments could capture the rent value of resources
without distorting incentives for their efficient exploitation. They could auction the
rights to those resources and obtain certain revenue equal to the expected rent value
or, through a Brown Tax, they could themselves undertake the risky exploration and
mine development investments necessary to realise that value. Problems with
exclusive reliance on one mechanism or the other led the Commission to recommend
the auctioning of rights subject to the application of a Brown Tax at a moderate rate
(40 per cent being mentioned as a possibility).
The Commission did not make specific recommendations for implementation of its
favoured policy approach and its arguments were pretty thoroughly ignored. They lay
more or less dormant for almost 20 years until being dusted off and closely echoed by
the AFTS Review, with the most important differences being that the AFTS Review
did make definitive and detailed recommendations for policy implementation, at least
on the taxation aspect, and that these have not been ignored.
2. Defining the boundaries of a project is not a straightforward matter in many cases. There are
often questions about whether infrastructure investment (especially in transport and port
facilities) should be included as part of the “project” and, if it is not included, about the
charges for its services that should be allowed in calculating the “mine gate” value of minerals
output in the assessment of project net cash flow.
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exceeds the risk-inclusive discount rate that a mining company would apply to such a
project, the investment will be undertaken.
If a Brown Tax in its most transparent form is imposed at the rate of 40 per cent, the
government will pay the mining company $40 in year 0 and “tax” future positive net
cash flows at the 40 per cent rate. As a result, the company‟s net expenditure on the
project is reduced to $60. In the favourable outcome, the company pays tax of $60
($150 x 0.4) in each of years 1 and 2, and retains $90 of the net cash flows generated
in those years. In the unfavourable case, both the government and the company
receive zero payment in years 1 and 2. Since both its initial investment cost and all
future net receipts have been reduced to 60 per cent of their pre-tax value, the
company still earns an expected return of 32 per cent on its investment. If 100 per
cent of the project was a worthwhile investment for the company, 60 per cent of it will
be similarly worthwhile, so the tax will neither discourage nor encourage the
investment.
The result, from the point of view of the mining company is the same as if it had
entered into a joint venture arrangement with another company, which supplied 40 per
cent of the required capital but had no management role. Of course, it might have
preferred not to enter into such a joint venture arrangement, for two possible reasons.
First, if the expected return exceeds the company‟s risk-inclusive discount rate so that
pure profits are expected to be made, the company would prefer to capture all of them
rather than only 60 per cent of them. Such pure profits reflect the rent value of the
resources being exploited. The greater those are expected to be, the more resistant
one would expect the mining company to be to sharing them.
Secondly, the company may possess expertise that is not generally available and
which enhances either the probability of achieving the successful outcome or the size
of the positive net cash flows associated with it. The company will not want to share
rents due to that expertise with a partner. The AFTS Report recognises this but points
out that, although the government would be expropriating 40 per cent of any
company-specific rents, it would also be leaving 60 per cent of the resource rents in
the hands of the company. Both parties bring something intangible and difficult to
measure to the project and they are sharing in the total rents generated.
For brevity of future reference, the transparent form of the Brown Tax is referred to as
the Direct Capital Contribution (DCC) approach. Alternatively, the government may
“borrow” its 40 per cent share of investment costs from the company and repay this
“loan” from its share of future positive net cash flows. If the government provides a
credible guarantee that the “debt” will fully be repaid, regardless of the project‟s
outcome, the “loan” is a riskless asset and the interest rate applied to it should reflect
that. Viewed properly, in our example the result will be that the mining company
holds two distinct assets: a $60 stake in the project, whose pay-off is uncertain and
depends on whether the favourable or unfavourable outcome occurs; and a $40 loan to
the government whose pay-off is certain. On the former asset it requires a risk
inclusive expected rate of return: on the latter asset it doesn‟t.
There are various ways that repayment of the government‟s debt could be scheduled.
Under the Petroleum RRT, the deductions arising and carried forward at the uplift rate
can (and are required to be) used as rapidly as positive net cash flows within a project
permit. I will call this the Early Expensing (EE) approach. In contrast, the RSPT
limits the deduction available in each year to the accumulated interest on the debt plus
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the amount that would be deductible for depreciation purposes under the company tax.
This is the Allowance for Corporate Capital (ACC) approach. The result is that the
government‟s debt is repaid more slowly than with EE, so net tax revenue is collected
somewhat sooner but it is also somewhat more likely that a cash payment will be
required at the end of a project‟s life.
So long as the government guarantees ultimately to meet its debt obligation and the
uplift rate is set equal to the riskless rate of interest, scheduling of the debt repayment
should be a matter of indifference to both the government and the mining company.
In the following illustrations it is assumed for convenience that the relevant riskless
rate of interest is 10 per cent per annum and that the depreciation deduction allowed
under the company tax for our hypothetical project is 50 per cent per year in each of
years 1 and 2 if the project is successful and 100 per cent in year 1 if it is not.
Table 1 shows the net cash flows both for the company and the government under the
different arrangements. With DCC, the net cash flows of the project as a whole are
just split 60:40 between the company and the government, as previously described.
For the EE and ACC cases, two separate net cash flow streams are shown for the
company, where (P) denotes those relating to its 60 per cent interest in the project and
(L) denotes those associated with its “loan” the government.
In the EE case, the company carries the total investment cost forward at the 10 per
cent interest rate, giving it a deduction in year 1 of $110. In the successful outcome,
this reduces its tax base to $40, on which it pays $16 tax (0.4 x $40) and,
consequently, retains $134 of the total project net cash flow. Disaggregated, this is
equal to the $90 it would have received under DCC plus $44, which is full repayment
of the $40 loan to the government with 10 per cent interest. Since the government‟s
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debt has been fully discharged in year 1, the company‟s tax base in year 2 is the whole
of the project‟s net cash flow, on which it pays tax of $60, so the outcome for both
parties in that year is the same as under DCC. In the unsuccessful case, the
government recognises the $110 deduction in year 1 when the project terminates and
writes a cheque for 40 per cent of that amount. From its $60 investment in the mining
project, the company receives exactly the same flow of income as under DCC. From
its $40 loan to the government, it receives full repayment with interest in year 1,
regardless of the project‟s outcome.
Under the ACC approach of the RSPT, the company again has a carried forward
allowance of $110 in Year 1. However, it is now only able to deduct the $10 interest
component of this plus the amount allowable in the depreciation provisions of the
company tax. In the unsuccessful case this is the whole $100 of expenditure, so it can
claim $110 and, as in the EE case, the government writes a cheque for 40 per cent of
this amount. In the successful case, with 50 per cent depreciation allowed in each of
years 1 and 2, it can deduct only $60 in year 1 ($10 + $50), giving it a tax base of $90
on which it pays $36 tax, so it retains $114 of the total net cash flow in that year. This
is equal to the $90 it would have received under DCC plus $4 interest on its $40 loan
to the government plus repayment of half the capital value of that loan. The reduced
RSPT Allowance of $50 ($110 - $60) is then carried forward with interest to give it an
allowance of $55 in year 2, all of which can be deducted since it is equal to the $5
interest component plus the $50 depreciation the company is allowed in that year.
Consequently, the company‟s tax base is reduced to $95, on which it pays tax of $38,
retaining $112 of the total project income. Disaggregated, this is equal to the $90 it
would have received under DCC plus repayment of the $20 outstanding balance of its
loan to the government with $2 of interest.
So long as the company can borrow to finance its loan to the government at the same
interest rate that the government pays on the loan, the EE and ACC approaches are
both exactly equivalent to the DCC case. If, however, the interest rate at which the
company is able to borrow exceeds that paid by the government, the enforced loan
will impose a cost that is greater the longer this loss-making asset has to be held, so it
will be greater under the ACC approach of the RSPT than it would be with EE.
It is tempting to think that this excess cost must exist, since the interest rate at which
companies normally can borrow exceeds the long-term government bond rate that
constitutes the “allowance rate” for the RSPT. But, of course, corporate borrowing is
never entirely riskless and the corporate bond rate includes a risk premium. If, in this
case, financial institutions can satisfactorily secure lending against the government‟s
guaranteed payments, they will not need to charge any risk premium.
All this, of course, is critically dependent on the credibility of the government‟s
guarantee, an issue that wouldn‟t arise under the DCC approach.3 Whether
companies could or couldn‟t finance their compulsory lending to the government at an
interest rate as low as the long term government bond rate is a matter for speculation,
leading to argument about whether the RSPT allowance rate should be higher than
this (and by how much). But it would be inefficient for the government to borrow
from mining companies at a rate higher than it pays to borrow in the market generally.
Since the government can borrow at the long term bond rate, why should it not do so
3. This is subject to the qualification that, since the project may pass through future periods of
negative net cash flow to which the government should contribute its share, the risk of the
government defaulting on its obligations is not entirely eliminated in the DCC case.
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and meet its 40 per cent share of project costs up-front, converting the RSPT to a
transparent Brown Tax?
If the commitment to honour the obligations implied by the RSPT is as strong as the
commitment to honour official debt, a proper government accounting system should
treat both equally. That is, it should record the government as having acquired the
same liabilities in either case and, on the other side of the balance sheet, the same
assets. Only if it is more likely that a future government may default on the RSPT
liability is there any difference, and fears of that (whether realistic or otherwise) make
the “loan” to the government a risky proposition for which interest at the long term
bond rate will not adequately compensate.
One response to that concern has been to suggest that the RSPT should be remodelled
along the lines of the RRT. That is, abandoning the guarantee of full loss offset and
increasing the uplift (allowance) rate to compensate. It is useful to consider that
possibility in the context of our previous example, using the EE case in Table 1 as a
comparator, assuming the objective is to achieve the same result, and supposing the
company to be risk neutral.
Without guaranteed loss offset, the government pays nothing if the investment is
unsuccessful so, compared to the EE case, the company will be $44 worse off in year
1 with that outcome. Since the two outcomes are equally likely, a risk neutral firm
can be compensated if the amount it receives in the successful case is increased by the
same present value sum. That can be achieved by increasing the deductions available,
through an increase in the uplift rate, so that it pays less tax.
In our example, the uplift rate would need to be set at 90.4 per cent to produce this
result. As illustrated in Table 2, that would give the company a deduction of $190.40
in year 1. Since this exceeds the project‟s net cash flow in that year, the company
would pay no tax and would keep the whole $150. This would give it $16 more than
in the EE case of Table 1, so the government would still “owe” it $28 ($44-$16).
Carrying forward the unused deduction of $40.40 to year 2 at the 90.4 per cent uplift
rate would give it a deduction of $76.90 and taxable income of $73.10 in that year.
After tax, the company would be left with $120.80, which is $30.80 more than in the
EE case of Table 1: equal to the $28 “owed” by the government after year 1, plus
interest at the 10 per cent riskless rate on that amount.
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It may appear from this that the RRT can be structured to have the same neutral effect
on investment incentives as a Brown Tax, but that is an illusion. The required uplift
rate is specific to the details and assumptions of this particular example. Any change
in the time profile of project net cash flows, in the probability of achieving the
successful outcome, or in the discount rate employed by the company will change the
uplift rate needed. Even if the government were prepared to tailor the RRT uplift rate
to each separate investment, it would never have the information necessary to do so.
A uniform uplift rate applied across a broad class of “similar” investments will
inevitably be too low in some cases (and deter investment) and too high in other cases
(and encourage excessive investment).
Indeed, even in the concrete example given, the RRT is neutral only if the company
cannot change the time profile of positive net cash flow receipts in response to the tax.
Suppose, in the successful outcome, that it can shift some net cash flow from year 1 to
year 2 on a dollar for dollar basis. It wouldn‟t choose to do this in the absence of any
tax, since $1 next year is not as valuable as $1 today, but the 90 per cent uplift rate
gives it a powerful incentive to do so. Shifting $10 of net cash flow from year 1 to
year 2 creates an additional deduction of $19 in the latter year, so the net effect is to
reduce its taxable income by $9 and its tax payment by $3.60. Thus, after tax receipts
in year 2 will be increased by $13.60, a return of 36 per cent on the $10 of forgone
year 1 receipts.
Although the effect is exaggerated in this simple example, a general problem of the
RRT is that the (unknowable) uplift rate that is high enough not to discourage
investment significantly at the margin ex ante can subsequently provide strong
incentives for inefficient behaviour at the expense both of the government‟s revenue
and of efficient resource exploitation. There are various band-aid ways of reducing
these problems, some of which are employed in the treatment of exploration
expenditure under the Petroleum RRT, but these are necessarily arbitrary. One
possibility would be not only to allow but also to require companies to pool RRT
assessable income and deductions across projects. That would increase the extent to
which investments in new projects were immediately expensed against assessable
income from more mature projects, so that the RRT uplift rate became irrelevant. But
that is simply to say that the solution to the problems of the RRT is to convert it to a
DCC-type Brown Tax.
A somewhat different, albeit absurd, argument in favour of the RRT alternative to the
RSPT has been the assertion that the guarantee of full loss offset is of no value
because companies don‟t plan to make losses. Taken to its literal extreme, this would
solve the problem of the ACC approach since the credibility of a guarantee that is
certain never to be called upon is of no importance. However, those making this
assertion suffer from the unreasonable conviction that they should be compensated
(through an increase in the uplift rate) for the removal of a guarantee that has no value
to them.
The RSPT is a less distorting means of capturing resource rents than the RRT and
should provide greater expected revenue (evaluated at the riskless rate of interest).
However, it achieves this by exposing the government (i.e. the Australian taxpayer) to
a greater level of risk since it makes the government a full partner, rather than a fair-
weather partner, in exploration and mining activity: provided, of course, that the
government‟s guarantee of full loss offset is intended to be cast iron. If it is, then
public understanding of the tax would be enhanced (and a lot of uncertainty and
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unnecessary debate avoided) by the government contributing its 40 per cent share up-
front and converting the RSPT to a transparent Brown Tax.
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deduction provides or by direct payment. The effect of this will be that exploration is
not, in fact, subject to the standard income tax at the company level but, rather, to a
Brown Tax at the company tax rate.
In fact, even with its ACC approach, the RSPT will also act as a DCC-type Brown
Tax on exploration spending for companies with RSPT assessable income. This is
because immediate deductibility under the company tax rules automatically makes
exploration expenditure immediately deductible under the RSPT. For a company able
to make immediate use of the deduction, the combined effect of the RSPT and the
exploration rebate is that the government will pay, up-front, $56.80 of every $100 of
exploration expenditure. Of course, in exchange, it will also take 56.8 per cent of any
resulting profits through the combined effect of the two taxes. If the company does
not already have RSPT assessable income, the ACC approach means the
government‟s RSPT contribution will be deferred, either until the exploration project
terminates or until a mine is developed that generates assessable income, but the end
result will be the same.
For new projects, the assertion that the combined effect of the RSPT and the company
tax will be to tax “mining industry profits” at the rate of 56.8 per cent is a gross
distortion. In the case of non-exploration expenditure, the returns on mining company
dollars (i.e. those supplying 60 per cent of the total funds) will be taxed only at the
company tax rate of 28 per cent. For exploration expenditure, the returns on mining
company dollars (i.e. those supplying 43.2 per cent of the total funds) will not be
taxed at all.4
4. That is, they will not be taxed in the hands of the company. Dividends distributed to resident
shareholders are, of course, subject to personal rates of income tax and for those earnings the
company tax is washed out by the imputation arrangements (and is consequently irrelevant).
5. Details of the proposed mechanics of the RSPT and of the transition rules for existing projects
are taken from Department of the Treasury (2010).
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With a DCC-type Brown Tax, the government would then pay up-front 40 per cent of
this starting base amount and take 40 per cent of subsequent net cash flows. The
effect would be the enforced acquisition of a 40 per cent share of the project‟s assets.
Of course, of all the projects that have commenced since, say, 1990, the government
would only be taking a 40 per cent share in those that had survived, but the true extent
of the cherry-picking is greater than that.
In the actual transition rules, the starting base allowance will continue to be carried
forward at the allowance rate and can be written off against RSPT income at a
declining rate over 5 years (36 per cent in the first year, 24 per cent in the second,
etc), but the deductions provided cannot be transferred between projects and the
government will not refund losses at the RSPT rate on project termination.6 The
effect, therefore, is the enforced acquisition of a 40 per cent share only of the “good”
projects (those that are ultimately able to make full use of the deductions).
Failure to apply the RSPT fully to the starting base, with guaranteed loss offset, has
no obvious explanation other than a desire to maximise expected tax revenue. While
it is true that it has the worthwhile effect of preventing projects being kept artificially
alive until the implementation date, and incurring wasteful additional expenditure
along the way, that could be achieved simply by allowing projects terminated at any
time after the announcement date to carry forward losses for later reimbursement.
The transition rules for new investments undertaken between the announcement date
and the implementation date, on the other hand, appear to offer large incentives for
truly wasteful expenditure. The capital cost of such investments will be carried
forward, undepreciated, at the RSPT allowance rate and then treated according to
standard RSPT rules from the implementation date onwards. Suppose, then, that
expenditure of $100 on 1 July, 2010 leads to increased income of $80 on 1 July, 2011,
after which the investment has no further value. The actual rate of return is minus 20
per cent. However, with an RSPT allowance rate of 5 per cent per annum, the
investment contributes $110.25 to the RSPT Allowance on 1 July, 2012. Assuming
the true 100 per cent depreciation of this investment is recognised, so the whole
amount is immediately deductible, and that projects owned by the company can fully
utilise this deduction, it is worth $44.10 in reduced RSPT payments. This, combined
with the $80 received one year earlier, yields a 17 per cent per annum after tax return
on the initial investment. This is an extreme example but it clearly illustrates the
nature of the incentive provided. It would not arise if only the depreciated value of
the investment were included in the Starting Allowance since, in this particular case,
that value would be zero.
The greatest part of the mining industry‟s dissatisfaction with the RSPT, and a lot of
the more general community concern (insofar as the community has been able to
figure out what it should and shouldn‟t be concerned about), springs from the
application of the RSPT to existing projects. The government may be paying market
value for 40 per cent of the picks and shovels, as it were, but it isn‟t paying 40 per
cent of the market value of the resources that they are designed to extract. The
government‟s position, of course, is that these belong to the “Australian people”
whom it represents. The industry‟s position is that it was promised these resources
6. The accelerated depreciation provided for the starting base allowance is designed to ease cash
flow constraints that companies otherwise might suffer in the early years of the RSPT by,
effectively, deferring payment of tax.
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(less royalties) and that it was on that basis that the risky investments in the currently
successful projects (and in those that were not successful) were made.
Misleading and confusing statements aside, this is an argument about two things.
First, there is the distributional issue – the adverse effect on the wealth of mining
company shareholders who, as a result of the large expansion of superannuation funds
that successive governments have actively sponsored, include just about everybody to
some extent. The government appears to have neglected this diffused impact and
supposed that it would be seen as affecting only a wealthy minority. In fact, the
average person probably needs a clearer demonstration than has been offered that
there will be offsetting benefits flowing from the transfer of part of her wealth to the
government‟s coffers. Equally, though, the mining industry has not placed very much
explicit emphasis on this issue, probably because it also believed that it would not
resonate very widely.
Most of the debate has been less about equity issues in the retroactive application of
the RSPT than about the extent to which it will affect the perceived riskiness of future
mining investment in Australia. All of the assertions relating to effects on investment,
employment, output (and even the prices of things that use mineral inputs!) hinge on
that. Aside from uncertainties associated with the ACC approach of the RSPT, which
sensibly should be removed by shifting to a pure Brown tax, the increase in
“sovereign risk” is the only comprehensible explanation that has been offered in
support of the welter of claims that projects will be, or already are being, abandoned
or deferred because of the tax.
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course, questions to which nobody knows the answer. Reports of what suppliers of
finance are alleged to have said don‟t provide reliable information even if they are
true. Markets are known to over-react to news and to take some time to digest its true
consequences. Given the mining industry‟s strong and vociferous reaction to the
RSPT proposal and its essentially false representation of the effects on new mining
investment, it would be surprising if there were not some short-term alarm in financial
markets. In the longer-term, a calmer appraisal of the situation will determine
people‟s risk perceptions.
Of the two questions posed in the last paragraph, the first is probably the less
important. The current Australian government has demonstrated that it is prepared to
act to secure rents that it sees as the property of “the Australian people”. If one had
previously held the naïve belief that no Australian government would ever do such a
thing, presumably one would now think it more likely than before that some future
Australian government might also do so. The more important question, though, is
how likely is it that a future Australian government would feel justified in acting in
this way? If the perception is that the new tax provides a more reasonable sharing of
the benefits of Australia‟s resource wealth between mining companies and the
community than the existing regime, arguably the risk is reduced rather than
increased.
This is not to say that a future government might not be tempted to increase the RSPT
tax rate, say to 50 per cent. With a pure Brown Tax, this would mean that it was
taking 50 per cent of the returns from projects to which it had contributed only 40 per
cent of the cost. The best protection against this (as with the Goods and Services Tax,
but with much better reason) is to make it relatively difficult to change the legislation
determining the tax rate.
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guaranteed loss offset means that it actually only applies to “good” projects. Over
time, however, things will be less rosy. After the initial cherry picking wears off, the
government will receive only what it pays for with its risky investments in exploration
and mining activity. From those investments it will approximately receive the
average rate of return earned by the mining sector, and that is not guaranteed to be
high or even positive.
Although the fact that the government will be taking a share in every single mining
investment eliminates almost all of the idiosyncratic risk, it does little to reduce
market risk since mineral commodity prices tend to move together. Thus, there may
well be periods when a sustained market downturn means that returns on the
government‟s investments are very low. The Commonwealth Treasury believes that
this is unlikely in the next decade or so, but it is not impossible.
It was earlier argued that conversion of the RSPT to a transparent Brown Tax is
desirable in order to eliminate uncertainties for investors about the credibility of the
government‟s guarantee of full loss offset. It is also desirable in order to make clear
to governments themselves the long-run budgetary implications of the tax. Otherwise
there is the clear danger, of which signs are already evident, that the government will
spend the net revenues received in prosperous times without regard to the potential
liabilities it is building up as new projects are developed. If, on the other hand, the
government pays its 40 per cent share up-front, borrowing to finance this, it will be
more obvious that the revenue available to be spent is only that which exceeds the
debt service charges, and that it should only pay itself a “dividend” that reflects the
sustainable level of such net earnings.
The Industry Commission (1991) explicitly recognised this issue and argued that
application of a Brown Tax arrangement be administered through a special fund. One
could envisage the fund as having the authority to borrow, with normal government
guarantees, and to make payments to, and receive payments from, mining companies
(channelled through the tax system). Aggregate receipts and payments associated
with the tax would thus be separated from general government revenues, and only
such distributions that the fund determined should prudently be made would be
available for government spending.
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revenue. Why not assess that capacity on the basis of what the states and territories
could have raised, rather than what they choose to raise?
A more cooperative view is that application of a Brown Tax would be much more
difficult for individual states and territories than for the Commonwealth. As noted,
the Brown Tax requires the government to take a silent equity stake in exploration and
mining activity equal to the tax rate. This might expose state revenues to a greater
degree of revenue instability and uncertainty than was acceptable, particularly in those
states where mining is most heavily concentrated. Both the level of exposure to risk
and their more limited capacity to smooth revenue flows by borrowing create
problems for individual state governments. Also, the costs of administering a Brown
Tax arrangement would be relatively high for governments that do not already have a
taxation apparatus accustomed to dealing with company income.
It was a privately held view in the Industry Commission that, without Commonwealth
action to coordinate the application of a Brown Tax and smooth state revenues, there
was little chance of its recommendation being acted upon. It was hoped that the
Commonwealth, to whom it was reporting, would consult with the states and
territories on how its recommendations might be implemented, but the government of
the day chose not to follow this path.
One might, however, have anticipated this sort of consultation from the current
Commonwealth government before deciding how to implement the AFTS Report‟s
recommendations. Although the probability of such discussions delivering a sensible
agreed policy outcome on this (or any other) issue is admittedly difficult to
underestimate, it is normally considered diplomatic for the Commonwealth to engage
in the process before ultimately exercising its muscle. In this particular case, state
governments would at least have had the opportunity to understand the effects of the
tax and be better prepared to assess the validity of mining industry assertions about
the consequences for activity within their jurisdictions.
In the event, at least in the short-term, the Commonwealth has elected to go it alone.
Rather than securing agreement from the states to abolish royalties in exchange for
agreed payments from the RSPT revenues, the government has chosen to nullify their
effects by refunding royalty payments to companies. Thus, states and territories will
continue to impose royalties and keep the revenue they generate, while the
Commonwealth will allow royalty payments as a credit against RSPT liability or, if
the project is not able to make full use of the credit, will reimburse the excess amount
in cash. The effect, up to the reimbursement limit, will be that royalties have no
impact on mining company profitability or on the incentives to undertake exploration
and mining investment.
An obvious problem is that, unless it is capped, the reimbursement of royalties
provides state and territory governments with an open-ended invitation to increase
royalty rates at the Commonwealth‟s expense. Consequently, the extent to which
royalties will be reimbursed is limited to the rates applying or foreshadowed at the
time of the RSPT announcement. There is nothing to prevent royalties being
increasing beyond this limit. Indeed, if they wished states and territories could restore
the same distorting effects as previously existed while doubling their revenues. Of
course, the Commonwealth can use its control over general revenue disbursements to
deter such actions, but agreement over the distribution of RSPT proceeds in exchange
for the removal of royalties would be greatly preferable. The fund proposed in the
previous section could maintain state by state accounts and a revenue smoothing
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distribution back to states could be devised that left them at least as well-off as any
royalties they might have chosen to impose would have done. It is not necessary for
the Commonwealth to seek simultaneous agreement from all of the states and
territories in this matter. For example, whether Western Australia chooses to enter
into such an agreement has no obvious bearing on whether Queensland might choose
to do so.
An issue deserving some attention is the amount of net RSPT revenue that the states
and the Commonwealth could reasonably each lay claim to in such agreements. If the
source of this revenue is the rent value of state-owned resources, the answer might be
that “all of it” should go to the states from which it was derived, but one needs to be
careful about what that means. If the Commonwealth were to provide a guaranteed,
stable mineral revenue stream to each state, it would need to be compensated for the
risk that the earnings on the assets that it holds might not generate sufficient revenue
to support this. That is, the states would have a reasonable claim only on the certainty
equivalent of the expected net revenue stream. The rest of it should remain with the
Commonwealth. In that case, though, it should not be thought that Commonwealth
revenue had really been increased, since the amount it retained would simply be what
was necessary to compensate the Australian taxpayer for the risks to which she was
being exposed.
Aside from the desirability of agreement on the royalty issue, a problem with
unilateral Commonwealth action is that it leaves unaddressed those recommendations
of the AFTS Review (and of the Industry Commission) that are completely outside
Commonwealth powers. These include the use of cash bidding, in conjunction with
the RSPT, as a means of allocating mineral rights and the abolition of certain stamp
duties and fees. Agreements with states and territories would potentially allow these
matters also to be dealt with.
While it may have been sensible for the Commonwealth to take the initiative in
reforming the means of charging for mineral resource depletion, and possibly even to
have done so without prior consultation with the states and territories, that should be
seen as a first step. Consultation and agreement with the states is ultimately necessary
to generate a stable rationalisation of lease allocation and charging mechanisms.
5. CONCLUDING REMARKS
As many have observed, there is a lot to be desired in the manner of the government‟s
handling of the AFTS Report and its own policy response and presentation,
particularly on the mining tax issue. Nevertheless, at least in this author‟s view, the
central thrust of the Report‟s recommendations on this issue does represent a
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significantly worthwhile reform of the means of capturing mineral resource rents for
the community.
In the interests of transparency and reduced uncertainty it is highly desirable that the
RSPT be modified to a pure Brown Tax, in which the government contributes its 40
per cent share of investment costs up-front. This is important for two reasons.
First, it will eliminate a lot of confused debate and allow people to see clearly that it is
inconceivable that the tax will have the dire consequences predicted for exploration
and mining activity, unless its introduction does have the effect of generating
increased sovereign risk concerns. Anyone can guess, but a reasonable guess is that
significant elevation of such concerns is unlikely to be other than a short-term
reaction, for which the mining industry‟s own rhetoric may be as much to blame as
anything.
Secondly, contributing its share up-front will force the current and future governments
more clearly to understand the implications of the tax for sustainable revenue flows.
Responsibility for administering the RSPT arrangement and managing the flows of
funds should ideally be separated from general budgetary considerations through
establishment of a special fund for that purpose. Legislation establishing the RSPT
and associated administrative arrangements should, so far as possible, make it difficult
for future changes, especially in the tax rate, to be introduced.
Application of the new tax to existing mining projects will clearly impact significantly
on the after-tax profitability of those operations, reducing share prices and the wealth
of people holding those assets. That effect can be softened by making the transition
arrangements more generous but, at the end of the day, it is to a greater or lesser
extent an inevitable cost of the tax reform. Persuading people that this is a cost worth
bearing has not ranked high enough on the government‟s agenda.
As indicated in the last section, ultimately it is important for the Commonwealth and
the states and territories to reach agreement on the resource charging mechanism and
the distribution of the net revenues involved as well as, potentially, on other matters
raised by the AFTS Report. Fortunately, such agreements do not need to be entered
into simultaneously, so initial unwillingness of some parties to act cooperatively
should not impede the possibility for others.
No matter how much transparency is improved, how much more generous the
transition arrangements are, or how clear it may become that sovereign risk is an
exaggerated concern, the mining industry can still be expected to oppose the tax. This
is because it expects projects to earn more than the required, risk-inclusive rate of
return: that is, to earn “super profits”. The RSPT is not a tax on super-profits (it is
not really even a “tax”) but, by taking a 40 per cent share in projects, it limits the
industry‟s share of such profits to only 60 per cent so, however misleading the name
may be, perhaps it is not wholly inaccurate.
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