31 May 2010

Australian minerals: where is FIRB?

As one of his justifications for the sudden imposition of a resource rent tax on the production of Australian minerals the Prime Minister evokes economic nationalist sentiment by asserting that the Australian community is not getting its fair share of Australia’s mineral riches.

There is some truth in this, but the absence of a resource rent tax is not the principal reason for this, and the imposition of a resource rent tax is not a sure solution.

My perspectives on this issue and past attempts to deal with it:

(1)    When the Whitlam Government was elected in December 1972 there was comparatively little beneficial ownership of Australian mineral resources on the part of Australian companies or the Australian public, and there were few companies with the resources and access to capital to undertake minerals exploration and development in their own right. BHP was one, Western Mining was another.

(2)    The situation was exacerbated by an engineered oversupply of steel making raw materials and, later, of steaming coal. The steel making raw materials were sold into a monopsonistic market in which Nippon Steel conducted the purchase negotiations on behalf of the nine Japanese steel mills, and China, Korea, India and Pakistan had contracts in which they took product at the Japan price with a discount of about 5 per cent.  Oversupply was maintained by the signing of new long-term contracts, even as existing contracts were being seriously underperformed.

(3)    The Minister for Minerals and Energy in the Whitlam Government, Reginald Francis Xavier “Rex” Connor, had three principal measures for dealing with this:

(i)  The Government required all companies proposing to develop Australian mineral resources to seek at least 50% Australian equity.  The policy was applied flexibly; in the early days companies that came to talk to the Department were told that if they made a diligent effort and came with a proposal that had anything over 25% they would not have trouble.

There was one exception to the flexible application of foreign investment in minerals. Since the days of John Gorton there had been a rigorous policy of 85% Australian equity in any uranium development, and that policy was maintained.

(ii) The Government introduced legislation to establish a Government owned statutory corporation, the Petroleum and Minerals Authority, which would have power to take an equity stake in selected ventures. As a Government owned company it would never have the capital to become a big player in the mining industry but it meant that the Government could test the bona fides of foreign companies seeking an Australian partner – how could they say they could not find an Australian equity partner if they had not talked to the PMA?  And the Government would always have the option of taking an equity stake in a mining project if it felt that it was in the national interest for it to do so.

This was a high stakes game and both the mining industry and the Opposition resisted the creation of the Authority with a passion.  The legislation was frustrated in the Senate and the Petroleum and Minerals Authority Act 1973 was one of the Bills passed by the historic Joint Sitting of the two houses of the Commonwealth Parliament following the double dissolution election of 1974.

(iii) Export controls were imposed on all minerals, in order to enable the Government to maintain surveillance of prices and contract terms in long-term export contracts. The principal aim was to counter the monopoly purchasing power of the Japanese steel mills or the coordinated buying practices of the Japanese power companies; there was very light-handed regulation of commodities like silver, lead and zinc, which were traded on the London Metals Exchange.

(4)    The cries of the wounded rang out over the minerals policy battlefield throughout the three years of the Whitlam Government. Civilisation as we knew it was coming to an end, we can never do business on this basis. The foreigners hated the foreign investment restrictions, they hated the export controls, everyone hated the PMA. Foreign companies said that it would be “very difficult” for them to invest here in the future, and “very difficult” for them to go on buying from us.

(5)    Nevertheless there were some creative responses. CRA (Conzinc Rio Tinto of Australia), now Rio Tinto, was at that time about 63% owned by its British parent RTZ, with most of the rest in the hands of the Australian public.  Its CEO, Sir Roderick Carnegie, came to the Government with an interesting proposal.  He said that under the policy as it stood, CRA would always have to look for an Australian joint venture partner.  He said that CRA did not like joint ventures, and proposed to Whitlam and Connor that, in return for an undertaking to sell down the parent company’s equity over time, CRA be recognised forthwith as an Australian company.  This led to an intense period of negotiation, in which I was involved, and a deal was done.

(6)    Some other interesting things happened over time as a result of the policy. In 1975 the PMA took over 50% of Delhi Petroleum’s production interests in the Cooper Basin, and 25% of its exploration interests (from memory these were taken over by CSR when the PMA’s portfolio was liquidated).  BHP began to expand its role, acquiring Utah Mines Ltd and its major coal assets in 1984, and CSR took an increasing interest in the minerals sector. By 1986 RTZ’s equity in CRA had dipped to below 50%. BHP bumped American Metals Climax (AMAX) from its Pilbara iron ore assets in about 1990.

(7)    When the Fraser Government took over in 1975 the Petroleum and Minerals Authority was quickly despatched, but the foreign investment policy remained, and export controls were kept in place, and although controls on minor minerals and LME minerals were relinquished, the controls on iron ore, coal and uranium were maintained.

(8)    The Treasury hated, and actively subverted, the whole framework from the start.  In 1975 I attended meetings of the Treasury-chaired Foreign Investment Committee as the representative of the Department of Minerals and Energy. Treasury never saw a foreign investment proposal it didn’t like, and could never be persuaded that a proposal was non-compliant.

My former Treasury colleagues seemed to live in a parallel universe in which the government of no other industrialised country intervened in the market place – they all left everything to the wisdom of the market and so should we.  These people seemed never to have heard of the US Army Corps of Engineers, or the US Atomic Energy Commission, or the National Aeronautics and Space Administration, or indeed the US Department of Defense.  And they seemed touchingly unaware of the extent to which the governments of Continental Europe occupied the commanding heights of their respective economies, and had equity in all sorts of private-looking companies.

When the Whitlam Government fell at the end of 1975, it turned out that one of the Assistant Secretaries in the Treasury’s Foreign Investment Division had Liberal pre-selection for a Victorian Senate Seat.  Many years later Canberra Times editor Jack Waterford revealed that the Division Head had been the real “Mr Williams” who had leaked damaging information about the Loans Affair to the then Opposition, and who in return for this sterling service which contributed so much to the demise of the Whitlam Government, became a kind of protected species under the Fraser Government.

(9)    As noted above, when the Fraser Government took over the foreign investment policy and the export controls were maintained.  The export controls were administered by Doug Anthony and his Department of Trade and Resources, and Doug made valiant efforts to uphold the national interest, taking considerable political heat in the process.  It was hard yards on the foreign investment side, however, especially when John Howard was Treasurer; like the Treasury itself, Howard never believed in any of that stuff.  We worked long and hard doing the due diligence on the various petroleum and minerals proposals that came in, but it was all steadfastly ignored, and some crazy things were approved.

(10)  In the neo-liberal reformist atmosphere of the Hawke and Keating Governments the export controls were maintained after a fashion, but the foreign investment controls were increasingly symbolic – it would be a bad look to abolish the Foreign Investment Review Board, but let’s not have it say no to anybody. In 1995 the Australianisation of CRA became a dead letter with the dual listing of Rio Tinto on the London and Australian stock exchanges.

(11)  When John Howard became Prime Minister the game was up and the companies knew it. Rio Tinto completed the reversal of the Australianisation project by taking all of the strategic functions back to London, and in 2001 BHP was allowed to merge with the British-Dutch company Billiton, on terms which suggested that BHP needed Billiton more than Billiton needed BHP.  John Howard’s principal concern was that the headquarters of the merged company remain in Melbourne – seeing the icon leave the country would have been a bad look.  The one big surprise was Peter Costello’s refusal to permit Shell to take over Woodside.

The point of all of the above is to indicate that if the Australian public is not getting a fair share of the benefits of Australia’s mineral wealth, it is to a substantial extent because a succession of Australian Governments have been asleep at the wheel in relation to resources policy. There is a certain irony in the Treasury’s newfound obsession with the economic rents it sees accruing to the large mining companies.  When the rents were accruing to the Japanese steel mills through their monopsonistic purchasing practices, or to the aluminium multinationals through fancy transfer pricing tricks, they were relaxed and comfortable.

If the Rudd Government really wants a larger share of the proceeds to accrue to the Australian public, there are instruments available to it apart from a completely untested approach to resource rent taxation:

(1)    It could start taking foreign investment policy seriously. We have a Foreign Investment Review Board; why not use it? Is every foreign investment proposal that comes forward in the national interest? Really?

(2)    It could direct the Future Fund to purchase shares in BHP, Rio Tinto etc. They are traded on the Australian stock exchange, they are freely available to anyone who wants to pay the market price.  If the benefits of the assets they control are so self-evident, how could there be any objection to that?

(3)    Better still, it could establish a proper sovereign wealth fund, into which all of the Petroleum Resource Rent Tax and any resource rent tax on minerals could be paid for the benefit of future Australians, rather than paying it into general revenue and frittering it away on middle class welfare.

All of the above policies are debatable – none of this is easy. But let us have the debate and make robust, rational decisions, rather than sleepwalking into another policy debacle on the basis of an insufficiently considered new approach to taxation of one of our major industries.

Resource rent tax: why GE modelling?

In its editorial today The Australian Financial Review comments:

The only honourable course for the government now is to release all of its RSPT-related modelling so the public – aided by independent experts – can decide.

While it is about it, the Government might like to explain to us why it chose to use a General Equilibrium model (the KPMG Econtech model) rather than an input-output model like Treasury’s own PRISMOD model on which Treasury normally undertakes its tax and price effect modelling.

I am no econometrician but I do know a little about mathematics.  What I know about mathematical models like a GE model is that they are, in mathematicians’ terms, models of complex non-linear systems in which everything is connected to everything else, leading to feedback loops all over the place. Classic examples of such systems are ecological systems, weather systems and economic systems. They are chaotic in a strict mathematical sense, leading to the mathematics of these systems being known in the popular literature as “chaos theory”.

One of the defining characteristics of these complex non-linear systems is acute (and I mean acute) sensitivity to initial conditions, leading to the notion that the beating of a butterfly’s wings in the Amazon can trigger a tornado in Texas.  This phenomenon was discovered by meteorologist Edward Lorentz in 1961. He was running weather simulations and decided to check something that was occurring part of the way through a particular simulation.  He re-started the calculation by feeding the output from his simulation as data for the new run, and noted to his surprise that the simulation very quickly diverged from the simulation he was checking.  On considering what was happening he realised that, whereas his normal input data was to six significant figures, the model’s output data was only to three significant figures.  If you restart the model with a number like 0.493 instead of 0.493127, the whole simulation goes off course.

It should be noted that these models are completely deterministic – there are no random elements in them, and you can calculate a unique set of results from the data input.  The problem is that a tiny variation in the initial data can produce a quite different unique set of results.

GE models have their uses, which mainly revolve around understanding the processes going on in the system – a small change in A produces a big change in B but only a modest change in C – but they are almost useless as predictive tools because they are so sensitive to the data they are fed. That is why we can never hope to predict the weather more than a week (at best) in advance – we can feed more and more data into bigger and bigger super-computers, but it will never be enough.

To return to the specific subject of the KPMG Econtech modelling of the RSPT, acute sensitivity to “initial conditions” includes of course acute sensitivity to the assumptions which are fed into the model.  AFR journalist John Kehoe has some interesting things to say about that on page 6 of today’s Australian Financial Review:

 It is believed Treasury directed KPMG Econtech to assume the 40 per cent RSPT would not distort mining investment and the modelling projections were arrived at independent of key design features of the tax, including the rate, uplift factor, depreciation allowances and transition arrangements.

These design features are all assumed to be “perfect” so only pure resource rents are taxed by the RSPT.

Of course what those of us in the real world want to know is whether or not the tax will in fact distort mining investment. We want to see modelling which demonstrates that, not modelling which assumes it.

To turn to the PRISMOD model, this was the model which was developed by the young Ken Henry and his team on the instructions of Treasurer John Kerin at the end of the Hawke era, and which was used to such devastating effect in the Keating era by Treasurer John Dawkins to destroy John Hewson’s Fightback! package.

So I would like to see what that traditional Treasury tool, the PRISMOD model, would show us about this proposed tax, and I would like to know why the KPMG Econtech model was chosen in preference to it.

George Fane on the resource rent tax

Distinguished ANU economist George Fane does a brilliant demolition job on the Government’s proposed Resource Super Profits Tax (RSPT) in today’s edition of The Australian (see Reputation of the nation on the line here).

Fane comments:

The resource rent tax looks like the answer to a Treasurer's prayer: a non-distorting tax that allows the community to share equitably in the value of resources that rightfully belong to the community. Unfortunately, it is a chimera.

Later in the piece:

If the guarantee that future tax credits will be refunded is really cast-iron, the Treasury should issue the bonds needed to pay cash refunds to the companies for initial losses in the year when they are made. The companies would presumably prefer the cash to the promise, so everyone would be better off. The only benefit to the government from not cashing the credits arises because the guarantee is not cast-iron.

This is obviously the case, since the RSPT rules are so complicated that they could be changed with negligible electoral consequences. To adapt an aphorism attributed to Ed Murrow, anyone who is not confused by the RSPT cannot have understood it. The accounting rules are too hard for economists, the economics is too hard for accountants and it is all too hard for everyone else.

There is plenty more, and the article is well worth reading in full – access it here.

It is not just the mining ads

Today the whole nation is riveted, as well it might be, on the Government’s outrageous intention to spend $38 million of taxpayers’ money selling its unsaleable Resources Super Profits Tax (RSPT). As a former Treasury colleague of mine would have said, you can feed a lot of widows and orphans for $38 million.  You could probably even buy a few demountable classrooms.

What is outrageous about the mining ads is that they almost certainly will not meet the only test of respectability that I would regard as acceptable – they will not contain what people in the intelligence world would call “actionable intelligence”.

Put into everyday English, what I am saying is that the only time the Government is justified in spending your money in advertising to you is when there is information you need in order to inform an action that you need to take – and I am not referring here to informing your voting intentions – or an action that you need to avoid taking.

For example, if a government decides to offer free flu shots to all people over 65, then it is perfectly proper to promote that fact in order that the relevant members of the population know about and can decide what to do. The advertisements should not contain any gratuitous pats on the back for itself, but advertising the core information is perfectly proper.

The Government argues that its ads are necessary to counter disinformation from the mining industry. Stripped of the hostile and emotive language, what the Government is really saying is that we have suddenly discovered what we should have known all along, that we should explain this difficult policy, and that is what the advertising campaign is for.

That doesn’t meet any worthwhile test of respectability. Explaining policy is the core business of Ministers.  The problem is that they cannot explain it because like the rest of us they find it very difficult to understand.  Respected Melbourne University economist John Freebairn, a consultant to the Henry Review, was quoted in the Weekend Australian Financial Review, 29-30 May 2010, as guessing that there would  be only about half a dozen experts in the whole of Australia who would intimately understand the workings of the super profits tax.

Since the time of Paul Keating there has been a cliché in Australian politics, “If you can’t understand it, don’t vote for it”. I would add another rule of thumb for our political masters: “If you can’t understand it, don’t inflict it on the rest of us”.

The forthcoming mining ads are not the only Government advertising that fails the test I have proposed. Last night on SBS Television I saw an Australian Government sponsored advertisement for “Health Reform”.  In the light of the current debate about the mining tax advertisements I watched it very carefully for actionable intelligence. It contained none. It told me that the Commonwealth is to become the dominant funder of our hospital system and that as a result everything will be so much more wonderful than before.  It contained no information upon which I could act – it was purely and simply an advertisement promoting the current Federal Government.

30 May 2010

Why Julie Bishop must go

Julie Bishop’s behaviour last week in relation to the expulsion of an Israeli diplomat demonstrated conclusively that she has no place dealing with sensitive matters of foreign relations, and indeed is not fit to hold a leadership position with any self-respecting Australian political party.

Politics is a rough game but there are certain courtesies and civilities to be observed within our parliamentary system or the system cannot operate and, when it comes to matters of national security, the nation’s interests are put at risk.

When I heard that Julie Bishop had said in relation to the expulsion that there was no absolute proof of Israeli involvement in the forging of Australian passports, I wrote, “What would she regard as proof, I wonder”. At that stage I assumed that she had no more knowledge than I had, i.e., what was in the public domain. When I heard that she had been given a briefing on the matter by Australian security agencies, I was shocked.

I think Julie Bishop violated three rules of political courtesy and common-or-garden professionalism in relation to this matter.

(1)    If she was not prepared to accept a priori that the senior officers of the security agencies would behave in a professional manner and brief her in good faith on the evidence as they saw it, she should have said so and declined the briefing.

(2)    If she was in any doubt about what the evidence showed she should have told them and asked them questions to establish whether she and they really did draw different conclusions from the same evidence, or whether there was some misunderstanding on one side or the other.

(3)    If she remained unconvinced, she should have advised the briefing officers at the time that she found the evidence unpersuasive, and having been given the courtesy of a briefing she owed it to the Government to tell the Prime Minister and/or the Foreign Minister that she was not convinced and that she proposed to say so.  It was outrageous, and insulting to all concerned, for her to rush off and say that there was “no absolute proof” (whatever that means) and that the Government was just trying to curry favour with the Arab States in the interests of its aspirations to win a seat on the UN Security Council.

In her television interview she showed herself, not for the first time, to be completely out of her depth.

In our parliamentary system, there are times when it is in the interests of the nation’s security that the Government be able to take the Opposition leadership into its confidence and brief them on sensitive matters to ensure that our security interests are not inadvertently compromised by their public response to Government action. This need could arise at any time.  By her behaviour Julie Bishop showed that she cannot be trusted to behave appropriately in such matters, and that she lacks the judgement to be entrusted with sensitive classified information.  She must go.

25 May 2010

More on the resource rent tax

Too complicated and too greedy is how Brian Toohey described the proposed new resource rent tax in his weekly column in last weekend’s Australian Financial Review.  A good case could be made to sustain both of those charges:

-  Removing $9 billion per annum from the cash flows of the successful mining companies is no trivial matter, especially with an approach to resource rent taxation which has never been tried anywhere else in the world. The risk of unintended consequences is very large.

-  In my public service career I was always taught that public policy which is not understood by the general public is not sustainable: it will either fail to be implemented or it will in due course be abolished. The Government should have learned that lesson from its failure to get its emissions trading scheme over the line, a fact which is in large measure due to its failure to communicate the scheme to the public at large.  The lesson was not learned, and the Government has launched its resource rent tax on an utterly unprepared industry and public. It could have been handled a different way (see Resource rent tax: what happened to the nemawashi?) but it wasn’t.

 Some more comments on the proposed tax:

(1)    There is indisputably a case for a resource rent tax. Whenever a company is granted a mining lease, it is granted access to a finite, publicly owned resource. The quality of the resource is known to a certain level before a company commits itself to the development, and a project financier is prepared to lend the money, but the full extent and quality of the resource is often revealed only progressively over time. 

How remunerative the project turns out to be will depend upon the quality of the resource, the mine planning and management skills of the company, and the technology it employs. It also depends upon the future trajectory of the price of the commodity being mined, which is beyond anyone’s control – it depends upon future economic conditions, changes in the demand for the commodity due to technological change, and the worldwide investment decisions of other mining companies.

In the event, some mines will make a “normal” level of profit, and the company will simply pay the royalties plus company tax at the normal rate.  Some will make an extraordinary profit – an economic rent – and the policy question is how, not whether, the public should share the economic rents with the mining company which is profiting from the exploitation of the finite publicly owned resource.

 (2)   The argument by the mining companies that they pay more tax than the Government claims because the Government is not including the royalty payments to the states is disingenuous. The royalty payments to the state are a price for access to the resource and are simply a cost like exploration or operating costs.  The question is whether the companies pay their “fair share” of company tax once all allowable deductions have been taken into account, i.e, do they pay the full 30% of their profits.

(3)    The short answer to that question has to be in the affirmative. I do not think that anyone is suggesting that companies like BHP or Rio Tinto are not compliant with the tax law, and if they are not, there are the normal legal remedies for that.

(4)    The more complex answer, which nobody seems to be bothering to explain, is that the proportion of their total revenues which mining companies actually pay under our tax laws is an artefact of the tax law itself and of the ongoing resources boom. 

This is because the Australian tax law, like the tax law of every country with a significant mining industry, provides for accelerated write-off of mining investment, in recognition both of the risks of mining investment and of the fact that we are all competing for mobile capital. When the industry is expanding rapidly there is a lot to write off; once the boom conditions fade, much of the write-off has already taken place and the companies pay more tax.

Treasury hates this accelerated write-off and always has. There is a long history to this one and the current debate gives me an acute sense of déjà-vu.

During the Whitlam years Minerals and Energy Minister Rex Connor commissioned Sydney financial journalist Tom Fitzgerald to write a report on the Australian mining industry, a report the production of which was greatly accelerated by the calling of the double dissolution election in 1974.  The Minister gave him a very broad brief – what is Australia getting from its mining industry? – and left to get on with it.

It is best to let Tom Fitzgerald tell the story himself (see The Life and Work of Tom Fitzgerald on the Curtin University website here):

The approach to join Minerals and Energy came from Lenox Hewitt. He asked me, before I could join, to come and meet the Minister which I did. I was impressed with the Minister, Mr Connor’s, range of issues that he thought the Department should apply itself to. They were all intelligent questions. He wasn’t of course seeking anything like immediate responses. But he gave me an outline of things that he thought the Department should consider. They were good ideas.

I moved into that Department the day after the budget, probably in September, 1973.

To sum up very briefly I think there were three elements of my thesis. The first was the scale of the taxation concessions granted by the federal government to the mining industry. And the way in which some of those concessions which were not outright reductions in tax but deferments of tax could in practice lead to an enormously advantaged acceleration of growth in the industry. Which may not have been contemplated by the people who drew up the tax concessions in the era of the Chifley government when Australia was thought to be barren of minerals. The taxation concessions greatly advantaged expanding mineral companies. The emphasis being on expanding.

The second part was the extent of the overseas ownership of these advantaged mineral exploiters. And the third, in a way to me the most interesting, was the power and disposition of state governments, without any reference to the federal government, to grant great mineral rights to companies, foreign or local, which would automatically mean granting extraordinary federal taxation concessions to the expansion of those deposits. And I had to spend quite a substantial part of the paper trying to set out the nature of the tax concessions and the real meaning of what was commonly and loosely described as ‘deferred tax’ provisions made by the companies.

Fitzgerald was raising sophisticated arguments about the public policy issues posed by Australia’s emergence as a major, and largely foreign-owned, force in the world minerals industry, arguments which he saw as requiring careful though and analysis. 

In the hothouse atmosphere of the double dissolution election, however, the issues he had raised were misused.  Treasury, which had already secured the launching of an Industries Assistance Commission inquiry into taxation of the mining industry, seized its chance and in effect ambushed the Government to secure a dramatic change in the applicable tax regime, without the inconvenience of waiting for the IAC Report.  The write-off regime was changed from immediate write-off of 100% of capital expenditure to write off over 40 years or life of mine, whichever was less. This was a novel experiment; at that stage Canada and Brazil, our principal competitors then as now, had similarly rapid write-off regimes – indeed one of them (I don’t remember which) allowed immediate write-off of 130% of capital expenditure, against which our 2.5% per annum was a sorry sight indeed.

Unfortunately for the Treasury that was not the end of the matter. Treasury got caught in the revolving door of its own cleverness when, shortly after the Fraser Government took office, the Industries Assistance Commission Report on the Taxation of the Mining Industry hit the deck and the whole question was reopened.

I represented Deputy Prime Minister Doug Anthony’s Department of National Resources at the months of interdepartmental committee meetings that ensued to examine the IAC Report and prepare recommendations for the Government on each and every aspect raised by the IAC, and when it came to the Cabinet meeting Doug dragged me into the Cabinet room to help him make the arguments against the wall-to-wall Treasury and Tax Office officials that were already there, this being Budget Cabinet.

In the event Cabinet settled upon an accelerated regime which was less generous than the previous immediate write-off – capital investment could be depreciated on the basis of deducting 20% of the declining balance, i.e., 20% of expenditure which had not yet been deducted.

One conversation from that era sticks in my mind. At one stage I spoke to the head of the Economic Division of the Prime Minister’s Department to make the point about the rapid write-off that was available in Brazil and Canada. The response of this former Treasury officer was, “Just because other countries have silly policies doesn’t mean that we have to have silly policies” – thereby revealing a rather tenuous grasp of the implications of an open global economy, of which he was a staunch advocate.

 (5)   Accepting the case for a resource rent tax, which I do, the question is, how best to capture the economic rents.  The scheme devised by Ken Henry is an elegant and sophisticated one, but it has two fatal flaws: it is too difficult to explain, which makes it impossible to carry in an hostile political environment; and it deals with the industry as a whole without adequate consideration of its impacts on particular categories of players, and it would appear, inadequate consideration of how mining projects are selected for development and financed.

As has been pointed out by a number of writers, companies like BHP Billiton and Rio Tinto do not value the fact that the proposed tax system will cover 40% of their losses.  This is because they do not set out to make losses, and they are very good at what they do.  Companies like that will not invest in a new mine unless they are confident that when it goes into production it will be in about the bottom quartile of costs for that particular commodity, so that if there is a downturn with accompanying decline in the market price for the commodity, a lot of other people will get hurt before they do.

Junior and would-be miners, on the other hand, may well value the new regime because a marginally economic discovery might be worth a punt if the Government is going to assume 40% of the risk. For my part, I am not looking for an opportunity to co-venture with Fly By Night Minerals NL to the detriment of the value of my superannuation fund’s shares in BHP and Rio Tinto.

What I would welcome would be a regime, along the lines of the existing Petroleum Resource Rent Tax (PRRT), which allowed the mining companies to develop their discoveries at their own risk, and taxed profits above a certain level at a higher rate.  We have such a system in place, and everyone understands it. As Toohey comments in his article, sometimes second best can be the superior solution.

(6)    The claim made by the mining industry that the proposed regime would make Australia the highest taxed country in the world undermines as much as helps their case.  According to the letter to shareholders from BHP Billion Chairman Jac Nasser, the current effective rate of tax in Australia is 43%, compared with 23% in Canada and 27-38% in Brazil. On these figures Australia is already significantly levying higher taxes than its principal competitors. As far as one can tell the companies are pretty happy to be here.  My experience is that countries which charge low tax rates (tax holidays, 15% company tax etc) do so because they need to in order to overcome the disadvantages of investing there.  Here as elsewhere there is no such thing as a free lunch.

(7)    The claim that the new regime should apply only to new investments is entirely without merit.  No country grandfathers all the decisions it makes that impact upon investors – changes in the tariff, the decision to float the dollar, the decision to allow in foreign banks and on and on the list goes. On the argument being put by Jac Nasser and others the Government would have to maintain an individually tailored tax and tariff regime for every company in Australia.

(8)    The claim that the regime should not apply to all mineral commodities is extraordinary. If we are talking about taxing economic rents on finite resources, it doesn’t matter whether the super-profit is made mining gold or gypsum. And if the industry is not particularly profitable, it will only be subject to normal rates of tax.

(9)    The Prime Minister and Treasurer are loudly proclaiming that the resources in question belong to all Australians.  That is a view which is consistent with their strong centralising tendencies which would have State Governments simply serving as branch offices for Canberra. The fact is that the resources belong to the Crown in right of the State – that is, the public to which these finite publicly owned resources belong is the public of each individual state and territory.

That is why royalties are levied by the states, and to this extent the proposed imposition of resource rent taxation by the Commonwealth is a cash grab from the states, and the fact that the Commonwealth has shirked the hard yards of rationalising the ramshackle royalties regimes of the states gives the states a strong incentive to increase their royalty rates, with adverse effects on state and national welfare, particularly where royalties are levied on a unit of production basis. The issue raised by Tom Fitzgerald regarding the capacity of the States to take unilateral actions that trigger the Commonwealth’s accelerated write-off regime also remains unaddressed.

Perhaps an elegant solution would be for the Commonwealth to take over the whole business and levy royalties and a PRRT-type resource rent tax for and on behalf of the states, perhaps with the retention of an agreed share.

My proposed solution will not come to pass, of course, and this will stand as one of the worst examples of public policy making since the Government’s inept approach to emissions abatement.

The return of class struggle

Unfortunately for the chances of what could have been one of the great Australian reforms of all time, the establishment of a well designed resource rent tax, it did not take long for the case for it to be couched in terms of the class struggle. The big miners aren’t paying their fair share of tax, they are big multinational corporations, they are foreign owned.

These are emotive, populist arguments and none of them supports a case for a resource rent tax. Nor does the prospect of all of the wonderful things that we could spend the money on – lowering the company tax rate, increasing the superannuation contribution or whatever. The case for a resource rent tax rests solely on the fact that the mining companies, large or small, Australian or foreign owned, are being granted access to publicly owned finite resources, the exploitation of which will in some cases yield economic rents, i.e. super-normal profits. The public is entitled to a share of those super-normal profits. It is as simple and unemotive as that.

Unfortunately, running the case on emotive, resource nationalist lines undermines the prospect of successfully achieving the reform, as does the abject failure to prepare the ground (see Resource rent tax: what happened to the nemawashi?).  I am all for resource nationalism, and have more than a few scars to prove it, but we have to be smart about it.

The government’s inept handling of a series of major and complex reforms has landed it in deep trouble with the electorate just months before an election – trouble from which only Opposition figures Tony Abbott, Joe Hockey and Julie Bishop are working effectively to save it.

Failure to get this one up and being swept away on the electoral tide may help Mr Rudd to go down in history as a great Labor hero in the tradition of Jack Lang, Ben Chifley or Gough Whitlam, but it won’t do much for the rest of us.

24 May 2010

Expelling an Israeli diplomat

In expelling an Australian diplomat the Australian Government has responded appropriately to the forging of four Australian passports, which it is satisfied was the work of the Israeli Government. Foreign Minister Stephen Smith rightly states that this is not the action of a friend.

Former Foreign Minister Alexander Downer does not contest the conclusion that the Government has drawn from the evidence presented to it by the Australian Federal Police and the security agencies, but says that expelling an Israeli diplomat is an over-reaction on the grounds that everyone does it (did ASIS do it on his watch I wonder?).

How little he understands the rules of the game. Others may well do this sort of thing – I would never seek to argue that this particular Israeli action is the first time in the history of human endeavour that an intelligence agency has forged another country’s passport. The point is, when they do it, or otherwise break the laws of a foreign country, they do so in the realisation that if they are caught their government will be mightily embarrassed (come to think of it, that doesn’t seem to apply to Israel, they are pretty hard to embarrass) and any operatives who are caught with their hands in the cookie barrel will face the full force of the law. Viewed in that light, the Australian Government’s response was rather benign.

But then Alexander always was rather relaxed and comfortable about the Australian national interest. It was on his watch that an Australian company, the recently privatised AWB Limited, violated Australian domestic law and channelled over $300 million to the Saddam Hussein regime, at a time when we had Australian service men and women in harm’s way leading the multinational naval force in the Gulf, and Alexander was running around the country saying that he was a big fan of sanctions.  Didn’t he know, or didn’t he care?  We will never know, because Prime Minister Rudd is not interested in finding out. 

Ever the insouciant one, Alexander responded to a reporter’s question about the fact that Britain had expelled an Israeli diplomat, how could we be expected to do less, by saying that it was a long time since our hands were tied by what Britain did.  We are independent now, he said (not that that stopped us from going along for the ride in the Anglo-American illegal invasion of Iraq).

How glad I am that Alexander Downer isn’t Foreign Minister any more.  

As for the current Opposition spokesperson, Julie Bishop echoes the line of Israeli Foreign Minister Avigdor Lieberman that there is no proof of Israeli Government involvement. What would she regard as proof, I wonder.  It seems to me to be beyond reasonable doubt. Even Alexander didn’t seem to be questioning that.

War Powers Bill: submission by the Submarine Institute of Australia

In its submission to the Senate Foreign Affairs, Defence and Trade Legislation Committee inquiry into the Defence Amendment (Parliamentary Approval of Overseas Service) Bill 2008 [No. 2], the Submarine Institute of Australia (SIA) raised a matter to do with submarine operations:

The submarine’s greatest strength is its ability to operate undetected in sea areas controlled by a potential adversary. It goes without saying, therefore, that the success of submarine operations relies on strict security – disclosure of submarine operational plans negates the submarine’s primary advantage – potentially putting the submarine at greater risk and leading to deterioration in strategic circumstances.

The Institute expressed concern that that the draft Bill would require public disclosure of submarine
operational plans in order to meet the Parliament’s requirement for approval of “warlike” operations. SIA’s solution is “that the Bill be amended to make provision for the Prime Minister to determine that covert operations are excluded from the requirement to achieve Parliamentary Approval of Overseas Service”.

While the issue raised by SIA is an important one I do not agree that the Bill is a problem in this respect.  Section 50C (11) of the Bill expressly states that service beyond the territorial limits of Australia “does not include service by members of the Defence Force ... on an Australian vessel or aircraft not engaged in hostilities or in operations during which hostilities are likely to occur”. 

The whole point of most covert operations is to avoid hostilities; they cease to be covert once the shooting starts.  So if we really are talking about operating “undetected in sea areas controlled by a potential adversary”, I think that the government of the day would be perfectly entitled to consider such operations to be operations during which hostilities were not likely to occur.

Another concern expressed by SIA was:

It is also possible that the threat level for a submarine operation currently underway could be reassessed to ‘warlike’ due to deteriorating circumstances. If that led to public disclosure in the Parliament then that operation could most likely not continue.

The relevant section of the Bill is Section 50C (10), which requires the Minister to report regularly to Parliament on the status of each deployment, what efforts are being made to resolve the circumstances which led to the deployment, and whether there is any reason why Parliament should not resolve to terminate the deployment.

It is a matter for argument how a covert operation that was overtaken by “deteriorating circumstances” would be impacted by the provisions of the Bill. I would be inclined to argue that if the deployment were not a reportable one at the time it took place then it would not be the subject of the regular reports on deployments authorised by the Parliament contemplated by Section 50C (10).

Be that as it may, these are questions of the drafting of the Bill, and whether some particular provisions need to be modified. They do not go to the question of whether or not the control of the war making power should pass to the Parliament. Nor did SIA oppose the central purpose of the Bill – it simply asked for the Bill to be amended to make provision for the Prime Minister to determine that covert operations are excluded from the requirement to achieve Parliamentary Approval of Overseas Service.

Practical questions such as that raised by SIA could have been addressed in the course of hearings had the major political parties agreed to hearings being held.

Referring to the SIA submission and a submission from the Navy League of Australia, the Committee Report made the remarkable observation (page 12) that:

... although only two submissions expressed reservations about the use of classified material, both were in a position to have sound knowledge about the nature and extent of such information and the likely security implications should it be disclosed.

They neglected to say that the joint submission from a former Defence Secretary (myself), another former senior officer of Defence (Andrew Farran) and a former diplomat with a deep background in intelligence (Garry Woodard) saw no such difficulties. They failed to notice the dog that did not bark. Again, this is a question that could have been tested had the Bill been taken seriously enough for the Committee to hold formal hearings.

For the text of the Bill click here.

22 May 2010

Resource rent tax: what happened to the nemawashi?

The Japanese have a marvellous expression, nemawashi, which refers to the processes to be undertaken in advance of any complex negotiation between powerful competing interests. Taken from bonsai cultivation, it means literally “going around the roots” and refers to the spreading and pruning of the roots that is the essential foundation of repotting the plant and shaping its future growth.

In a business or government negotiating context it refers to a process of lower level operatives sounding out in advance the positions of all the other parties, with a view to finding a position upon which it might be possible to gain consensus, before the senior leaders find themselves sitting across the table from each other. The aim is to achieve an outcome that everyone can live with, without the need for shouting, screaming, table thumping or other unseemly behaviour, without the need for bruised egos, and without giving rise to lasting enmities at the leadership level that make it hard to do business in the future. It sounds cumbersome, and might appear more time consuming, but it is actually both more efficient and more effective than launching powerful players into a doomed process which leads to a standoff, so that no one is happy.

Nowhere is the need for this more evident that in the chaotic process that has left the Government and the mining industry trading insults. How did it come to this, the national government and one of the nation’s most important industries at each other’s throats?

There are impeccably sound reasons for the Government to introduce a resource rent tax on the mining industry. The miners will not like it, because it will reduce their revenue.  That is not the issue. The issue is to design it in such a way that it has minimal effect on their investment and production decisions. We do not want them to invest elsewhere, we do not want them to defer investment, and we do not want them to cease production prematurely.

I have been around this buoy.  In 1976-77 the Fraser Government had on its agenda the pricing of domestically produced crude oil. This arose because when crude oil was discovered in Bass Strait in the mid-1960s the Esso-BHP joint venture unwisely asked the Commonwealth Government to fix the price of domestically produced crude oil. They said that the cost of production from the Bass Strait fields would be such that it would be only marginally profitable in competition with comparable imported crudes; they needed an extra few cents per barrel. The message was clear: without this assistance, Esso-BHP would sit on their discovery.  The Commonwealth agreed to use its powers under the Customs Act to require all sellers of petroleum products to uplift Australian crude in proportion to their retail sales of “white products”.

After the dust settled on the 1973-74 Middle East oil shocks, when the OAPEC (Organisation of Arab Petroleum Exporting Countries) producers placed an oil embargo on the United States and others following the Yom Kippur War, the Whitlam Government, and then the Fraser Government, and Esso-BHP were left in a position where the domestic crude oil price was about $US 2.13 per barrel and the internationally traded price was about $US 12. Because of the framework put in place at Esso-BHP’s request, the domestic price could only be raised by decision of the Commonwealth Government. 

The Government realised that it would have to move in the direction of world parity prices – which meant that over time it would be raising the price of the major input to Australian petrol and diesel to about six times its current level.

Equally, it realised that the price rise when it did occur could not be allowed to accrue as a massive windfall gain to Esso-BHP. Accordingly, it was decided that some form of super-tax would have to be levied on Bass Strait production. Critical to the design of this tax was that, while it should limit the windfall gains from known oil deposits (“old” oil) due to the oil price rise, it should not act as a deterrent to explore for oil that would be economic at the new international price level. It was also decided that it should not apply to small fields.  At the end of the day a crude oil excise was levied on “old” oil, with an exemption for the first 30 million barrels so that small onshore deposits would not get caught up in the system.

Consultations with the industry took place over several months before the design of the scheme was settled.  It was left to me as head of the Energy Policy Division of the then Department of National Resources to conduct the consultations with the Australian Petroleum Production and Exploration Association (APPEA).

It was made clear to the industry from the start that we were not there to ask them whether an additional tax was a good idea, we were there to advise them of the Government’s intentions and talk about the design of the scheme with a view to avoiding unintended consequences. Officers of other Departments attended the meetings, we duly reported back to the Government, and we had a lot of debate between Departments about the significance of what we had heard. 

We got a range of reactions.  Most of the large companies were pretty mature about it.  Some insisted that this had to be a departmental stunt that the Government didn’t know about because we now had a Liberal Government and it was in favour of free enterprise.  Some of the smaller explorers, like the American solo oilmen who had sold or  mortgaged their houses to chance their arm wildcatting for oil, could see the long dark night of socialism descending.

The point in the current context is that this was an orderly process, conducted without high drama.  The Government did not announce the policy and then have the public treated to the sight of the Prime Minister jumping into aircraft and rushing around the country to consult irate industry leaders who felt that they had been ambushed.  They were consulted, they had their say, and what they said was taken into account in designing a scheme they would have preferred not to see introduced.

So for my money the Government would have been well advised to publish the Henry Tax Review the day it was delivered to them, accompanied by a statement that this was an independent review, and the Government would consider it carefully and announce its decisions in due course after consultations with affected parties and relevant experts. 

Even better, the Government could have issued the Henry Report as a Green Paper, called for comment upon it over a period of months, then considered the responses and issued a White Paper.

Once they had decided to sit on it they were committing themselves to springing their policies fully formed upon a startled world once they did release it, a move that Sir Humphrey Appleby would undoubtedly have described as “courageous”.

Better do the nemawashi next time, Prime Minister.

Patrolling in Afghanistan

This article, In Ambush, a Glimpse of a Long Afghan Summer, from the New York Times, 19 May 2010, describes a Taliban ambush on a routine US Marine patrol in the area around Marja, a richly irrigated zone of farming villages in Helmand Province that was both the centre of Afghanistan’s opium production and a haven for its insurgency.

Well worth a read to get a feel for what both the Marines and the local farming population go through day by day.

Afghanistan is a wicked problem

Over the last thirty years there has emerged a substantial literature on so-called “wicked problems”. This is the class of problems that may be considered highly resistant to solution, by contrast with so-called “tame” problems, those that might be technically complex to solve but can be tightly defined and a solution fairly readily identified or developed.

The terminology was originally proposed by H. W. J. Rittel and M. M. Webber, both urban planners at the University of California, Berkeley, USA in 1973. In a landmark article, the authors observed that there is a whole realm of social planning problems that cannot be successfully treated with traditional linear, analytical approaches. To the extent that they can be modelled mathematically the mathematics is non-linear: everything is connected to everything else, and there is acute sensitivity to initial conditions.

There is a good succinct summary of the characteristics of wicked policy problems on the Australian Public Service Commission website here. In brief, these characteristics are:

-  They are difficult to define clearly: different stakeholders have different versions of what the problem is, and there is usually an element of truth in each of those versions.

-  They have many interdependencies and are often multi-causal. Often, there are also conflicting goals and objectives within the broader policy problem. This means that solving them requires coordinating inter-related responses, and accepting trade-offs between conflicting goals.

-  Attempts to address wicked problems often lead to unforeseen consequences. This arises from the complex connections between the component elements of the problem.

-  Often they are not stable: the nature of the problem is changing while the attempt is being made to fashion and implement a solution.

-  They are socially complex and it is their social complexity that often overwhelms the efforts to solve them.

-  They hardly ever sit conveniently within the responsibilities of one organisation.

-  The solution to wicked problems involves changing behaviour of some or all of the stakeholders.

-  Some wicked problems are characterised by chronic policy failure.

A most important characteristic of wicked problems is that they have no stopping rule, i.e., no mechanism for deciding whether to stop or continue a process on the basis of present and past events. Another is the fact that every attempt to solve a wicked problem is a “one-shot operation” because there is no opportunity to learn by trial and error; every attempt is significant.

Some researchers make a distinction between wicked problems and super wicked problems. The latter have the following additional characteristics:

-  Time is running out.

-  There is no central authority.

-  Those seeking to solve the problem are also causing it.

I think there will be ready agreement that the Afghanistan problem has the above three characteristics, so if it really is a wicked problem, it is clearly a super wicked problem.  When one looks at the characteristics of wicked problems as outlined at the beginning of this essay, it is easy to discern the key elements in the Afghan situation: different perceptions of what the problem is, multi-causality of the origins of the problem, interconnectedness between the important elements of the problem, conflicting goals and objectives within Afghan society, the nature of the problem keeps changing, they are socially complex, they don’t sit within the responsibilities of any one organisation, there is a fundamental need for behavioural change amongst most of the stakeholders, there is certainly chronic policy failure, and there is certainly no “stopping rule”, no protocol that tells us when it is time to give up and go away.

The question is what to do about it, and the purpose of this essay is to try to establish a basis for thinking about the problem in a manner that might point the way to a solution.

If it is accepted that Afghanistan is a wicked problem, it may well be productive to consider the generic approaches that have been taken to the solution of such problems.

Efforts to solve wicked problems usually involve one of the following three approaches:

Authoritative, in which an attempt is made to reduce the complexity of the problem by placing responsibility for solving it in the hands of a few people

Competitive, in which the opposing ideas are left to battle it out, with a requirement that the adherents of each viewpoint put forward their preferred solutions

-  Collaborative, in which an attempt is made to engage all stakeholders in order to come up with a solution that is best for all.

Authoritative approaches would seem to be ruled out if it is agreed that Afghanistan is a super-wicked problem. There being no central authority sitting above the whole problem (unless perhaps all the parties were to agree to place the problem in the hands of the United Nations and to abide by the outcome), there is no-one to select the smaller number of people who will come up with the solution on behalf of all stakeholders.

That circumstance could change, of course, if there were to be a genuine ceasefire and the various parties appointed a number of delegates to negotiate a solution that everyone would be prepared to accept and abide by.

The competitive approach is in effect what we are locked into at the present time, with the different ideas about the preferred solution being backed by force of arms (often financed by the drug trade or covert assistance from foreign governments pursuing their own agenda) and organised violence.

A collaborative approach seems to represent the only hope. As Chairman of the US Joint Chiefs of Staff Admiral Mike Mullen told Congress in September 2008, we cannot kill our way to victory.  What is needed, Admiral Mullen said (see Fox News report here):

... is better Afghan governance, more foreign investment, a viable alternative to the poppy farming, greater cooperation with Pakistan and more U.S. nonmilitary assistance.

That sounds to me like the start of a collaborative solution, with the notable absence of any reference to engaging the opposing forces, especially the many insurgents (David Kilcullen’s “accidental guerrillas”[1]) who are not fighting us out of religious or ideological antipathy – they are fighting us because we are in their country, or their valley, or their village.

In future posts I will attempt to explore in more depth what a “collaborative approach” in the relevant sense might look like.

One point I would make at this stage. The NATO forces have to make a clear choice between a collaborative solution and a competitive one. In a competitive solution the focus of the military effort will be on attacking the opposing forces. In a collaborative one, the focus will shift to protection of the population and avoidance of the collateral damage and collateral recruitment to the opposing forces occasioned by “targeted” military strikes gone wrong. We cannot have a collaborative solution with a little bit of killing our way to victory thrown in. If we want to solve this thing we are all going to have to take a deep breath and deal with some very unpleasant people. But then, we have done that before.


[1] David Kilcullen, The Accidental Guerrilla: Fighting Small Wars in the Midst of a Big One, Oxford University Press 2009.