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.


David Brown said...

Your blog is fantastic, I only just discovered it. Thank you for taking the time.

When you said, "proposed imposition of resource rent taxation by the Commonwealth is a cash grab from the states", you neglected to remember Tom Fitzgerald's observation, "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".

I'm also brave enough to remind you that the basis for State mining royalties is hardly legal granite, and in any case could most probably be overridden by the federal government if they wanted a big enough fight. The word "CommonWealth" was chosen deliberately. In this case, they've gone for a workaround.

Finally, although I'm something of a fan of Brian Toohey dating back to the seventies, I've yet to read a commentator who demonstrated that they really understood the mathematics of the proposed tax. Understanding is paramount to venturing any sort of opinion on how it might affect financing, investment, etc.

As someone with not inconsiderable technical experience in mining royalties, I've spent the last couple of weeks trying to absorb everything that's been written on this subject, as well as any related tax research that I can find. The more I understand it, the more amazing it appears.

From an investor's point of view, Australian mining ventures will become one of the global investment jewels. Every mine is a balanced risk proposition, with 40% of your investment capital-guaranteed and returning the Australian government bond rate. The remaining 60% is subject to a modest profit tax of 28%. And there are NO royalties!

Coincidentally, this makes such ventures perfect investment vehicles for superannuation funds, and guess who's about to get an additional third in employer contributions from 10 million Australians?

This potential change in capital origin, coupled with the extra retention of profits through taxation, could finally shift Australia's current account into positive territory. As I said, amazing!


I did in fact remember Tom Fitzgerald's observation about the power and disposition of state governments - it is in the quoted portion of his observations.