Wednesday, May 26, 2010

Three of the best things written about the Resource Super Profits Tax

Ben Smith was the consultant to the 1986 Gutman inquiry into the taxation of gold mining that recommended the exemption be removed, subsequently making Australia making billions.

John Freebairn of the economics faculty at Melbourne University has the most lateral tax mind in the business as well as the most human understanding.

Alan Mitchell, economics editor of the Australian Financial Review sees clearly where others see fog.

These pieces shows each at the top of their game:


Ben Smith

When the Government
announces a 40 per cent
resource super profits tax, which,
when combined with the company
tax, has the effect of increasing the
tax on mining profits to 57 per
cent, the natural reaction is to
think that the industry’ s
predictions about its impact may
well be correct.

ln fact, they are entirely false.

The most basic principle of
economics is that the incentives to
undertake activity are influenced
by the marginal effects of policy
measures. In this case, marginal
effects means tlteimpact onprofits
from new investments in
exploration and mining, including
extensions of existing mines, as ,
distinct from the impact 'on profits
from projects whose investment
cost is already sunk.

Consider the following analogy.

Suppose the Government
announced a one-off measure to
expropriate 5 per cent of the wealth
of every citizen as measured at
midnight last night and that,
starting tomorrow, the tax rate on
employment income would be
reduced to zero.

Of course, many people would
hate this package and there would
be much debate about the
desirability of the redistribution
involved, but it wouldnft stop
anyone turning up for work
tomorrow. On the contrary,
elimination of the tax on labour
income would create anincreased
incentive to 'seek employment.

That is pretty much the resource
super tax story. Its application to
the profits earned from existing
operations will expropriate a
significant chunk of wealth held-in
the form of mining shares. This will
affect almost everyone to some
extent, since superannuation funds
hold a-lot of mining shares, but it
will most adversely affect those
who, like mining industry
executives and directors, are both
wealthy and hold a relatively large
proportion of their wealth in
mining stocks.

A For new investments in
exploration and mining, however,
the resource super tax is not a tax
on super profits, because it is not in
any meaningful sense a "tax" at all.

In effect, the Federal
Government (and you, as the
taxpayer) will take a 40 per cent -
equity share in all new investment
and will receive 40 per cent of the
profits, just as any private joint
venture partner would do. Of
course, the mechanics of the
resource super tax are not as
simple and transparent as that.

The Government won't provide
its 40 per cent stake up-front, but
will guarantee to pavit out of its
share of the protits or, if the project
is not sufticiently profitable, by a
cash payment at the end of the
project’s life. Hence, the
Government will be borrowing the
cost of its 40 per cent share from
the "company, paying interest on
that loan at the long-term
government bond rate, and
guaranteeing that the debt will be
fully repaid by one means or
another. For every $100 of project
cost, the company will stillhave to
find $100 of initial funding.

However, only $60 of that will
actually be investment in a risky
venture, in exchange for which it
will get 60 per cent of the profits.
The other $40 will be a risldess loan
to the Government, on which it will
(appropriately) earn the riskless
rate of interest. So long as the
company can itself borrow $40
against the security of the
governments guarantee, at an
interest rate that is no higher than
the long-term government bond
rate, there is no "tax" involved.

So where does the 57 per cent tax
rate come from?.Well, if you
incorrectly think of the
Government’s 40 per cent share of
the profits as a "tax" and then add
on the company tax that will be
paid on the companys 60 per cent
share, you arrive at-that figure as
the "tax rate" on the total profit.

But this is a gross distortion.

Mining company dollars have
financed only 60 -per cent of the
project and that share of the profits
will be taxed 'only at the reduced
company tax rate' of 28 per cent.

But wait, there's more. Currently,
mining is subjept to state and
territory royalties, which tax the
profits earned by mining
investments and deter otherwise
worthwhile activity. Under the
resource super tax, the Federal
Government will reimburse
companies for any royalties paid,
with the result that the mining
industry dollars invested in
projects will have significantly
more favourable tax treatment
than at present.

The expropriation of shareholder
wealth resulting from the
application of resource super tax to
existing operations may cause
mining companies to kick and
scream, but don’t worry about
Whether they are going to turn up
for work tomorrow.

In fact, the only danger to future
exploration and mining activity is
the possibility that suppliers of
finance might believe the
industry’s rhetoric, but the market
is smarter than that and banks are
no doubt already figuring out ways
to squeeze a margin out of lending
against a cast-iron government
guarantee.

Ben Smith is a former head of the
School of Economics at the Australian
National University and was an associate
commissioner on the Industry
Commission's 1991 Inquiry into Mining
and Mineral Processing in Australia.




John Freebairn

The resource super profits tax (RSPT) is a less distorting and more efficient tax than the state-based royalties which it will replace. It results in different and subtle changes in the distribution of the tax burden across different mines and different phases of the commodity cycle. Any assessment of the RSPT needs to take place in the broader income tax context, including in particular corporate income tax.

Other taxes, including the GST and state payroll and stamp duties, will continue to apply.

It is useful to compare and contrast the corporate income tax and the proposed RSPT.

The corporate tax rate, now 30 per cent and to be reduced to 28 per cent from July 2014, is applied to a measure of gross receipts less the sum of any royalties and RSPT, depreciation, running expenses, interest and the nominal value of any losses carried forward. The RSPT at a rate of 40 per cent is to be applied to a measure of gross receipts less the sum of depreciation, running expenses, a normal rate of return on debt plus equity capital, and any losses carried forward scaled up by the normal rate of return. The normal rate of return is to be the 10-year government bond rate. Relative to corporate income tax, the RSPT allows a deduction for the normal rate of return on both debt and equity capital, and treats the two types of finance similarly. Losses carried forward are indexed; they are treated symmetrically with gains, thereby providing for neutrality of tax treatment of risky mining investments.

Under the proposed changes, mining companies will still pay a royalty at current rates to the state and territory governments, but the commonwealth will directly compensate them. In effect, the miners will no longer pay the royalty. This is a clumsy political expedient to avoid a fight with the states over federal-state financial relations.

The distribution of the RSPT will vary across mines. For any particular mineral or energy there is a range of mines ranked by low to high costs of production. The lowest-cost mines have rich deposits close to the surface and easy to mine, ready access to transport and other infrastructure, and low costs for environment and heritage protection. These mines earn very large returns above production costs. At the higher end of the cost scale are mines that barely cover production costs because of comparatively poorer deposits, more difficult and costly mining, longer distances from or more costly infrastructure, and incur significant costs to protect the environment and heritage values.

Under the RSPT, the low-cost mine will pay a relatively high tax burden, but the combined RSPT and corporate income tax burden will be at most 56.8 per cent on the above-normal profits or rents on the mining operation. By contrast, the marginal mine will earn very little to no rents, pay no RSPT and likely no corporate income tax.

Here lies the greater efficiency of the RSPT. Under the royalty system some mines at the higher end of the cost scale will be unprofitable, even though they can cover the social opportunity costs of plant and equipment and labour, and these investments will be deterred. But such investments and production would be viable under the RSPT.

Further, even though the shareholders of the low-cost mines receive less with the RSPT, as compared with the royalty system, it is still highly profitable, and the investment and production would take place. In fact, they continue to receive more than 40 per cent of the return over and above the opportunity cost of the funds in alternative investments in the economy. The RSPT could be much higher, close to 100 per cent, without deterring the investment.

Super resource rent returns are largely restricted to the natural resource industries, where the quality and associated production costs of different resource units vary. By contrast, most of the manufacturing and services industries are characterised by close to constant returns to scale production technologies. That is, the RSPT cannot be a precursor to similar taxes in most of the rest of the economy.

Second, the RSPT tax take will vary over the commodity cycle. Despite the optimism of some that China and India will drive a never-ending resources boom, just as night follows day, commodity booms are followed by commodity slumps. The royalty system imposes a similar cost burden on miners through the boom and slump times. The RSPT plus corporate income tax collected will rise with booms, when capacity to pay is greater, and fall in slumps, when capacity to pay is reduced. In effect, government, on behalf of the citizens who own the basic resources, becomes a shareholder in the mining industry.




Alan Mitchell

A tax on tobacco, says an apparently perplexed Tony Abbott, will reduce smoking, but a tax on mining is supposed to increase mining.

Of course, the whole nation is trying to get its head around this exotic animal that economists call a resource rent tax. But the answer to Abbott's puzzle is that, despite its name, the government's resource super profits tax is not a normal tax on mining.

Arguably it is not a tax at all, although that is what economists insist on calling it. It is a charge set by the owner of the mineral resources for the right to exploit those resources. It is no more a tax than the rent Westfield charges Woolworths. And like any such charge, it is tax deductible. It is pre-tax.

To get a sense of how it works, imagine you owned a strip of land and the title to the minerals under the ground. How much could you sell the mineral rights for?

If the land already had been explored so everyone knew what was there, the maximum price obviously would be related to the value of the minerals.

But it could not be the entire value. The mining company would have to cover its costs, including the cost of the capital supplied by its shareholders. It would have to make a normal profit, including a margin for risk related to future mineral prices, etc.
But, as the owner of the minerals, you might reasonably hope to get a price that approached the full value of the minerals less the miners' costs (including its normal profit). And if it were a competitive market, with miners trying to outbid each other, you probably would.

That is, you would be pocketing what economists call the expected economic rent of the project, which is the expected profit in excess of the costs of exploiting the resource, including a miner's normal rate of return on capital. And that is the profit in excess of the minimum rate of return needed to justify the miner's investment in the project.

Of course, if there had been no prior exploration and no one knew for sure the value of the deposit, you wouldn't get as much money. The miners would make their own assessment of the chances of finding something, and its likely value. They would subtract a bigger margin for risk from the price they were prepared to pay.

But, either way, the price extracted by you as the owner would not deter the miner from going ahead with the project, because it would still expect to make its required rate of return.

An upfront sale of the right to develop the mineral resource transfers all the risk and rewards to the miner. As the owner, you might prefer to maintain an interest in the development of the mineral resource as a silent partner – to share the risks and the profits.

In that case, the profits in excess of the miner's costs would be shared, as would the losses.

That is basically what the government has done on behalf of the community, which owns the nation's mineral resources. The resource rent "tax" reduces a miner's share of the expected net present value of the project (excluding costs and a normal profit) and the associated risk. This, among other things, should lower the miners' required risk premium. For risk-averse investors, this might increase the value of the project because the reduction of risk is worth more than the loss of expected earnings.

In the case of new projects, this new effective partnership arrangement should have no adverse effect on investment and output, and might increase it. Even with 40 per cent of the economic rent going to the resource owner, the miner is still earning a profit in excess of that required to justify the investment.

The government's resource super profits tax is intended to leave the "cut-off" point for new projects unchanged: no project that would have gone ahead without the tax should fail to go ahead with the tax.

With the resource rent tax in effect replacing state royalties, the new tax should increase the number of marginal projects that are developed.

For a number of existing projects, there is an element of retrospectivity and an argument for a transitional arrangement.

But, thanks to China and India, there has been a big, semi-permanent shift in the prices of Australia's minerals that was not contemplated when the existing state royalty arrangements were introduced. No mining company could have seriously expected to simply pocket the super profits while their partners and owners of the mineral resources sat silent.




Related Posts

. Five easy pieces - the Mining Super Profits Tax

. Okay so no-one likes to part with profit, but the mining fight is becoming a spectator sport

. It's not a tax, it applies to more than super profits, so how did so many people get it so wrong?

. Henry to miners: no compromise on where the tax kicks in

. We'll still be mining


3 comments:

Taylor said...

Thanks Peter these are useful. Frankly I'm a bit disappointed in Ben Smith's piece as his academic work on resource taxes is much more nuanced and sceptical, to my mind. I thought the Geoff Carmody piece that you referenced earlier was better as a piece of high quality economic journalism.

I also find Smith's freewheeling approach to the expropriation of property here rather breathtaking. I trust foreign investors will take the same view, as otherwise it will surely impact on the view that the government bond rate is the appropriate discount rate for the Commonwealth's promises to pay expenses.

I also tire of the joint venture metaphor. Legally it's not a joint venture (if it is it's unconstitutional). Functionally it's not a joint venture unless the government pays up where necessary. But that's precisely the question in issue.

Anonymous said...

Ben Smith taught me resource economics at ANU - can you please provide the link for his piece?

Thanks,

Kymbos.

Peter Martin said...

I wish I could Kymbos.

There's no link.

I got this from the print edition of the Canberra Times which I scanned and corrected by hand.

Ben's wonderful.

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