Wednesday, June 23, 2010

Wednesday Column:Why economists and miners disagree, and why they are both right

Want to hear a good economist joke? The economist and the entrepreneur are out for a walk. The entrepreneur points down and says "there's a $20 note on the footpath".

The economist replies, "no there's not; if there was, someone would have picked it up by now".

We laugh because it makes the economist sound stupid, but also because we know the economist will pretty soon be right. If the money hasn't been picked up, it will be - most probably by the entrepreneur herself.

Which cuts to the quick of why mining executives and the sort of economists employed by the Treasury don't understand each other - genuinely.

That, and something called the fallacy of composition.

Let's start with the miners... They say the proposed tax will make Australia a less attractive place to mine. While still attractive (miners will get 60 per cent of everything they make above the bond rate before paying tax) Australia will be pushed down the list of attractive locations. Management and capital are limited, and so they will be more likely to direct those limited resources somewhere else.

Alan Auerbach is professor of economics at University of California, Berkeley. The Henry Review consulted him while drafting its report and he is back in Australia for the conference on the wash-up.

Here's how he characterises the differences between the camps:

"One thinks that if the project earns a satisfactory rate of return it will be undertaken; the other thinks miners look for the highest rate of return and then stop."

"We teach our students in economics and business that if their cost of funds is say 10 per cent or whatever, and there is one project that earns 50 per cent and one that earns 20 per cent, they should undertake both. The miners seem to be saying - we only have one chief executive, he can only think about one thing at a time, and the bank won't lend us more money - we will stick with one."

The miners are saying that if there is $20 lying on the footpath they are going to leave it there.

The point about the fallacy of composition is that both the miners and the Treasury might be right.

Let's talk about football. If you go to oval with a fruit box and stand on it you will get a better view. But if everyone goes to the oval with a fruit box and stands on it the view won't have improved at all. The fallacy of composition is the fallacy of thinking that what is true for an individual is true overall.

Auerbach says he accepts that a single mining company might say, "our executives need to play golf and do other things, we will just do one mine and we do it in Brazil instead of Australia because taxes are lower there".

But then he says another company will come in, buy the right to mine the land at a lower price (the tax will have pushed down the price) and mine it anyway. What was true of one company will not be true of companies in general.

And it is companies in general that matter to the Treasury and Australia, even if those companies don't yet exist. Fortescue calls itself "the new force in iron ore". It was created in 2003. New mining companies do arise to sweep up notes left on the pavement by the older more choosy ones.

But what if they can't get the finance? To a Treasury or academic economist the concept of not being able to get finance for an attractive proposition is a strange one. The tax is designed to ensure the proposition remains attractive. Sixty per cent of excess profits are always left in and if the profits drop too low the tax drops to zero. But it could happen. Sometimes (usually for short periods of time) capital markets don't work.

But the minerals will still be there, ready to be mined as soon as someone can get the finance. Businesses are not so lazy as to let money lie on the footpath long while there's a chance of picking it up.

Or at least that's how the Treasury and the professor see it.

But can't our big mining companies see that too? Can't they see that if they don't mine someone else probably will, I naïvey asked the professor.

His brutal reply was that even if they can see it they don't care.

"It is wrong to think that if a company is against a tax it is because the tax discourages activity in the industry," he tells me.

"You could come up with a higher tax that would actually encourage activity in their industry; I believe this is such a tax - but it would still make the industry unhappy."

The professor's bottom line: the industry does see things differently to the Treasury, most likely genuinely. But even if they could see things more broadly they would still oppose the tax. It is designed to grab more of their profits.

Published in today's SMH and Age

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. "Resource companies will leave only when there are no more minerals to extract"