ben smith on the rspt

8/9/2019 Ben Smith on the RSPT

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CHARGING FOR NON-RENEWABLE RESOURCE DEPLETION

Or

SLIMMING THE GOOSE: LessFoie Gras

but More Golden Eggs?

Ben Smith

Visiting FellowCollege of Business and Economics

Australian National University

Paper prepared for the conference: Australias Future Tax System:A Post-Henry ReviewSydney, 21-23 June, 2010


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Together with its release of the report on Australias Future Tax System (AFTS,2009), the Commonwealth government announced the intention to introduce aResource Super Profits Tax (RSPT) applying to all mining activity, coupled with thecapped refunding to mining companies of royalties paid to state or territorygovernments. Also foreshadowed was an amendment to the company tax provisions,introducing a Resource Exploration Rebate whose effect would be to ensure that allcompanies were able to take advantage of the immediate deductibility of explorationexpenditure. The exploration rebate was not a recommendation of the AFTS Report,nor was the Report responsible for the name given to the proposed new tax.

The RSPT announcement has given rise to a heated debate, if that term appropriatelydescribes a barrage of assertions and counter-assertions degenerating into a largelymisleading advertising battle. The premier of Queensland has recently appealed to

both the mining industry and the government to put away the baseball bats and toengage in serious and sensible discussion. A prerequisite for that is a clearrecognition and understanding of the issues.

There are, I think, four central questions:

how does the RSPT compare with other means of charging for the depletion ofnon-renewable resources, assuming a greenfields situation and a singleauthority responsible for implementation;

what are the issues and effects associated with applying that mechanism toprojects that have previously been operating under a different regime;

how should the revenue flows from resource charges be treated in the contextof the governments budget; and

what issues and problems result from the fact that more than one level ofgovernment asserts an interest and responsibility in this area?

The last of these questions arises because, while they may loosely be described asbelonging to the Australian people, onshore mineral resources are constitutionallythe property of the states in which they are found. Mining companies access themthrough leasing agreements with state or territory agencies and the Commonwealthhas no direct power to regulate or charge for their exploitation.

Part 1 of the paper focuses on the first question, and is concerned with the applicationof resource depletion charges, and the RSPT in particular, to new investments inexploration and mining, abstracting from the question of which government is the

responsible authority. It makes up over half of the paper. The other three questionsare addressed more briefly in succeeding parts.

1. CHARGING FOR NON-RENEWABLE RESOURCE DEPLETION

Production and sale of mineral commodities involves the use of three main factors ofproduction: the capital and organisational expertise of mining companies, the labouremployed, and the non-renewable resources whose stocks are depleted by mining.The value of the last of these depends on their ultimate scarcity, on their quality (afunction both of the nature of the material produced and its extraction cost) and,because these goods are bulky and relatively expensive to transport, on their location.For the last 50 years, Australia has been able to exploit the good fortune of havingabundant, high quality stocks of a wide range of mineral commodities, most notably


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of the key steel-making raw materials, iron ore and coal, and of being located close tothe worlds fastest growing markets for those materials, first in Japan, Korea, andTaiwan and subsequently in China and India.

Like the rent value of land, the rent value ofin situ minerals is a residualwhat is leftover after the other factors employed in production have been fully compensated. Ifiron ore simply lay on the surface in known locations, needing only to be scraped upand moved to a shipping point at which it could be sold for a known constant price of,say, $100 per tonne of contained iron, and if the cost of hiring the necessaryequipment and labour (including the required managerial expertise) were also aknown constant amount of $60 for every tonneof contained iron, the residual (or rent)value of the resource would be $40 per tonne. The owner of a deposit of this resourcecould charge mining companies a royalty of $40 for every tonne removed withoutdeterring them from engaging in the activity. However, mining doesnt work likethat.

First, some tonnes of contained iron are more costly to extract than others, either

because mining conditions are themselves more difficult or because the concentrationof iron in the material being mined is lower. Thus, there will be some tonnes that costless than $60 to extract and others that cost more than this amount. If the resourceowner charges a $40 royalty in this situation the more costly ore will not be minedand its rent value will be forgone. Moreover, for the material that is extracted theresource owner will only have collected the full rent value of those tonnes that costexactly $60. If there are some tonnes that cost only $20 to extract (so their rent valueis actually $80), only half of that rent will go to the resource owner and the other halfwill remain with the mining company.

Secondly, the price at which the contained iron can be sold is not constant or certain.

For example, it may vary between $50 and $150 per tonne. If the mining companycould hire equipment and personnel on a week-by-week basis, and if it faced a $40per tonne royalty, it would extract little, if any, material when the price was very lowand a large amount when the price was high. But mining doesnt work like thateither. Mine development requires large initial investments and, to a significantextent, the future pattern of extraction (how much ore and of what grades) isconditioned by them. The variable cost per tonne extracted may be relatively low upto the design capacity of the mine, but rise sharply as that capacity limit isapproached. Consequently, in the short to medium term, mine output is fairlyinsensitive to price changes (with the consequence that minerals prices are highlysensitive to demand changes). The mining companys problem is to decide in

advance what sort of mine to build, on the basis of its expectations about future pricesand costs. The higher the royalty per tonne, the more likely it is that the company willdecide either to forgo the project entirely or to high grade the deposit, taking onlythe highest quality, lowest cost material and leaving lower grade ore in the ground.One result in the latter case may be that mining the lower grade ore may neversubsequently be commercially viable, regardless of any future royalty regime.

Finally, of course, mineral resources are not just lying around in plain view waiting tobe picked up (though sometimes the situation is not very different from that).Deposits have to be discovered and delineated by exploration before they can bemined. For each highly profitable mining operation, there are many investments in

exploration that have either failed entirely or delivered resources that are only


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marginally worth mining and dont repay the cost of their discovery. Application of afixed royalty to successful outcomes reduces the incentive to engage in exploration.

The challenge, then, is to devise a means of identifying the rent value of resourcesthat, to a greater or lesser extent, are yet to be discovered that is, identifying theresidual amount that remains after mining companies have been fully compensated forthe risky investments in exploration and mine development that are required - and amechanism whereby the owner of those resources can capture (at least a reasonableshare of) that value without reducing the incentives for their efficient exploitation. 1

A Short History of the Mining Tax Debate in Australia

Royalties, whether a fixed amount per tonne as in the preceding example, apercentage of the ex-mine value of output, or a percentage of the accounting profitattributed to the mining operation, all tax the returns on investment in exploration andmining and have the kinds of distorting effects described above. These are minimisedif royalty rates are set at very low levels, but that leaves the resource owner capturing

only a small share of the rents accruing from the exploitation of mineral resources.The inherent bias towards (current) development and jobs has an importantinfluence on the outcome of this policy trade-off.

The stability of a royalty regime is also a potential concern for investors becausegovernments have incentives to raise rates when market conditions are favourable (i.e.when additional revenue can be obtained without seeming to impact on activity) butnot so readily to lower them in the opposite circumstance, and/or to depart from thepre-announced uniformity of rates by the ex postintroduction of special arrangementsfor projects that are observed to be highly profitable.

Interest in designing charging arrangements that more effectively capture the value of

in situ resources, without substantially deterring exploration and mining activity, wasstimulated by the Resource Rent Tax (RRT) proposal of Garnaut and Clunies-Ross(1975). This would impose a relatively high rate of tax on returns from a project thatexceeded a specified threshold rate of return, leaving returns up to that rate untaxed.The argument was that, so long as the threshold rate was set at the rate of returnmining companies required to induce them to undertake risky exploration and miningactivity (the supply price of investment), any returns in excess of that could beconsidered to reflect the inherent rent value of the resources being exploited. The factthat projects could earn returns up to the threshold rate without paying any tax wassuggested to mean that the RRT would have minimal effects on incentives toundertake exploration and mining activity.

In 1987, the Commonwealth government replaced the previous crude oil excisearrangements with a RRT for offshore oil and gas production, other than on the NorthWest Shelf. In the Petroleum RRT, both the uplift (threshold) rate and the tax rate (40per cent) were set at more moderate levels than might have been expected from theoriginal Garnaut and Clunies-Ross argument, for reasons that will emerge below.

Although the RRT was generally recognised in the academic literature as beingsuperior to traditional forms of royalty, the claim that it could be non-distorting in itseffects on exploration and mining investments was the subject of a considerable

1. Or, more accurately, that do not distort those incentives more than they are already distortedby the application to mining investments, as to all other investment, of the standard income(corporate and personal) tax.


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debate. Among the main contributions to this were those of Swan (1976, 1978),Garnaut and Clunies-Ross (1979), and Fane and Smith (1986). An important elementin that discussion was comparison of the effects of the RRT with those of amechanism suggested by Brown (1948).

The Brown (or Pure Rent) Tax is neutral in its effects on investment decisionsbecause, at least in its most transparent form, it is not a tax at all. The governmenteffectively purchases a silent equity share in the exploration/mining project equal tothe tax rate and, like any private joint venturer, receives a corresponding share of theprofits. Thus, if the tax rate were 40 per cent, the government would contribute thatshare of all investment costs and the 40 per cent tax on future returns to the projectwould simply be the means by which the government collected its equity share of theprofits. The mining company would have put up 60 per cent of the cost of the projectand would receive 60 per cent of the returns, subject to no charge, so its incentive toundertake the project would be unaffected.

In the transparent form of the Brown Tax, the government contributes to investment

costs as they are incurred, financing this by general government borrowing.Alternatively, however, the government may borrow from the mining company tofinance its share of costs, repaying this loan with interest from its share of the futureprofits. To make this equivalent, the government would need to guarantee to meetany outstanding balance of its debt by a direct payment to the compan y if, over thelife of the project, its share of the profits turned out to be insufficient to provide fullrepayment. Given the certainty that the debt would be fully repaid by one means oranother (assuming the governments guarantee to be credible) the interest rate atwhich it accumulated would not need to include any risk premium.

With some refinements, the case just described is exactly what the AFTS Report has

recommended and what the government has indicated it will introduce as theResource Super Profits Tax (RSPT). From the point of view of the mining company,the difference from the transparent Brown Tax is that, in addition to meeting its 60 percent share of the investment costs, it is effectively obliged to purchase an unofficialgovernment bond of value equal to the other 40 per cent of those costs. If it can

borrow against the security of this riskless asset at the same interest rate that theasset earns, then it should be indifferent between the two arrangements.

Fane and Smith (1986) showed that the RRT can similarly be characterised as a casein which the government borrows from the company to finance a share of investmentcosts equal to the tax rate, but only commits to repaying the loan to the extent that itsshare of future profits provides sufficient funds. In that case, the company bears therisk that the project will not be sufficiently profitable for the loan to be fully repaidand needs to be compensated for this by being offered an interest rate (the uplift orthreshold rate in the RRT formula) that includes an appropriate risk premium.

In fact, the RRT can be thought of as the equivalent of a Brown Tax, to which hasbeen added a tax on investment whose rate is higher the greater the uncertaintysurrounding the investment outcome plus a subsidy to investment whose rateincreases as the uplift rate rises and as the degree of uncertainty surrounding theinvestment decreases. For a given level of investment uncertainty (and time profile ofpossible outcomes), there exists an uplift rate at which these tax and subsidy elementsexactly counteract one another, so that the RRT has the same neutral effect as the

Brown Tax, but that neutral uplift rate varies dramatically from project to projectand, within a project, between different kinds of investments (see Smith, 1999 for an


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extensive discussion of this). Any uniformly applied RRT formula will havesignificant deterrent effects on some investments, while providing significantincentives to over-investment elsewhere. Notably, although the balancing point atwhich the taxing and subsidising elements of the RRT exactly counteract one anotheris independent of the tax rate applied, the magnitude of the distorting tax or subsidy

that emerges when the uplift rate is set incorrectly increases with the tax rate. In orderto avoid substantial distortions to investment decisions when the uplift rate is too highor too low, which it almost always will be, the taxing authority is obliged to keep thetax rate at a relatively moderate level.

In a rough and ready attempt to deal with the fact that investment risk varies betweendifferent kinds of investments, the Petroleum RRT was amended so that the uplift rateapplying to mine development expenditure was reduced below that for explorationexpenditure. The AFTS Report suggests that the uplift rate on developmentexpenditure (5 percentage points above the long term government bond rate) is stilloverly generous, citing the corporate bond rate (about 2 percentage points above the

long term government bond rate) for comparative purposes. However, this would bethe relevant yardstick only if companies could finance projects subject to the PRRTwholly by borrowing at the corporate bond rate, with the debt secured only againstthose projects rather than against the assets of the company as a whole. The plain factis that the taxing authority does not, and cannot, know what the appropriate RRTuplift rate for any given investment is (and hindsight is not a useful guide). All it cando is to set a uniform rate across a broad class of similar investment types, knowingthat this rate will be either too high or too low in almost all cases, and to moderate thedistorting effects of this by keeping the tax rate applying to returns in excess of theuplift rate at a relatively modest level.

Instead of attempting to capture the value of in situ mineral resources throughroyalties or other taxing mechanisms, such as the RRT or Brown Tax, the governmentcould auction the rights to exploit those resources. That approach was advocated by,among others, Dowell (1981) and Porter (1984), who argued that, in a competitivebidding process, companies would pay an amount equal to the expected value of theresource stocks. Although, in a few cases, companies would subsequently make (andretain) very large profits, in many more cases positive prices would be paid for rightsthat turned out to be more or less worthless. Overall, the community would be fullycompensated for the value of the mineral rights that had been transferred, given theinformation available at the time of the auction.

Reliance on auctioning as the sole means of capturing resource rents dependsimportantly on the credibility of the governments commitment not subsequently toimpose royalties or other charges on any mining activity that takes place. This is theSovereign Risk problem. If companies believe that highly profitable miningventures will, in fact, be subject to significant resource taxes, regardless of any priorundertakings (and history gives them every reason to hold this belief), they willreduce their bids accordingly. Of course, this is something of a chicken and eggsituation. When mining companies are seen to have acquired mineral rights cheaplythat will provide ammunition for arguments in favour of introducing new taxes on anyhigh profits that may be earned, making it more likely that the expectation of suchtaxes will be realised.

If mining companies are anyway going to anticipate the probable imposition ofmining specific charges, uncertainty can be reduced by informing them in advance of


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the nature of those charges. That is, by auctioning rights subject to the application ofa specified form of charge on mining activity. If that charging mechanism can beseen to guarantee the community a significant share of any rents earned, regardless ofthe quality of deposits discovered or future market conditions, the sovereign riskconcern that additional charges may be imposed will be abated and companies are

more likely to bid the full residual value of the rights. Independently of that issue,Emerson and Lloyd (1983) argued that a combination of up-front auction paymentand conditional tax payment would generate efficiency gains by allowing risksassociated with resource development to be divided between the mining company andthe government in a manner that reflected their relative risk preferences.

A separate concern about auctioning has been fear that competition in the biddingprocess would be limited, other than for areas of known high prospectivity. In theabsence of significant competition, companies will bid less than the expected value ofthe resources independently of any sovereign risk concerns.

A company gains access to resources through the granting of an exploration licence

and, if a worthwhile deposit is discovered, a mining licence. Except where there isevidence that more than one company is currently interested in the area, anexploration licence is granted to the initial applicant for a limited period (e.g. 6 years)on conditions that require bona fide exploration to be conducted and a progressivesurrendering of the area covered (together with disclosure of all information gainedabout the surrendered land, which is then made available to any other interestedparties). This is commonly referred to as a First Come, First Served allocationmechanism. In cases where there is wider interest, companies are most commonlyinvited to submit work programs that detail their exploration plans, with the licencebeing awarded to the company that submits the best program. Although there is noexplicit indication that best means most expensive, it is hard to imagine that this

is not the dominant criterion. Thus, companies are provided with incentives todissipate the expected rent value of resources by enlarging their explorationexpenditure beyond what would be efficient in order to win the auction.

Regardless of other considerations in the resource charging debate, there is a verystrong case for replacing work program bidding with straightforward cash bidding andleaving the winners to decide for themselves how most efficiently to exploit theresource rights they have acquired. No community advantage accrues from providingincentives for companies to undertake a larger exploration program than they wouldotherwise choose in areas that are already believed to be of prospective interest.

This is somewhat less clear in areas that are of limited current interest to explorers,where the first come, first served arrangements apply. Exploration data from suchareas may provide information about the prospectivity of neighbouring areas, so thatthere is an external benefit that the exploring company does not capture and does nottake into account in determining its exploration program. These explorationspillovers, as the AFTS Review calls them, provide the only reasonable justificationfor the work commitment and limited tenure conditions of exploration licences, whoseeffect is to give companies incentives to explore more rapidly and intensively thanthey otherwise might have chosen.

In its report on Mining and Mineral Processing in Australia, the Industry Commission(1991) reviewed the arguments outlined above and concurred with the view thatexisting royalties should be replaced by a more efficient mechanism, combined where


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possible with the auctioning of mineral rights. The problems of designing a RRT thatwould not generate significant distortions to investment decisions led it to favour aBrown Tax arrangement. Recognising that, by itself, this would capture resourcerents for the community only to the extent that the taxing authority also bore the risksthrough its implicit equity stake, the Commission considered the possibility of

imposing the tax at a high rate, with the consequence that the authoritys implicitequity share would also be large. Its view was that this would create difficulties, bothbecause mining companies with only a small stake in each project would havereduced incentives to operate efficiently and because it might expose the governmentto a greater level of risk and revenue uncertainty than was acceptable. One could addto this the problem of maintaining a non-managerial role as a silent partner in anindustry that was, effectively, a majority-owned public enterprise.

In keeping with the main thrust of the academic debate, the Commission concludedthat there were only two ways governments could capture the rent value of resourceswithout distorting incentives for their efficient exploitation. They could auction the

rights to those resources and obtain certain revenue equal to the expected rent valueor, through a Brown Tax, they could themselves undertake the risky exploration andmine development investments necessary to realise that value. Problems withexclusive reliance on one mechanism or the other led the Commission to recommendthe auctioning of rights subject to the application of a Brown Tax at a moderate rate(40 per cent being mentioned as a possibility).

The Commission did not make specific recommendations for implementation of itsfavoured policy approach and its arguments were pretty thoroughly ignored. They laymore or less dormant for almost 20 years until being dusted off and closely echoed bythe AFTS Review, with the most important differences being that the AFTS Reviewdid make definitive and detailed recommendations for policy implementation, at least

on the taxation aspect, and that these have not been ignored.

The RSPT and Other Cash Flow Taxes in Detail

Like the RRT, the RSPT is a project-based tax on net cash flows: a project being anoperation conducted on an exploration or mining lease or on a set of related leases.2Project termination occurs when the company surrenders the relevant lease area.Deductions against RSPT assessable income are transferable between projects withina company.

It is useful to illustrate and compare the effects of the RSPT by considering a specific,simple example of a mining project. This consists of an investment of $100 in year 0,

with two equally likely outcomes. The favourable outcome is that the project returnsa positive net cash flow (current revenue minus current costs, not including financingcosts) of $150 in each of years 1 and 2, after which it ends. The unfavourable case isthat it produces no future net cash flow and is terminated in year 1. The expectedoutcome, then, is a $75 ($150/2) net cash flow in each of years 1 and 2 and this yieldsan expected rate of return on the $100 investment of 32 per cent. So long as that

2. Defining the boundaries of a project is not a straightforward matter in many cases. There areoften questions about whether infrastructure investment (especially in transport and port

facilities) should be included as part of the project and, if it is not included, about thecharges for its services that should be allowed in calculating the mine gate value of mineralsoutput in the assessment of project net cash flow.


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exceeds the risk-inclusive discount rate that a mining company would apply to such aproject, the investment will be undertaken.

If a Brown Tax in its most transparent form is imposed at the rate of 40 per cent, thegovernment will pay the mining company $40 in year 0 and tax future positive netcash flows at the 40 per cent rate. As a result, the companys net expenditure on theproject is reduced to $60. In the favourable outcome, the company pays tax of $60($150 x 0.4) in each of years 1 and 2, and retains $90 of the net cash flows generatedin those years. In the unfavourable case, both the government and the companyreceive zero payment in years 1 and 2. Since both its initial investment cost and allfuture net receipts have been reduced to 60 per cent of their pre-tax value, thecompany still earns an expected return of 32 per cent on its investment. If 100 percent of the project was a worthwhile investment for the company, 60 per cent of it willbe similarly worthwhile, so the tax will neither discourage nor encourage theinvestment.

The result, from the point of view of the mining company is the same as if it had

entered into a joint venture arrangement with another company, which supplied 40 percent of the required capital but had no management role. Of course, it might havepreferred not to enter into such a joint venture arrangement, for two possible reasons.

First, if the expected return exceeds the companys risk-inclusive discount rate so thatpure profits are expected to be made, the company would prefer to capture all of themrather than only 60 per cent of them. Such pure profits reflect the rent value of theresources being exploited. The greater those are expected to be, the more resistantone would expect the mining company to be to sharing them.

Secondly, the company may possess expertise that is not generally available andwhich enhances either the probability of achieving the successful outcome or the size

of the positive net cash flows associated with it. The company will not want to sharerents due to that expertise with a partner. The AFTS Report recognises this but pointsout that, although the government would be expropriating 40 per cent of anycompany-specific rents, it would also be leaving 60 per cent of the resource rents inthe hands of the company. Both parties bring something intangible and difficult tomeasure to the project and they are sharing in the total rents generated.

For brevity of future reference, the transparent form of the Brown Tax is referred to asthe Direct Capital Contribution (DCC) approach. Alternatively, the government mayborrow its 40 per cent share of investment costs from the company and repay thisloan from its share of future positive net cash flows. If the government provides a

credible guarantee that the debt will fully be repaid, regardless of the projectsoutcome, the loan is a riskless asset and the interest rate applied to it should reflectthat. Viewed properly, in our example the result will be that the mining companyholds two distinct assets: a $60 stake in the project, whose pay-off is uncertain anddepends on whether the favourable or unfavourable outcome occurs; and a $40 loan tothe government whose pay-off is certain. On the former asset it requires a riskinclusive expected rate of return: on the latter asset it doesnt.

There are various ways that repayment of the governments debt could be scheduled.Under the Petroleum RRT, the deductions arising and carried forward at the uplift ratecan (and are required to be) used as rapidly as positive net cash flows within a projectpermit. I will call this the Early Expensing (EE) approach. In contrast, the RSPTlimits the deduction available in each year to the accumulated interest on the debt plus


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the amount that would be deductible for depreciation purposes under the company tax.This is the Allowance for Corporate Capital (ACC) approach. The result is that thegovernments debt is repaid more slowly than with EE, so net tax revenue is collectedsomewhat sooner but it is also somewhat more likely that a cash payment will berequired at the end of a projects life.

So long as the government guarantees ultimately to meet its debt obligation and theuplift rate is set equal to the riskless rate of interest, scheduling of the debt repaymentshould be a matter of indifference to both the government and the mining company.In the following illustrations it is assumed for convenience that the relevant risklessrate of interest is 10 per cent per annum and that the depreciation deduction allowedunder the company tax for our hypothetical project is 50 per cent per year in each ofyears 1 and 2 if the project is successful and 100 per cent in year 1 if it is not.

Table 1: Comparison of Alternative Cash Flow Taxes

Net Cash FlowAttribution Successful Outcome

UnsuccessfulOutcome

Year 0 Year 1 Year 2 Year 0 Year 1

Total Project -100 150 150 -100 0

DCC: Company -60 90 90 -60 0

DCC: Government -40 60 60 -40 0

EE: Company (P) -60 90 90 -60 0

EE: Company (L) -40 44 0 -40 44

EE: Government 0 16 60 0 -44

ACC: Company (P) -60 90 90 -60 0

ACC: Company (L) -40 24 22 -40 44

ACC: Government 0 36 38 0 -44

Table 1 shows the net cash flows both for the company and the government under thedifferent arrangements. With DCC, the net cash flows of the project as a whole are

just split 60:40 between the company and the government, as previously described.For the EE and ACC cases, two separate net cash flow streams are shown for thecompany, where (P) denotes those relating to its 60 per cent interest in the project and(L) denotes those associated with its loan the government.

In the EE case, the company carries the total investment cost forward at the 10 percent interest rate, giving it a deduction in year 1 of $110. In the successful outcome,this reduces its tax base to $40, on which it pays $16 tax (0.4 x $40) and,consequently, retains $134 of the total project net cash flow. Disaggregated, this is

equal to the $90 it would have received under DCC plus $44, which is full repaymentof the $40 loan to the government with 10 per cent interest. Since the governments


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debt has been fully discharged in year 1, the companys tax base in year 2 is the wholeof the projects net cash flow, on which it pays tax of $60, so the outcome for bothparties in that year is the same as under DCC. In the unsuccessful case, thegovernment recognises the $110 deduction in year 1 when the project terminates andwrites a cheque for 40 per cent of that amount. From its $60 investment in the mining

project, the company receives exactly the same flow of income as under DCC. Fromits $40 loan to the government, it receives full repayment with interest in year 1,regardless of the projects outcome.

Under the ACC approach of the RSPT, the company again has a carried forwardallowance of $110 in Year 1. However, it is now only able to deduct the $10 interestcomponent of this plus the amount allowable in the depreciation provisions of thecompany tax. In the unsuccessful case this is the whole $100 of expenditure, so it canclaim $110 and, as in the EE case, the government writes a cheque for 40 per cent ofthis amount. In the successful case, with 50 per cent depreciation allowed in each ofyears 1 and 2, it can deduct only $60 in year 1 ($10 + $50), giving it a tax base of $90

on which it pays $36 tax, so it retains $114 of the total net cash flow in that year. Thisis equal to the $90 it would have received under DCC plus $4 interest on its $40 loanto the government plus repayment of half the capital value of that loan. The reducedRSPT Allowance of $50 ($110 - $60) is then carried forward with interest to give it anallowance of $55 in year 2, all of which can be deducted since it is equal to the $5interest component plus the $50 depreciation the company is allowed in that year.Consequently, the companys tax base is reduced to $95, on which it pays tax of $38,retaining $112 of the total project income. Disaggregated, this is equal to the $90 itwould have received under DCC plus repayment of the $20 outstanding balance of itsloan to the government with $2 of interest.

So long as the company can borrow to finance its loan to the government at the same

interest rate that the government pays on the loan, the EE and ACC approaches areboth exactly equivalent to the DCC case. If, however, the interest rate at which thecompany is able to borrow exceeds that paid by the government, the enforced loanwill impose a cost that is greater the longer this loss-making asset has to be held, so itwill be greater under the ACC approach of the RSPT than it would be with EE.

It is tempting to think that this excess cost must exist, since the interest rate at whichcompanies normally can borrow exceeds the long-term government bond rate thatconstitutes the allowance rate forthe RSPT. But, of course, corporate borrowing isnever entirely riskless and the corporate bond rate includes a risk premium. If, in thiscase, financial institutions can satisfactorily secure lending against the governments

guaranteed payments, they will not need to charge any risk premium.All this, of course, is critically dependent on the credibility of the governmentsguarantee, an issue that wouldnt arise under the DCC approach.3 Whethercompanies could or couldnt finance their compulsory lending to the government at aninterest rate as low as the long term government bond rate is a matter for speculation,leading to argument about whether the RSPT allowance rate should be higher thanthis (and by how much). But it would be inefficient for the government to borrowfrom mining companies at a rate higher than it pays to borrow in the market generally.Since the government can borrow at the long term bond rate, why should it not do so

3. This is subject to the qualification that, since the project may pass through future periods ofnegative net cash flow to which the government should contribute its share, the risk of thegovernment defaulting on its obligations is not entirely eliminated in the DCC case.


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and meet its 40 per cent share of project costs up-front, converting the RSPT to atransparent Brown Tax?

If the commitment to honour the obligations implied by the RSPT is as strong as thecommitment to honour official debt, a proper government accounting system shouldtreat both equally. That is, it should record the government as having acquired thesame liabilities in either case and, on the other side of the balance sheet, the sameassets. Only if it is more likely that a future government may default on the RSPTliability is there any difference, and fears of that (whether realistic or otherwise) makethe loan to the government a risky proposition for which interest at the long termbond rate will not adequately compensate.

One response to that concern has been to suggest that the RSPT should be remodelledalong the lines of the RRT. That is, abandoning the guarantee of full loss offset andincreasing the uplift (allowance) rate to compensate. It is useful to consider thatpossibility in the context of our previous example, using the EE case in Table 1 as acomparator, assuming the objective is to achieve the same result, and supposing the

company to be risk neutral.

Without guaranteed loss offset, the government pays nothing if the investment isunsuccessful so, compared to the EE case, the company will be $44 worse off in year1 with that outcome. Since the two outcomes are equally likely, a risk neutral firmcan be compensated if the amount it receives in the successful case is increased by thesame present value sum. That can be achieved by increasing the deductions available,through an increase in the uplift rate, so that it pays less tax.

In our example, the uplift rate would need to be set at 90.4 per cent to produce thisresult. As illustrated in Table 2, that would give the company a deduction of $190.40in year 1. Since this exceeds the projects net cash flow in that year, the company

would pay no tax and would keep the whole $150. This would give it $16 more thanin the EE case of Table 1, so the government would still owe it $28 ($44 -$16).Carrying forward the unused deduction of $40.40 to year 2 at the 90.4 per cent upliftrate would give it a deduction of $76.90 and taxable income of $73.10 in that year.After tax, the company would be left with $120.80, which is $30.80 more than in theEE case of Table 1: equal to the $28 owed by the government after year 1, plusinterest at the 10 per cent riskless rate on that amount.

Table 2: Application of a Neutral Resource Rent Tax

Year 0 Year 1 Year 2

Project Net Cash Flow -100.00 150.00 150.00

Carried Forward Deduction 190.40 76.90

Taxable Income -100.00 -40.40 73.10

Tax 0.00 0.00 29.20

Post RRT Income -100.00 150.00 120.80

Post EE Income -100.00 134.00 90.00

RRTEE 0.00 16.00 30.80


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It may appear from this that the RRT can be structured to have the same neutral effecton investment incentives as a Brown Tax, but that is an illusion. The required upliftrate is specific to the details and assumptions of this particular example. Any changein the time profile of project net cash flows, in the probability of achieving thesuccessful outcome, or in the discount rate employed by the company will change the

uplift rate needed. Even if the government were prepared to tailor the RRT uplift rateto each separate investment, it would never have the information necessary to do so.A uniform uplift rate applied across a broad class of similar investments willinevitably be too low in some cases (and deter investment) and too high in other cases(and encourage excessive investment).

Indeed, even in the concrete example given, the RRT is neutral only if the companycannot change the time profile of positive net cash flow receipts in response to the tax.Suppose, in the successful outcome, that it can shift some net cash flow from year 1 toyear 2 on a dollar for dollar basis. It wouldnt choose to do this in the absence of anytax, since $1 next year is not as valuable as $1 today, but the 90 per cent uplift rate

gives it a powerful incentive to do so. Shifting $10 of net cash flow from year 1 toyear 2 creates an additional deduction of $19 in the latter year, so the net effect is toreduce its taxable income by $9 and its tax payment by $3.60. Thus, after tax receiptsin year 2 will be increased by $13.60, a return of 36 per cent on the $10 of forgoneyear 1 receipts.

Although the effect is exaggerated in this simple example, a general problem of theRRT is that the (unknowable) uplift rate that is high enough not to discourageinvestment significantly at the margin ex ante can subsequently provide strongincentives for inefficient behaviour at the expense both of the governments revenueand of efficient resource exploitation. There are various band-aid ways of reducingthese problems, some of which are employed in the treatment of exploration

expenditure under the Petroleum RRT, but these are necessarily arbitrary. Onepossibility would be not only to allow but also to require companies to pool RRTassessable income and deductions across projects. That would increase the extent towhich investments in new projects were immediately expensed against assessableincome from more mature projects, so that the RRT uplift rate became irrelevant. Butthat is simply to say that the solution to the problems of the RRT is to convert it to aDCC-type Brown Tax.

A somewhat different, albeit absurd, argument in favour of the RRT alternative to theRSPT has been the assertion that the guarantee of full loss offset is of no value

because companies dont plan to make losses. Taken to its literal extreme, this would

solve the problem of the ACC approach since the credibility of a guarantee that iscertain never to be called upon is of no importance. However, those making thisassertion suffer from the unreasonable conviction that they should be compensated(through an increase in the uplift rate) for the removal of a guarantee that has no valueto them.

The RSPT is a less distorting means of capturing resource rents than the RRT andshould provide greater expected revenue (evaluated at the riskless rate of interest).However, it achieves this by exposing the government (i.e. the Australian taxpayer) toa greater level of risk since it makes the government a full partner, rather than a fair-weather partner, in exploration and mining activity: provided, of course, that the

governments guarantee of full loss offset is intended to be cast iron. If it is, thenpublic understanding of the tax would be enhanced (and a lot of uncertainty and


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unnecessary debate avoided) by the government contributing its 40 per cent share up-front and converting the RSPT to a transparent Brown Tax.

Interaction of Resource Charges and the Company Tax

Under the RSPT proposal, payments to the government would (like royalties) be

deductible expenses for company tax purposes while receipts from the government tocover residual losses would add to assessable income. Otherwise, no change in thecompany tax rules for mining is needed.

This works with the ACC approach of the RSPT, because the loan to the governmentautomatically depreciates at the same rate as the capital invested in the project, sothere is no need to recognise that the company holds two different kinds of assets incalculating allowable depreciation deductions. In the successful case of the earlierexample, when the company claims a depreciation deduction for company tax of $50in each of years 1 and 2, this is equal to the $30 depreciation on the companys 60 percent share of the project cost plus the $20 depreciation in the value of its loan to the

government. Under the EE approach, on the other hand, because the loan is fullyrepaid in year 1 the company should be allowed to deduct the whole $40 depreciationon it in addition to the $30 depreciation on its share of the project asset, and then todeduct only $30 of project asset depreciation in year 2. If it is only entitled to deduct$50 in each year, it will pay company tax in year 1 that should have been deferred toyear 2.

The same problem arises more strongly with a DCC-type Brown Tax. In that case,one could think of the company spending $100 in year 0, of which $60 is investmentin the project and $40 is a loan to the government that is immediately repaid (whichis, in fact, what would happen if the up-front contribution took the form of

reimbursement for expenditures undertaken). The receipt of $40 from the governmentwould be assessable income, against which the company could fully depreciate itsloan asset so that no tax was payable. Then, only the remaining $60 of its expenditurewould be undepreciated capital invested in the project, and this would entitle it to a$30 deduction in each of years 1 and 2 in the successful case.

Amendment of the RSPT to convert it to a transparent Brown Tax would, therefore,require modifications to the company tax provisions for mining that the ACCapproach avoids, but these are quite straightforward.

Exploration expenditure is accorded somewhat concessional treatment in the companytax rules by being immediately expensed. As Swan (1978) was first to point out,

successful exploration creates an asset that should be depreciated over its economiclife, so only unsuccessful exploration expenditure should be immediately deductible.However, because it is generally impracticable to distinguish between exploration thatwas entirely unsuccessful and that which contributed in some fashion to discoveries,the expedient approach has been to allow all such expenditure to be immediatelyexpensed.

Previously, this has discriminated in favour of companies with diversified mining andother interests, since they are more likely to be able to make immediate use of theavailable deductions. The proposed Resource Exploration Rebate means thatcompanies unable to claim the deduction against otherwise assessable income will beeligible for a cash payment of the same value. That is, the Commonwealthgovernment will guarantee to meet a share of the cost of all exploration equal to thecompany tax rate, either through the reduction in company tax payments that the


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deduction provides or by direct payment. The effect of this will be that exploration isnot, in fact, subject to the standard income tax at the company level but, rather, to aBrown Tax at the company tax rate.

In fact, even with its ACC approach, the RSPT will also act as a DCC-type BrownTax on exploration spending for companies with RSPT assessable income. This isbecause immediate deductibility under the company tax rules automatically makesexploration expenditure immediately deductible under the RSPT. For a company ableto make immediate use of the deduction, the combined effect of the RSPT and theexploration rebate is that the government will pay, up-front, $56.80 of every $100 ofexploration expenditure. Of course, in exchange, it will also take 56.8 per cent of anyresulting profits through the combined effect of the two taxes. If the company doesnot already have RSPT assessable income, the ACC approach means thegovernments RSPT contribution will be deferred, either until the exploration projectterminates or until a mine is developed that generates assessable income, but the endresult will be the same.

For new projects, the assertion that the combined effect of the RSPT and the companytax will be to tax mining industry profits at the rate of 56.8 per cent is a grossdistortion. In the case of non-exploration expenditure, the returns on mining companydollars (i.e. those supplying 60 per cent of the total funds) will be taxed only at thecompany tax rate of 28 per cent. For exploration expenditure, the returns on miningcompany dollars (i.e. those supplying 43.2 per cent of the total funds) will not betaxed at all.4

2. APPLICATION TO EXISTING PROJECTS

The government has announced that the RSPT will also apply to existing projects,

except for those subject to the Petroleum RRT where companies will be given achoice as to which regime they wish to have applied.

It would be possible, but not practical, to exempt past investments from the RSPT.This would require all future investment in existing projects also to be exempted sinceit is impossible to identify dollars of net cash flow within a project as being derivedfrom one investment rather than another. Nearly all of the investment that will takeplace over, say, the next 5 years is likely to be in existing projects in the strict sensethat, even though nothing may yet have been spent on actual mine development orassociated infrastructure, exploratory drilling and planning expenditures have beenincurred. Very little of the next 5 years expenditure is likely to be on genuine

greenfield projects. Confining reform of the charging mechanism to them wouldlikely mean that it didnt start to impact significantly for a decade or more.

As initially announced, the transition rules for an existing project will provide aStarting Base that consists of the accounting value of assets, not including theresource itself, as of the last audit date prior to the announcement and carried forwardat the RSPT allowance rate to the implementation date for the tax (1 July, 2012). 5

4. That is, they will not be taxed in the hands of the company. Dividends distributed to residentshareholders are, of course, subject to personal rates of income tax and for those earnings the

company tax is washed out by the imputation arrangements (and is consequently irrelevant).5. Details of the proposed mechanics of the RSPT and of the transition rules for existing projects

are taken from Department of the Treasury (2010).


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With a DCC-type Brown Tax, the government would then pay up-front 40 per cent ofthis starting base amount and take 40 per cent of subsequent net cash flows. Theeffect would be the enforced acquisition of a 40 per cent share of the projects assets.Of course, of all the projects that have commenced since, say, 1990, the governmentwould only be taking a 40 per cent share in those that had survived, but the true extent

of the cherry-picking is greater than that.

In the actual transition rules, the starting base allowance will continue to be carriedforward at the allowance rate and can be written off against RSPT income at adeclining rate over 5 years (36 per cent in the first year, 24 per cent in the second,etc), but the deductions provided cannot be transferred between projects and thegovernment will not refund losses at the RSPT rate on project termination.6 Theeffect, therefore, is the enforced acquisition of a 40 per cent share only of the goodprojects (those that are ultimately able to make full use of the deductions).

Failure to apply the RSPT fully to the starting base, with guaranteed loss offset, hasno obvious explanation other than a desire to maximise expected tax revenue. While

it is true that it has the worthwhile effect of preventing projects being kept artificiallyalive until the implementation date, and incurring wasteful additional expenditurealong the way, that could be achieved simply by allowing projects terminated at anytime after the announcement date to carry forward losses for later reimbursement.

The transition rules for new investments undertaken between the announcement dateand the implementation date, on the other hand, appear to offer large incentives fortruly wasteful expenditure. The capital cost of such investments will be carriedforward, undepreciated, at the RSPT allowance rate and then treated according tostandard RSPT rules from the implementation date onwards. Suppose, then, thatexpenditure of $100 on 1 July, 2010 leads to increased income of $80 on 1 July, 2011,

after which the investment has no further value. The actual rate of return is minus 20per cent. However, with an RSPT allowance rate of 5 per cent per annum, theinvestment contributes $110.25 to the RSPT Allowance on 1 July, 2012. Assumingthe true 100 per cent depreciation of this investment is recognised, so the wholeamount is immediately deductible, and that projects owned by the company can fullyutilise this deduction, it is worth $44.10 in reduced RSPT payments. This, combinedwith the $80 received one year earlier, yields a 17 per cent per annum after tax returnon the initial investment. This is an extreme example but it clearly illustrates thenature of the incentive provided. It would not arise if only the depreciated value ofthe investment were included in the Starting Allowance since, in this particular case,that value would be zero.

The greatest part of the mining industrys dissatisfaction with the RSPT, and a lot ofthe more general community concern (insofar as the community has been able tofigure out what it should and shouldnt be concerned about), springs from theapplication of the RSPT to existing projects. The government may be paying marketvalue for 40 per cent of the picks and shovels, as it were, but it isnt paying 40 percent of the market value of the resources that they are designed to extract. Thegovernments position, of course, is that these belong to the Australian peoplewhom it represents. The industrys position is that it was promised these resources

6. The accelerated depreciation provided for the starting base allowance is designed to ease cashflow constraints that companies otherwise might suffer in the early years of the RSPT by,effectively, deferring payment of tax.


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(less royalties) and that it was on that basis that the risky investments in the currentlysuccessful projects (and in those that were not successful) were made.

Misleading and confusing statements aside, this is an argument about two things.

First, there is the distributional issue the adverse effect on the wealth of mining

company shareholders who, as a result of the large expansion of superannuation fundsthat successive governments have actively sponsored, include just about everybody tosome extent. The government appears to have neglected this diffused impact andsupposed that it would be seen as affecting only a wealthy minority. In fact, theaverage person probably needs a clearer demonstration than has been offered thatthere will be offsetting benefits flowing from the transfer of part of her wealth to thegovernments coffers. Equally, though, the mining industry has not placed very muchexplicit emphasis on this issue, probably because it also believed that it would notresonate very widely.

Most of the debate has been less about equity issues in the retroactive application ofthe RSPT than about the extent to which it will affect the perceived riskiness of futuremining investment in Australia. All of the assertions relating to effects on investment,employment, output (and even the prices of things that use mineral inputs!) hinge onthat. Aside from uncertainties associated with the ACC approach of the RSPT, whichsensibly should be removed by shifting to a pure Brown tax, the increase insovereign risk is the only comprehensible explanation that has been offered insupport of the welter of claims that projects will be, or already are being, abandonedor deferred because of the tax.

Sovereign Risk and the Mining Tax

Sovereign risk arises from the concern that a future government will take actions that

reduce investment returns below what was expected given the policies in place at thetime they were undertaken. The greater the perceived probability of this occurring,the more investors will discount potential favourable outcomes and the less likely theyare to supply finance for projects.

The mining industry is, by its nature, a prime target for these kinds of actions. Itundertakes investments that are risky and many of these will fail or be only barelyprofitable, but the visible result is the projects that are successful and that may earnvery high profits. It is tempting for governments to raid those profits, especially incountries where the capacity to raise revenue by other means is limited and wherepolitical and social stability is weak.

In countries with more stable processes of policy formation and a much broaderrevenue base, the more likely reason for policy action to expropriate mining profits isa perception that the existing regime has not served well as a means of returning to thecommunity an adequate share of the value of the resources being exploited. Otherthings equal, the countries posing the greatest sovereign risk concerns are those thatinitially promise the most generous tax regimes. Mining companies then need toconsider how long they are likely to be able to exploit that situation before lifebecomes more difficult.

In the current case, there are two questions. First, will the retroactive application ofthe RSPT to existing projects make investors more likely to fear similar actions in the

future? Secondly, does the structure of the RSPT itself make it more or less likelythat investors will fear future action that reduces after-tax profitability? These are, of


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course, questions to which nobody knows the answer. Reports of what suppliers offinance are alleged to have said dont provide reliable information even if they aretrue. Markets are known to over-react to news and to take some time to digest its trueconsequences. Given the mining industrys strong and vociferous reaction to theRSPT proposal and its essentially false representation of the effects on new mining

investment, it would be surprising if there were not some short-term alarm in financialmarkets. In the longer-term, a calmer appraisal of the situation will determine

peoples risk perceptions.

Of the two questions posed in the last paragraph, the first is probably the lessimportant. The current Australian government has demonstrated that it is prepared toact to secure rents that it sees as the property of the Australian people. If one hadpreviously held the nave belief that no Australian government would ever do such athing, presumably one would now think it more likely than before that some futureAustralian government might also do so. The more important question, though, ishow likely is it that a future Australian government would feel justified in acting in

this way? If the perception is that the new tax provides a more reasonable sharing ofthe benefits of Australias resource wealth between mining companies and thecommunity than the existing regime, arguably the risk is reduced rather thanincreased.

This is not to say that a future government might not be tempted to increase the RSPTtax rate, say to 50 per cent. With a pure Brown Tax, this would mean that it wastaking 50 per cent of the returns from projects to which it had contributed only 40 percent of the cost. The best protection against this (as with the Goods and Services Tax,but with much better reason) is to make it relatively difficult to change the legislationdetermining the tax rate.

Modifying the Transition Rules?

There is a strong case for amending the transition rules so that guaranteed loss offsetapplies to the starting base allowance. Beyond that, there may also be a case forreducing the impact on existing projects by phasing in the tax, an approach the AFTSReport rejected. For example, while allowing deductions to be valued at the 40 percent rate, the tax rate imposed on residual taxable income might be phased in over,say, 5 years. This would have little, if any effect, on new projects or those still in theconstruction phase, since they will have little assessable income during that period,but it would provide a degree of relief to those projects that have been operating for alonger period and about which the expropriation concern is more relevant.

The AFTS Report correctly says that such a phase-in arrangement would havedistorting effects in the short-run. Incentives would be provided for income to beearned earlier rather than later (as indeed they more strongly are in the intervalbetween the announcement and implementation dates), and there would be incentivesto undertake short-lived new investments in which the government would take a 40per cent share but not receive 40 per cent of the returns. Nevertheless, these effectsmay be a sensible price to pay to ease concerns about the wealth transfer impacts ofthe tax.

3. THE MINING TAX AND THE GOVERNMENTS BUDGET

Application of the RSPT to existing projects will provide the government with largewindfall revenue gains in its early years of operation, particularly if the absence of


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guaranteed loss offset means that it actually only applies to good projects. Overtime, however, things will be less rosy. After the initial cherry picking wears off, thegovernment will receive only what it pays for with its risky investments in explorationand mining activity. From those investments it will approximately receive theaverage rate of return earned by the mining sector, and that is not guaranteed to be

high or even positive.

Although the fact that the government will be taking a share in every single mininginvestment eliminates almost all of the idiosyncratic risk, it does little to reducemarket risk since mineral commodity prices tend to move together. Thus, there maywell be periods when a sustained market downturn means that returns on thegovernments investments are very low. The Commonwealth Treasury believes thatthis is unlikely in the next decade or so, but it is not impossible.

It was earlier argued that conversion of the RSPT to a transparent Brown Tax isdesirable in order to eliminate uncertainties for investors about the credibility of thegovernments guarantee of full loss offset. It is also desirable in order to make clear

to governments themselves the long-run budgetary implications of the tax. Otherwisethere is the clear danger, of which signs are already evident, that the government willspend the net revenues received in prosperous times without regard to the potentialliabilities it is building up as new projects are developed. If, on the other hand, thegovernment pays its 40 per cent share up-front, borrowing to finance this, it will bemore obvious that the revenue available to be spent is only that which exceeds thedebt service charges, and that it should only pay itself a dividend that reflects thesustainable level of such net earnings.

The Industry Commission (1991) explicitly recognised this issue and argued thatapplication of a Brown Tax arrangement be administered through a special fund. One

could envisage the fund as having the authority to borrow, with normal governmentguarantees, and to make payments to, and receive payments from, mining companies(channelled through the tax system). Aggregate receipts and payments associatedwith the tax would thus be separated from general government revenues, and onlysuch distributions that the fund determined should prudently be made would beavailable for government spending.

4. RELATIONSHIP WITH STATES AND TERRITORIES

All of the preceding discussion has been conducted as if there were a single level ofgovernment whose responsibility it was to determine and administer the appropriatecharging mechanism for the depletion of mineral resources. In fact, as noted in the

introduction, the direct constitutional responsibility lies with State and Territorygovernments whereas the RSPT is a Commonwealth tax.

One question that arises is, if it is desirable to replace traditional forms of royalty withrent-based charges (and the Brown Tax in particular) why have State and Territorygovernments not done so? The idea is not new. The Industry Commissionrecommended it in 1991 but no government has followed up on it.

The strict constitutional adherent view is that states and territories should beallowed to determine for themselves how best to regulate and charge for the use oftheir property and that it is no business of the Commonwealth if they choose to do thisinefficiently and at the cost of potential revenue. However, the Commonwealthoversees the distribution to the states and territories of general government revenuevia a formula that takes account of the capacity of those regions to raise their own


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revenue. Why not assess that capacity on the basis of what the states and territoriescould have raised, rather than what they choose to raise?

A more cooperative view is that application of a Brown Tax would be much moredifficult for individual states and territories than for the Commonwealth. As noted,the Brown Tax requires the government to take a silent equity stake in exploration andmining activity equal to the tax rate. This might expose state revenues to a greaterdegree of revenue instability and uncertainty than was acceptable, particularly in thosestates where mining is most heavily concentrated. Both the level of exposure to riskand their more limited capacity to smooth revenue flows by borrowing createproblems for individual state governments. Also, the costs of administering a BrownTax arrangement would be relatively high for governments that do not already have ataxation apparatus accustomed to dealing with company income.

It was a privately held view in the Industry Commission that, without Commonwealthaction to coordinate the application of a Brown Tax and smooth state revenues, therewas little chance of its recommendation being acted upon. It was hoped that the

Commonwealth, to whom it was reporting, would consult with the states andterritories on how its recommendations might be implemented, but the government ofthe day chose not to follow this path.

One might, however, have anticipated this sort of consultation from the currentCommonwealth government before deciding how to implement the AFTS Reportsrecommendations. Although the probability of such discussions delivering a sensibleagreed policy outcome on this (or any other) issue is admittedly difficult tounderestimate, it is normally considered diplomatic for the Commonwealth to engagein the process before ultimately exercising its muscle. In this particular case, stategovernments would at least have had the opportunity to understand the effects of the

tax and be better prepared to assess the validity of mining industry assertions aboutthe consequences for activity within their jurisdictions.

In the event, at least in the short-term, the Commonwealth has elected to go it alone.Rather than securing agreement from the states to abolish royalties in exchange foragreed payments from the RSPT revenues, the government has chosen to nullify theireffects by refunding royalty payments to companies. Thus, states and territories willcontinue to impose royalties and keep the revenue they generate, while theCommonwealth will allow royalty payments as a credit against RSPT liability or, ifthe project is not able to make full use of the credit, will reimburse the excess amountin cash. The effect, up to the reimbursement limit, will be that royalties have noimpact on mining company profitability or on the incentives to undertake explorationand mining investment.

An obvious problem is that, unless it is capped, the reimbursement of royaltiesprovides state and territory governments with an open-ended invitation to increaseroyalty rates at the Commonwealths expense. Consequently, the extent to whichroyalties will be reimbursed is limited to the rates applying or foreshadowed at thetime of the RSPT announcement. There is nothing to prevent royalties beingincreasing beyond this limit. Indeed, if they wished states and territories could restorethe same distorting effects as previously existed while doubling their revenues. Ofcourse, the Commonwealth can use its control over general revenue disbursements todeter such actions, but agreement over the distribution of RSPT proceeds in exchange

for the removal of royalties would be greatly preferable. The fund proposed in theprevious section could maintain state by state accounts and a revenue smoothing


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distribution back to states could be devised that left them at least as well-off as anyroyalties they might have chosen to impose would have done. It is not necessary forthe Commonwealth to seek simultaneous agreement from all of the states andterritories in this matter. For example, whether Western Australia chooses to enterinto such an agreement has no obvious bearing on whether Queensland might choose

to do so.

An issue deserving some attention is the amount of net RSPT revenue that the statesand the Commonwealth could reasonably each lay claim to in such agreements. If thesource of this revenue is the rent value of state-owned resources, the answer might bethat all of it should go to the states from which it was derived, but one needs to becareful about what that means. If the Commonwealth were to provide a guaranteed,stable mineral revenue stream to each state, it would need to be compensated for therisk that the earnings on the assets that it holds might not generate sufficient revenueto support this. That is, the states would have a reasonable claim only on the certaintyequivalent of the expected net revenue stream. The rest of it should remain with the

Commonwealth. In that case, though, it should not be thought that Commonwealthrevenue had really been increased, since the amount it retained would simply be whatwas necessary to compensate the Australian taxpayer for the risks to which she wasbeing exposed.

Aside from the desirability of agreement on the royalty issue, a problem withunilateral Commonwealth action is that it leaves unaddressed those recommendationsof the AFTS Review (and of the Industry Commission) that are completely outsideCommonwealth powers. These include the use of cash bidding, in conjunction withthe RSPT, as a means of allocating mineral rights and the abolition of certain stampduties and fees. Agreements with states and territories would potentially allow these

matters also to be dealt with.

In the current confrontational environment, it has been suggested that, in introducingthe RSPT with reimbursement of royalties, the Commonwealth may be acting outsideits constitutional powers and that the legislation, if it comes to pass, may be thesubject of a constitutional challenge. Although this is a matter for experts, it is notobvious that the proposed arrangements either tax state property (unless investing inits exploitation is regarded as taxation) or interfere with the rights of states themselvesto regulate and charge for the use of that property (unless states argue that theintended effect of royalties is to discourage activity and that the Commonwealthsreimbursement of them frustrates that intent).

While it may have been sensible for the Commonwealth to take the initiative inreforming the means of charging for mineral resource depletion, and possibly even tohave done so without prior consultation with the states and territories, that should beseen as a first step. Consultation and agreement with the states is ultimately necessaryto generate a stable rationalisation of lease allocation and charging mechanisms.

5. CONCLUDING REMARKS

As many have observed, there is a lot to be desired in the manner of the governmentshandling of the AFTS Report and its own policy response and presentation,particularly on the mining tax issue. Nevertheless, at least in this authors view, the

central thrust of the Reports recommendations on this issue does represent a


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significantly worthwhile reform of the means of capturing mineral resource rents forthe community.

In the interests of transparency and reduced uncertainty it is highly desirable that theRSPT be modified to a pure Brown Tax, in which the government contributes its 40per cent share of investment costs up-front. This is important for two reasons.

First, it will eliminate a lot of confused debate and allow people to see clearly that it isinconceivable that the tax will have the dire consequences predicted for explorationand mining activity, unless its introduction does have the effect of generatingincreased sovereign risk concerns. Anyone can guess, but a reasonable guess is thatsignificant elevation of such concerns is unlikely to be other than a short-termreaction, for which the mining industrys own rhetoric may be as much to blame asanything.

Secondly, contributing its share up-front will force the current and future governmentsmore clearly to understand the implications of the tax for sustainable revenue flows.Responsibility for administering the RSPT arrangement and managing the flows offunds should ideally be separated from general budgetary considerations throughestablishment of a special fund for that purpose. Legislation establishing the RSPTand associated administrative arrangements should, so far as possible, make it difficultfor future changes, especially in the tax rate, to be introduced.

Application of the new tax to existing mining projects will clearly impact significantlyon the after-tax profitability of those operations, reducing share prices and the wealthof people holding those assets. That effect can be softened by making the transitionarrangements more generous but, at the end of the day, it is to a greater or lesserextent an inevitable cost of the tax reform. Persuading people that this is a cost worth

bearing has not ranked high enough on the governments agenda.

As indicated in the last section, ultimately it is important for the Commonwealth andthe states and territories to reach agreement on the resource charging mechanism andthe distribution of the net revenues involved as well as, potentially, on other mattersraised by the AFTS Report. Fortunately, such agreements do not need to be enteredinto simultaneously, so initial unwillingness of some parties to act cooperativelyshould not impede the possibility for others.

No matter how much transparency is improved, how much more generous thetransition arrangements are, or how clear it may become that sovereign risk is anexaggerated concern, the mining industry can still be expected to oppose the tax. Thisis because it expects projects to earn more than the required, risk-inclusive rate of

return: that is, to earn super profits. The RSPT is not a tax on super-profits (it isnot really even a tax) but, by taking a 40 per cent share in projects, it limits theindustrys share of such profits to only 60 per cent so, however misleading the namemay be, perhaps it is not wholly inaccurate.


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References

AFTS (2009), Australias Future Tax System, Report to the Treasurer of the ReviewCommittee, Australian Government, Canberra.

Brown, E.Cary (1948), Business-Income Taxation and Investment Incentives, inIncome,Employment and Public Policy: Essays in Honour of Alvin Hansen, New York:Norton.

Dowell, R. (1981), Auctions and Investment Dilution: Alternatives to the Resource RentTax,Economic Papers, 67, pp.43-55.

Emerson, C. and Lloyd, P.J. (1983), Improving Mineral Taxation Policy in Australia,Economic Record, 59, pp.232-44.

Fane, G. and Smith, B. (1986), Resource Rent Tax, in C.D.Trengove (ed),AustralianEnergy Policy in the Eighties, Sydney: Allen and Unwin, pp.209-41.

Garnaut, R. and Clunies-Ross, A. (1975), Uncertainty, Risk-Aversion and the Taxing ofNatural Resource Projects,Economic Journal, 85, pp.272-87.

Garnaut, R and Clunies-Ross, A. (1979), The Neutrality of the Resource Rent Tax,Economic Record, 55, pp.193-201.

Industry Commission (1991), Mining and Minerals Processing in Australia, Report No.7,Canberra: AGPS.

Porter, M.G. (1984), Resource Taxation 1984,Economic Papers, September, pp. 11-21.

Smith, B. (1999), The Impossibility of a Neutral Resource Rent Tax, Working Papers inEconomics and Econometrics No.380, Australian National University, Canberra.

Swan, P.L. (1976), Income Taxes, Profit Taxes and the Neutrality of Optimising Decisions,Economic Record, 52, pp.138-

Swan, P.L. (1978), Australian Mining Industry Taxation and the IndustriesAssistance Commission: an Appraisal of Two Reports, in B.Smith (ed),Taxation of the Mining Industry, Centre for Resource and EnvironmentalStudies R/GP 12, Australian National University, Canberra.

Department of the Treasury (2010), The Resource Super Profits Tax: a fair return tothe nation, Australian Government, Canberra.

ben smith on the rspt

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