Australia's Future Tax System

Final Report: Detailed Analysis

Chapter C: Land and resources taxes

C1. Charging for non-renewable resources

C1–1 The community's return from the exploitation of its resources

Non-renewable resources are a significant asset of the Australian community. Australia has the world's largest economically demonstrated reserves of brown coal, lead, mineral sands (rutile and zircon), nickel, silver, uranium and zinc and the second largest reserves of bauxite, copper, gold and iron ore (contained iron) (Geoscience Australia 2009).1 Australia's proven oil reserves are the 26th largest in the world. Australia's natural gas reserves are the 14th largest in the world and, under current production rates, could continue to be exploited for the next 65 years (BP 2009).

Treasury expects the strong demand and prices for Australia's non-renewable resources to continue, driven by growth in India and China, and accordingly projects that Australia's terms of trade will be well above its historical average for decades to come (Treasury 2009).

Given the size and value of Australia's non-renewable resource stock and the expected strength of commodity prices, it is important that the community receives an appropriate return from the exploitation of its resources by private business.

Maximising the value of the rents from non-renewable resources

The finite supply of non-renewable resources allows their owners to earn above-normal profits (economic rents) from exploitation. Rents exist where the proceeds from the sale of resources exceed the cost of exploration and extraction, including a required rate of return to compensate factors of production (labour and capital). In most other sectors of the economy, the existence of economic rents would attract new firms, increasing supply and decreasing prices and reducing the value of the rent. However, economic rents can persist in the resource sector because of the finite supply of non-renewable resources. These rents are referred to as resource rent.

The value of a stock of resources is the net present value of the associated resource rent — that is, the expected receipts less expected costs of exploiting the resources, discounted for the required rate of return to compensate owners for the time value of money (the risk-free return) and a premium for the risk associated with investment (the risk premium return for systematic risk). This value can fluctuate over time due to changes in supply (for example, unexpected discoveries) and demand (for example, changes in consumer preferences or the development of substitutes).

The optimal rate for exploiting non-renewable resources is, in theory, determined by the required rate of return (Hotelling 1931). The owner of the resource can maximise the value of their resource stock by extracting quantities at a rate such that the expected value of the remaining resources rises over time at the required rate of return. If the resource rent is expected to rise more than the required rate of return, the owner could increase wealth by postponing production to take advantage of future higher prices or lower production and exploration costs. On the other hand, if the resource rent is expected to rise less than the required rate of return, the owner could increase wealth by bringing forward production and investing the proceeds from the sale of resources into another asset.

The owner of a non-renewable resource would therefore erode the value of the resource if exploitation is either faster or slower than the optimal production rate determined by the market's required rate of return. Arguments for exploration and production faster than this rate can fail to recognise that resources kept in the ground will generate a better return for the owner if higher rents can be obtained in the future (due to future higher prices or lower exploration and production costs). Similarly, arguments to bring forward exploration and production to create jobs can fail to recognise that this may be at the expense of future jobs in the resource sector (as there is a finite stock of resources) and may have an adverse impact on other sectors in the economy from which labour and capital are diverted.

Charging for the exploitation of non-renewable resources

As owners of natural resources on behalf of the community, the Australian and State governments should seek to obtain an appropriate return from resource exploitation under public or private production. In Australia, governments have traditionally allowed private firms to exploit non-renewable resources in return for a charge (see Box C1–1 Alternative ways of capturing a return for the community).

Where governments allow private businesses to exploit non-renewable resources, governments can charge for the resources through either taxes or auctions (also known as 'cash bidding'), or a combination of both. Providing private businesses with the right to exploit the community's non-renewable resources is akin to selling a public asset. Resource taxes and auctions of exploration permits are therefore different from most other sources of tax revenue in that they are a charge for the sale of a public asset.

A well-designed tax will generally be more effective than auctions as a primary way of charging for the right to exploit non-renewable resources. Nonetheless, an auction system is a useful mechanism for supplementing a well-designed tax because auctions can enable the relevant jurisdiction to allocate exploration permits to the most efficient producer without distorting exploration decisions. Further, auctions can be used to collect upfront any expected rent above that anticipated to be collected by a tax. In effect, an auction can serve as a safety valve, mitigating any expected advantage to the winning firm that may arise if the tax system mismeasures the resource return (Danish Hydrocarbon Tax Committee 2001).

Box C1–1: Alternative ways of capturing a return for the community

Governments have a range of options for obtaining a return from resource exploitation under public or private production.

  • Public production allows the government to control exploration and production expenditure, but may lower the return to the community if public enterprise is less efficient at resource exploration and production due to a lack of expertise and market discipline.
  • Outsourced production allows the government to benefit from market pressure and external expertise, but may suffer from the principal-agent problem as the interests of private producers are not necessarily aligned with the community's.
  • Joint ventures with private producers allow the government to benefit from market pressure and expertise, and align the interests of private producers with that of the community by providing private producers with a share of the resource rent. But this lowers the community's share of that rent.
  • Auctions of exploration permits collect value (under private production) based on market expectations about the value of the resource rent rather than the actual resource rent. Auctions will not collect the full expected value of resource rents if bids are tempered by concerns that the government will increase taxes in the future or if auctions are poorly designed.
  • Resource taxes applying to private production can promote efficiency if they are designed properly. But, like joint ventures, they give away a share of the rent and thereby a share of the community's return. If designed poorly, resource taxes can distort investment and production decisions and thereby erode the return to the community.

Principles

Through the Australian and State governments, the community owns rights to non-renewable resources in Australia and should seek an appropriate return from these resources.

A well-designed resource tax is more effective than an auction as a way of charging the private sector for the right to exploit non-renewable resources. But auctions can complement resource taxation by allocating exploration permits to the most efficient producer without distorting exploration decisions and by collecting upfront any expected rent above that anticipated to be collected by the resource tax.

Addressing exploration spillovers

Exploration can provide benefits to businesses other than the business undertaking the exploration (a positive spillover), in the form of valuable information to holders of exploration permits in neighbouring areas or businesses considering exploration in these areas. These spillover effects may provide an incentive for businesses to delay exploration so that they can benefit from information provided by others. Businesses can overcome this problem by entering into arrangements that share the cost of exploration with holders of exploration permits in neighbouring fields. Alternatively, the government could overcome the spillover problem through the management of exploration permits; for example, by only issuing exploration permits for areas where there are no neighbouring exploration fields. Limited tenure on exploration permits would limit the extent of delay in undertaking exploration.

There can be a 'public good' justification for the government to be involved in the provision of pre-competitive geological data, in collecting and providing public access to geological data flowing from exploration, and in publishing the results of geological research (Industry Commission 1991). Such information assists efficient private exploration and provides input into resource planning and land management.

Beyond this, it is unlikely to be desirable for the government to provide concessions from a resource tax in order to encourage exploration and production faster than the commercial rate or encourage exploration in specific geographical areas. There is no evidence of significant market failures in field exploration (Industry Commission 1991). Providing concessions is likely to reduce the overall return to the community from its natural resources.

Principle

Concessions should not be provided to encourage exploration and production at a faster rate than the commercial rate or to encourage exploration in specific geographical areas.

Choosing the appropriate type of resource tax

There are three main types of tax that can be used to charge for the exploitation of the community's non-renewable resources:

  • A rent-based tax, under which the government collects a percentage of the resource project's economic rent (see Box C1–2 Rent-based taxes).
  • An income-based tax, under which the government collects a percentage of a resource project's net income, thereby taxing economic rent as well as the normal return to capital invested in a resource project.
  • An output-based royalty, under which the government collects either a charge per unit of output (a specific royalty) or a percentage of the gross value of output (an ad valorem royalty).

Resource taxes can be evaluated according to three broad criteria: economic efficiency; the size, variability and timing of the return received by the government; and administration and compliance costs.

Economic efficiency

The more economically efficient a resource tax is, the less investment and production decisions are distorted. A more efficient tax is less likely to make an otherwise commercially viable project unviable and less likely to create a bias toward less or more risky investments.

Box C1–2: Rent-based taxes

A rent-based tax imposes a tax on economic rents over time by collecting a share of a measure of profit. Alternative forms of rent-based taxes include:

  • A Brown tax — a cash flow tax levied at a constant percentage of the difference between receipts and expenditure, or net cash flow (Brown 1948). Where there is a negative cash flow, the government refunds the tax value of the negative cash flow to investors and thereby contributes to its share of the costs of investment at the same rate as it shares in receipts. This allows the government to collect a share of the rent equal to the tax rate (see example in Annex C1 Relationship between the rate of tax on land and a tax on economic rent).
  • A Garnaut and Clunies Ross resource rent tax — a cash flow tax levied at a constant percentage of the annual positive net cash flow (Garnaut & Clunies Ross 1975). It is similar to a Brown tax, but does not provide a cash refund for the tax value of negative cash flows. Instead, negative cash flows are carried forward with interest (the uplift rate). The petroleum resource rent tax (PRRT) is an example of such a tax.
  • An allowance for corporate capital (ACC) — a cash flow equivalent tax levied on profit measured as net income less an allowance (Boadway & Bruce 1984). The allowance compensates investors for the delay in the government's contribution to the cost of investment due to the slower recognition of expenses through depreciation and the lack of an immediate refund for losses.

These rent-based taxes seek to tax the economic rent associated with the underlying activity, irrespective of the form of financing. They do not therefore provide a deduction for interest or financing costs incurred at the investor level.

Under certain conditions, these taxes provide equivalent outcomes, except in respect of the timing of cash-flows received (and paid) by the government (see Annex C1 Relationship between the rate of tax on land and a tax on economic rent).

A well-designed rent-based resource tax is less likely to distort investment and production decisions. This is because rent-based taxes do not apply to the normal rate of return to investment in projects. The government achieves this by effectively contributing to costs at the same rate as it shares in receipts from resource production.

Essentially, under a resource rent-based tax, the government is a silent partner whose share in the project is determined by the tax rate. However, each partner contributes something additional to the partnership — private firms contribute rents associated with their expertise and the government contributes rents associated with the rights to the community's non-renewable resources. These rents are also shared according to the tax rate.

By contrast, output-based royalties discourage investment and production because they are levied irrespective of the costs of production. Consequently, investors receive a lower post-tax return from a more expensive operation because costs are not recognised for tax purposes. This is particularly important for risky projects. Output-based royalties can therefore result in some economically viable projects not proceeding.

Under an income-based tax, while the government contributes a share of the project's costs by allowing a deduction for the depreciation of assets (where the project has receipts sufficient to cover expenses or where a loss offset is provided), it also taxes the normal return to investment in the project. Taxing the normal return distorts investment and production decisions and thereby erodes the value of the resource rent.

The use of output-based royalties or an income-based tax can be expected to result in fewer discoveries, less output from discovered deposits and earlier closure of projects than otherwise. Therefore, they erode the value of resources for the community while still giving away a share of the resource rent.

Rent-based and income-based resource taxes involve governments accepting risk

The government cannot accurately measure rents by targeting a charge on cash flows above the required return, which varies among projects and is difficult to measure. Instead, the government must, in theory, share in the risk of a resource project in order to correctly tax rent and avoid distorting investment and production decisions in the process. The government can achieve this by recognising the cost of investment for tax purposes and, in effect, contributing a share of project costs at the same rate as it shares in receipts.

Under an output-based royalty, the government does not share in the risk of the project because it does not recognise the costs of investment for tax purposes. Under a typical income-based tax, the government shares in some of the risk associated with the project, but only recognises expenditure where it can be offset by revenue.

By contrast, under a rent-based tax the government shares in the risk of the project. It can do this in two ways. The government can provide an immediate refund for the tax value of expenditure (under a Brown tax). Alternatively, it can allow expenditure (whether in the form of a loss or of a measure of corporate capital) to be carried forward with interest for tax purposes and utilised as a deduction against future income.

Using the second approach, the government would need to compensate investors for the delay in utilising the deduction by effectively paying interest on the value of the expenditure carried forward. The interest rate (akin to the uplift rate of the petroleum resource rent tax or the allowance rate for an ACC) should be set at a rate to make investors indifferent as to whether they receive the tax value of deductions in the current year or later. It therefore needs to compensate investors for the time delay and the risk that the government will not contribute to its share of the costs. If the government promises to provide a refund for the tax value of losses at the time a project is closed (full loss offset), the appropriate interest rate is the government bond rate (see Box C1–3).

Box C1–3: The appropriate rate to compensate investors for the lack of an immediate tax refund under a rent-based tax

The appropriate uplift or allowance rate to compensate investors for the lack of an immediate tax refund is independent of the riskiness of the project where the government promises to provide a refund for the tax value of losses at the time a project is closed or a full loss offset (Fane & Smith 1986).

The uplift or allowance rate does not need to reflect the required rate of return of the project, which includes a risk premium that varies according to the project and is therefore difficult to measure. Where the government provides a full loss offset, the riskiness of the project is irrelevant as the delay is equivalent to a loan from a business to the government.

If a full loss offset is not provided, investors will be uncertain about whether they will receive the full tax credit in the future. In this case, the appropriate uplift or allowance rate would need to include a premium to compensate investors for the risk that they will never receive the tax value of the deduction. The appropriate rate would depend on the 'risk characteristics of the project and the financial structure of the firm only to the extent that these factors affect the probability that the tax credits will never be redeemed' (Fane 1987).

For example, if the government allows losses to be transferred from one resource project to another within a company but does not allow residual losses to be refunded, the appropriate uplift or allowance rate would need to compensate investors for the risk that a particular company will never be able to utilise the value of the tax deduction. A proxy for this is the company's bond rate, which includes a premium to compensate for the risk that the company will default. If the government does not allow losses to be transferred from one project to another nor residual losses to be refunded, the appropriate uplift or allowance rate would need to compensate investors for the risk that a particular project will never be able to utilise the value of the tax deduction. A proxy for this is the (hypothetical) project bond rate, which includes a premium to compensate for the risk that the project will default on a loan because it does not have income.

However, it is not practicable to determine the appropriate uplift or allowance rate for each company or, still less, each project. In the absence of this, a uniform allowance rate would over-compensate less risky projects or companies and under-compensate more risky projects or companies. A uniform allowance rate would therefore provide an incentive for successful firms to delay production so that they can carry forward losses to take advantage of the excessive uplift rates. Providing a full loss offset overcomes these problems.

Sovereign risk

Sovereign risk is the risk that investments will be reduced in value by future changes in government policy. Sovereign risk discourages investment by increasing the required rate of return for investment. Therefore, sovereign risk can lead to an inefficiently low level of exploration and production that erodes the value of non-renewable resources.

Sovereign risk may be reduced under a system that investors perceive to be more stable over the long term. A rent-based tax is likely to be accompanied by lower sovereign risk because it collects a constant share of the rent under varying economic conditions. In contrast, output-based royalties have higher sovereign risk as the government has an incentive to make ad hoc adjustments to the royalty rates in response to changes in the value of the resource rent.

Evidence of the stability of rent-based taxes is provided by Australia's PRRT and by Norway's rent-like petroleum taxation system, both of which have been stable over many years compared to other petroleum producing countries.2 For Norway, a stable resource charging system appears to have played an important role in supporting petroleum exploration and development activity (Osmundsen 2010). Activity remained strong despite a decline in the prospect of new discoveries in Norway's continental shelf.

The size, variability and timing of the return

Governments are concerned with receiving an appropriate share of the return to resource exploitation irrespective of future market conditions, the variability in the stream of revenue collected, and the time lag between production starting and tax revenue starting to flow.

Output-based royalties provide a relatively predictable stream of revenue from the time production commences, but as this does not vary with profits, royalties fail to collect an appropriate share of the return to resource exploitation during periods of high profitability.

In contrast, both a rent-based tax and an income-based tax vary with profits. However, governments should be better able to maximise their return over time with a rent-based tax, as its greater efficiency means that more revenue can be raised without making more marginal projects unviable.

However, a rent-based tax has the longest delay before the government collects revenue because tax is only collected once receipts cover expenses including a normal return to investment. The delay in collecting tax could create a public perception that the resource sector is not paying for its exploitation of non-renewable resources, as projects could be generating significant operating profits but not yet paying tax.

Administration and compliance costs

Output-based royalties typically have low administration and compliance costs because they are calculated as a percentage of the value of production or as a specific charge per unit produced. Hence, output-based royalties may be an appropriate charging mechanism for those non-renewable resources where the administration and compliance costs are likely to outweigh the potential efficiency and revenue gains from a rent-based tax.

An income-based tax has higher administration and compliance costs than output-based royalties, though these may be reduced if the tax is based on the existing income tax system.

Compared with these tax types, a rent-based tax is likely to have higher administration and compliance costs as it requires the calculation of a profit base that measures rent over time, even though it could make use of some aspects of the income tax system.

Principle

For non-renewable resources that are expected to generate significant amounts of economic rent, a rent-based tax is the most suitable charging mechanism, as the potential economic efficiency and revenue gains are likely to outweigh the higher administration and compliance costs of this tax compared with output-based royalties and income-based taxes.

For non-renewable resources expected to generate low rent and where the administration and compliance costs are likely to outweigh the potential efficiency and revenue gains from a rent-based tax, output-based royalties may be an appropriate charging mechanism.


1 Economically demonstrated resources are identified according to two parameters: the degree of certainty of the existence (quantity and quality) and the degree of economic feasibility of exploitation (based on commodity prices, operating costs, and capital costs, including the required rate of return).

2 Norway's petroleum tax system approximates a rent-based tax. Though based on the company income tax system, it applies an uplift to expenditure to exempt the normal return from tax and reimburses the tax value of exploration expenditure for companies in a loss position. Norway imposes a total tax rate on petroleum rents of 78 per cent, consisting of a 50 per cent rent-based tax rate and company income tax of 28 per cent, with no deduction at the company income tax level for tax paid under the rent-based tax.