The architect of the resource super profits tax insists the critics don’t understand what’s being proposed.
AUSTRALIA is fortunate to have an abundance of natural resources. These natural resources are assets belonging to all Australians, including Australians not yet born. Where we undercharge for the exploitation of these resources, the wealth of current and future Australians is eroded.
At present, the charging is affected by a plethora of distorting excises and royalties levied by the Commonwealth, state and territory governments. In general, royalty adjustments have not kept pace with the value of our resources. Yet there are also many mining projects that are close to being unprofitable but which nevertheless make substantial royalty payments to state governments.
A better designed, more efficient, approach to charging for the exploitation of Australia’s natural resources should be able to raise more revenue – that is get a better return for the community – while still attracting more investment.
The tax review panel recommended that the current royalty based charging arrangements should be replaced with a resource rent-based tax. The panel’s preferred approach is based on the Allowance for Corporate Capital (ACC). The ACC is part of a small family of taxes that tax only ‘economic rent’. Unlike royalties, which tax gross receipts, the ACC, by taxing only economic rents, or supernormal profit, does not distort production and investment decisions. Further, because it is a tax on rents, it should have no impact on prices.
The ACC recommended by the panel, and subsequently accepted by the government in the form of the RSPT, would represent world’s best practice in charging for the exploitation of non-renewable natural resources.
I know that some of you would have found some of the commentary surrounding the government’s proposal a little confusing. And its theoretical basis would not be familiar to all of you. So I’ll spend just a few minutes on that topic.
In concept, the point of departure for the RSPT is the pure Brown tax.
The Brown tax is a pure rent tax, in which investments can be expensed, or written off immediately and a refund provided for the tax value of any negative cash flow – in this way the government effectively finances a share of the investment equal to the tax rate. The government receives the same share of all future net cash inflows. Hence, the government is, effectively, a silent partner in the investment, sharing in costs, risks and returns.
By expensing capital and taxing cash receipts, the Brown tax effectively taxes a share of the present value of the project. So, a project that has a positive net present value before tax, that is a project earning economic rents, will remain worthwhile after tax, providing the tax rate is less than 100 per cent.
But the panel did not recommend a Brown tax. Instead, we recommended the ACC. I will not go into the reasons for this today. All I want to do is demonstrate that the two taxes are equivalent.
An ACC with refundability of the tax value of losses in the event of project failure and an uplift equal to the bond rate is a neutral tax on economic rent or supernormal profit.
Under the ACC, the deduction or tax credit is deferred to a later period. This can be done by allowing losses to be carried forward, allowing assets to be depreciated over time, or some combination of both.
However, the deferred tax credit needs to be indexed to ensure its real value is not eroded over time. This begs the question: what is the appropriate indexation, allowance or uplift rate?
The answer to that question depends upon the refundability of losses. In order to preserve neutrality of the ACC with respect to risk taking, which is important given the risky nature of exploration and resource investments, the panel recommended that the tax value of any losses (including the net value of any undepreciated capital) be refunded when a project closes. That is, the panel recommended full-loss offset.
Now, among public finance people, it has been long understood that, given a full-loss offset, the appropriate allowance, or uplift, rate for carrying forward unutilised losses (or un-depreciated assets) is the before tax risk-free rate of return. A proxy for the risk-free rate of return is the rate applying to government bonds.
Some of the reactions to the proposed RSPT have suggested that: the government bond rate is too low; that it does not reflect the return required due to the riskiness of resource investments; that it does not represent a threshold against which to measure rents; and even that it is inconsistent with basic financial market theory such as the Capital Asset Pricing Model. All of these statements are incorrect.
The source of the confusion seems to be an interpretation of the RSPT as the petroleum resource rent tax (PRRT) with no loading on the government bond rate. The PRRT has a 5 per cent loading in excess of the bond rate for most capital expenditure. So, on that interpretation of the RSPT, it looks much less generous than the existing PRRT. But the interpretation is misguided.
The RSPT has a very different structure from the PRRT, most notably in its treatment of losses. Abstracting from the treatment of exploration losses, the RSPT is equivalent to a PRRT that provides a loading in excess of the bond rate at least as large as the project-specific risk premium – whether that risk premium is 5 per cent, 10 per cent, or even 50 per cent.
By the way, the PRRT provides a loading in excess of the bond rate, not because it is trying to define a measure of supernormal profit or rent, but instead, to compensate investors for the risk they may not be able to utilise their tax credits.
Under the ACC, on the other hand, by not providing immediate expensing, but guaranteeing full loss offset, the government is effectively giving the investor a second asset, a guaranteed tax credit that will be paid, with certainty, at some future date. The investor therefore holds two assets:
• a 60 per cent share in a risky resource project; and
• a risk-free asset in the form of a tax credit, with a government guaranteed present value of 40 per cent of the initial investment.
We can compare this with the PRRT, under which the investor holds:
• a 60 per cent share in a risky resource project; and
• a risky asset, in the form of a contingent tax credit for carry forward undeducted expenditure that evaporates if the investment earns insufficient income.
Another way of looking at the tax credit is that it is effectively the same as the government giving resource companies a government bond equal to 40 per cent of the investment costs, but with one difference – unlike a traditional government bond, payment occurs when the project makes a profit or, if the project is unsuccessful, when the project closes.
To understand why the panel considered the bond rate appropriate, it is useful to consider the two assets separately.
The appropriate rate of return for a resource project will include an appropriate risk premium, say 9 per cent. With a risk free rate of 6 per cent, the required rate of return is 15 per cent.
The required rate of return for the resource project is not, however, the appropriate discount rate for measuring the net present value of the guaranteed tax credit. The appropriate discount rate for the tax credit is the risk-free rate, because, unlike the PRRT, the tax credit is certain.
To ensure investors are neutral between holding the tax credit or another risk-free asset, the appropriate rate of return on the credit (or the uplift rate) is, therefore, the risk-free rate, for which the government bond rate is a proxy.
The RSPT has important economic effects. By rebating royalties, providing a generous exploration rebate, and financing a cut in the company income tax rate, it reduces significantly several of the features of the present tax system that act to discourage mining investment.
The RSPT itself, being a neutral tax, should have little impact on mining investment. Overall then, mining investment is encouraged.
This is an edited extract from Treasury Secretary Ken Henry’s address to the Australian Business Economists conference last week.