Australia's Future Tax System

Consultation Paper

Section 14: Natural resource charging

Overview

Natural resources are an essential input to Australia's productive capacity. The way in which Australia uses its natural resources is an important determinant of the level of economic growth. It also affects the environment now and into the future.

Ensuring the community obtains maximum value from the appropriate use of its natural resources is an important part of an efficient tax system. The tax system can influence the rate at which resources are extracted and the capacity of future generations to enjoy the benefits of natural resources. Issues which need to be taken into account in considering the taxation of natural resources include the size of the recoverable stock of the resource and how quickly (if at all) it is able to renew, the effect of taxes on investment decisions, which level of government taxes the resource, and the alternative uses of resources outside commodity markets.

Consultation questions

Q14.1 When considering the appropriate return to the Australian community for the use of its non-renewable resources, what relative weight should be given to the determinants of that return?

Q14.2 What is the most appropriate method of charging for Australia's non-renewable resources, given they are immobile but that Australia needs to compete globally for mining investment?

Q14.3 What is the role of the tax system in ensuring that renewable resources are used both sustainably and efficiently?

Taxing natural resources

Australia is endowed with significant natural resources. For example, in the non-renewable sector Australia has the world's largest reserves of brown coal, lead, mineral sands (rutile and zircon), nickel, uranium and zinc and the second largest reserves of bauxite, copper, gold, iron ore (contained iron) and silver (Geoscience Australia 2008).

The Australian natural resources sector can be divided into the non-renewable sector (mining and fossil fuels consisting of oil, natural gas and coal)15 and the renewable sector (forestry, fisheries, water and renewable energy).

There are two significant justifications for taxing natural resources differently from other factors of production:

  • they are assets that are taken to be owned by the community — taxation by government reflects one way of achieving a return for the community on its assets; and
  • they can be sources of location-specific economic rent — taxing such rents is efficient and avoids the economic distortions arising from taxing other factors of production.

To achieve an appropriate return for the community, government charging for resource use has to balance the returns required by private firms to develop the resource with the community's valuation of the resource.

The community's valuation of a resource can be difficult to determine. At a minimum, it will be informed by the market price of the resource. Selling a resource to one buyer at a price that is lower than another would pay, now or in the future, wastes the community's resource. The amount of the market value of the resource that can be captured by the community depends on the costs and risks associated with developing the resource. A company developing the resource effectively acts as an agent for the community — resources will not be developed if agents are not able to earn a sufficient rate of return on the investment.

Communities may place a higher value on a resource than its market price. This higher value may reflect:

  • Social benefits not reflected in the market price, such as the ecological value of fish stocks or the recreational value of native forests. These benefits can imply significantly different valuations to those in resource markets. For example, two forests may have identical market values for their timber, but one may be a sanctuary for an endangered species and hence be of much higher value to the community.
  • Preservation benefits to future generations. Communities may also have a stronger desire to preserve resources for future use, compared to agents extracting the resource. It has been argued that the value future generations place on resources are not adequately reflected in market prices. This may reflect uncertainty surrounding the preferences and other opportunities of future generations. Where this is the case, market driven outcomes are likely to result in resources being overexploited.

Taxation represents only one way in which governments can derive a return for the use of community assets. Another approach is to charge for the right to explore or use an asset. The most effective way to assign rights will depend on the characteristics of the resource. For example, depending on the level of certainty regarding the value of a particular resource, a bid or auction process could be undertaken to assign rights. In addition, some community valuations may be more directly targeted through regulation (such as the establishment of nature reserves).

14.1 Non-renewable resources

Summary of key messages from submissions

Some submissions argue that there is potential to increase revenue from natural resources in the context of the overall tax mix.

Submissions from the mining sector argue that the sector's large capital expenditures and the long life of investments require stability in revenue arrangements. Consequently, any changes to mining sector revenue arrangements should only apply on a prospective basis. These submissions also state that consultation with industry prior to the introduction of any changes to existing resource pricing arrangements is critical.

One mining industry submission favours profit based arrangements over ad valorem arrangements.

Submissions from the mining sector also propose more generous tax depreciation arrangements.

Existing arrangements

The Architecture paper outlines the significant variation in resource charging arrangements in Australia. Different resource tax, royalties or payment arrangements are imposed on the same type of resource depending on its location.

Resource rent taxes are designed to tax the economic rent of a mineral resource. This economic rent is the excess of revenue over costs, where costs are in effect defined to include, the minimum rate of return required to hold capital in the activity ('normal profits').

Some general features of the petroleum resources rent tax (PRRT), Australia's only resource rent tax, are worth noting. The PRRT taxes profits (at a rate of 40 per cent) generated by petroleum projects located offshore, with the exception of the North West Shelf project area. The PRRT is assessed on a project basis and the liability to pay PRRT is imposed on a taxpayer in relation to its interest in the project. This liability is based on the project's receipts less expenditures.

Deductible expenditure not offset against project receipts in a financial year is compounded at varying rates, depending on the type of expenditure and time between the expenditure being incurred and deducted. Compounded expenditure is available as a deduction against project receipts in future years.16

Design considerations

The overarching design issue with resource revenue arrangements is how to balance the competing objectives of enabling exploration and extraction, while ensuring the community receives the appropriate return on Australia's assets.

The recent cycle in resource prices, sustained increases followed by sharp decreases, serves to highlight the relative efficiency of the various revenue arrangements. The extended period of profitability in the mining sector resulted in an increase in revenues from company income tax and specific resource taxes, royalties and excises levied on mining, oil and gas resources (accounting for the major part of resource related revenues). However, the rate of increase does not appear to have been proportional to the growth in the operating profits of the mining sector (see Chart 8.12 of the Architecture paper).

The relatively slow growth in government revenues is partially explained by the prevalence of ad valorem royalties. Ad valorem royalty revenues do not vary in proportion with profits. A corollary is that in a period of lower operating profits for the mining sector total government revenues fall by less than operating profits. Indeed, a particular project may be in a loss making position but still be required to pay royalties. Royalty arrangements can therefore discourage higher risk projects. They can also impede the efficient development of otherwise marginally profitable reserves.

Resource rent taxes such as Australia's PRRT are designed to overcome these issues.

As resource prices rise, so does the portion of revenue that companies earn that can be considered 'super normal' profits. A resource rent tax increases the effective tax rate as the price of the resource increases, thereby capturing a component of the super normal profits. By excluding normal returns, it avoids discouraging marginal investments. Under other resource revenue arrangements (for example, an excise or royalty), while the total government revenue increases as prices rise, the effective tax rate falls and with it the taxation of super normal profits.

Some important design considerations for resource rent taxes include the need to set appropriate threshold rates of return before the tax applies (generally linked to the long term government bond rate), rates at which the tax is levied (sufficiently below 100 per cent to ensure that it does not seriously weaken efficiency incentives in the private sector) and carry forward loss rules. Issues also arise in determining the appropriate tax base in vertically integrated enterprises and identifying when one or more projects exist, given uncertainties in identifying the boundaries of deposits and discrete projects. Another design issue is the range of mineral commodities to be covered by any resource rent tax. For example, the case for imposing a resource rent tax on low value commodities (such as silica, limestone/lime, and construction materials) is not as strong as the case for high value commodities because of the lack of economic rent to be captured.

Another issue with a resource rent tax is the stability of the tax base compared with royalties. Resource rents tend to be more variable than the volume or value of the resource sold. While a tax based on rents may be more efficient than royalties, it is also likely to be a less predictable source of revenue. Tax base stability is an important consideration for state governments as they require a reliable revenue stream to fund their expenditure responsibilities. However, at the national level variability in resource revenue may be consistent with macroeconomic stabilisation objectives.

Resource specific taxes and charges need also to be considered in conjunction with the income tax system. Submissions from the mining sector focus on this issue. (Box 6.7 outlines a related proposal for flow-though treatment of shares in exploration companies). As income tax is also a tax on rents or above normal profits, changes in the company income tax base or rate may in turn require offsetting adjustments in resource tax arrangements. In this regard, it is notable that since the PRRT was introduced, the PRRT rate has remained constant at 40 per cent notwithstanding a decline in the company tax rate from 46 to 30 per cent. Consequently, the effective tax rate on above normal profits (or rents) from relevant projects has fallen from 67.6 per cent to 58 per cent.

One mining industry submission proposes a shift to profit based revenue arrangements away from ad valorem royalty arrangements, pointing to greater consistency with the proposition that resource discovery and extraction is a joint venture arrangement between the mining company and the government (on behalf of the community). The submission also argues that while resource revenue arrangements may have a different rationale to other taxes, they are a charge on the cost of doing business. This suggests that the capacity to pay might appropriately be struck as a share of profits.

Developments in other jurisdictions

Many factors affect investor decisions about where and how much investment to make in mines located in particular countries. These include such fundamental factors as the richness of the potential resource, law and order in the host country, the availability of supporting infrastructure such as roads, rail and ports, the availability of an appropriately skilled workforce and stable government. At the margin, taxation arrangements can also be important.

However, it is not easy to make international comparisons of tax regimes in the mining sector because of the complexity of aggregate tax arrangements. The relevant base for international comparisons is, therefore, not just the resource charge but the overall effective tax rate on companies, taking into account this charge and all other direct and indirect taxes.

Hogan (2008) details mineral taxation arrangements in various countries and, drawing on Otto et al (2006), discerns four current trends:

  • a shift toward profit based royalties in developed economies;
  • a shift toward lower rates and/or sliding scales under ad valorem royalties;
  • increased application and coverage of mineral taxation arrangements; and
  • increased emphasis on transparency of mineral taxation systems.

The allocation of charges and taxes between levels of government

Given the location specific nature of non-renewable resources, resource taxes are often considered to be appropriate taxes for sub-national governments in a federal system. However, if the value of natural resources is distributed unevenly across jurisdictions (in a per capita sense), this will affect the relative fiscal capacities of sub‑national governments. A horizontal fiscal equalisation process, whereby the revenue raising capacities of sub-national governments is equalised, may lessen this concern. Also, if the extraction of natural resources involves inter-jurisdictional externalities, some involvement from the national government may be warranted.

Consultation questions

Q14.1 When considering the appropriate return to the Australian community for the use of its non-renewable resources, what relative weight should be given to the determinants of that return?

Q14.2 What is the most appropriate method of charging for Australia's non-renewable resources, given they are immobile but that Australia needs to compete globally for mining investment?

14.2 Renewable resources

Summary of key messages from submissions

Submissions from environmental organisations argue that renewable resources are being used at a rate that does not take into account their full value and is, therefore, unsustainable.

Connected with this concern is a view that government involvement in the allocation and pricing of natural resources needs to be reviewed so that renewable resources are used more efficiently and in a way that improves environmental outcomes.

Pricing the value of renewable resources

In contrast to non-renewable resources, which have a limited supply and cannot be replaced once extracted, renewable resources can be used and replaced. Renewable resources are sustainable, provided the rate of replacement at least equals the rate at which they are depleted. While forestry, fisheries and water are often included in the renewable sector, the replacement rate for some of these resources may blur their classification as renewable resources. For example, the time taken to replace an old‑growth forest is sufficiently long to class such forests as non-renewable. Although most water is considered a renewable resource, some underground water resources in Australia are non-renewable. Over-use of other resources, such as fisheries, can damage their renewal potential.

Submissions argue that correctly valuing natural resources is the most effective strategy in advancing economic and environmental outcomes. In determining the value of renewable resources, there is a need to consider:

  • the cost to the community from the extraction of the resource and how quickly the resource can be regenerated; and
  • the benefits that the resource can provide to the community beyond its value in commodity markets.

The valuation of some renewable resources also needs to take into account the fact that they may exist such that no one individual can have complete control. In these situations, the incentives to utilise the resource are greater than to preserve it, since no individual can capture the value of the resource as an asset. This can lead to the extraction of renewable resources at rates which are unsustainable, potentially leading to complete depletion.

Governments may intervene to ensure that renewable resources are used sustainably through the imposition of a royalty-type tax which seeks to align extraction levels with sustainable supply and takes into account the ecological value of resources. The imposition of such a tax and the resulting higher extraction cost reduces the risk of over‑depletion. However, in practice there are difficulties in implementing this approach. For example, timber extracted from different parts of a native forest may have the same value as a commodity, but the externalities associated with their extraction (for example, loss of habitat for wildlife) can be vastly different. Different royalties may be charged based on the location from which trees are extracted, but there is a risk of such an arrangement becoming quite complex. Similarly, efficiently taxing the use of water to balance supply and demand may need to vary by location and over time.

One submission notes that institutional arrangements may also weaken the effect of taxes (and other instruments) as a means to correctly price renewable resources, in particular native forests. In Australia, native forests are in public ownership and managed by state forest agencies that are near monopoly suppliers of native forest timber. The conventional technique used to calculate a royalty for native timber in Australia is the residual value pricing method. This method estimates a derived demand curve for native timber for a timber mill by subtracting reasonable costs incurred by the sawmill from the prevailing market price, including an allowance for normal profit (similar to a resource rent tax). However, institutional arrangements may mean that the usual market incentives to minimise costs and seek an appropriate market return for timber are diminished. Under the residual value pricing method, no allowance is made for the costs incurred in supplying timber, as the price is determined by the market price for processed timber and the timber mill's production costs. This may also give timber mills an incentive to artificially inflate their costs so as to reduce the price they pay for logs. The underpricing of timber may increase the rate at which native forests are logged.

Governments may also impose a sustainable extraction limit on the available resource. The imposition of a limit can create rents for those who retain access. The value of the rents created by such restrictions can be returned to government by a number of means. This includes auctions or tenders for access to the resource (or a quota of the resource) on the basis that the value paid for access to the resource reflects the rent created. This can provide incentives for resources to be used efficiently.

Consultation question

Q14.3 What is the role of the tax system in ensuring that renewable resources are used both sustainably and efficiently?


15 For ease of reference the non-renewable sector is referred to as the mining sector.

16 In particular: for exploration expenditure incurred within five years before the commencement of the petroleum project, the compounding factor is the long term bond rate plus 15 percentage points; for exploration expenditure incurred more than five years prior to the commencement of the petroleum project, the compounding factor is the GDP implicit price deflator; for general project expenditure, the compounding factor is the long term bond rate plus 5 percentage points. Exploration expenditure can be transferred between petroleum projects provided there is common ownership over the period between when the expenditure is incurred and when the transfer occurs.