Australia's Future Tax System

Final Report: Detailed Analysis

Chapter C: Land and resources taxes

C1. Charging for non-renewable resources

Annex C1: Rent-based taxes — alternative forms

This annex explains how a Brown tax (cash flow tax) collects a share of rent and how it is generally equivalent to a Garnaut and Clunies Ross resource rent tax and an allowance for corporate capital (ACC) tax.

How does a Brown tax collect a share of rent?

A rent exists where a project's receipts are expected to exceed its expenses plus the required rate of return to compensate investors for the time value of money (the risk-free return) and a premium for the risk associated with their investment (the risk premium return for systematic risk). The value of the resource rent can be measured as the net present value of the project's cash flows discounted by the required risk-adjusted rate of return.

Under a Brown tax, the government is in effect a silent partner in the project, with a partnership interest equal to the tax rate. The government contributes to project expenses and shares in future receipts from the project at this rate.9 Consequently, its share of the value of any rent available is equal to the tax rate. In addition, the government receives cash flows associated with its share of the normal return and of good and bad luck associated with the project's riskiness.

Consider an example where an investor makes an investment, i, of $100 and expects to receive $150, r, at the closure of the project in one year. Assume the required rate of return for the investment is 20 per cent, comprising a risk-free rate of 6 per cent and a risk premium of 14 per cent. The expected excess return is the expected rent. For ease of exposition, assume the tax rate, t, is 50 per cent.

Chart C1–3 shows these returns from the project's net cash flows and illustrates the effective partnership arrangement established under a Brown tax. The vertical dashed line represents the tax rate, which determines the government's share of the project.

Chart C1–3: Entitlements under a Brown tax

Chart C1–3: Entitlements under a Brown tax

Under a Brown tax, the government and the private investor each contributes to the $100 investment expenditure (a negative cash flow) in year 1 — the government contributes i×t (50 per cent of $100), or $50, and the private investor i×[1−t] (50 per cent of $100), the other $50.

On their investment of $50 each, both the private investor and the government can expect to receive a rate of return of 20 per cent, and expect to share in any rent and good or bad luck.

Where the actual return is $150, the government and the private investor each receives their share of the $150 receipt (positive cash flow) in year 2 — the government receives r×t (50 per cent of $150), or $75, and the private investor receives r×[1−t] (50 per cent of $150), the remaining $75.

Of the $75 each partner receives, $60 compensates for their investment — $50 is the return of their initial contributions, $3 is the risk-free return and $7 is the risk premium return. The excess $15 each investor receives above the $60 they required is their share of the rent.

The present value of the government's share of the rent from the project is $12.50 ($15 rent received in year 2 discounted by the required rate of return), which is half the value of the project's rent (see Table C1–2). Although the investor made an initial investment of $100, their net investment in the project is $50 (i×[1−t]), as the government refunded $50 (i×t) in year 1 to pay for its share of the partnership established through the tax system.

Table C1–2: Net present value of total investment where investor invests tax refund into an equally risky investment

  Resource project
(required return = 20%)
Subsequent investment
(required return = 20%)
Total investment
Project
(1)
Private
(2)
Government
(3)
Private
(4)
Private
(5)
Cash flow ($) — Year 1 –100 –50 –50 –50 –100
Cash flow ($) — Year 2 150 75 75 60 135
Discount rate 20% 20% 20% 20%
Net present value $25.00 $12.50 $12.50 $0.00 $12.50

The investor can reinvest the $50 refund into another investment so that their total net investment is $100. The table shows the net present value of the cash flows from the total private investments where the private investor reinvests the $50 refund into another investment with the same required rate of return as the project (20 per cent), but one that does not yield any rent as it is a marginal investment. The net present value of the investor's total investment is $12.50 (column 5).

Alternatively, the investor could have reinvested the refund into an investment with a different required rate of return, such as a government bond with a required rate of return of 6 per cent (see Table C1–3). In this case, the net present value of the cash flows from total investments remains the same, as the risk-adjusted discount rate for the subsequent investment is also lower.

Table C1–3: Net present value of total investment where investor invests tax refund into a government bond

  Resource project
(required return = 20%)
Subsequent investment
(required return = 6%)
Total investment
Project
(1)
Private
(2)
Government
(3)
Private
(4)
Private
(5)
Cash flow ($) — Year 1 –100 –50 –50 –50 –100
Cash flow ($) — Year 2 150 75 75 53 128
Discount rate 20% 20% 20% 6%
Net present value $25.00 $12.50 $12.50 $0.00 $12.50

Garnaut and Clunies Ross resource rent tax

Under a Garnaut and Clunies Ross resource rent tax, the government imposes a cash flow tax levied at a constant percentage of the annual positive net cash flow from the project. 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') to be claimed as a deduction and utilised against future income. The government limits its risk by not providing a refund for the tax value of expenditure when a project fails. Consequently, the uplift rate should compensate investors for the delay of the tax credit (the risk-free return) and a premium to cover the risk that the government will never repay the tax value of expenditure (or provide a tax credit) at a future date.

There is no uniform uplift rate that could accurately compensate all projects for the risk that the government will never repay the implicit loan. This is because the required uplift rate would depend on the risk that a particular project will not be able to utilise the tax credit at a future date. Where the government allows projects to transfer losses to other resource projects within a company, the appropriate uplift rate would depend on the risk that a particular company will not be able to utilise the tax credit.

Consider the previous example again. This time the government will not contribute its share of the cost of investment until year 2 when the project has sufficient receipts to absorb expenses. For the sake of simplicity, assume that it is known with certainty that the project will be able to utilise its receipts in the second year (for example, because the government will allow the project to transfer its expenditure to other resource projects within the company and the investor is certain that there is another project within the company that can utilise the loss in year 2). In this case, the uplift rate should be equal to the government bond rate.

Under a Garnaut and Clunies Ross resource rent tax, the investor's share in the $100 project will still be $50 (i×[1−t]) and the government's share of the project will also be $50 (i×t). However, as the government will not contribute its share of the cost of investment immediately, the investor effectively reinvests the $50 refund into a temporary loan to the government, which pays the interest at the long-term government bond rate of 6 per cent (which is the required rate of return for investing in government bonds).

Table C1–4 shows the tax calculation for the project. In this case, the project will make a loss of $100 in year 1. The expenditure from year 1 will be carried forward to year 2. The government allows a deduction for tax purposes in year 2 of $106 (comprising $100 for the expenditure that was incurred in year 1 and $6 for the uplift).

In year 2, the investor will pay the government $22 in tax rather than $75 under a Brown tax (a difference of $53). The government thereby repays the investor $53 for the temporary loan ($50) and compensates the investor for the delay of its contribution under the Garnaut and Clunies Ross resource rent tax ($3, which is equal to the $6 uplift multiplied by (1−t)).

Table C1–4: Garnaut and Clunies Ross resource rent tax — worked example

Description Item Year 1 Year 2
Receipts (1) 0 150
less Expenses (2) 100 0
less Expenses carried forward from previous year (3) 0 100
less Uplift (6% applied to prior year's expenditure carried forward) (4) 0 6
Net profit (item 1 less items 2, 3, 4) (5) –100 44
Taxable profit (nil if item 5 is negative) (6) 0 44
Tax @ 50% (7) 0 22
Expenses carried forward (item 5 if negative) (8) 100 0

The investor will therefore make a total investment of $100 in year 1 and receive $128 in year 2 ($150 from the project less $22 in tax). This is equivalent to the cash flows and net present value shown in column 5 of Table C1–3 where the investor reinvested the tax refund in a government bond.

This shows that the Garnaut and Clunies Ross resource rent tax is equivalent to a Brown tax in apportioning the value of the rent if the uplift rate is equal to the government bond rate and if the investor is certain they can utilise the tax value of expenditure at a future date. In the absence of this certainty, the uplift rate should also compensate for the risk that the government will never repay the tax value of the investment. Given the difficulty in determining appropriate compensation for each project or company, equivalence breaks down.

Allowance for corporate capital tax

Under an ACC, the government contributes its share of project expenses at a slower rate than under a Brown tax. This delay occurs for two reasons. First, the government does not recognise expenses for assets immediately; instead assets are depreciated for tax purposes in line with their effective life. Second, the government does not contribute to expenses when the project is making a loss. The delay in the government's contribution to expenditure is equivalent to a loan from investors to the government. Under an ACC, the government compensates investors for this delay by effectively paying interest on undepreciated assets and unutilised losses through an allowance arrangement.

An ACC tax is only equivalent to a Brown tax where the interest payment compensates investors for the required rate of return associated with the implicit loan to the government, rather than the required rate of return for the project. The required rate of return on the implicit loan would comprise a risk-free return and a risk premium return to compensate investors for the risk that the government will never repay the tax value of the cost of the investment.

Under a full loss offset, the government promises to contribute its share of project expenses eventually, whether or not the project fails. The government could make this promise by refunding the tax value of losses (including undepreciated assets) when an unsuccessful project is closed. The government would then only need to compensate investors for the delay by paying the interest associated with government borrowing. This would compensate investors for the time value of money and the risk that the government will default on its guaranteed borrowing. A proxy for the appropriate rate is the long-term government bond rate.

Where the government does not provide the assurance of a refund, there is no uniform allowance rate that could compensate all projects for the risk that the government will never repay the implicit loan.

Consider the previous example again. This time the government will not contribute to its share of the investment until year 2, when the project's assets have been depreciated for tax purposes and the project has sufficient income to absorb expenses. A full loss offset is provided when the project is closed.

Under an ACC tax, the investor's share in the $100 project will still be $50 (i×[1−t]) and the government's share of the project will also be $50 (i×t). However, as the government will not contribute immediately to its share of the investment, the investor effectively reinvests the $50 refund into a temporary loan to the government, which pays an interest allowance at the long-term government bond rate of 6 per cent (which is the required rate of return for investing in government bonds).

Table C1–5 shows the ACC calculation for the project. In this case, the government allows $60 of the $100 expenditure for the project to be claimed as a deduction for depreciation in year 1 and the remaining $40 to be claimed in year 2.

The project will make a loss of $60 in year 1. This loss will be carried forward with undepreciated assets, $40, to make the ACC base $100 in total. In year 2, the project utilises the depreciation deduction ($40) and losses carried forward ($60) as well as the allowance ($6).

The investor will pay the government $22 in tax in year 2 rather than $75 under a Brown tax (a difference of $53). The government thereby repays the investor $53 for the temporary loan ($50) and compensates the investor for the delay of its contribution under the ACC ($3, which is equal to the $6 allowance multiplied by (1−t)).

Table C1–5: Allowance for corporate capital — worked example

Description Item Year 1 Year 2
Revenue (1) 0 150
less Expenses (such as depreciation) (2) 60 40
less Unutilised losses from previous year (3) 0 60
less Allowance (6% applied to prior year's ACC base) (4) 0 6
Net ACC profit (item 1 less items 2, 3, 4) (5) –60 44
Taxable ACC profit (nil if item 5 is negative) (6) 0 44
Tax @ 50% (7) 0 22
Utilised losses (item 5 if negative) (8) 60 0
Undepreciated assets (9) 40 0
ACC base (items 8 + 9) (10) 100 0

The investor will therefore make a total investment of $100 in year 1 and receives $128 in year 2 ($150 from the project less $22 in tax). This is equivalent to the cash flows and net present value shown in column 5 of Table C1–3 where the investor reinvested the tax refund into a government bond. This shows that the ACC tax is equivalent to a Brown tax in apportioning the value of the rent provided that the allowance rate is equal to the government bond rate if a full loss offset is guaranteed. Similar to a Garnaut and Clunies Ross resource rent tax, if the full loss offset were not guaranteed, the allowance rate should also compensate for the risk that the government will never repay the tax value of the investment.


9 This contrasts with an income tax system where the government contributes its full share of expenses only once assets are fully depreciated and the project has had receipts sufficient to cover all recognised expenses. The delay in the government's contribution is equivalent to a loan from investors to the government to purchase its share of the project. However, under an income tax the government typically does not compensate investors for the time value of the loan and the risk that the government will not repay the loan if the project fails to generate enough receipts to cover expenses.