Does a resource rent tax solve the problem of sovereign risk?

I have been a supporter of resource rent taxes for as long as I can remember. More precisely, my view has been that taxes on rents are better than most other taxes because they extract funds with minimal distortion to production and investment decisions.


I think the best way to think your way around the question of resource rent taxes is to imagine initially that you are the sovereign of a territory in which there has been no previous mining or exploration. You want to obtain revenue from the minerals in your territory by the inducing mining firms to use their expertise to explore and to mine.

One way of obtaining revenue from minerals is to auction off mining rights and promise mining companies that there will be no further taxes on the minerals they find. A major problem with such a ‘finders keepers’ policy is that on the basis of past experience mining firms have good reason to be skeptical that sovereigns will keep their promises to let them keep what they find. When valuable resources are found sovereigns (and democratic governments) have a habit of changing their minds and wanting more revenue. As a consequence of this ‘sovereign risk’, mining companies are not likely to be willing to pay anything like what an exploration lease would be worth to them if they could believe the sovereign’s promise of finder’s keepers.

Another way that governments can obtain revenue from minerals is through a system of royalty payments based on the volume or value of minerals extracted. This is like imposing an additional cost on mining activities and can deter mining that would otherwise be commercially viable.

By contrast, under a well-designed resource rent tax the sovereign is, in effect, a silent partner in the venture. The sovereign shares in the rents and risks of the project without distorting investment and production decisions in the process.

So far so good, but Australia is not a country in which there has been no previous mining or exploration. There is currently a great deal of mining being undertaken in this country under long-established systems in which state governments obtain revenue from royalties. In that situation it becomes important to consider how to make the transition from royalty payments systems to a resource rent tax without disturbing the reasonable expectations of miners of rewards that they are entitled to receive for the risks that they have taken. If the transition to a new tax is used by the government to grab a larger slice of rents from successful mines, the miners are likely to perceive that they have under-estimated sovereign risk in this country. They will also perceive that there is a chance that the rate of resource rent tax could be increased in future, particularly if there are further increases in mineral prices. If they factor that into their calculations of expected returns they will reduce their investment in further exploration and new mines – even if the structure of the new tax minimizes disincentives to investment.

As is well known, the Australian Government has recently announced the introduction of a resource rent tax and its intention to grab a substantial additional slice of mining profits on top of revenue raised from existing mining royalties. The main source of this sovereign risk, Kevin Rudd, has defended the tax grab on the grounds that ‘what we are doing is to recover national sovereignty over our own resources’. Actually, I must confess that I don’t think Mr Rudd has used those precise words. Those words were used by Hugo Chavez, president of Venezuela. As far as I can see, however, the main difference is that Hugo is less verbose than Kevin.
Here is what Kevin Rudd has been saying:

‘Over the last decade the mining companies generated $80 billion in higher profits. At the same time governments, on behalf of the Australian people, received only an additional $9 billion over that period of time. What we're saying is that the mining companies deserve a fair return on their investment - that's important - but we also believe the Australian people deserve a fair return on the resources which they themselves own, and remember, these companies- you mention in your introduction BHP and Rio. BHP's 40 percent foreign owned. Rio Tinto's more than 70 percent foreign owned. That means these massively increased profits, the $80 billion that I referred to before, built on Australian resources, are mostly in fact going overseas’ (Interview on AM, ABC radio, 3 May, 2010).

Why is the percentage of foreign ownership of BHP and Rio relevant to the issue of resource rent taxation? The unmistakeable message is that Kevin Rudd views foreign investors as fair game. Tax reform has become a cover for expropriation of rents from assets owned by foreigners. All we can hope is that the more sensible members of the Australian government will encourage second thoughts about the rate of resource rent tax that should be imposed - and urge Kevin to restrain his rhetoric - before too much harm is done to Australia’s reputation as a safe location for investment.
Winton Bates

Postscript notes:
1. As I explained in a subsequent post I regret comparing Kevin Rudd to Hugo Chavez.
2. The additional $9 billion dollars that the prime minister refers to as the amount the Australian people have recieved from mining companies over the last decade does not include company tax.
3. Mining companies would be wise to factor into their considerations of new projects the possibility that the tax rules will be changed in future if substantial new investment projects are not profitable. Under the proposed tax mining companies are supposed to get a subsidy equal to 40% of losses. A government that is prepared to change the rules opportunistically to grab additional tax revenue could also be tempted to change the rules opportunistically to avoid substantial revenue losses at some time in the future.
4. In a subsequent post I have discussed the risk that state governments could still increase royalty rates.