Comments on IMF Taxation of Natural Resource Rents Paper Revenue Watch, April 2012 Revenue Watch Institute (RWI) is pleased to offer the following observations on selected questions raised in the IMF s consultation paper on the taxation of natural resource rents. A number of common threads run through our comments: While there can be no one-size-fits-all fiscal regime appropriate for every country, fiscal regimes should generally have certain core features. o Gross income-based, royalty-type fiscal tools ensure that states directly share in the value of their resource endowments and assure governments a baseline level of revenues throughout production. o Flexible fiscal tools that are robust to changing economic circumstances enable states to share in windfalls, and are more credible than overly rigid contractually stabilized fiscal regimes. Fiscal regimes are best enshrined in generally applicable legislation, and ad hoc fiscal regime design in the context of negotiated agreements often results in sub-par fiscal regimes while exacerbating administration challenges. Well designed and transparent competitive rights allocation processes can support greater rent capture by the state. I/ Characteristics Bearing on Tax Design Whether weaknesses in macro-fiscal management within a resource rich country should inform tax design is a complicated question. Poor macro-fiscal management could weigh against design of a tax system that is excessively front-loaded. For instance, a fiscal regime emphasizing signature bonuses is likely to exacerbate the waste that accompanies weak macro-economic management. It is not necessarily the case, however, that a weak macro management environment should then weigh in favor of more rent-based systems (which tend to be more back-end loaded) over systems more heavily emphasizing royalties, for instance. Greater emphasis on profit- and rent-based measures can increase revenue volatility, the negative impact of which is likely to be much greater in a country with weak macro-fiscal management. We would argue that the need for a solid floor of revenues, as provided by a robust royalty, is even more important in a weak macro environment than elsewhere. However, we would also argue that all systems should have some mechanism for capturing a share of rents in the case of high windfall profits. While the increased revenues that can come with such tax systems will no doubt test weak macro-fiscal management systems, a 1
failure to share in windfalls makes a tax system vulnerable to excessive renegotiation and other disruptions that can be even more damaging, as discussed in greater detail below. Fiscal decentralization (distinguished from revenue sharing by the degree of autonomy in policy setting afforded the subnational government) can constrain rent capture in particular where subnational governments have weaker capacity than the central government or higher levels of corruption. Apart from these direct impacts on overall rent capture, fiscal decentralization can also have an important bearing on tax efficiency and the achievement of sector policy objectives. In order to maximize efficiency of revenue collection within a decentralized system and to reduce unnecessarily burdensome compliance costs borne by companies, rules should be carefully coordinated between the central and subnational governments. Australia s recent disputes between the central government and the states around the interaction of state-level royalties and the new central government resource rent tax illustrates well some of the challenges and the need for coordination. The creditability of state royalties against the MRRT sets up clear incentives for states to alter their royalty regimes, and the end result has potential to frustrate the intended effect of the new tax. II/ Specific circumstances: One size does not fit all Our reaction to this question is inherent in our responses to many of the questions discussed herein. Objective analysis of the modeled outcomes of fiscal packages under varying assumptions should serve as a core element of government decision-making. But it must be supplemented by a realistic assessment of the impact on various factors, including those listed below, on the tradeoffs among options and the likelihood of long-term success. Administrative Capacity. The relative ability of the state to monitor costs and counteract attempts to fiscal tax burdens to outside jurisdictions has a significant impact on a government s ability to successfully collect anticipated revenues. Policy-makers should take administrative capacity into account when choosing among fiscal instruments (see the discussion of royalties and resource rent taxes, below), and in the design of individual elements of the fiscal regime (particularly when dealing with transfer pricing, where administratively-challenged countries should seek to measure key variables relative to observable and verifiable variables such as world prices wherever possible. 1 Political Economy and Time Pressures. It has become a well-accepted position that in order to be stable, fiscal regimes should include progressive elements that are robust to changing circumstances, thus reducing the risk that as markets change citizens (or companies) will demand renegotiation as a result of feeling undercompensated for the value of the resource, as has happened repeatedly in recent years from Ecuador to Algeria to the Democratic Republic of Congo. At the same time, governments facing immediate-term time pressures to deliver results (a group including many new democracies in fragile states) have high political discount rates (see discussion of resource rent taxes vs. royalties, below), and may need to rely more heavily on fiscal instruments that deliver returns quickly. It is crucial that a system s design recognize these considerations and seek some effective valuation mechanism to help a government avoid sacrificing too much in the future in favor of revenues today. These considerations 1 Natural Resource Charter, November 2010, page 6, http://naturalresourcecharter.org/sites/default/files/nrc_brochure_nov2010_eng.pdf. 2
are also important for governments considering fiscal packages that include direct provision of infrastructure or payments made by companies directly to communities. Rather than dismissing such approaches out of hand as deviations from traditional tax-and-spend theories of public finance, RWI encourages international technical assistance providers to help governments analyze the value of the offered goods more objectively, so as to more effectively weigh advantages and disadvantages while remaining responsive to citizen demands for visible benefits. Risk Tolerance. As is discussed in detail below, the greater the tolerance of a government for risk, the more fitting a system oriented primarily toward profits-based fiscal instruments is likely to be. III/ Observations on extent of rent capture In the majority of the countries in which Revenue Watch works, rents appear to be significantly under-taxed relative to potential or optimal tax levels. Revenue Watch s analysis of EITI report data highlights just how little some resource rich countries, especially countries dependent on mining, have managed to collect. 2 In at least one reporting year for which EITI reports have been produced, mining revenues totaled less than $30 million in each of the following countries: Sierra Leone, Niger, Ghana, Liberia, Burkina Faso and Mauritania. While project lifecycles or other specific circumstances explain these figures to some extent, the persistence of such low numbers across (and within) countries suggests broader failures of policy and/or implementation. A recent World Bank study on the mining sector in Zambia highlights the scale of the problem there: Despite the revival of the industry since privatization, the mining industry s contribution to government revenues has remained low, peaking at just 1.4 percent of GDP in 2008. Mining taxes amount to just 8 percent of total tax revenue. This is a low figure given the industry s share of GDP (15 18 percent) and the value of copper exports (over $3 billion). Worldwide, taxes represent between 25 40 percent of export revenues. In Zambia, they represent 3 5 percent. 3 In the Philippines, the Finance Secretary recently revealed that the mining sector paid a mere $47 million in taxes in 2011, or 0.17% of total tax collections. Official statistics indicate a mineral export value for 2011 of $2.66 billion 4. The Philippine government s extremely poor resource rent collection is due to a host of factors, starting with widely granted and overly generous tax holidays and investment incentives and compounded by inadequate tax auditing and mineral production monitoring. These figures just a selection among many similar stories not only underscore the failure of countries to capture a fair share of mineral rents, they also highlight the inadequacy of some of the more commonly cited government take calculations, which appear at least in certain cases to overestimate the strength of 2 See A. Gillies: What Do the Numbers Say? Analyzing Report Data at http://www.revenuewatch.org/sites/default/files/eiti_numbers_2011-02-23.pdf 3 World Bank Zambia: What Would it Take for Zambia s Copper Mining Industry to achieve its Potential? Report No. 62378-ZM (2011) at: http://www-wds.worldbank.org/external/default/wdscontentserver/wdsp /IB/2011/08/18/000356161_20110818023945/Rendered/PDF/623780ESW0Gray0e0only0900BOX361532B.pdf 4 See Exports by Major Commodity Groups at: http://www.bsp.gov.ph/statistics/sdds/table2_1.htm 3
particular fiscal regimes by disregarding implementation failures or failing to take into account fully the effect of common incentives. Modeled take figures provide a useful basis for comparing fiscal regime design, but caution should be exercised in using them as a basis for predicting actual rent capture. IV/ Appropriate mix of royalty-type and rent-based taxes We believe that royalties should be a part of any well-designed extractive resource fiscal regime. Reasonable ad valorem royalties guarantee some revenue from the start of production and during periods of low profitability. Countries in a position to take on more risk, those with more diversified (and not highly correlated) resource bases, or those less reliant on resource revenues as a share of total revenues may well opt to de-emphasize royalties in favor of a larger (potential) share of rents, but even in such countries there is an opportunity cost to current production which should be reflected in the price of the resource to the producer. We believe that zeroroyalty regimes represent an inappropriate shifting of risk to the resource owner (the host country) risk that is exacerbated by the more difficult implementation of profit-based instruments requiring cost accounting. That being said, we believe that fiscal regimes focused too heavily on gross revenue-based measures are often susceptible to political pressure to renegotiate due to their inability to capture a significant share of unexpected windfalls. 5 So long as an adequate floor is created through a reasonable royalty and upside potential is preserved through use of more flexible instruments, we believe that the government s discount rate is a key factor in determining the relative mix of fiscal tools used. This will differ from country to country. Many resource rich developing countries face extremely urgent short term needs and many leaders, particularly in countries in early stages of transition, face significant political pressures to deliver results quickly in order to shore up legitimacy. While care must be taken to distinguish these preferences for short term revenues from run-of-the-mill short-sightedness, the high government discount rate implied by such preferences may weigh in favor of some form of bonus in certain cases, or a fiscal regime that otherwise ensures some significant early payment stream. V/ Administration challenges While the issue raised by the question in the discussion draft is no doubt of great importance, from our perspective a more fundamental impediment to extractive industry tax administration is the excessive use of bespoke agreements making ad hoc and often inconsistent changes to generally applicable fiscal rules. While variations to tax and royalty rates in negotiated agreements may not be appropriate policy, such variations do not generally pose material additional administrative burdens. However, where agreements deviate from basic legislative and regulatory rules in their calculation of income (e.g., utilizing different bases and value measurements for assessing royalties, providing entirely different thin capitalization rules or loss carry forward 5 Of course, gross-income based measures can be designed to capture an increasing share of rents. Variable rate royalties, for example, may utilize triggers based on changes to published price indices. While price alone is an imperfect proxy for rent, coupled with a review clause or other mechanisms such tools may be a means of balancing the respective advantages of royalties and rent-based mechanisms. 4
rules for different projects, allowing one company special exceptions to ring-fencing rules, establishing complicated multi-phase rate escalations for various charges, etc.) tax administrators and other regulatory bodies are put at a significant disadvantage. Greater use of standardized form agreements and reliance on legislated fiscal terms whatever the balance between gross income-based and rent-based tools ultimately chosen would foster much more efficient use of limited human and technological resources within already under-capacitated tax administrators. Questions of the relative ease of implementation of rent taxes versus royalties are certainly important, and we agree that rent taxes insofar as their cost accounting burden is not materially different from that of basic income taxes are not as difficult to administer as is often argued. VI/ Methods of awarding mineral and petroleum rights Where they are possible, competitive licensing processes provide the best tool for allocating petroleum and mineral contracts, and not just via the well-documented benefit of providing a market-based determinant of the government s maximum fiscal package. Well-designed bidding procedures provide the government with a system for choosing companies that are more likely to explore and develop resources effectively. Thus a competitive process can both enhance the likely fiscal take of the state in the event of production and increase the likelihood that production will be optimized (though there can be tension between these goals, as discussed below). An important component is the impact of auctions on middlemen companies that seek to profit from the undervaluation by the state of its assets while doing little or nothing to increase the expected value of a license. 6 Particularly in countries with weak institutions, these companies are frequently able to gain access to licenses through non-competitive processes, and can occupy acreage that could otherwise be more vigorously explored or developed by companies with deeper experience and a keener interest in investing. These middlemen sometimes seek to transfer (total or partial) control over the license to a company with a stronger commitment to investing. Several governments and international institutions (including the IMF) are working to improve strategies for taxing the inherent capital gain, but these mechanisms face certain fundamental challenges, and a competitive system that awards the right to the most effective partner from the outset represents a fundamentally more efficient mechanism for rent capture by the state (assuming, or course, that the underlying fiscal regime effectively captures a fair share of rent). An additional benefit of competitive award processes at least those which are conducted with appropriate levels of transparency is that by publicizing the bases of bids and awards, they provide an 6 This analysis should not be interpreted to suggest that there is no useful role for junior oil and mining companies that take on significant exploration risk and ultimately transfer control to another company for development or exploitation (though capturing capital gains poses a significant challenge for governments vis-à-vis these companies). 5
opportunity to increase public scrutiny on the execution of the contracts, thereby increasing the chances that the state and the contractor will abide by the agreed terms. The Republic of Guinea presents a powerful example of the risk of lost value associated with noncompetitive licensing processes, and of the potential of competition to be extended to new areas. In 2008, the Guinean government regained control of half of a concession that by that point had been demonstrated to contain one of the most attractive iron ore deposits in the world. The government awarded this relinquished acreage behind closed doors, to a company with no experience developing large-scale iron ore projects. Two years later, the company is reported to have sold a controlling interest in the project to another global iron major at a value of $2.5 billion. This represents value that could have accrued directly to the state if the allocation process was more efficient and the fiscal regime sufficiently robust. In its reform to the country s mining legislation, the new government elected in late 2010 decided to require that for any areas already prospected, containing a known deposit or attracting the interest of several companies, award will only be made via competitive tender. This sort of provision can be used to extend the reach of competitive processes beyond petroleum and into mining, where first-come-first-served awards have been more common. Despite the well-established benefits of competitive award procedures, many countries continue to award rights via opaque and closed-door proceedings, even in petroleum. A recent survey by Revenue Watch indicates that for many countries at the early stages of the development of their petroleum industries, including Ghana, Uganda and Sierra, licenses have overwhelmingly been awarded via noncompetitive processes. One challenge that international technical assistance providers can help governments overcome is the information deficits that prompt many public officials to shy away from public tenders because they believe that oil companies consider them to be frontier states that are not sufficiently attractive to justify bidding. We have encountered this argument frequently in our engagement with governments, particularly in Africa, and believe that it is important to give governments tools to recognize the attractiveness of their potential assets, particularly given the evolution of the global oil market and the intense competition among international oil companies for limited open acreage. It is important to note that by standardizing fiscal terms in law to the maximum extent possible and by insisting that contracts conform to the generally-applicable regime, states can reduce the impact of licensing processes on fiscal floors, enabling governments to direct selection criteria at technical competence, work plans and/or bids on fiscal terms (bonuses, production share) that build on the established floors. Beyond the classical considerations that go into the careful design of bidding systems (how many biddable terms, which biddable terms, etc.), it is also important that policy-makers structure auctions to reflect consideration of the following: 6
Pre-qualification. In order to accurately reflect market perceptions and achieve the goals of finding optimal contractors, governments must include rigorous pre-qualification procedures. Where company bids are not subject to strong pre-qualification, governments can encounter the situation most infamously encountered in Nigeria in the mid-2000s, wherein companies win ostensibly competitive bids only to either fail to make the payments due or to seek to quickly flip control to a higher bidder and reap the benefits of the margin. Transparency of Bidding Procedures, Bids, Contracts and Beneficial Ownership. In order for competitive processes to meet their potential, they must be conducted transparently. This includes making sure that bidding criteria and timeframes are clearly explained and widely disseminated, that the content of winning and losing bids are disclosed wherever possible, that the contracts resulting from the processes are published and that the ultimate beneficial ownership of licensees is disseminated. 7 Without transparency, the likelihood that competition will, on its own, produce better fiscal terms and especially that it will produce more effective enforcement of those tools is greatly reduced, especially in countries with weak institutions. In connection with the discussion in preceding questions on appropriate context-specific fiscal design, it is important that auctions are designed so as to be compatible with the financial goals and the political economy of the country in question. When deciding whether to establish a signature bonus, profit oil split or work program as the principal biddable item, a government should reflect carefully on short- and medium-term revenue projections, enforcement capability, geological risk and political pressures. An award based primarily on the work program, for example, may result in a lower promised fiscal package than one emphasizing the profit split, but this may be justified if the government is prioritizing maximum exploration of its acreage as its most important goal. Outside technical service providers would be well-served to help governments analyze these questions in context rather than proposing generic solutions based purely on numerical models of economic efficiency. VII/ Stability and credibility of fiscal regimes In the vast majority of cases, countries would be better off utilizing a fiscal regime established through general legislation. As noted in our response to earlier questions on ease of administration, we see clear evidence that contract negotiations involving numerous or significant deviations from generally applicable fiscal rules can undermine administrative efficiency and effectiveness. At the same time, the contract negotiation and renegotiation process itself can strain limited human resources within government, particularly where there is limited technical expertise within relevant ministries, and excessively drawn-out or poorly managed renegotiation processes the risk of which is heightened where government capacity is already low can discourage investors, leading to unnecessary delays on 7 For a more detailed discussion of the elements of a transparent allocation process, see Global Witness, Rigged? The Scramble for Africa s Oil, Gas and Minerals, January 2012, http://www.globalwitness.org/rigged/rigged.pdf. 7
current or planned projects. 8 Of course, negotiations over some aspects of major extractive projects are inevitable, but negotiations over fiscal regimes are often the most contentious and fiscal elements are better established in law. Negotiations should be reserved for other project-specific considerations. Legislated fiscal regimes may also have positive impact on investor perception of risk, as contract-based fiscal regime raise the likelihood of discriminatory treatment of different investors. Lastly, negotiations too often result in sub-par fiscal regimes, particularly where negotiable issues are not clearly defined in law and ministerial discretion is unchecked. For all of these reasons, we strongly believe that greater standardization is to the benefit of governments. That being said, the question posed here appears to consider the negotiation vs. general legislation decision in terms of its impact on stability and credibility. We would argue that legal stability is quite distinct from the issue of credibility, and that true stability (we prefer the term robustness to distinguish this concept from that of contractual stabilization) is more a function of the fiscal regime s elements than of the instruments that create that regime. The last several years have seen many contracts with legal stabilization agreements come under renegotiation pressure, as the terms so stabilized resulted in unsustainable rent sharing under sharply higher mineral prices. Such contracts were apparently not stable, even with the threat of arbitration. 9 Rather than relying on outdated notions of contractual stabilization, we believe the better approach is for governments to develop robust fiscal regimes that respond predictably to changes in economic circumstances and in a manner that preserves incentives for investors while effectively capturing a fair share of rents for the government. In this regard, flexible fiscal instruments such as resource rent taxes are quite promising. Contact: Matthew Genasci Head, Legal and Economics Revenue Watch Institute mgenasci@revenuewatch.org 8 Despite these risks, renegotiation can be worthwhile as a response to substantially flawed deals. A number of countries Liberia and Sierra Leone for instance have managed to significantly increase rent capture on strategic projects governed by unbalanced contracts through formal renegotiation processes. These processes have been resource-intensive, however, and the end result has seldom been as favorable as the generally applicable law would have been. 9 See, e.g., P. Daniel and E.M. Sunley, Contractual Assurance of Fiscal Stability in The Taxation of Petroleum and Minerals: Principles, Problems and Practice (IMF and Routledge, 2010) at 419 ( In some of these cases [of fiscal term revision], fiscal stability assurance were included in agreements illustrating that they do not necessarily prevent renegotiation, or unilateral action by governments, when circumstances are perceived to have changed. Contract renegotiation appears to have occurred mainly where fiscal regimes in place did not contain instruments that could respond with adequate adaptability and progressivity to changed circumstances. ) 8