TAX NEWS - June 2010

Tax will hurt investment

In 1948, the year my former Massachusetts Institute of Technology colleague E.C. Brown published a paper on cashflow taxes, roughly one-third of US underground coal was loaded by hand. These days machines called "continuous miners" with capacities of several tonnes a minute are used. The world of economics also has moved on since 1948, with research into the value of "real options".

The proposed resource super-profits tax will adversely affect investment and will give government more than its stated share of mining company profits. This is because the present design ignores real option value, does not address the challenges of valuing infrastructure appropriately, and taxes projects retrospectively.

Economists - and practical people - have always known taxes affect the investment and production decisions made by people and firms. In the 19th century, Britain had a windows tax. Houses with more windows were likely to belong to the wealthy, so a form of progressive taxation was introduced: houses with more windows paid more tax. If you've walked the streets of England, you may have noticed houses with bricked-up window spaces. These houses had spaces designed to be opened up and glazed once the owner could afford the tax bill.

A "Brown tax" is meant to be neutral and not distort economic activity. For a given tax rate, such as the 40 per cent proposed by the Australian government, the tax is supposed to be equivalent to the government being a 40 per cent owner in a given mining project. This is because, in a pure Brown tax, government would contribute 40 per cent of the cost of the project (in the year the costs are incurred) and take 40 per cent of the revenue. If a mining company was willing to invest $1 billion in the expectation of a positive return (even if that return was only $1, in net present value terms), then it should be willing to invest $600 million for 60 per cent of that return (with government contributing $400m and taking 40 per cent).

The RSPT ignores real options, which were first recognised as important to investment decisions in MIT research during the 1980s. Real options have significant value because they allow a firm to postpone an investment decision until it receives new information. This is especially important for mining investments where little value can be recovered if the project fails. For example, the most important unknown factor in the decision to develop a West Australian iron ore project is the future iron ore price. The option of waiting to see if Chinese, EU and US growth returns to pre-GFC levels is valuable before a mining company decides to spend billions of dollars on new mining projects.

Companies include the value of this "option to wait" in their investment decisions. The RSPT does not. This has two implications. First, if the investment rule miners use is different to the rule on which the super tax is calculated, then the tax necessarily distorts investment. Because revenue is taxed, but not all costs are reimbursed, investment will decrease. Given Australia's present economic situation of rapid growth, a tax policy that distorts investment decisions away from higher productivity investments would have large adverse effects on economic welfare. Second, by not paying 40 per cent of the opportunity cost of extinguishing an option, government is taking more than 40 per cent of the economic value of the investment.

Infrastructure investments (such as railways and ports) also have option value, and again entail significant risk (if iron ore demand falls, the Pilbara railway cannot be moved elsewhere). The standard regulatory approach to valuing infrastructure such as railways is a "cost of service" approach, which would not appropriately reward companies for their risky investment. But agreeing an approach that does is complex. If not done well, it can encourage inefficient operations. For example, even if trucking had higher costs than rail, if the super-tax methodology doesn't appropriately estimate the cost of providing infrastructure, then the after-tax profits of the mining company could increase by using trucks. The government needs to be sure it taxes minerals only "at the mine gate", not the supporting infrastructure investments.

Finally, by retrospectively applying the new tax to existing projects, government earns 40 per cent of the return, without a 40 per cent investment in the initial life of the project, again taking more than its stated 40 per cent share. Economists have long pointed out that royalties will distort investment decisions. Despite claims to the contrary, the RSPT is not a neutral tax, and it will also have an adverse effect on production and investment decisions. The government must understand the full impact of its proposal on investment and output.