TAX NEWS - June 2010

Tax theory all at sea in PM's push for a fair share

In introducing its radical pathway to the extraction of a "fairer share" of our natural resources wealth for working Australians, the Rudd government called on the ghost of an economist past to intellectually buttress its super-profits tax idea.

The spirit in question was professor E. Cary Brown, who back in 1948 published a seminal paper on the sort of cashflow tax that Treasury secretary Ken Henry recommended in his taxation review and that the Prime Minister and the Treasurer concluded ticked all political and economic boxes necessary to make it a budget-reinforcing, election-winning goer.

Rudd, Swan & Co introduced their resource super-profits tax declaring, in part: "It has long been recognised by tax policy specialists that a tax will not impact on investment decisions if it falls on the net cashflows, since any investment behaviour that maximises the present value of cashflows after tax will also maximise the present value of before-tax cashflows.

"This type of tax is often referred to as a Brown tax (after US economist Cray Brown)."

The thing is though, the tax Kevin Rudd is trying to sell actually looks nothing like the so-called Brown Tax and, as a result, will even more certainly reduce investment flows in Australian minerals projects and result in a bigger proportional tax take from existing projects than the government has foreshadowed.

What's more, even if the resource tax did look like a Brown tax, it still would not work.

You don't have to take my word for that. Instead listen to an old mate of Cary Brown. His name is Jerry Hausman and he is the current McDonald Professor of Economics at Massachusetts Institute of Technology.

It was Brown who gave Hausman his first job at MIT back in 1972, and Hausman went on to learn a whole lot more about life and economics during regular tennis matches against his department head.

Hausman says the Rudd government "might think they've got some kind of Brown tax, but actually they haven't even come close to it".

Not that missing the mark Brown set is actually such a bad thing, mind you. Because, with all due respect to Brown, Hausman does not actually have a whole lot of time for his tennis partner's ideas on the potential of cashflow taxes to sustain investment flows.

Hausman observes there is no working model of a Brown tax anywhere in the world and that is largely because "I don't think it works in the real world".

"It has theoretical properties but the theory of investment had moved a long way since 1948.

"That is not to say you could not redesign it to suit modernity. But in the real world, no one is going to do that."

Well, no one but Kevin Rudd, Wayne Swan and Ken Henry, and their collective problem is that in crafting their uniquely Australian version of a Brown tax, the government and its tax Svengali have ignored key elements of the Brown theory intended to entrench tax neutrality over the life of any capital investment.

As Hausman explains in The Australian today, the starting point for the Brown tax is that it will have no impact on investment flows. The key to establishing that neutrality is that government would contribute to the cost of a project at a rate equivalent to the cashflow tax rate it was going to charge. That contribution must be real and timely, not a credit promised on the never-never, nor some bogus form of underwriting that compensates an investor upon failure.

Logically then, if the Rudd government wants to retrospectively deal itself into mining Australia's asset wealth, it should pay, upfront, the equivalent of 40 per cent of the costs of those projects.

Plainly, the government is not prepared to do that. That means, inevitably according to Hausman, it will end up with "more than its stated share of mining company profits". In more expansive and technical analysis of the government's proposal prepared for BHP Billiton, Hausman is critical of a range of flaws in the government's chosen minerals tax model.

Hausman highlights, in particular, the failure to account for the value implicit in a company's ability to delay investment (the so-called real options theory) along with the fact that the mine-head taxation point makes it unlikely the taxman will take account of investment in the infrastructure that supports a mine (and usually costs between two and three times as much as the mine to build).

BHP's favourite MIT economist also considers that the tax "may create concerns over sovereign risk".

There has been some debate on whether Rudd's decision to shift the taxation goalposts on capital investments already made really does constitute sovereign risk.

Hausman has no doubt. "Public finance economists recognise that were a new tax to be applied to existing projects it may create concerns over sovereign risk."

He goes on to conclude: "To the extent that the government decides to apply a 'super tax' to existing projects, as well as new projects, despite concerns over increased sovereign risk, a different approach to determining the amount of tax is required and complex transition rules need to be applied.

"Otherwise, the government again gains more than its 40 per cent share of an existing mining project."