Neutrality of a Resource Super Profits Tax
Diderik Lund*
Department of Economics, University of Oslo, Norway
Final version 4 February 2011
Forthcoming, Australian Economic Review
Abstract (max 100 words)
A report by Hausman (2010a) claims that the Resource Super Profits Tax proposed in
Australia in May 2010 was distortionary because it did not allow deductions when companies
exercise real options. This note shows that standard financial theory leads to other
conclusions, and discusses some other points made by Hausman. The proposed tax system
did not necessarily distort the choice to close down an operation with large losses carried
forward. However, there could be some transitional problems, and the introduction of the
system could increase perceived sovereign risk. This must be weighed against adverse effects
of other distortionary taxes.
Short description (max 30 words)
This note comments on neutrality properties of the Resource Super Profits Tax
proposed by the Australian government, May 2010. Two points made in a report by Hausman
(2010a) are criticised.
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1.
Introduction
The proposal of a Resource Super Profits Tax (RSPT) was made in May 2010 by the
Australian government. After much discussion, partly connected to the national elections
later in the year, the proposal was revised in July 2010. There are still interesting issues,
raised in the discussion of the first proposal, that are not resolved.1
Based on standard theory the RSPT would be a neutral tax system in relation to new
projects. By taxing all cash flows, negative as well as positive, proportionally, the RSPT would
reduce the net values to companies by 40 percent, the proposed tax rate. Decisions on the
exercise of real options would not be distorted. For existing projects the RSPT would
represent a reduced after-tax value. Some companies would have invested differently in the
past, had they known that the RSPT would be introduced. This does not imply that they will
invest differently in the future. But two possible reasons for distortions created by the
transition rules will be identified. Also, increased rent taxation may lead to a higher perception
of political risk by the companies.
A report by Hausman (2010a), launched through a newspaper article (Hausman
2010b), suggests that the proposal has serious shortcomings. It is suggested that the tax
system should have allowed deductions when companies exercise real options, and that the
system would distort decisions to close down operations. These views are not supported
here.
2
2.
The RSPT and the Brown Tax
Brown (1948) proposed a tax system which has been a useful point of reference for
subsequent discussion of taxation of companies, and in particular companies earning rents
from natural resource extraction. When governments appropriate rent through higher tax
rates, the possible distortionary effects of taxation are exacerbated. Care must be taken to
design tax systems so that investment is not adversely affected.
The Brown tax is a proportional tax on companies' net non-financial cash flows with
full, immediate loss offset. The latter provision means that when the net yearly cash flow is
negative, there is a payout from the government of the negative tax. In terms of cash flows,
the government acts as a shareholder in the company. This points out the reason why the
system does not distort investment decisions. In standard theory all shareholders of a
company will agree on decisions irrespective of how large fractions they own.
The RSPT was intended to have the same economic effects as a Brown tax. It was
modified at one point, relative to the Brown tax: There would not have been payouts in every
year with negative cash flows. These would be carried forward with interest accumulation for
deduction in later years. If a company would close down operations without earning full
deductions, there would be a payout of the tax value of the remaining deductions, with
interest.
The RSPT has many similarities with a one-tier version of the Resource Rent Tax (RRT)
proposed by Garnaut and Clunies Ross (1975), but the final payout provision is different. In
relation to investments after its introduction, the RSPT thus alleviates a problem raised by
Dowell (1978), Mayo (1979), Ball and Bowers (1983), and Smith (1999) that the RRT taxes
successful projects but does not allow deductions for unsuccessful ones.
3
There have been discussions in the economics literature of the appropriate interest
rate to use for the accumulation, see, e.g., Section 6.2 in Lund (2009). The main question is
whether it should include a risk premium. Fane (1987) shows that a risk free interest rate is
the correct one to obtain neutrality, provided that the tax value of the deductions are
eventually obtained with certainty.2 To ensure this, the RSPT scheme promises to pay out in
case the company closes down while it still has unused deductions to carry forward. Hausman
(2010a, p. 8) points out that this is only neutral if companies and shareholders are convinced
by the promise. This is a valid objection. Perhaps a small risk premium should be added.
Similar rent tax systems have been introduced in Norway and suggested in Denmark, see
Lund (2002), who includes a discussion of this risk premium on p. 44.
While the (final) payout of tax values of unused deductions is an unusual feature of a
tax system, it is a natural building block if one wants a neutral tax system, but not a payout
in every year with negative cash flow. There is no practical alternative way to allow a higher,
risk-adjusted interest rate in the accumulation, since the appropriate risk adjustment would
vary a lot between projects. If the political risk is small enough, so that the system works, the
rules for depreciation deductions and loss carry-forwards can be designed in many different
ways. The RSPT would be equivalent to a Brown tax provided that the present value of
deductions is equal to the expense, see Boadway and Bruce (1984).
3.
Real Options
For the purpose of this section, the RSPT can be considered equivalent to a Brown
tax. This is also the way the topic is treated in Hausman (2010a, pp. 1–7).
The first (and main) claim in Hausman (2010a) is that the `RSPT ignores real options’
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(Hausman 2010b, fourth paragraph). The report suggests that investment theory since the
1980's has realised that flexibility is valuable. In particular, when a project requires large sunk
costs, which have little or no resale value, the possibility to postpone the project is valuable.
Without this possibility, when the question is whether to invest now or never, the traditional
criterion of positive net present value is adequate. But with the option to postpone, this might
be a better solution, even if immediate investment would result in a positive NPV.
Projects with flexibility have `real options’ in them, with positive value. These are, of
course, intangible values, and Hausman makes the point that they are not accounted for in
the proposed RSPT system. When an option to postpone is given up, this is in fact a cost, but
there is no deduction in the tax base for this loss of option value. Hausman (2010a, p. 7)
argues that there should have been, and that the proposed system would distort investment
decisions.
The counter-argument goes as follows.3 The standard theory for valuing real and
financial options, referred to by Hausman (e.g., the textbook by Brealey, Myers, and Allen
(2006)), has the property called value additivity. This means that a claim to
sequence of cash flows has a market value equal to
percent of a
percent of the market value of the total
sequence of cash flows. If this had not been true, one could create additional value in
financial markets by combining or splitting existing assets.
The cash flow tax suggested by Brown (1948) is neutral exactly because of value
additivity. Whenever there is a real option, the government will take the same percentage of
future cash flows (and pay out if they are negative), irrespective of which decision is made by
the company, in all future states of the world. There should not be a deduction for loss of
option value because there is no cash flow related to this loss.
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Not only does the tax reduce the value of claims to all cash flows and all real options
by the same percentage, it is also non-distortive on the optimal decisions to be made by the
companies (relying again on standard theory). As an example, consider the optimal strategy
in McDonald and Siegel (1986), one of the seminal articles in the real options tradition. There
is an investment cost
to be paid now or in the future to acquire an asset (e.g., the cash
flow stream from a project) which has a value
. Both
and
fluctuate according to
geometric Brownian motions with drift. The optimal strategy is to exercise the option, i.e.,
incur the cost, at the first time when
both
and
/
exceeds a trigger value
. A Brown tax will reduce
by the same percentage, and will thus not affect the optimal strategy. The
boundary `is homogeneous of degree zero in
and
’ (McDonald and Siegel 1986, p.713).
Multiplication of both of them by the factor `one minus the RSPT tax rate’ would not change
the strategy.
The Brown tax is thus neutral in the sense that it never creates negative after-tax value
out of positive before-tax value, or vice versa, and that it does not affect decision making by
companies that maximise market value. If this had not been the case, there would also be a
divergence of interest between shareholders in these companies, even in the absence of a
tax. Contrary to the findings of standard financial theory, shareholders with different
ownership shares would have had different views on value maximising decisions.
If an asset were bought or sold by a company subject to the RSPT, the cash flow from
the sale would be included (negatively or positively) in the base for the RSPT. This would
include a valuation of real options included with the asset, so the RSPT would not distort
decisions to buy or sell assets or decisions by firms outside the sector to supply assets to the
sector. Only in relation to the transition into the system would there be a need to assess asset
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values (other than cash flows), including real options, see Section 5 below.
4.
Closing Down Prematurely
A particular type of real option is the option to close down operations. If a large
accumulated deduction is being carried forward, the company may consider whether to sell
its remaining assets or to close down and cash in the promised refund. Another company may
be interested in taking over, perhaps because the other company specialises in producing
towards the end of the productive life of a mine or oil field.
Hausman (2010a, p. 12) claims that the decision, whether to sell or close down, would
be distorted by the RSPT with a tax rate . Let
time when the project may be sold at a sum
profitable to close down if
be the loss carryforward with interest, at a
. Hausman's interpretation is that it is more
. This is a potential distortion, since a positive
implies
that the project has value for someone, and should not be closed down.
Another interpretation is that the RSPT would not be distortionary. This requires that
even if the project is sold, the difference
will earn a tax refund of
how the system would work, a positive value of
prefers to sell, since
0 implies that
. If this is
is sufficient to ensure that the company
, irrespective of the tax rate, and
irrespective of .
Whether this is how the system actually would work, may not be obvious, and
Hausman makes the reservation that he only relies on his understanding of the rules.
Hopefully, the rules will be practiced as suggested here if and when a similar resource rent tax
system comes into place.
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5.
Expropriation and Transition Problems
Even if one agrees that the RSPT is non-distortionary in the dimensions mentioned
above, there are issues in relation to its introduction when there are existing projects and
existing tax systems. These issues could be separated under two headings, the question of
expropriation and sovereign risk, and the question of a transition between the old and the
new tax system.
The first issue would exist even if the old system was neutral as well, e.g., if one
considered an increase in the tax rate from, say, 10 percent to 40 percent. Some will question
whether the government has the right to increase taxes after investments have been made,
while others will point out that, even it has this right, the increase harms the government's
reputation, increasing the `sovereign risk’ perceived by the companies. Hausman (2010a,
p. 13) does `not want to enter the debate about the increase in sovereign risk.’ Accordingly,
the topic is not pursued here.
Hausman has a valid argument when pointing out that the effect on previous
investments is asymmetric. When a company has had both successful and unsuccessful
projects in the past, only the successful ones that are still operating would be subject to the
new tax system. If there had been a neutral system when the company started up, it should
also have allowed deductions for the unsuccessful investments. This would have been a
necessary condition for neutrality as seen from the time of start-up.
The transition rules of the RSPT (Treasury of Australia 2010, pp. 33–35) specify how
companies with existing assets in the sector would be taxed. The book value of existing
assets would be allowed as tax deductible in the RSPT, but if income is never sufficient to give
effective deductions, the pre-existing assets cannot be claimed as basis for refunds or
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deductions transferred to other projects. This differs from the treatment of new investments.
Hausman points out that existing assets actually may have market values much higher than
the book values, especially when assets give rise to real options. This is true. It means that
the RSPT would compensate companies imperfectly, and to some extent treat companies
with equal pre-existing values differently. One might say that this has to do with fairness and
with sovereign risk. For the remainder of this section, the focus is instead on distortionary
effects, i.e., on possible effects on decisions.
It is clearly of interest to ask whether the transition rules imply that the RSPT would
affect future decisions of companies with pre-existing assets in the sector. This is a different
question from the question of whether the RSPT would mimic the effect of a neutral system
existing before activities started. As a first approximation the answer is that the transition
rules are unimportant for subsequent decisions, although there are a few reservations.
In what sense are the transition rules unimportant? There are no income effects in
standard models of the companies' decisions, so they make the same decisions for the future
whether they have been compensated much or little for the introduction of a new tax system.
In fact, there might not have been any compensation at all, i.e., the system might not have
allowed deductions for any part of pre-existing assets, or there might have been deductions
also of pre-existing real option values. In both of these extreme cases, subsequent decisions
would remain unaffected to a first approximation.
The two main reservations to this first-approximation result have to do with the
financing of the companies and the possible limitations to loss offset provisions. There is not
one single, standard, agreed-upon theory of the financing of companies. Some companies
may face financing constraints, and may thus act differently when after-tax profits are lower.
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This would be most serious for smaller, independent companies.
The loss offset provisions would not create a problem if the deductions for pre-existing
assets had values to the companies that were independent of subsequent decisions. In that
case the tax value of deductions would be earned irrespective of decisions, and no distortions
would occur. This was proposed for new investments, but not for pre-existing assets. This
feature of the transition rules may affect decisions. If a company faces the possibility of
closing down operations without being able to effectively earn all deduction values, these
deductions create incentives. This would act as a subsidy to investments which increase the
probability of deducting all carry-forwards, relative to investments which reduce this
probability.
6.
Conclusion
One should not conclude that the RSPT would be distortionary solely due to the
existence of real options. Moreover, a possible interpretation of the rules implies that the
RSPT would not distort a company's choice between selling a project or closing down, even
when it has large losses to carry forward. But there could be distortions if those deductions
arise from investments made before the introduction of the RSPT.
The proposed rules for transition into the new system were intended to compensate
for part of the loss in value for companies with pre-existing assets. This would only be
imperfectly achieved. But even then, the rules would not necessarily distort subsequent
decisions. In standard economic models of the decisions of companies, there are no income
effects. Two possible reservations are pointed out, that financing constraints might imply
income effects, and that imperfect loss offset in the transition rules might distort some
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decisions.
Whether the government is willing to increase the perceived sovereign risk is a political
question. Companies may suspect that they will get similarly unfavourable treatment in the
future, although a high rent tax in itself is no reason to expect subsequent increases. The
Treasury of Australia (2010, p. 20) argues to the contrary, that the RSPT would be stable and
thus would lower sovereign risk. In any case, if there are drawbacks, the government must
compare them with the drawbacks of other types of taxation, which may have stronger
distortionary effects.
References
Ball, R., and Bowers, J. 1983, `Distortions created by taxes which are options on
value creation: The Australian Resources Rent Tax proposal’, Australian Journal of
Management, vol. 8, no. 2, pp. 1–14.
Boadway, R., and Bruce, N. 1984, `A general proposition on the design of a
neutral business tax’, Journal of Public Economics, vol. 24, no. 2, pp. 231–239.
Bond, S.R., and Devereux, M.P. 1995, `On the design of a neutral business tax
under uncertainty’, Journal of Public Economics, vol. 58, no. 1, pp. 57–71.
Brealey, R., Myers, S. and Allen, F. 2006, Principles of Corporate Finance, 8th ed.,
McGraw-Hill, New York.
Brown, E.C. 1948, `Business income, taxation, and investment incentives’, in
Income, Employment and Public Policy: Essays in Honor of Alvin H. Hansen, ed L.A. Metzler,
11
Norton, New York, pp. 300–316.
Dowell, R. 1978, `Resources rent taxation’, Australian Journal of Management,
vol. 3, pp. 127–146.
Fane, G. 1987, `Neutral taxation under uncertainty’, Journal of Public Economics,
vol. 33, pp. 95–105.
Frijters, P. 2010, `Post-mortem on the RSPT I: the other hired guns’, blog entry,
July 5, viewed October 2010, <http://economics.com.au/?p=5882>.
Garnaut, R. and Clunies Ross, A. 1975, `Uncertainty, risk aversion and the taxing
of natural resource projects’, Economic Journal, vol. 85, pp. 272–287.
Hausman, J. 2010a, `Analysis of the taxation of mineral rent: Mineral industries in
Australia’, report, Massachusetts Institute of Technology, June 16, viewed October 2010,
<http://sites.google.com/site/jh2010tax/rspt-paper>.
Hausman, J. 2010b, `Tax will hurt investment’, The Australian, 18 June.
Lund, D. 2002, `Petroleum tax reform proposals in Norway and Denmark’,
Energy Journal, vol. 23, no. 4, pp. 37–56.
Lund, D. 2009, `Rent taxation for nonrenewable resources’, Annual Review of
Resource Economics, vol. 1, pp. 287–308.
Mayo W. 1979, `Rent royalties’, Economic Record, vol. 55, pp. 202–213.
McDonald, R. and Siegel, D. 1986, `The value of waiting to invest’, Quarterly
Journal of Economics, vol. 101, pp. 707–727.
Smith, B. 1999, `The impossibility of a neutral Resource Rent Tax’, Working Paper
in Economics and Econometrics 380, Australian National University, Canberra.
Sureth, C. 2002, `Partially irreversible investment decisions and taxation under
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uncertainty: A real option approach’, German Economic Review, vol. 3, no. 2, pp. 185–221.
Treasury of Australia 2010, The Resource Super Profits Tax, A fair return to the
nation, Announcement paper, May, Canberra.
*
Address: P.O.Box 1095, Blindern, NO-0317 Oslo, Norway, phone +47 22855129, fax +47 22855035,
e-mail diderik.lund@econ.uio.no, web page http://www.sv.uio.no/econ/english/people/aca/dilund. Thanks to
Geir Asheim and an anonymous referee for helpful comments and to Jerry Hausman for clarifying his positions.
The responsibility for remaining misunderstandings, errors and omissions is my own.
1
Some of the points to be made here, have been hinted at in a blog entry, Frijters (2010).
2
The argument is extended by Bond and Devereux (1995).
3
This author has claimed elsewhere (Lund 2002, p. 39; 2009, p. 295) that a Brown tax is non-distortionary
when there are real options, but no detailed argument was given. Sureth (2002) has an explicit demonstration
of the result.
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