MINING TAXATION AND
LEGAL FRAMEWORK
Gangadhar Prasad Shukla
Duke Center for International Development
Duke University
May 2007
Outline of Presentation
• Some special features of the exhaustible natural
resource sector
• Designing an appropriate fiscal policy for the mining
sector
• Alternative tax regimes and their implications for
government revenues and economic efficiency
• Hidden costs, nuisance taxes and tax incentives
• Costs of administration and compliance
• Cost of uncertainty
• Concluding observations
Exhaustible Natural Resources and the
World Economy
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Some Basic Data About Exhaustible Natural Resources
Contribution of exhaustible natural resources (Minerals, Oil,
and Gas) in more than 30 countries exceeds 10% of GDP.
In about 20 countries, share of Oil and Gas alone ranges
between 18 to 87 percent of the economy and the annual
average revenues from this sector comprise between 43 to 85
per cent of total government revenues.
The exports earnings from Oil and Gas make up for any where
between 50 to 95 percent of total exports earnings in these
countries.
The non-fuel sector constitutes between 10 to 35 percent of
GDP and 25 to 95 percent of exports earnings in 15 countries.
What is Unique About this Sector?
Special features:
• As the resources are exhaustible, a user cost associated with
their exploitation; resource used today not available in future.
• Inter-temporal exploitation an important issue; a certain
extraction profile maximizes the wealth or Net Present value
(NPV) of the resource.
• A “Resource Rent” associated with exploitation of this sector;
unlike other sectors optimization rule not simply “marginal
revenue equals marginal cost”.
• Though producers have some market power, generally prices
determined in world market and producers are price takers.
• With several benefits to economy, many costs also involved.
Costs Associated With Extraction
• In addition to cost of extraction, following costs to economy:
– Cost of environmental degradation: Damage to air and waterways used
by the community.
– Dutch disease: Increased payment to factors of production in the
resource sector may increase cost of production of other tradable
sectors whose output prices are internationally fixed, thus causing a
squeeze on those sectors; also appreciation of currency may cause
problems to other tradable sectors.
– Cost of administration and compliance: different tax regimes have
different costs of compliance and administration.
– Cost of uncertainty of government revenues: Mainly due to uncertainty
about future costs and prices. Revenues from different types of taxes
(royalty to income tax) exhibit different levels of uncertainty and thus
impose different costs on the economy.
Designing an Appropriate Fiscal Policy for
the Sector
• Most resource rich developing countries have low capacity for
domestic investment and require foreign investment by
multinational corporations.
• While fiscal policy plays important role in creating appropriate
environment for attracting investment in general, it has added
significance for investment in this sector.
• Fiscal policies could be designed in two ways:
(a) Maximize tax revenues from the resource sector; do not impose any
conditions on investors; and government itself undertakes the
development work using the revenues.
(b) Create linkages with other sectors of economy; e.g. investors required
to use indigenous raw materials and labor, develop downstream
processing, sell a minimum share of production in domestic market. In
this case, investors often ask for concessions on fiscal measures to
comply with the constraints.
Fiscal Policy for The Sector (Contd.)
• The preferred fiscal policy in most resource rich countries has
been to maximize tax revenues since the loss in tax revenue
from concessions is generally much greater than the potential
benefits associated with such linkages.
• The tax system applied to the mining sector is generally of
concessionary type. The title of the resource is transferred to
the investor and the government primarily uses taxes, royalties
and different kinds of fees as instruments to collect revenues.
• The contractual type where the government retains ownership
of the resource - more common to oil/gas sectors where the
oil/gas companies have a right to the production or revenues
from sale depending upon the contract. In addition,
government applies taxes, royalties and bonuses on the
contractor’s share.
Optimization and Extraction Profile
The Optimal Extraction Rule flows out of the resource owner’s efforts to
maximize the wealth from the resource body:
n
NPV = Σ [P(t) × q(t) – C(q(t))]/(1+r)t - K
t=1
Where: P(t) = price of the resource in period t,
q(t) = quantity of resource extracted in period t,
C(q(t)) = cost of extraction, a function of quantity extracted,
K = fixed costs,
n = years of extraction or life of the mine; r = discount rate.
Plus some side conditions specifying rate of extraction, nature of cost
function, quantity of total resource.
• Prices may be modeled either as known with certainty or as stochastic.
• Usually a non-linear optimization problem. Various optimization
techniques employed (Euler's equation, maximum principle, dynamic
optimization) and the solution yields both optimum extraction period (life)
and quantity to be extracted in each year.
Alternative Fiscal Regimes
• Severance tax or royalty – either specific (unit) or ad valorem;
administratively simpler, ensures early and steady government
revenues but is not linked to profits; changes extraction
profile and may cause inefficiency and high grading.
• Progressive royalty to capture windfall gains.
• Income Tax - administration complicated, no efficiency loss
but government revenues not guaranteed.
• Progressive income tax or resource rent tax – again to capture
windfall gains by applying higher tax rates on above-normalreturn.
• Property tax – not very common sometimes used by local
governments, administration complicated and creates
inefficiency.
• Royalty plus income tax – a combination of the two, causes
inefficiency but some revenues ensured to government.
Other Taxes, Fees and Equity Participation
• Withholding taxes on dividends and interest payments
generally applied on transnational companies.
• Normal indirect taxes such as VAT are common but exports
taxes sparingly applied (on precious metals).
• Generally mining equipment exempt from import duty.
• A variety of license fees at different stages of exploration and
development (prospecting, retention, extraction) may be
applied.
• Sometimes equity participation sought by the government
(fully paid, concessional or carried interest basis).
• In some cases, joint venture or full ownership through State
Owned Enterprises (SOE). Generally, the revenues from SOEs
are quite uncertain.
Nuisance Taxes and Hidden Costs
• In addition to the main stream taxes, some governments in
developing countries employ a set of taxes that do not generate
a lot of revenues but add considerably to the cost of
compliance; e.g. employment related taxes, development
levies, stamp duties etc.
• Mining investors in many developing countries are subject to a
variety of indirect hidden costs in the form of high electricity
tariff, high prices of fuel, road toll and vehicle taxes, and
restrictions imposed on extracting ground water etc. These
“hidden” costs act like additional indirect taxes on mining
companies.
• It may seem surprising but these costs may often create as
onerous a burden as the burden of all taxes put together,
subjecting the investor to a form of second taxation.
To Give or Not to Give Tax Incentives?
• Various types of tax incentives in vogue
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Tax holidays and reduced tax rates
Tax credit or accelerated depreciation
Liberal loss carry forward rules
Immediate expensing
• But the question remains: do incentives pay? No
concrete evidence that tax incentives effective in
attracting more investment while loss of revenues is
certain. However, tax incentives quite common and
given mostly due to tax competition.
• Better to offer a stable tax system and a sound social
and physical infrastructure by using tax revenues.
Cost of Administering (Including
Compliance) Different Types of Taxes
• Income tax Cost of administration and compliance
high as both revenues and costs of extraction have to
be assessed and income tax laws are fairly complex
(estimated at about 2.74% of the total tax revenue).
• Severance tax for unit tax, cost very low. For advalorem royalty, a little higher but still low (cost
estimated at about 0.34% of total tax revenue).
• Property tax Cost of administration of the same
order as for income taxes, some variation in cost
depending on whether revenues or net present values
used as the tax base.
Stochastic prices and Cost of
Uncertainty
• With price uncertainty, another issue arises: uncertainty of
prices and quantities of extraction.
• Actual quantity of extraction, and thus government revenues,
in a specific future year will be any one of the several probable
values estimated today. The divergence between the expected
revenue and the realized revenue for any future year imposes a
cost on society, referred to as cost of uncertainty or risk.
• This is a function of the spread among the different probable
values of revenues in future, which in turn are a function of the
type of tax regime. Estimation of the cost of uncertainty for
different taxes, yields the following:
Income tax - High; Severance tax - medium; Property tax - low
Variability of Revenues Under
Alternative Tax Regimes
No. Tax Scenarios
Coefficient of Variability
I
II
III
IV
Base case: all taxes
Unit royalty
Ad valorem royalty
Income tax
0.070
0.024
0.038
0.126
V
VI
VII
Royalty & Income tax
Variable royalty
Presumptive income tax
0.075
0.124
0.115
VIII
Resource rent tax
0.132
The Trade-off: Comparing Costs of
Different Taxes
Cost Type
Income Taxes
Royalty
Property Tax
0
High
High
Administration
High
Low
Medium
Uncertainty
High
Low
Medium
Medium
Lowest
Highest
Inefficiency
Total
In Conclusion
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Output related taxes – specific or ad valorem
royalty - are easy to administer, produce a stream of
tax revenues with lower variability. But these taxes
cause economic inefficiency. For variable royalty,
economic inefficiencies persist and variability of
revenue stream increases.
Income related taxes do not create economic
inefficiency but have high administrative and
compliance costs and produce a revenue stream
with higher uncertainty/variability.
Additional profits tax or resource rent tax are again
economically efficient but are harder to administer
and produce revenue streams with higher
uncertainty/variability.
In Conclusion (Contd.)
• Property taxes are both economically inefficient and
hard to administer.
• A better option may be to use a combination of
royalty and corporate income tax. Rather than trading
royalty for a resource rent tax, it may be better to
keep normal corporate income tax along with a
moderate ad valorem royalty.
• Tax incentives should be eliminated or reduced. A
better approach may be to improve the basic
infrastructure, remove the nuisance taxes and lower
hidden costs of doing business.