Wednesday, August 11, 2010

George Fane Seminar @ Arndt-Corden Division of Economics

I went to George Fane's seminar yesterday on "The Taxation of Rents from Mineral Resources". It was well-attended by both people from ANU and the public service. The seminar might have provided the answer to my confusion about why the Henry Review and most economists discussing it argue that royalties are inefficient, while my intuition tells me that they're not so bad.

One of the cases that Fane looks at is where mining companies engage in "work program bidding" with the government. Companies promise to carry out exploration and development of the mining lease they are allocated. The company that promises the most gets the lease. It seems that this is the way that mining leases are mostly allocated in Australia. Under this arrangement, assuming that all companies have the same cost structure, competition between companies would result in bids to spend so much on development so that the average cost of production (including a normal return on capital) is equal to the price of the mineral. If a company doesn't bid that much then another company has an incentive to bid more. As a result there are no "rents" from mining. This resource regime is similar to an open-access resource.

Introduction of a royalty will discourage this overbidding. In theory the royalty can be chosen so that the marginal cost of production is equal to the price of the mineral in the market. This level of production is the efficient level. The royalty collected by the government is then equal to the difference between the price of the mineral and the average cost of production. The government receives all the "rent" from production of the resource.

In this case, removal of royalties and introduction of a Brown tax results in over-exploitation of the resource and "dissipation of rents". Royalties are efficient and "rent taxes" are inefficient. (From here on, is my interpretation of what this means, not what George Fane said:) The model underlying the Henry Review analysis must be one where private landowners are developing the mineral resources on their own land. Obviously, they won't waste resources in doing so. Introduction of a royalty tax by the government is then distorting and inefficient. The Brown tax, where the government demands a share in the enterprise would be efficient assuming that the goverment really shares in all costs (including the CEO's time etc.) and there is no uncertainty.

(Back to what Fane said in the seminar:). Fane also discussed the case of auctioning mining leases. With no uncertainty a rent tax simply decreases the amount paid for mining leases by the amount of the rent tax. Introducing a rent tax results in the government taking on more risk. Rather than getting higher auction proceeds they take a bet on getting higher revenues from a rent tax but they also take on the risk that mineral prices are lower or the lease property is not as productive as expected and they have to pay out money to the mining company.

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