EXPLOITATION OF OIL AND GAS: LESSONS FROM INTERNATIONAL EXPERIENCE

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MINING TAXATION AND LEGAL FRAMEWORK
Gangadhar Prasad Shukla Duke Center for
International Development Duke University May 2007
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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

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Exhaustible Natural Resources and the World
Economy

• 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.

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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.

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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.

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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.

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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 contractors share.

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Optimization and Extraction Profile

• The Optimal Extraction Rule flows out of the
  resource owners efforts to maximize the wealth
  from the resource body
• n
• NPV S P(t) q(t) C(q(t))/(1r)t - K
• t1
• 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.

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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-normal-return.
• 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.

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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.

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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.

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To Give or Not to Give Tax Incentives?

• Various types of tax incentives in vogue
• 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.

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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
  ad-valorem 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.

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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

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Variability of Revenues Under Alternative Tax
Regimes
No. Tax Scenarios Coefficient of Variability
I Base case all taxes 0.070
II Unit royalty 0.024
III Ad valorem royalty 0.038
IV Income tax 0.126
V Royalty Income tax 0.075
VI Variable royalty 0.124
VII Presumptive income tax 0.115
VIII Resource rent tax 0.132
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The Trade-off Comparing Costs of Different Taxes
Cost Type Income Taxes Royalty Property Tax
Inefficiency 0 High High
Administration High Low Medium
Uncertainty High Low Medium
Total Medium Lowest Highest
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In Conclusion

• 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.

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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.