firm is only US$6.3 million due to long project lead times and the substantial risks of project failure along the way. The US$6.3 million in project resource rent available for taxation, as viewed by the firm, is trivial in the scheme of government fiscal revenues and probably less than the resource rent available from the activities of firms in other sectors based on our previous analysis of firm market capitalizations.

The government wishes to completely tax away the resource rent. Since it does not know the probability of success at each stage, it cannot discern what the project resource rent is. To determine the resource rent, it could auction off the lease at time zero, where a competitive auction would presumably yield a bid of US$6.3 million. That would drive the resource rent as perceived by the project owner to zero. If this approach is taken, no additional taxes or royalties could be expected over the life of the project. If they were, the project would become uneconomic at time zero and would be abandoned. Or the government could instead give the lease away for free and apply a tax to the eventual, or ex post, project outcomes via either a cash flow tax or a flow resource rent tax. The government is taking on project risk here because it would be required to pay into the project under negative technical outcomes. Or taxation could be applied only to positive cash flows if and when they occur via a windfall tax. Based on the company’s probability analysis, taxing surplus in this way during the project’s 15-year operating life will require a cash flow tax rate of 23%, generating average tax revenue of approximately US$100 million per year, or US$500 million each five years of project operations.<sup>35</sup> This equates roughly to an average 26% profits tax, the exact rate depending on the nature of the depreciation allowance.<sup>36</sup> The impracticality of taxing exactly the resource rents of the project via a targeted windfall profits tax, the windfall being the event that the project is successful, is evident. For the government to implement a windfall profits tax that exactly taxes the surplus of this project during operations, it would have to be able to calculate this surplus as we have done in our example and then estimate the exact tax rate that drives the surplus to zero. To accomplish this, the government must know the success probabilities the company is using in its analysis so the government could apply a full allowance for investments made at a successful project stage, enhanced for failure risk. This information requirement is infeasible. It would also require the tax rate to be set individually for each project because better projects generate more resource rent and would require higher tax rates.

A resource rent tax with allowance for quasi-rent based on past capital expenditures, as done in Norway, is also impractical. With the firm’s estimate of a 90% probability of failure at the first stage and the subsequent project failure probabilities, the US$630 million in total investment for a successful project would need to be “uplifted” to a US$4.6 billion depreciation allowance over a successful project’s 15-year operating life.<sup>37</sup> The appropriate amount of uplift can only be known if all the firm’s expectations are known. A cash flow tax, where the government provides cash flows to the firm each time it conducted a negative exploration campaign as well as when exploration was successful, would be manageable as it is entirely an ex-post exercise. However, it exposes the government to large tax outflows to subsidize project failures, which is untenable financially and politically. The approach that governments in general take is to tax a portion of profits, or revenues, be they windfall profits or not, with the hope of taxing only

> 35 This is the cash flow tax rate that, in expectations, drives the project resource rent to zero. It was determined using Excel’s Solver add-in.

> 36 The 26% rate assumes straight-line depreciation in the calculation of profit.

> 37 Resource rent taxes require uplift of negative cash flows at some rate of return, with investment success probabilities factored in. This last point is ignored in academic discussions of resource rent taxes.

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