metadata: authors: 0: author: Boadway, Robin
1: author: Flatters, Frank
docna: 0: docna: The taxation of natural resources :
            principles and policy issues
docty: Policy Research Working Paper
subtopic: Tax Administration,Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Social Policy,Legal Products,Tax Law,Judicial System Reform,Common Property Resource Development,Public Sector Economics,Coastal and Marine Resources,Legal Reform,Legislation,Regulatory Regimes,Energy and Natural Resources,Public Finance Decentralization and
            Poverty Reduction,Global Environment
teratopic: Finance and Financial Sector Development
abstracts: cdata!: Natural resources are typically subject
            both to taxation under the income tax system and to special
            resource taxes.  Properly designed income taxes attempt to
            include capital income on a uniform basis.  But in most
            countries the income tax treats resource industries more
            favorably than most other industries - through favorable
            treatment of such capital expenses as depletion, exploration
            and development, and the cost of acquiring resource
            properties.  The case for special resource taxes is
            precisely to tax resource rents over and above the levies
            implicit in general income taxes.  There are two
            justifications for this:  (a) the efficiency-based argument
            that a tax on resource rents is nondistorting and
            complementary; and (b) the equity argument that the property
            rights to resources ought to accrue to the public at large
            rather than to private citizens since the rents represent
            the bounty nature has bestowed on the economy rather than a
            reward for economic effort.  If the main purpose of a
            resource tax is to capture rents for the public sector, the
            base of resource taxes should be economic rents (or their
            present value equivalent), contend the authors.  Actual
            resource taxes differ from rent taxes in significant ways.
            Unlike a general income tax - which allows the resource
            industries to understate capital income - resource taxes
            often overstate rents.  This is because they typically do
            not offer full deductions for all costs, especially capital
            costs. Some systems tax revenues without allowing any
            deductions for costs; others allow the deduction of current
            costs only.  As a result, they discourage investment
            activity in resource industries, encourage the exploitation
            of high-grade relative to low-grade resources, and make it
            difficult to impose high tax rates for fear of making the
            marginal tax rate higher than 100 percent.  The authors
            discuss three alternative ideal ways for the government to
            divert a share of rents to the public sector:  levy a tax on
            rents, ideally in the form of a cash flow tax; require firms
            to bid for the rights to exploit resources; and take a share
            of equity in the firm.  They discuss these options in terms
            of their implications for the ability of firms to obtain
            finance, the allocation of risk, the share of rents accruing
            to the public sector, the extent of involvement of foreign
            firms, and other factors. The time has come in many
            countries, they say, when gains from further refinement of
            imperfect existing taxes on resources are less than
            replacing them with simpler, more efficient forms of pure
            rent taxes.
repnme: repnme: The taxation of natural resources :
            principles and policy issues
display_title: The taxation of natural resources :
            principles and policy issues
listing_relative_url: /research/1993/10/698803/taxation-natural-resources-principles-policy-issues
topicv3: Natural Resources m1326446 1979,Personal Property Rights m1326571 1907,Tax Expenditures m1326898 1122,Environment, Natural Resources and Blue
            Economy m1327391 566,Taxation m1327615 1121
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Development Economics and Chief Economist
no_of_pages: 72
model_extractions: <!-- Start of picture text --> P*Vvy Re |a<br>Polloy T11<br>[<br>Pubi Eooaomiom|<br>WPS 1210<br><!-- End of picture text -->

This paper- aproduct of the Public Economics Division, Policy Research Department- is part of alarger effort in the department to analyze public policy options for natural resource taxation. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Carlina Jones, room N 10-063, extcnsion 37699 (October 1993, 57 pages).

Natural iesources are typically subject both to taxation under the income tax system and to special resource taxes. Properly designed income taxes attempt to include capital income on a uniform basis. But in most countries the income tax treats resource industries more favorably than most other industries - through favorable treatment of such capital expenses as depletion, exploration and development, and the cost of acquiring resource properties.

not offer full deductions for all costs, especially capital costs. Some systems **tax** revenues without allowing any deductions for costs; others allow the deduction of current costs only. As a result, they discourage investment activity in resource industries, encourage the exploitation of highgrade relative to low-grade resources, and make it difficult to impose high tax rates for fear of making the marginal tax rate higher than 100 percent.

The case for special resource taxes is precisely to tax resource rents over and above the levies implicit in general income taxes. There are two justifications for this: (1) the efficiencybased argument that a tax on resource rents is nondistorting and complementary, and (2) the "equity" argumelA **t** hat the property rights to resources ought to accrue to the public at large rather than to private citizens since the rents represent the bounty nature has bestowed on the economy rather than a reward for economic effort.

If the main purpose of a resource tax is to capture rents for the public sector, the base of resource taxes should be economic rents (or their present value equivalent), contend Boadway and Flatters.

Actual resource taxes differ from rent taxes in significant ways. Unlike a gencral income tax - which allows the resource industries to understate capital income - resource taxes often overstate rents. This is because they typically do Boadway and Flatters discuss three altemative "ideal" ways for the governnent to divert a share of rents to the public sector:

* Levy a tax on rents, ideally in the form of a cash flow tax.

* Require firms to bid for the rights to exploit resources.

* Take a share of equity in the firm.

They discuss these options in terms of their implications for t-he ability of firms to obtain finance, the allocation of risk, the share of rents accruing to the public sector, the extent of involvement of foreign firms, and other factors.

The time has come in many countries, thev say, when gains from further refinement of imperfect existing taxes on resources are less than replacing them with simpler, more efficient forms of pure rent taxes.

The Policy Research Working Paper Series disseminates the findings of work under way in the Bank. An objective of the scrics is to get these findings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do riot necessarily represent official Bank policy.

Produced by the Policy Research Dissemination Center
# **The Taxation of Natural Resources: Principles and Policy Issues**

by Robin Boadway* and Frank Flatters*

* Of Queen's University, Kingston, Ontario. This paper is intended to serve as a training document. We are grateful to Anwar Shah for suggestions on earlier drafts of this paper.
# Table of Contents

|||||Page No.|
|---|---|---|---|---|
|L|Intr|oduct|ion.1.<br>....................|1|
|II.|The|Goa|ls of Resource Taxation ...................|.<br>6|
||1.|The|Concept of Resource Rents ..........<br>. . ..|. ..<br>.<br>6|
|||a.|Non-Renewable Resource Rents .......<br>. . .|. . .<br>.<br>6|
|||b.|Renewable Resource Rents .......<br>. . . . . .|.<br>.<br>.<br>7|
||2.|Rea|sons for Taxing Resource Industries .. .........|.<br>. 10|
|||a.|Rent Collection.<br>..................|10|
|||b.|Capital Income Taxation .1.0.........<br>.|......<br>lO|
|||c.|Industrial Policy ....................|.<br>11|
|||d.|Risk Pooling and Financing ................|. I|
|||e.|The Taxation of Foreigners ................|. 11|
|||f.|Exercise Monopoly Powers in World<br>Markets ....................|12|
|||g.|Conservation of Resources<br>................|. 12|
|III.|Prin|ciplo|s of Taxing Resource Rents . . . . .<br>. . . . . . .|. . . . . 13|
||1.|Som|e General Issues||
|||a.|Ex Ante versus Ex Post Rent Taxation .13||
|||b.|Problems o0 Measuring Rents .14||

**-I-**
|||c.|Monitoring and Implementation Problems ..... . .<br>. 15|
|---|---|---|---|
|||d.|<br>Relation with Other Taxes .........<br>. . . .. . . .<br>. 16|
|||e.|Absence of Loss Offsetting and<br>Uncertainty .................<br>....<br>...<br>. 16|
|||f.|Treatment of Foreign Income ........<br>. . . . . . .<br>. 17|
||2.|So|me Equivalent Ways of Measuring Rents ......<br>. . .<br>. 18|
|||a.|Economic Rents .............<br>.. .. ...<br>.. .<br>. 18|
|||b.|Cas', Flow ...................<br>...<br>....<br>. 22|
|||c.|Cash-Flow Equivalent ...................<br>. 24|
||3.|Ren|t-Maximizing Decision Rules ......<br>........<br>. . .<br>. 25|
|||a.|Non-renewable Resources ........<br>. . . . . . .. .<br>. 26|
|||b.|Renewable Resources<br>.........<br>.. . . .. . . ..<br>. 26|
|||C.|Inventories ..................<br>....<br>....<br>. 27|
||4.|Me|chanisms for Taxation of Resource Rents .<br>....... .<br>. 27|
|||a.|Auctions ............................<br>28|
|||b.|Cash Flow and Equivalent Cash Flow|
||||<br>Taxation ..........................<br>31|
|||c.|Royalties ............................<br>33|
|||d.|Production Sharing and Public Sector|
||||<br>Equity Participation ..................<br>. 34|
|IV.|The|Cost|s of Imperfect Rent Taxes..............<br>.. ..<br>. 36|
||1.|Intr|oduction .....<br>. ........................<br>. 36|
||2.|Dec|isions Affected by Rent Taxes ........<br>. . . . . . .<br>. 37|
||3.|Roy|alty Structures .......................<br>..<br>. 37|
||4.|Exp|ort Taxes ............................<br>. 39|
||5.|Con|cessions and Leasing Arrangements ...<br>. . . . . . .<br>. 40|
||6.|Me|asuring the Distorting Effect of Taxes ......<br>. . . . .<br>. 41|
|V.|Poli|cy Im|plications ............................<br>. 42|
||1.|Intr|oduction . . .<br>. . . . . . . . . . . . . . . . . . . . . . . . . . 42|
||2.|Poli|cies for Capturing Resource Rents .. .<br>.........<br>.<br>. 44|
|||a.|Cash Flow or Cash Flow Equivalent<br>Taxes.<br>.<br>....<br>..<br>....<br>44|
||b.<br>Auctioning of Leases or Property|
|---|---|
||Rights.<br>.<br>_545_|
||c.<br>Public Sector Equity Pariticpation .45|
|3.|How Actual Policies Differ from True<br>Rent Collection Devices .46|
||a.<br>Tax Measures .46|
||b.<br>Auction Systems_.50_|
||c.<br>Producticn Sharing .................<br>.<br>_50_|
||d.<br>Equity Participation .51|
||Other Design Issues .............<br>.<br>52|
|4.|Conclusion**.**. ....<br>. .......<br>......<br>. .....<br>...<br>53|
|Ap|pendix: Measuring Marginal Effective Tax Rates<br>in Resource Industries..<br>..............<br>_5_|

- iii -
# THE TAXATION OF NATURAL RESOURCES: PRINCIPLES AND POLICY ISSUES

## by

## **Robin Boadway and Frank Flatters Queen's University, Kingston, Canada**

## EXECUTIVE SUMMARY

Resouirce taxes are part of the overall svstern of taxes which impinge upon **the** incomes of businesses. The system usually includes direct income taxes of a general nature, indirect taxes of various sorts including sales and excise taxes as well as export and import duties, and taxes specifically designed for resource industries.

Income taxes are intended to tax capital and personal income of residents and, where possible, of non-residents earning income in the country of taxation. If designed ]properly, income taxes tax all capita] incorrme on a uniforin basis, including both the normal return to capital and _any_ rents. In most countries, however, the capital income tax system treats resource industries quite favourably relative to other industries. This occurs mainly because of the favourable treatment afforded various capital expenses. stch as exploration and development, the cost of acquiring resource properties and depletioni. The consequence is that equity income in the resource industries is often un(lertaxed relative to other industries.

The case for special resource taxes is precisely to tax resource rents over and above the levies that are implicit in general income taxes. There are two justifications for this. One is the efficierncy-based argunment that resource rents are non-distorting. The other one, which is complementary, is that the property rights to resources ought to accrue to the public at large rather than to private citizens, since they represent the bounties nature has bestowed on the economy rather than a reward for economic effort of sorme sort. This can be viewed as a sort of equity argument.

Given that the mnain purpose of resource taxation is to capture rents, the appropriate form of taxation is one whose base is econormic rents. Actual resource taxes seem to differ from rent taxes in sigiifican'r ways. Unlike with the general income I whch includes provisions which allow the resource induistries to understate capital inc-me. resource taxes often overstate rents. This is because they frequently -lo not offpr full deductions for all costs. particularly capital costs. Some systems tax revennu s .x _r_ ut givir.g any deductioin for costs: others allow c irrent costs to
be deducted. As a consequence, they discourage investment activity in the reoiirce industries, encourage the exploitation of high gra(les of resources at the expense of low grades, and make it difficuilt to imp)ose higlh tax rates for fear of iriaking the marginal tax rate gree _r than 100%.

There are three alternative 'ideal' ways for the government to divert a share of rents to the public sector. The first is to levy a tax oIn rents. The ideal sort of rent tax is a tax on the real cash flows of resource firins. For noni-renewable resource firrns, the base woul(i include all revenues on a cash b)asis less all current anr( capital costs including (osts of acquiring resource proplerties, exploration expenses, development expenses **an(l any** processing expenses inicurred by the rtsource firm. For renewable resource firms, similar costs woul(d be deducted including costs of property rights, harvesting cos's, any rei.ewal costs such as replanting or restocking, as well as any processing costs done by the firm. There shotuld be **Ino)** deductions for other taxes paid. Of course, cash flow accounting should be done from a social point of view so any external costs should be inc'uded as costs on a cash basis. It may also be necessary to require the firrm to cover the external cost associated with shutting down, though that may be doiuc by forcing firms to post bon(ls an(l/or through other formns of regulation. Both corporations and unincorporated **firms** should be subject to the tax.

The principal difficulty with a full-fle(dged cash flow tax is that it generaily iml)lies that tax liabilities will be negative for new and/or growing firms. Fully refundable tax credits are called for in these circumstances. Governments are reluctant to nmake such ipaym1ents, and( firiis are unilikely to believe government commrlitments to inake therml. However, this problem can be solved by using a modified cash-flow tax base in whicL the firm can capitalize cost deductions in a straightforward way. In particular, aniy costs can be capitalized, aIl(l those that are receive a full nonmiinal initerest deduction based o0! the ful'l book value of the capitalized cost.

The second way for thc government to share in the rents is to require i>rms to bidl for the riglhts to exploit resources. **In** the case of non-renewable resources, this woul(l occur prior to the exl)loration stage. r'or renewable resources, the, bid would be for a knowii stock of resources. As long as the bidding system were competitive and all bidders were equally well informcd. thc value of the bid would be equal to expected future net rents (net of futuire expected taxes) corrected for a risk factor. For **such** a system to work, the prop)erty rights obtained must be perpetual. Otherwise, there woul(d be anl incentive for the operator to extract the resource inefficiently.

Even with a well-functioning auction. the crtnsequences can (liffer fromn that under a rent tax. For one thinig. the auction will yield 1000/%c of the expected value of the rents to the bidder. whereas the tax rate irlav be less thani that. Under anl
auction, the cash flow cons quences are much different as well. Net rents rnust be entirely paid ul) front, whereas with taxes they are spread out into the future. If there are any capital rnarket constraints, this will be reflected in the size of the bid. Also, the risk effects can be diffr'rent. Under the auction systerm, the firm is forced to bear the risk associated with resource exploitation, whereas with the cash flow tax the public sector shares the risk. **_One_** important reason why the public sector may b- better at d-aling with, risk is that soIme of thi. risk facing the operator is the risk of higher taxes in the .'a ure. The time iniconisistenicy which gives rise to this will le more severe tinder any system. Thlus while this risk makes it rxioi e appropriate to **use** an auctiori systo;,:n, it also reduces the l)rice that bi(lders will be willing to pay for a **long** termil lease.

Firnally, the public sector may obtain a share of the rents by taking on a share of equity in the firm. One way is for the governmerlt to contribute to a share of 'he costs and claim an equivalent share of the equity. This would be financial equivalent to a cash flow tax, though perhaps rnore difficult to implement. The public sector would have to idenitify both the cash costs and the revenules accruiing on the relevant operat' -n of the firm. On the other hand, unlike with a cash flow tax, this gives the pubiic sector a sav in the decision-making responsibilities that come with share ownership. As we'll, it inay be privy to information that it otherwise would not obtain. With cash flow taxation, by contrast, tile gi)vernmenit is only a silent partner.

The above rmethod requires the governmeint to provide cash **up)** front. This could he avoidle(d if, instead of 1)eiIig p)rovj(ied with money up fronit, the firm could deduct its share of the -osts later on against dividenlds. As long as the costs were appropriately deducted with interest, the scheme would l)e financially equivalent to the cash-iiow equivalent schemes outlined earlier. As with taxation but in contrast to auctions, equity participation schemes will divert less thani 100%o of the rents to the public sector.

Revenue-raising policies actually **used** will generally differ froIm those outlined above. This irmplies that they are not pure rent c,)Jlecting devices, ani(i hence distort resource allocation decisions as well. InI the case of taxes. it has b)een the exception rather than the rule that rent taxes have **been** tiUsed **in** the resoIIrce inIdustries. Indeed, there are very few examples of cash flow type taxes. We consi(ler the most commonly used taxes.

Perhaps the most common form of resource charge has been a levy based on the9 quantity extracteJ, variously referred to as a royalty or severance tax **in** nonrenewable resources antd a sturmpage fee in forestry. It is difficult to uniderstand thc attraction of this type of charge apart from simplicity. Somietimes these levies have been viewed less as a form of tax than as a fee chlarged l)y the public scctor
for remiiovinig resources from public or Crown lanids. However, from an economnic poinlt of view, theiy are e(luivalent to a prodluction tax. In their simple formti, they tax revenues with no accounting for costs. As such, they act as a disince.itivc for investment and extraction of resources an(l coincidentally generate less revenue for the public sector than could( be obtaine(d by a rent tax. Furthermore, since no account is taken of costs, they discriminate against high-cost reveutle sources at the expense of low-cost olnes. This effect of crudle royalty systemiis is generally known as high-grading of thc resource.

The effect .,f produlction taxes can differ according to whether the tax rate is based on (quantity produce(l (per uniit tax) or upon the selling price (ad _vatoremn)._ In principle, an _ad valorern_ rate can always be chosen such that it is equivalenit to a given per unlit rate. When prices are changing, _ad valo7irn_ aIi(l per unit production taxes will lhave different effects. Sirnce _ad valocmrn_ taxes rise withl increasing prices (and vice versa), this implies that an _ad valorern_ tax has sonic risk-sharing effect that the per unit does not have, and( in peziods of rising resource taxes, it discourages investmrent more. Similar effects occur when the citiality of a resource varies within a given deposit.

Increasingly, royalty schemes have been designed to be more sophisticated than simple production taxes. Some royalty bases have been dlefined to be revenues net of some measure of current costs. This goes part way towards making royalties reflect rents. Another method is to make the royalty rate itself a sliding scale !)ased on either resource prices (an _excess_ **_pTicef_** _tax)_ or on the quality of the resource. These are sormetimes referred to as _windfall taxes,_ reflecting the fact that purpose has been seen as a way of creaiming off resource rents generated by price increases. Again, this is an imperfect way of taxing resource renks ir ggeneral, although it can succeed in obtaining chan)ges in rents from e-isting resource firnms who have benefited from an uinexpecte(d increase in price. However, this is done at thf; expense of discouraging incrermnental investments.

Resource properties are usually also subject to general income 'taxes. However, in some instances, taxes specific to the resource industries are also based onl somre measur'] of income. In stuch cases, the tax is often designed in similar ways to the general income tax and has built into it soirie of the same biases. That is, it affords rapid write-offs for acquisition costs, exploration and development, and often gives a depletion allowance. Although this generates some revenues, it also provides a subsidy to marginal projects. That is, average tax rates are p)'sitive while marginal tax rates are negative. Furthermore. the rate of return to equity at which they usually becomc effective has tended to be extremely high, so that they have not been very effective collectors of excess profits or rents.

Sorne tax regimes impose an annual rental fee or charge for the use of resource
properties. If their ratos were such as to refle :t the true capital **valuc** of the properties being used(, they ,oulld be like a rent tax. However, they are typically set at arbitrary and more or les. aiorninal rates. It would be difficult to administer sulch a tax based on the true economic valve of the resource property in question since rnarket values do not exist. Thus, sorne administrative discredion WOi.iY be required. If all anniual rent tax is to be charge'1 it **seerns** preferabl1c to **use** a proper rent tax.

**In** primary prolduct exportinig countries, cxport taxes have been aL imiajor source of government **revenue.** if the country is a pr -e taker on international mnarkets, anl export tax has exactly the **same** effcct as a production tax frorm the point of view of the prodtucers. From this viewpoint, therefore, export taxes share the same difficulties as prodtuctiorn taxes in collecting rents for the governnment. However, consumers pay a lower price under the export tax. Although tl.(re miay be some distributive reasons for prcferring an export tax, iriost (:ountries. have foun(d tllat export taxes on resnurce products (e.g. rubber in Malaysia) have been regressive. Taxes on exports to irduce local downstream processing industries can also be a very costly way of dis;' pating resource rents. Evril in cases where the resource-e.-porting country rnight have a long terni comparative a(lvanitage in furtner processing, the use of export taxes to speed up the process car? be very costly.

Expert taxes inay be justified if the coutnrtry has sonie monopoly power in world rmarkets by the usual optimai tariff argurnents. If so, that woulld be a separate justification for export taxes over anid above rent collectioni devices.

Auction systemls tend not to be used much, especially nTl developing countries. **One** reason might be that the con(litions do not lernd themselves to cornpetitive bidding procedures. Many resource pro ccts are large and may not involve mnore than one different investor at the same tiine, For whatever reasons, iiudividual deals are struck with resource prodlucers involving different types of pul)lic p rticipationi. These cani take various formi, Under the siniplest fornm of production sharinig is that iii which the government takes a given share of the Prodtuct. It is analogous to sharecropping in agr:cul.ure, and is identical to an _ad_ valc-em production tax at the same rate. It differs from a tax on pure rent since no **.** sts are deducted. Since it is _ad valorem,_ some risksharing is implicit in the scheme.

Since produiction sharing schemices are subject to negotiation, the proportion of sharing could vary from project to project. In this way some account can be taken of different potential rents. However. as long as costs are not explicitly deducted, such schemes will not reflect pure rents.
SonXe schemnes accountt for costs partially by havinig the production sharing cut in only afte.: some minimium guarantee level of revenues. As well as allowing the firm to cover some part of initial costs before sharirng its outpt.t, this provi(les an ad(ditional **mneasure** of risk-sharinig. However, even if the minrirrmumri were set **such** that total costs were covered, **dhere** would still be a marginal disincentive involve(d once the production sharirng begins to apl)ly.

Gover:1e11neits Illay also n1egotiat2 to adopt equity l)ositionls in resource firrins. At one extreme, the government **cdtuldl** simpl)ly l)tlrchase si -es of a resource firm oIn the **open** market. **Since the** market value of the firmn shotul(d capitalize all expected future net renits o2 the firln, however, thlis wouild not be expected to yield anly net revenues to the government. **To** facilitate rent transfer to the governeniit, the governmiiienit Imust succeed ili obtaiining shareholdinlg privileges at below the rvntrket value of the shares.

At the other extreme, the governlnenlt imxay simply take "free equity" in the firm, theieby entitling itself to a share of future dividend(s of the firm. 'I'his will differ fronm a rent tax regimc ly thie fact that no implicit deduction is given for the initial equity put in by the firm. This nmay approxiniiate the initial capital costs incurred by the firm. It would then be similar to a royalty system with current costs (leducted.

Instead of taking free equity, the government may pay sonle price for it. To obtainl some -),are of the rents, the price woul(d lhave to be less thani the market price of the shares taken. Equity sharirlg schermies of this forimi will be equivalent to rent taxes if the payment inade l)y the governrrlenit is equal in present value to an equivalent shlare of the cash costs of the project. If this payment is made up front, it woul(l have the identical financial effect as a cash flow tax. The onliy real difference is that the government obtains voting rights. If the payment is spread out into the futuire ke.g., taken out of futu.re dividends), it should be carried forward withi interest. In either casc., the governnrlt will obtain only a share of the refits ratiaer tllaIl the entire amouniit. system.

There are a number of other design issues involved in resource taxation which may cause them to differ from ideal rent taxes. Arrangements with the private sector for sliarinlg rents are sometimes specified oiily for a limited period of time. This may bet because of conlscious design, or it may be because of the inevitable inability of governrilernts to commit to fixed policies for long periods of time. In any case, the result is an inefficiency which is hard to avoid.

Many non-renewable resource operations face costs of shut-down such as clean- **iij)** costs to avoid environmental danmage. Sirnply requiring firms to meet such costs may be unenforceable since they may be able to avoid thern by just abandoning
the site. Clean up could be eniorced by requiring the firm to post bonds against the cost of cleanup, or, equivalently, by irnposing a withhol(ling tax **in** respect of resource management which is refundable once the clean, up is completed.

Sornc sorts of policies rnay **iiivolve** administrative discretion. Economtists genlerally view these sorts of policies with some suspicion and prefer those for which **he** terms of eligibility are au`omatic. Discretionary policies often **lend** themselves to costly rent-seeking behaviour.

In **inany** countries jurisdiction over resources is decentralized at least partly to lower levels of government. This can give rise to prol)lermls of tax coordination among various levels of governmrent as well as to different fiscal capacities among lower levels of government. As the literature on fiscal federalisrm makes clear, the latter can cause inequities across the federation and inefficiency in the allocation of mobile factors of production in favour of the wealthier states. Many countries have instituted mechanisms to enable at least some share of resource rent to be shared among states.

Many of the firms that operate in less developed countries are foreign firms. This gives rise to various other issues. For one, certain tax measures may be preferred to others to the extent that foreign tax crediting is facilitated. Use of the income tax system rather than free equity or production sharing arrangements nlay have that property. As well, the ability of foreign conmpanies to shift profits through transfer pricing and other means will limit the extent to which some types of taxes on resource rents will be effdctive. This may help to account for the growing use of other mneasures **such** a.: royalties, equity participation and leasing of property rights.

Developing country governments have become increasingly conscious of the desirability of levying taxes on econoImic rents arising froni natural resources occurring within their boundaries. At the same time they have shown increasing sophistication in modifying the crude fiscal instrurnents that have been traditionally used for this purpose in order to both decrease the efliciency costs arising from the use of imperfect rent taxes **and** increase the proportionl of the rents that they are able to attachi for public purposes. The time has now been reached in many countries at which the gains from further refinement of what are basically very crude taxes such as royalties and export levies might be far exceeded by replacing them with rriuch simp)ler forms of pure rent taxes.
# THE TAXATION OF NATURAL RESOURCES: PRINCIPLES AND POLICY ISSUES

## by

## **Robin Boadway and Frank Flatters**

## **Queen's University, Kingston, Canada**

## **I.** INTRODUCTION

The raising of revenues from the economric activity associated with the exploitation of natural resources is virtually a universal phenomenon among the nations of the world. This can take several different forms. It may consist of taxes specific to the resources in question. It may involves special mreasures applicable selectively to the resource industries within more general systems of taxation (such as the corporation income tax). Or, it may consist of varying degrees of public owners.iip of resource property rights ranging from ownership of the resource being exploited which are sold or leased to private sector resoarce firms, to joint public-private ventures, to outright public ownership and operation of the resource firnms themselves. Our purpose in this study is to concentrate on the use of taxation measures by the public sector to extract revenues fromn resources industries, especially taxes specific to the resource sector. However, we will not be able to do so in isolation frorn these other measures, some of which represent relatively close substittutes for taxation. In this introductory section we set the stage for the subsequent analysis by outlined some general features of resource industries and resource taxation found across countries.

It is useful to begin with some discussion of the types of resources themselves. Natural resources consist of the various materials endowed uipon a nation by nature which are u.seful in the production of goods and services. It is cornmon to classify natural resources as being of two broa(d types, though the distinctiorl is sometimes ambiguous. They are the following: _Renewable Resources._ Renewable resources are those that can generate a continuous flow of output for an indefinite period of timrie. They include such things as fisheries, forests, hydro-electricity, water supplies, clean air and agricultural land. In each case, as some of the resource is taken for econormic use, the resource can replenish itself by natural or artificial means A characteristic feature of renewable resources is that the level of flow of resource that can be sustained is an endogenous variable. It can depend upon the stock of the resource that is maintained, upon natural rates of renewal of the resources (e.g.. biological rates of growth) and upon coinservation and husbandry practices of those exploiting the resources (e.g., replantirng of forests.

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regulations on the size of fish taken, fertilization practices, use of reservoirs, etc.). In some cases, it is also true that the dynamrlics of resource renewal are such that extinction of the stock can occur in the case of overexploitation. The tax treatmient of renewable resources necessarily involves consideration of the dynamics of the resource renewal process. In some cases, the exploitation may involve a continuouls flow of output (e.g., fisheries, hydro-electricity); in others, it may involve a scries of cycles of extraction and replenishment, as when clear-cuitting is use(d in forests.

_Non-Renewable_ Resources. Non-renewable resources are those such that, in **prin-** ciple, there is a fixed amount available for use. Two types **r;i** industries account for the most important non-renewable resources hydro-carboni fuels (oil and gas) and mining. The latter, in tutrn, can be subdivided into nmetallic and non-mretallic mining, and these can be subdivided according to type of resource. Thus, base and precious metals are often distinguished within the metal rmining sector, and so on. The two broad categories, oil and gas and rnining, share some features in common, but they also differ in some important ways. Both are non-renewable in the sense that there is ultimately a fixed stock of the resouirce (ignoring the fact that hydro-carbons regenerate themselves over very long periods of time). The stock is, however, typically both of unknown size and of variable quality. Because it is of unknown size, new deposits must continually be discovered and there is an exploration industry which is devoted to that. The tax treatment of exploration activities will be of some importance for our later discussion. The variability of quality can come about because of (different concentrations of the resource in a given deposit or of differing costs of extraction. Differences in quality are also important for tax policy since they res-It in different costs to the econiomy of obtaining the resource. A related characteristic of ioin-renewable resources is that they are typically found **in** impure formn. that is, mrixed with other elements. This implies that fuirther processing is an important part of obtaining the resource. This, too, will have tax implications. One way in which oil and gas differs from mining is that many of its products can be used only once. Thus, natural gas and engine gasoline are burned off when used. On the other hand, the products of mining can often be re-used. This mneans that there **can** be an active recycling industry. In that sense. they approach being renewable resources.

We can summarize the above by listing the possible stages of production for non-renewable resources:

- exploration (development extraction .processing

- recycling

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Processing itself may consist of several steps including cor.nentrating, mrilling, etc. At any stage beyond extraction, there rnay also be the holding of inventory, which involves decision-rnaking.

Governments inmpose a variety of types of taxes and other levies on their resources industries. Taxes of a general broad-based sort, such as the corporate tax and general sales taxes, also apply to the resource industries. However, they often have special provisions applying to the latter. For exainple, corporate tax systerns often allow rapid write-offs for resource activities such as exploration and developrrient as well as special depletion allowances on non-renewable resources. There may also be investment incentives such as preferential tax rates, tax holidays and investment tax credits. Higher sales tax rates may be levied on the consumption of oil and gas products. These broad-based taxes tend to be levied on a _residence_ basis, that is, on the tax base of taxpayers resident in the country levying the tax.

Taxes specific to the resource industries are most often applied on a _source_ basis, that is, on the tax base in the country where the base is generated. The simplest of these is a specific output or production tax levied on either the output or the revenues of a resource industry. In the mining industry, this is sometimes referred to as a _severance_ tax. When the property rights to the resource are owned by the state, it may be referred to as a _royalty._ In the case of forestry, it is sometimes called a _stumpage fee._ The rate may be stated in _per unit_ terms or in _ad valorem_ terms. It may be a flat rate, or it may be graduated according to price, size or quality of deposit, etc. Production taxes may allow sonic costs to be deducted from them. In the simplest case, currenit or operating costs may be deducted. More generally, the tax can be a _profit tax_ in which both capital costs and current costs are deductible. The tax treatment of capital costs is an important characteristic of resource taxes since resource industries tend to be relatively capital-intensive. Capital costs may include depreciation of installed capital, intercst costs and depletion allowances. There may also be incentives for certain types of activities such exploration, developmnent and further processing. A variation on profits taxation is the so-called _rate-of-return_ tax %hich is a tax levied **oII** rates of return in excess of a cut-off rate.

Another very important variant of profits taxation is the so-called _cash flow tax._ The base for this tax is the real cash flows of the firm defined to be total cash (as opposed to accrued) revenues from the sale of output less total cash outlays on both current and capital inputs as they occur. The full and immediate write-off of all investment expenses implies that there is no need for costing capital on an accrual basis using depreciation and cost of capital deductions. Nor is there any need for indexing. Under this form of a cash flow tax, only real as opposed to financial transactions have tax implications. It is what the Meade Report (1978) referred to as an R-based cash flow tax. It would also be possible to treat financial _3_
purchases and sales on a cash flow basis, and there may be some merit from doing so in industries in which significant profits are generated from finanicial transactions, sulch as in financial interrnediation. However, in discuissirng the cash flow tax in the context of the resource industries, our focius will be on the real side of the firm. There are very few instances of a pure cash flow tax, though some counitries use partial variants of it. One important reason is the fact that, under a cash flow tax, firms undertaking expansionary investments will typically b)e in a loss p)osition with negative tax lial)ilities. Symmetric treatment woul(l require that the governiiment mnake good these negative taxes, b)ut this is rarely done. That is, _f7ill loss offsetting_ is not the rule.

This problem of the tax treatment of losses is a more general onie that applies to any sort of tax allowing deductioins for costs. It will l)e of some importance in our discussion of resource tax policy. Typically, tax systemns allow _partial lo.9s offsetting_ of the following type. Firms in a loss positioIl are allowed to carry the losses backward for a given number of years and forward for a given number of years without interest. If special investinent incentives are in place, the ability to offset losses may be affected. For example, if countries offer a tax holiday in whicli zero taxes are payable, firms may be preclude(d from carrying forwar(d losses into years in which the tax rate is positive. Naturally, the problem of loss offsetting is only relevant under tax systems in which deductions for costs are allowed from the base. Prodllction or output tax bases could not be negative.

In ixiany cou.ntries, resource products are trade(d on international markets. This gives rise to tra(le taxes as a forrmi of revenue raising. In the case of an exporting couIntry, anl export talx caii be use(. Its effects will differ from a source-l)ased production tax since (loiiiestic consumnption of the resource is excluded from taxation. Siiilarly, resource-importing couintries imay employ tariffs on resourcc iriiports. Equivalent ineasures such as quotas and( licenses can )e uised iri lieu of trade taxes, although their reventues mnay accruel to the p)rivate rather than the publ)lic se(2( t or.

There are various noni-tax mneaslures thait could be undertake n by the governinent to divert revenues froml the resource inrduistries to the p)ublic sector. Thefse typically involvc the direct exercise of prop)erty rights by the public sector. One C(omMo form tllis takes is the sale of leases frorn the pubulic sector to the private sector for the exploitation of a partic2xlar resource. This is **conurnron** in the oil an(l gas industry. in forestry. in the fishery **ai(i** in nilling industries. The sale often takes the form of an auction in which **competing** bids are tendered. **The** auction itself rnay take variotus **foriis. including both** sealed **aid(i open bidding.** Dep)en(ling on the resource. **the** lease mnay involve the righlt to explore (as in oil and gas) or **the** riglit to extract a **kiowii** source of resource (as in forests an(n fislidig groun(ls). **The** termns of leases imay vary as well. An important elemjent of a lease rixay **b)( thhe** 4
time period over which it applies. The length of the lease or concession may affect the speed with which a nonrenewable resource is extracted as well as the way in which a renewable resourct, is nlariage(l. OInly a lease of indefinite d(trationl would be equivalent to full private ownersllii) of the resource l)roperty. Note that there may be an interaction between the leasing systerm and( the sub)sequent taxation if the p)rofits fromii the resource. The purchase of a lease is an acquisition cost whichl is typically treated as a cost deductible froIm the tax l)ase. AnI alternative would be for the lease to be creditable against tax liabilities. The relationship l)etwec leases aLnd p)rofits taxes will be discussed further below. A related rueasixre that can be use(i is licensing. Frmns canl be reqluire(l to l)ay a license fee to exp)loit resource properties. Depending on lhow licenses are allotted andl how their p)rices are set, they can have very sirnilar effects to leases.

Direct public sector participation in resource production is another way of obtaining a share of revenues from resources. This cari take the form of joint ventures in which the public sector puts ui) a certain share of the capital to full public ownership. This bears somne analogy with cash flow taxation. As we discuss later, cash flow taxatioln has the effect of mraking the governimenlt a _silent partner_ inI the ownership and profits of the firm. Public share ownership makes the government an active I)artner. As long as the governmlent is not in a positioII to exercise control of the firm, the results should be sirnilar, with one major exception. For firrmis in a loss position, public share purchases will be like cash flow taxation with fuill loss offsetting. It will therefol dliffer in effect froii cash flow taxation with only partial loss offsetting.

The public sector mlay also engage in regulatory activities which affect the behaviouir of resource firins without generating any revenues for the pub)lic sector. Various aspects of the resouirce firm's b)ehaviour inay be regulated, fromIi exploration to dlevelopment through to extraction. In addition to havinig the disadvantage of Iiot generating revenUes for the publ)hlic sector, regulation is also a discretionary forrn of intervention which c'aII indluce inter-firmi ohistortioIs oin the economly.

Before leving this introductory se(tioin, there are three further instituitiornal features of the resource ind(uistries which are worth highlighting. Trhe first is that there is often a significant presence of foreign-owned firms in the resou.rce sector. espe cially in developing countries. The tax treatment of such firmns hoth by the host coulntry and by its home government is an important determinant of the incentive to invest in the former. Typically, a foreign firm is liable for taxation both at home and in the host country. However. there mlay **he** rTieasuires in place to reduce the possibility of double taxation. Corporate tax systems typically offer partial tax credits oIn simnilar taxes paid abroad. Thus. the United States taxes the profits of foreign subsi(liaries of its domestic firms when profit arc repatriated and offers a tax credit **ii1)** to the amoulnt of home country tax liabilities. Sinilar practic(es 5
are applied elsewhere. Resource taxes may not be creditable against horne country taxes, in which case they may serve to discourage investmenit in the host country. This rnay be important in designing the tax system to apply to resources.

A second institutional feature of resource taxatioII is that, in federal economies, jurisdiction over resources may be divided between two levels of governmenit. For exarmple, general taxes such as corporate taxes **rmiay** be levied by the central level of government, while special resource taxes inay be applied at a lower level of government. This cormplicates the tax systerm considerably.

Fiiially, resource exploitatiorl may givc rise to environmental costs of various sorts. These costs mnay be external to the resource firmi itself. If so, special rmeasures may have to be taken to ensure that the external costs imposed on the environment are taken into consideration by the firm in its decision-irlaking.

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# **II. THE GOALS OF RESOURCE TAXATION**

As meDtioned, go iernments typically tax resource industries over and above other industries, often with special taxes applying on resources alone. In this Section, we consider the reasons for this practice. The mnost important objective of resource taxation is to obtain some share of the rents for the public sector. We begin with1 a discussion of the concept of resource rents and then turn to a the reasons for taxing resources, one of which is to obtain a share of the rents for the public sector.

# 1. **The Concept of Resource Rents**

One of the key characteristics of natrural resources is the fact that they generate _economric rents._ The rent of a stoc.. c; resource is simply its ultirnate economic value, or the _economic profit_ from its exploitation. More specifically, the flow of rent from a given amount of resource is the difference between the real accrued revenues it generates and all real accrued costs of obtaining those revenues. It is useful to distinguish non-renewable from renewable resource rents.

# a. _Non-Renewable Resource Rents_

For a non-renewable resource such as a mine, the accrued revenues result frorn the final sale of the mineral to a user. The accrued costs include all the current and capital costs associated with exploring for the mineral, developing the mine site, extracting the ore, and1 processing it to obtain the mineral in usable form.

Revenues and current costs are conceptually quite easy to account for on an accrual basis. Revenues include the sale value of the resource when the transaction occurs independent of when cash actually changes hand. Accrued revenues will differ from cash receipts by accounts receivable. The saimne applies for current inputs. Their accrued costs differ frorn cash costs by accounts payable. The valuation of accrued revenues and costs should be at their value at the time of transaction rather than actual cash receipts or disbursements. These will differ typically by implicit interest costs. This makes exact mreasuiernent difficult.

Capital costs are even more difficult to impute since all capital expenditures must be appropriately capitalized. Thus. the cost of using depreciable assets includes three components -- true depreciation of the asset, the real financial costs of holding the asset whether the financing be by debt or retained earnings or new equity, and any real capital losses resulting from changes in the replacement cost of holding the asset. All of these are difficult, if not impossible, to measure since they require one to know the true rate of depreciation of the asset. For a depletable asset, similar components should be included as costs, but in this case depreciation 7
is replaced l)y (lepletion of the asset through exploitation. Note that the acquisitioii eost of the dep)letal)le asset here includes the purllchase p)ri(e of any lease or proI)prty rights as well as exploration an(I d(eVelop)ment expenises. These iritist be ca)italized apl))rop)riately as al)ove. Any lhol(iing of inventories of goods in p)rocess or firlal pro(luct Illust also be accounteild for oni an accrual l)asis. The cost of ulsilig inv;mtories iticlidles the replac mient cost (f the inventory when used plus the real cost of llol(lilig the inventorie'S inichi(linig hothi fLiaticial andol storage costs. Notice that if current inl)uts are used to p-oduce inventories, they sliotilol( iiOt b)e treated as a cost Uniitil the inventory is use(l to produce rv(enues.

Finally, mininig activities involve sonie risk and(i the fuill costs of risk-takinig sh0otil(d be taken inlto accouit. There are various sorts of risk inivolve(l. **In** the exploration stage. there is the risk associated witl riot knowinig wlhat size of deposit will be found, There is a risk associated with future changes in the price of inputts (capital andI labour) required to exploit the mine. And, there is the risk associated with ulncertairnty al)out the final price of thie miniierail whCII it is eventually sold. The measurement of the cost of risk-taking is riot simple since it depernds upon the extent to which risks can _b)e_ pooled oni cal)ital niarkets. Thlls, if capital markets were perfect, the onily risk that need be a concern is the norl-diversifiable risk associited with the iminling activity. In l)rincil)le. this component of risk Tlay be observable as the _beta Cc(fjticjciat_ in eImp)irical cap)ital asset pricinig mo(dls.

# b. _Renieable II so Rc ni.ts_

Simiiilar p)rinciles)1 ap)p)ly to a relewal)l( resource. thlioigl the emlp)hasis will differ soiriewlat. Agailn. tlIe ec( onoTuciC ren1t from a re newable resource like a forest or a fishlinlg; gro lll(l will he the flow of accrtui d revenues less thle flow of all accrued costs on a real b)asis. Accounting foI revennes receive(l and( for current inpuits used to lprodle revenues is sirmiilar to the case of non-renewable resources. Capital costs are somewhat different in nature. Any depreciable assets iISe(l in exploiting the renewab)le resource arc treate(d as above. HOW(eV(e,v. the asset associated with the reniewal)le resource itself is quite different fromn a stock of ncn-renewable resource. UIilike witli the formier. there will typically be 110 exploration costs associated with discovering it. And(. since it is renewable. it regernerates itself over tiunie.

Cdnside r a fishlinig grolii(i as an example. The evolution of the stock of fish throuigh time depen(ds jointly u1pon the biological growthi rate of the stock (which itself typically deperpds ll)pon the stock) and( the rat* at which fish are taken froimi the fishlinig gi-mind. There is usually iio reso mrce costi involved with this b)iological process (although fishi farimis may use restocking techniques). The opportunity cost of taking a(l(ditional fish **froni** the fislinlg ground at a point in time is the present valuhe of the foregolne flow of fislh that rlo.el] tS **ili** thle fitlire. This is obviously a 8
difficult thinrg to account for. It **p)resumIes,** for example, a particular patternl of behaviotur into the fature, ideally optimal behaviour. A simiilar accouniting (lifficulty arises with a forest, except here there is the additional corliplication that costs of reforestation imiust b)e taken into account. As witlh the fishinig grounid, thelr is a natural growth rate Of trees, so _the_ stock of trees depends jointly upon the **frequency** of cutting and(i the growth pattern of the s)pecies of trees. **Tl1us** the op)portuini ty cost of additional cutting **can** 1)e treatd(l as the cost of rle)lantiIig pluis the prcselnt value of the change **in** the value of trees harvested into the future. Again, this is a difficult thinig to **ineasure.** Finally, the property **used** fol renewable resolurce exl)loitation **Iliay** have an alte'rnative use ill which case thlat slio01(i l)(e )aprt of the opportunity cost of obtaining the resource. For **exaniple, iii** the case, of a forest, tlhei land miay have a site value **independent** of its use for p)lantinlg trees. The cap)italized value of the land(i ought to b)e part of the ongoing cost of op)erating the forest.

The aniount of renit that a given resource will generate depends upon the behaviour of the agent responsible for exploiting the resource. The agent's behaviour. in turn, depends **uponi** the instituitiornal setting, including the way in which p)roperty rights are defined, the efficiency of capital inarkets, amid the tax or regulatory systemi inI place. The lbasic p)resuml)tioIl is that p)rivate sector operators will inaximnize the present value of after-tax economnic profits (rents) over the appl)hicable timne horizor. If private ownership is absolute, the time horizoni will be the indefinite future. We will refer to the valuc of rents generated by p)rivate optimizing b)ehlavioulr _as priiatc rent.s._ They may (liffer froml _social_ rents. which are the rents attainab)le fromi the resource from s(ci ety's point of view. Private renits xxiay differ fromii social renits for a variety of reasons. If taxes apply **oni** the firimi. they are p)art of the social return, biUt not of the private returil. If the activities of the firmii generates external costs. **such** as degradation of the envirotiment. these will forimi p)art of social costs lbut nlot private costs. If the tinme lhorizoni of the private sector is limited by inistittutionial coIIstrainlt, thet ieitasureiment of rents fromii a )rivate point of view will differ fromli that for society. Furthermliorc, potential social rents imay well dliffer substantially fromII actual social rents generated iiy thle exploitationI of a resource. All of the above distortionis can giv ris to a pattern of explloitation which is sub-optimal fromn a social point of view. **One** of' ouir pnurposes later onl in t his sti (ly is to coIIsider witli more precision ihow various taxes im-pinge upon thc lbhaviour of resource, mianagers.

Naturally. the **amounit** of rent thlat **can be** genrated fromii a itreiewale or **nonI-** renewable resource **depends** upon tlic features of the resource iii (ulestion. Mines with higher (Iiality ores will generate higher rents. Resources wvlichi are found in isolate(d locations will l)e costlier to exploit and(I will generate lower rc ts. _RB_ emits will also vary withi tHie stock of a resource. F' r any giv(lle r(isMUree. we call I liiik of therel b)eing a spectrum of low remit to higih rent sto cks raig,i ng frorti negative to positivC. Onily those resource stocks witli miomi- negatiVe rI'llts will lt WI rthi eXp)loiting. Thousc resou.rce stocks for whuichi ren ts are zero will 1h reifcrr( d **to ajS**<sup>_M'(17(1777(11_</sup> _Z_ **H._Al)**<sup>17</sup> 9
_stocks._ Those with positive rents will be called _inframarginal._ The location of the marginal resource stock along the spectrum will also depend upon the *,istittutional setting. For example, if the tax system impinges upon the marginal resource, it will Inake the after-tax rent negative and another resource deposit will becorme the marginal one. Much of our later analysis will consider precisely the issue of how the tax system affects the marginal resource stock.

We have noted a several points that the measurement of rents is a difficult thing, both conceptually and practically. This is because all accounting is on an accrual basis and in real termris, and many of the costs that rnust be impute(d are not observable and therefore hard to measure. This would seem to inake the concept of rents virtually impossible to use for any policy purposes and, as we shall see, that would be very unfortunate. The concept of rents as defined above is an economically attractive one since it measure the flow of the contributior. the resource mnakes to real economic output at aily point in tirne as an economist would see it. However, there is an alternative measure which gives the same present value of economic rents but a different time pattern. That is the _cash flow._ It consists simply of the difference between all cash receipts from the sale of output less cash expenditures for both current and capital inputs. Because capital costs are not capitalized, costs occur much earlier in time than under an accrual accounting system. Thus, the pattern of cash flows is typically lower earlier on and'higher later thanl for econormic profits. However, in present value terms, cash flow is the same as economic profits. It also has the advantage of being much easier to measure than economic profits since all items are, in principle, observable. There is no need to measure imputed costs, nor is there any need to index. The concept of cash flow will play an important part in our analysis of tax policy options and we discuss it in rnore detail below.

One final irmportant property of the concept of econornic rent should be mentioned before turning to tax issues. Since rent reflects the present value of the economic profits that a resource is expected to generate into the future, the value of the resource stock **in** question should be) precisely the present value of its future rents. That is, future rents are said to be _capitalized_ into the value of the resource. Because this is so, any tax changes that affect the value of rents in the future will be inmmediately capitalized into the current value of the resource. In that sense, current resource owners bear future expected resource taxes.

# **2. Reasons for Taxing Resource Industries**

Given the different types of resource taxes use(d in practice, it is not surprising that there rmay be differing motives for taxing them. We present here a non-exhaustive list of somne of the reasons for taxing resources in general and for the specific types of taxes somnetimies used.

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# _a. Rent Collection_

The rnain justification for taxing resource firms is to obtain a share of the rents for the public sector. Fromn a tax policy point of view, the taxation of rents is an ideal source of revenue since a rent tax is non-distorting (i.e., efficient) if desigrned properly. By definition, rents are the net value of the resource aIi(l do nct represent the returni to any variable factor of production. Since the objvctive of a firrn will be to maximize the present value of rents, a proportionlal tax on rents will not affect the choices of the firm. Maxirriizinrg pre-tax rents will call for _the_ samle behaviour as maximizing a given proportion of pre-tax rents.

The equity properties of taxing rents are not as clearcut. For one thing, **the** ownership of rents are riot necessarily correlated with a characteristic of taxpayers deemed worthy of special taxation on equity grounds. Furtlhermiiore, as mentioned above, taxes on rents can get capitalized into current values and thus effectively be incident on current owners. This is questionable on equity grounds.

# b. _Capital Income Taxation_

It may be desirable to tax resource industries as part of the general taxation of capital income iri an economy. In this case, capital income can be thought of as including both the normal return to capital plus rents. The task of taxing capital incoxne falls jointly upon the corporate income tax and personal income taxation. In these systems, capital income on debt tends to be taxed primarily at the personal level. The corporate tax is usually levied on equity capital income, which includes rent. Special measures rnight be applied to resource industries as a way of ensuring that rents are included properly in the base.

# **_z._** _Industrial Policy_

The design of the tax system as it applies to resources may be chosen so as to achieve certain objectives of industrial policy suich as the encouragement of further processing of resources or the maintenance of sorme inimuirim level of activity for skrategic reasons. This is more often a reason for encouraginig the activity through subsidization than the taxing of it to obtain revenues.

# d. _Risk Pooling and Financing_

As mentioned earlier, taxation of resources can be analogous to the public sector becorning a silent partner in the firm. The deductibility of costs combirned with the taxation of revenues is like the acquisition of new equity for the firm. This can be advantageous for the firrm in a couple of ways if capital markets are imperfect. For one, if the governiment is better able to pool risks than the firm, the taxation of resource profits can encourage risk-taking and be socially beneficial. Also, the 11
taxation system can serve to improve cash flows in perio(ls of expansion thereby assistirng firrIs which have liquiidity prob)lemns because of diffihcuties in ob.'aiing otitsi(le finance. The effectiveriess of the tax systein for these purposes depends upon the firmii being able to t, ke full tax advantage of deductible costs. In the absence of fulll loss offsetting, that will not be the case.

_(!. Thc Iaxation of Forciqner.s_ If foreigners own resources in the country, the ability to extract tax revenutes froil the.ln will provide ani a(d(litional incentive for taxationi. Thlere are two sorts of circumstances in which taxes iiiay be obtained from11 foreigners. _The first_ is when the tax applies onl rents, ill which case the inotivatioii is exactly as in a. above. The seconrd is to exploit foreign tax crediting arrangements. If foreign governmients offer tax credits on investments imade abroad, it is in the interest of host countries to tax the firmn up) to the limit of the credit. This can significantly affect time desigfl of the tax systenm and the level of taxation. In the absence of crediting arrangemients, any attempt to tax capital incomlie of foreigners will not succeed if the coulltry is a price-taker in internatioinal capital markets. The tax will simply be shifted ba(ck to non-ca)ital factors in the host couintry.

# f. _Ezercizse Monopoly Powr•sr in World Marketsz_

SomIe countries miay be imiportaInt enuigh sup)liers of a resource on worl(d mrarkets that they are able to influence its price. One way of exxploiting this p)ower is to use tax policy. In this case, the a)p)ropriate tax woil(d p)resurnably be an export tax. Alternatively, p)ublic participation iiay serve to monopolize the sale of the resource (lirectly.

g. _Concsrvation of Re.so'irces_ Finally, tax policy ilay be used as a way of inducing firmls to tax account of external factors in their resource management d(ecisions. Production taxes rnay )e use(d to redluce the rate of exploitation of resources for social reasons. The latter may include environmental costs which dep)end uporn thc rate of extraction or equity concerns for futuire generations.

As mentioned, of all these reasons for taxinig resources, that of capturing a _share_ of rents for the public sector is by far the (lolnianrt one. The next seCCtio0n is devoted to issues arising from the attempt by the public sector to tax the rents accruling oIn natulral resources.

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# III. PRINCIPLES **OF** TAXING RESOtJRCE RENTS

There is a large literature in p)alblic finance concerned with the dlesign of a ta: on pule profits or rents. Indeed, nmuch of the theoretical literature oll the corporate t az has address('dl precisely that issue. Most of the analysis has coicerned ecollornic profits in genreral without specific reference to the rcsource industries, tlhat is, witlhotit spec. ying the source of rents. A firmn is siniply assiliiied to have a decreasing returns to scale (i.e., strictly concave) pro(du(ctiorn furnction involviing a current input an(l a dep)£(!ciahlv capital inlp)ult. Part of the puiirpose of this section is to apply **the** results of this tiLalysis explicitiy to the resource industries where the rents arise because of a given aniiouniit of natural resource, reInewal)le or otherwise. Altlhoulgh the general princi)les of taxing rents remrain intact whatever the source of the rents, sorme special issues apply in the case of resources whiclh affect the design of revenueraising inecthanismis. It is useful to begin witli a discussion of sorne general issues that arise in the taxatioi- of resource rents blefore turninig to specific miiechailisrms.

# **1. Some General Issues**

As wc will see below, the p)Ii1cipies of designinlg a proper rerit tax in the ideal world often used by econornists are fairly straightforwar(d and can take a variety of alternative forms. However, in attecript.,ig to apply thlis **ini** practice to the resource indlustries, several concep)tual probleilms caan arise. It is useful to begin with a list of sornie of these conceptual prol)lenlis as a preludie to considerirng the various iriecharisrris.

## a. _Ex Ante tvcr7%sv_s Ez Po,ost Rent Taxatiorn_

A stock of resouirces will yield a flow of rents over timre. In the case of renewable resources. this flow can go on indefinitely, while for non-renewable resources the flows call only Sumlll ulp to the given stock. Rent tax ition can be designed so as to (divert a shale of the rents to the public sector frorn the private sector after they accrue. This is referred to as **_r.z_** post rent taxation. O(n the rother hand, as will be seen later, some rent tax rnechanismns ta'.e a share of the rents before the rents actually accrue. This is _ex ante_ rernt taxatioI. In principle. _ex po.st_ and _ex ante_ rent taxation can bel designe(i to yield equivalent revenues in present value terms, and part of the literature is devoted to ensuring that the base of the rent tax is equivalent in preseit value termns to the flow of accrued rents thermselves. Economnists have tended to view these taxes as having the saime efficiency p)roperties as actual rent taxes and have advocated their use. Sorme of themn are attractive precisely because tl.ey are easier to iinpleincint thani accrued rent taxes. The flip side of this is that whatever the rent tax collected, only its p)resent value counts anyway since future 13
# taxes should be capitalized into the value of the resource property.

However, the very fact that the public sector can apparenitly choose the timie patterni of rent tax revenues gives rise to a couple of funtdarmiental problerns which are related to one another. The first is that governments can chalnge tax rates at will over time as circumstances change. Thlls, there will be sortme uncertainty about future tax liabilities on this account aloine, III a sense, this woul(l argue **in** favour of a tax base in which tax liabilities are incurred as **u)** front as possible. Theiri the consequence of possible tax cihanges later on will be less sirnce the base will be lower then.

Related to this is the fact that there is a fundamental _time inconsistency_ problem inherent in the taxation of natural resources. Once a resource property is acquired either through outright purchase of the rights to a known stock or by incurring exploration and development expenditures, governments have an incerntive to tax the stock fully. If they could cornmit to a predetermined tax policy, they might choose a policy which induces the optimal amouat of exploration, developnient and renewal. However, such commitmnent is not possible. Since private operators know that such comrmiitment is impossible, they will adjust their behaviour in anticipation of future government tax policies. The result is inefficient behaviour. This seerns to be an unavoidable problem.

It is one that also applies to foreign investors. If host goveriinents could comrmit themnselves to future policies, b)oth taxation and expropriation, they could choose their policies to attract the mrost efficient level of foreign investment. However, once the foreigin investment is in place, it becormes a fixed factor which is a good target for taxation. Foreigr. investors will anticip)ate this and act accordingly. The result will be a sub-optimial level of investment.

# b. _Problems of Measuring Rents_

We have already ma(le sorne reference to the fact that rents are virtually impossible to measulre as they accrue. To do so requires being able to measure accrued real capital costs accuratcly. including real depreciation, real costs of financing, real capital losses, replacement cost of inventories, thie cost of risk-bearing, etc. Special problemns arise **in** the resource induistries, both renewable and non-renewable. In the case of renewable resources, there mnay be costs associated with using the resource property for resource extraction as opposed to sorle other use (e.g., recreation. farminlg) and( this must be accounted for. The cost associated with current extraction itself is a particularly difficult concept. In principle, the opportunity cost of increaseld current extraction. is postponed futuire extraction. Given that the dynamics of extraction is itself liable to be rather complicated. this opportunity 14
eost is difficlllt to liwaslirc. Siiiiil.arly, replenishln(ent or renewal costs are difficult to mneasure oll an accrutals basis since they sholuld be irnputed to the period at which the resource is eventually extracted.

Similar problems arise with non-renewable resources. The costs of extraction are somewhat simpler to account for since they are simply the value of the resource currently extracted, it being no longer available for use. However, exploration anl( developmient costs should be capitalized as should any resource acquisition costs. This gives rise to problems not unlike the measurement of capital depreciation costs.

# c. _Monitoring and Implementation Problems_

All tax systems are subject to enforcement problems, especially those administered on a self-assessment basis. Resource taxes would not be immunune to this; in fact, such problems may be more severe in the resource industries if additional taxes are to be imposed. Problems can arise both through outright evasion or through avoidance. Evasion is an illegal activity which involves deliberately under-reporting tax liabilities. Given the fact that firms cannot be perfectly monitored, it is impossible to eliminate evasion entirely. Its incidence can be reduced by increasing resources devoted to auditing and by increasing the penalty for being detected. Of course, if administrative corruption is present, evasion becomes more difficult to control.

Avoidance refers to the reduction of tax liabilities by undertaking measures to divert revenues and costs among activities. Unlike with evasion, under-reporting is not involved. However, the rncans of reporting certain items rnay be affected. There are various ways of doing this. One is by the use of _transfer pricing._ Transfer pricing is a phenornenon that occurs primarily in vertically-integrated firms in which sales from one to another are not done at arm's length. Profits are diverted from highto low-taxed firms or activities by changing the price that is charged inl intra-firlll transactions. Thus, if a resource firm is also involved in downstream processing, it may be able to avoid part of any special resource tax imposed upon it by arranging to sell its resource outpuit to the processing firm at artificially reduced prices thereby taking more of its profit in the upstream firm. As well as shifting profits through transfer pricing, financial transacbions can also be used. For example, if interest is deductible, firms can arrange to do their borrowing through the firm with the highest tax rate thereby reducing their overall tax burden. Again, resource firms may be particularly susceptible to these practices since they may face extra taxation. Finally, firms can rearrange their overhead and adnministrative costs by changes in marketing, head offices, research and development, and so on.

A final technique for avoiding taxes is to make masquerade profits as costs. This is a particular problem with cash flow types of taxes. Closely-held firms can 15
**arrange** to take **sO)lne** of the ir profits as salary paynients thereby imiaking their cash flows **appear** smaller **andi** redlucing taxes based **oII** cash flows. Thiis **can be aln** issuie ill the desigin of taxes based oni **cash** flows.

# _cd. Re/labton 'cn',Ih Oth,cr Iaxe.(11_

Rcso(rce t aXes will typically be part of a 11(ore general businless tax System which ilc hli(leS (cor)(o)ration illnco m)eI t(axationi as Well **as perso(nal** taxatic)n. Tlhe isslue then arises as to whet her I ()1i typ( of tax liab)ility Shocu)lld be (de(dlulte(I against the tax _l)ase_ or credlitedl against the tax liablilitics of allot her. **In** tlihe case of corp)orate all(l personal taxes, there is a strong argunicent in favouir of integrating the two systemls by giving somIe sort of credlit at the plersoInal 1(V(e l for taxes ha Lvinlg **been** paid by corlporations. This is usually (donle by **Ineatis** of a dividend tatx cre(lit administered at the ipersonial level. This reflects the fiact that the corporate tax is intenoded essenItially as a withholding (evice against (loecstic tax lial)ilities for personal taxation. However, resource talxatioi is intended to be anl additional source of tax **burden** over an(i al)ove income taxation. Tlhuis. crediting it. or eV(n allowing a (leleduction for it against corl)orate taxes is not (lesird(l. Ildeed, the opposite is the case. It can be argueld that corporate taxes shlold( be (id(hicte(l algainst the resource tax base. If so. the rent tax woil(l impose n1o further (listortionis over and al)ove those already ilm)pose(l by thle corporatc tax. Failing to allow a dedc Iction woiilol imply that the resource tax further l cc oli)polllds thlce (distorItion of thle corporate tax. **Ill** fact, ani efli(cilet Syste e woulld allow a fllll tax cred it of thll( corporate tax against the resource tax. This wolull 1iiI(do th<sup>1</sup> cc (listortil- igffe(c(t of tle( formler. Hfowever it woulld also 1111(1d tl(' effect th(e (c )rp)() ate tax has ont taxinig, ca)ital income thereby defeatinig its p)11r)po)Sc'. FIirt hleriic ne. it clla - un(d0 t1heo ai1vantm,it 'S of obt aining a foreign tax credit ill thlie case of fireigtil fims.

**(3⁄4** _Ab~o.' ufLo,', Oflf14 tt/?lj oind UPC'_ 7tUiflt1

I(osttt tax tllstc lls (ourcc tax(eS inclh ded . do Ilot offer fuill loss offset tiig. At best Hey offer p)artial loss offlsettilng lby all(winog fiirllls in a loss position to carry forward Or backward l sses fmi a liinited 1i umber of years. Firmiis can be iii a loss position for a **iliumbcr** of reaso ns. They iiiay be yo( nf,. growing firiiis wlo **are** involve(l hieavily **in** illvestlleilt 1)11 whose rVCtIIlies are exl)ecte d( to accruc *ciiy ill thle fii tir(. Tllhey may be firins wlic o t( 111p1 prarily ill a ]o9 css 0)SitiO( l)e sc of depr ss5(l otpulit priees. 01r the' Illay bI duclinilg firilis. Tle albse 1cc of filll loss cff(sc tting is particularly harmllfull lor l first two type)s of fii iiis. 'Tlhese call **Ibc** firms whichi are stretchied fOrc finallc in 01' WhlIm I I arn ll liilcertaill (ci Vir'clirilits. s Imperfcct loSS offsetting c(an ('XaWcralat(c I(tlh problctI's.

1GC
**Resource firmis** are tylpically relatively **11or0** likely to **experience** p)erio(ds of loss. Since tley **are** hlighly (ap)ital-inteIiSivc, they are typically ill **a** loss position whell **yotiung and** growinig. As well, their fortuics **arc** likely to bc ili 1!1(>1'(' tilctaitin **since** resource prices are kinowin to fluctuiate niorc tHan t **han for** other Pr(oducts.

# _f._ **_Treubtcii(7lt_** _of Forcigv nc o ct_

A fin.al relevanlt general colisideratioxi is thc fart that the resource buiisiniess is typically an international **one.** That, is, **resou rce** fixiiis ofte'l opcratc ill iiloii t hal **mlc** counltry. This cati have stvveral imiplicationis for their tax tre atinent. _For_ **one** tlinllg. initernational op)erations **open up** opportunirties for avoidance of thi soirt discussed earlier. This Iweaiis that if onc coiiintry's tax rates are oit of line wit li those ill othl- **ers,** it **milay** he difficult to imioniitor and enforce tatx collections. Also. international tax coniventions will have at bearing oni the tax treatment of resource firixis Capital importinig countries will need to take accoinIt of the homie, country tax treatimenlt of foreign firmris. For example, if home countries credit taxes p)ai(l abroad. Which is often thie casel for bhusiness taxes, it is in the interest of thc lhost country to take advantage of the credlit by mimicking the home country's tax system.. If such credlits are not available, or if a (leductioll system is uised. atte(mpts to tax capital income of foreign firims will be frustrate(l. Becaise of the miobility of capital. the tax will enrd III) b)eing shifted 1)ack to other factors ol pro)(hIct ioll in thl hIost<sup>(olliltry.</sup> OnI the othier han(l, if the tax is onl the renlt _componeint of_ eqIlit y i Iico(%II. it II('I lnot Ie shifted. Indeed, it will nlot be except by the IIS(e of avoidance techii(jues. ryp)ically resource tax systems will niot be elig;il;Ic for forcig,n tax crediting So will CoTSti tllte ani additional t ax l)birden on foreign (corp)orationls. Tlis will provide some incentive for tax avoidancc Ileasures.

Resourcle taxes. uilike income taxcs are gneraLIIy le vied ulsinlg, ti[C lo tirCf ITrillciple rather than oi a worldwide orI residency basis. Each c( iit iy trealts as its **0** property rights sonim share of the t he res( 'urce renlts acCrlillpg wit lill their l oudl I( - aries. This is p)rob)ably a necessary featurc o _r( 'so()Irc_ t.ax r **('iI!Jmes** rather thialil l)eilig an abstractt principle of the (clivisil **of** _oi_ intc(rlmat iolial property IVi,it.s. It would lie very difficult to imionitor rents earned abroad by (loinestic firimis.

Given this backgroun(l of general issuies. let **uis 1ioW** nIIrn to a c onsideratioll of sonme of the **means** by which resource rentIS can I)( taxed. Inl prillciplc. the rcis ('trce tax l)ase coUl(d be defined as economic p)rofits or lc( its of r S( il(r firiIls Itil a **It tax** applied to tlhat. However, as icileitioiled airlier. such ri tlX 1),Is(' W()I i(l 1Ic vir tlially irnm)ossil)le to iplj)lem(cnt. It wouil(l involve imipuijltiIc()rsts to the firIII wilih are n(ot (directly observable **including** ( cprc( iiati;on. depiltinI (of no ni-Io'lle'wal(i rSe)1s(m('i . the cost of :uirmrenit uises if rnewabc r sourlc rl)le _(s_ . risk. and t lie r 'al c0 ist of fiil ui,1(C. Thits. frorim a practical poinit of **view** it is Ilot f(easile) to **tax** le'llts s t.sl'v' a1'(rlc.

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Fortunately, there are other ways of devising a tax base which are equivalent in present value terms. We begin with an outline of alternative equivalent measures of economic rents.

# 2. **Some Equivalent Ways of Measuring Rents**

It is useful to begin by recalling precisely what is included in the definition of economic rents in principle before turning to alternative equivalent measures.

# a. _Economic Rents_

Current rents are defined to be the value of current outpuit sold by the firm in the current period less the full opportunity cost incurred by the firm during the period to produce those outputs. The costs can be sub-divided into two categories - the costs of current inputs and the costs of capital inputs. Current inputs are those which are used in the period in which they are purchased. Capital inputs are those which produce services over several periods. Their contribution to each period must be appropriately capitalized. All costs must be measured in terms of a common numeraire, typically either currenlt dollars or constant dollars, The fact that prices are changing over time gives rise to two complications. One concerns the price of capital goods and the other concerns the discouiit factor to use. These will be discussed below.

_Current Inputs._ Current inputs are typically taken to include such things as wages and salaries, rmaterials, fuels, rents, and so forth. The classification of inputs as current is not withouit arribiguity. Some inputs which may appear as current may actually have a capital component to them. One exainple concerns labour costs. In mnany cases, labour once hired can be viewed as a _quasi-fixed factor._ Typically, there is a period of training involved early in the tenure of the worker. To the extent that the firm bears the cost of that training (e.g., if the training yields skills which are specific to the firrm), part of the wage payment reflects not a payment for the production of current input, but for the production of future input. In this case, part of the wage represents a capital cost and should be capitalized. Also, the wvage pa+ftern rnay Ilot follow the productivity pattern of the worker over the ernployrnent tenure of the worker. For example, the firm may use the wage profile to increase attachment to the firmn essentially by postponing wage payments. Alternatively, the firm may act as a sort of financial intermediary to the worker by providing more funds in the form og higher wages earlier in the work life.. Finally, labor of the firm might also be uied to produce and/or install tangible capital for the firm, such as buildings, machinery and inventory. That part of the wage bill ought to be treated as a capital input, though it is difficult to distinguish the amount of the 18
wage bill that goes for these purposes. For all these reasons, wage paymenits irnay not properly reflect current output. A true measure of profits would require wages to be appropriately adjusted. Of course, that would be very difficuilt to do, and to that extent rents will be incorrectly rneasure(l.

For closely-held businesses in which owners are also mnanagers, another (lifficulty arises. The reward that the owner-manager receives for operatiIng the **blusiness** will be partly a return to capital and partly a return to labour. In practice, the two will be difficult to distinguish. This will be irmportant if capital income anld lab)our incomes are treated differently for tax purposes.

Another example concerns the acquisition of intangible capital by the firnm including goodwill and knowledge. Often this is a result of particular types (f expenditures such as advertising and marketing. These costs should, in principle, also be capitalized, but are typically treated as if they were currenit costs. Again, to capitalize the costs of using intangible capital would be extrermely difficult, if not impossible. This will be another source of inaccuracy in the measurerrment of rents.

These sorts of examples can occur in the resource industries as well. In nonrenewable resources, exploraticn expenditures help to create information about the location and size of deposits. This is a form of intangible capital which ought, in principle, to be treated as suclh.

_Capital Inputs._ Even more difficult coilceptual issues arise in the treatmeilt of capital inputs. They yield productive oultput over more than the period in which they arc acquired. The problem is to attribllte to a period the full cost of using the capital. In principle there are three sorts of costs associated with the use of capital for a period:

- i. Depreciation. We will use the term depreciation in a genIeral sense to inclul(dc all forms of UsiIng **tip** capital including wear and tear of machinery and buildings, depletion of a stock of non-renewable resource, the use of an item from inventory, and the use of the existing stock of renewable resource. Sonic of these are more readily measured than others. For non-reniewable resources and inventories, the current usage should simply be costed at the full value of the amount taken. These may be readily measurable using rriarket values. In the case of depreciable capital, the reduction in the value of the capital **dlue** to depreciation through use should be treated as depreciation. Since full markets for depreciating capital typically (1o not exist. this is virtually impossible to measure precisely. For renewable resources. as we have mentioned earlier, the opportunity cost of taking sonme resourcc now is the change in the amount that may be taken in the future. This requires that the optimal path of fu-

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ture extraction be known. In all cases, depreciation should b)C costed at its replacemnernt value.

- ii. Fi nancin Costs. Holding a stock of cap)ital of any kind( for a perio(i of tirne involves fiinanicinig costs, either payments such as interest that muist **be** made to creditors, or compensation for the use of one's own capitai. The latter is the cost of equity capital and is the rate of return that is just re(lllire(l to cornpensaLe the owner for ulsinlg his funi(is in this firin instead of placing theml elsewhere. Thus, it is an opportunity cost which partly takes the form of a forgone return. The cost of equity finarncinig for a give(I firil will consist of two **components** the market rate of return that could have beei earned elsewhere plus the risk premliumxi associated with this firm. The latter is (lifficult to measure. The financing cost shoul(d be based on the full replacernent value of capital of all forms held by the firm. This includes the **net** value of accounts payable (i.e., accounts payable less accounts receivable). Furthermnore, the cost of finance should be the real cost rather than the norninal cost. For example, the nominal interest rate will include a component which compensates creditors for the fall in the value of their asset due to inflation. As such, it represents a chaiige in the principal rather than an interest cost. The nominal interest should be reduced by the rate of inflation, unless, of course, the asset is indexed for inflation.

- iii. Capital LossL.C. Finally. if the relative price of a capital good falls over the period, that shouild also be treated as a cost of holdirng the capital. Of course, this terin couild either be positive or negative. If the price of a non-renewable resource in the gr(ouln(d rises, this reduces the cost of holding it, and vice versa. In(leed, in the theory of resource extraction, expected changes in price are a hey deterIninant of the decision as to how mullch to extract.

Capital costs should include each of the three itemls as apl)rop)riate for all forms of capital whether del)reciable capital, land(. inventories, non-renewable resource stocks or renewable resouirces. There shoiil(d be no other deduictionis for these items. In particular, costs of acquiring the capital, incluiding leases and property rights to resources shouild not be deducted. To do so would involve double-colunting.

_Present_ Value and _Discounting._ The above discussionl concerns rents in the current period. Firins will typically operate for several perio(ds and will take decisions from a long-term perspective. At a givcn point of tirne, what will be re]evant is the present value of future rents rather than just current perio(d rents. This shotuld b)c what a profit-inaximizing firmn is interested in imaxirmizing. There are several **iSStles** involved in measuring the present value of future rents. One concerns the tinme horizoni its(, lf. The typical practice is to take the time horizon as being the 20
indefinite future (i.e., infinity) if there is no reason to expect the firm to terminate operations before then. Even though the current owners will no longer be owners at some time in the futulre, they still have an interest in the subsequlenit operations of the firin since that determines the value for which they (or their estate) can sell the firrn. A finite-titile horizon will be relevant if, for sonme reason, the firrn expects to cease opcrations. In the resource industry, a firmi may expect the resources it holds to run ouit. Or, it mray have acquired property rights for a fixed length of time only. Another reason for ceasing operations is the possibility of bankrupcy. In any case, in the event of ceasing operations, there must be an accouniting of the disposal (scrap) value of assets on harn(i at the tile. There may also be certain costs associated with shutting down, such as responsibility for disposing of hazar(lous waste in the case of mrines.

Another issue is the choice of a discounit factor. Assuming well-functioning capital markets, this should be the rate at which the shareholders of the firm are able to convert present into future consumption. Presumably this is some variant of the market interest rate. Note that there is no need to incorporate into the discount factor a risk component. This is already included as part of the cost of earning income in each period.

A final issue in discounting is the treatment of inflation. We have already noted that in accounting for depreciation. the replacement value tor capital ought to be used, and the same applies for all forms of capital from inventory to non-renewable resources. That correction is intended to correct for changes in the relative value of capital. There is, in addition, the issue of how to treat changes in the general price level, or inflation. There are two alternative but equivalent procedures that can be used. One is to ineasure all revenues and costs in current dollars and to discouint using a nominal interest rate. The other is to deflate all future prices to some constant dollar value, and discount themrl using a real discount rate. Note that this is quite separate frorn the use of a real interest rate for rneasuring the cost of finaince. The latter should be done **iII** any case.

We can suirirnarize succinctly the present value of future rents (econoinic profits) for a representative special case in the following expression which ignores taxes: where _1?_ is the discount rate of the firmn, _Pt_ is the price of output in period t, Yt is the quantity of output sold, Wt is the pricc of the cuirrent input _Lt, Qt_ is the price of the capital good, 6 is the depreciation rate, and Kt is the stock of capital. Note that all prices and rates of return are in nominal terms. It is assumed for illustrative purposes that the firm produces a single output using one current input 21
**ali(l 1one** current outp)llt. It is also **assurried** that depreciation is a fixed proportion of the existing stock (i.e., exponential or declining balance), ana that the nominal disconIit factor is fixe(d. **Assume** further that the inflatiorn rate is constanlt at the rate 7,r. Themi (1) **can** be rewritten in the following equivalent form:

where **_r, pt_** Wt **_and_** _(it_ are real equivalents of their associated nomiinal values and are definied as: (1 +r)(1 +-r) = (1I-+R), (1 +Ipt)(l +7r)<sup>t</sup> = (1 _+Pt), (1_ +wt)(1 4-r)(1 + Wt) anld (1 + q(t)(1 + 7r)t =- (1 t- _Qt)._ This illustrates the equivalence of Iusilng nominal prices and discountiing by **it Inioinial** (liscount rate, anid tusinlg real prices with a real discount rate.

# b. _Cash Flow_

The above description of economic rents confirms that it is very difficult to measure rents. However, there are alternatives which have the same present value as rents but which are much easier to measure. As we have mentiorned, one of these is the cash flow of the firm, which is simply the net value of all real transactions of the firm during a period. More specifically, the cash flow of the firm would include the cashi receipts from sales of outputt less the full cost of purchases of all inputs, both capital and cuirrent. Revenues and currenit costs woulid all be accounted for on a cash basis rather than an accrual basis. So would all capital costs. The cost of capital installatior wou(ld b de(lducted fully as the investment occurred. There is no need to account separately for depreciation, cost of finance and capital gains. The cost of inventory **use** woiil(l )e deducted when the inventory was acquired rather than when it is **used,** and at the actual price of acquisition. There is thus no need to irripute re,placemient costs or to worry about the cost of finanicing and capital gains. As well. the cost of acquiring resource properties incliiding exploration, development, prol)erty rights, etc. woul(d all be deducted **ui)** front as would the cost of intangibles. Thus, there woul(d be generally no need to worry about either imputing costs which did not go throulglh the market nor to ind(ex capital costs. Furthermore, there is no need to incluide the cost of risk-taking as a separate cost.

That is not to say that there would be no problems at all in measuring cash flows. There are still a couple of difficulties. One concerns owner-managed firms. These firms coul(d arbitrarily reduce the values of their cash flows by paying profits out as salaries. As well, international conmpanies could change their cash flows in various juris(lictions by me ans of transfer pricing. However, these difficulties already exist in the rent tax.

The present value of cash woul(d he obtained by simply discounting rents at 22
**the** sharcelold(rs' (liscollult ratc. (Of course, there may be some ambiguity here as well sincc differnIIt shareholders may have different discount rates, say, due to different tax rates. Again, a similar problem also arises with discountinlg rents.) The important feature of the present value of cash flow for our purposes is that it should be exactly the same as the present value of rents. This **can** be illustrated using the same example as above.

The present value of cash flow is defined as: where It is investment expenditures. To see the equivalence between (3) and (2), note first that the terms involving revenues and current costs are identical so we can concentrate on the capital costs. To make things as simple as possible to explain, suppose thiat the rate of increase in capital goods prices is constant at p = _Aqt/qt._ Then, the price of capital goods at time 9 is related to that at time t _< s_ as follows. _q8_ = (1 + p) _qt._ (4) Consider the total amount of investment undertaken at time t, **It.** Given the depreciation rate 6, it gives rise to a stream of capital at each time s in the future equal to (1 + _6)-(8)I 1_<sup>_t._Using (4), the value of this stream of capital is given by</sup> where K' is the arnount of capital at time s that resulted from investment at time t. The total capital at time _s_ is given by: Substitution of (5) into (2) and simplification yields (3). Intuitively, the present value of the future stream of accrued costs resulting from $1 of investment is just $i.

Thus, the present value of cash flow is equivalent to the present value of economic profits. Naturally, the time profile of the two will differ. It should be obvious that net cash flow is typically lower than rents in early periods and higher later on. This may cause difficulties for governments in attempting to tax cash flows, and it would be useful to seek ways of avoiding the problem. Fortunately, there exists an alternative to cash flows which has the same present value, which is almost as easy to implement and whose net value can take on any arbitrary time profile. We turn to that next.

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# _c. Cash-Flo'w Equivalent_

A very general tax base can be defined which has the sarne p)resent value as rents an(l cash flows, and( for which rents and( cash flows are special cases. First of all, define _an accounting stock of capital At_ implicitly in the followinig way: where _cyt_ is the proportion of the existing accounting stock of capital that is written off **in** period t. We will refer to **att** as the _taz depreciation rate_ at timne _t._ Note that it can vary over tine. The i(lea is that all new investment increases the accounting stock of capital, while aity tax depreciation **re(luces** it. Tlhis, the accounting stock of capital is siniply the aggregate of l)ast undepreciated investment evaluated at historic cost (i.e., there is no inflation indexing imposed). The _cash-flow equivalent_ income base is defined as: The present value of the cash-flow equivalent income base is therefore: Several observations can be made about the cash-flow equivalent tax base. First, by a technique analogotus to that used for cash flows, it can be shown that the value of £ is equivalent both to _7Z_ and to _C._ The form of the cash flow-equivalent base is sinmilar to that of the rent base except that capital costs are based oIn the accounritirng cal)ital stock. Nomninal deductions are given for the cost of finainee of RAt, anld depreciation is also based onI At. The rate of depreciation at is quite arbitrary. It can vary by size arid over time as well. The higher is the depreciation rate, the lower will be the accounting stock of cap)ital and( the lower will be the cost of finance write-off. The cash-flow equivalent base woul(l replicate rents if the depreciation rate were set equal to the _true econornic depreciation r te_ that is, if _(tt =_ o -- _AQt/Qt._ That can l)e seen directly. Of course, it is ciiffleilt to do so exactly since truie (lep)reciation cannlot be observedl. At the sairie time, the cash-flow equivalenit 1)ase ap)proaches cash flow as the depreciat:ion rate approaches infinity.

In principle, the depreciation rate can be arbitrarily chosen. It can even be chosen by the firm. However, it mlight be natuiral to constrain the choice of ot by the firm. For example. the firm inight be tempted to choose att as high as possible to postpone tax liabilities. The government mriight then constrain the firnm never to have a negative cash flow. If this constraint were imposed. the system would be exactly like a cash flow System with loss carry-forward at the interest rate P.

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As mentioned, a useful property of the cash-flow equivalent tax base is its ease of implementation relative to true rents. There is rio **need** to ol)serve true depreciation. Nor is there aniy need to inledX for inflation. The depreciation rate used is completely arbitrary. It can be at different rates for different tyl)es of capital. It is even possible to treat current inputs as capital ones for this purpose. Siniiilarly, all expenditures on resources **can be** included as forrmis of accounting cap)ital **ani(** have ai book value associated witlh tlhemIt. It is always possible to lilpl) together various types of expend(Iitures into a single composite stock of capital for accounting purposes as long as they have the **sainel** tax depreciation rate.

In short, the theoretical literature tells uts that it is relatively easy to dlevise anl **incoilme** measure which is equivalent **in** p)resent value terms to rents. With this background, let us consider the sorts of **mnechianisms** that have **been useCd** for taxing resources and compare thern against the rent **benchmnark.**

# **3. Rent-Maximizing Decision Rules**

Eiquations (2), (3) **and** (7) all yield the sarnne value. Any of therm **could )(e** viewed as being lie objective fniictiori for a profit-inaxinlizing firml inl the absence of taxes. Maximizing themn will give rise to a stream of deirmands for current and capital inptuts 'by the firm. It is worth at this point indicating the conditions that characterize the optimnal choice of current and1 cap)ital inpuits in the al)sence of taxes so we can indicate later how taxes impinige on these decisions by the firmri. To do so, we suppose that the quiarntity of outl)ut is detern-ined l)y a p)roduction fu.nction Yt _F(Lt, Kt_ ), and that the firnm is a p)rice-taker in all markets. Under these assuminptions, the rnarginial conditions dletermiining the choice of current inputs Lt and capital inipuits _Kt_ in each ( )erio(l are giveII by: These equtationis state that inlputs shoill( l)e used up) to the point at which marginal benefits equal rriargirial costs. The rrargirnal beniefit is thc value of thc marginal product given by the left-hand sidc of the two equations. The margiinal cost of usirig the current input is simply its price per uinit, Wt. For the capital input, the marginal cost is the right-han(d side of equation (9), and( is referred to as the user _co,st of cap jtal._ It consists of the three costs of hol(dinig capital: real depreciation, the cost of finance and(i the capital loss. Note that equtationis (8) and( (9) cari be rewritten inl terinis of real prices as follows:
_(9')_ The above equation for capital costs is a general one that can be applied to all sorts of capital, although it is most directly applicable to depreciable capital. It is useful to recast it to apply to other types of capital specifically used il. the resource industries. Three cases are considered - non-renewable resources, renewvable resources and inventories.

# a. _Non-Renewable Resources_

Consider the case in which a firm has a stock of non-renewable resource and has to choose the rate of extraction. Let the real price of a unit of the resource be **_pt_** and the real marginal cost of extracting a unit of the resource be **ct.** The stream of prices is given to the firm, but the marginal cost rises with the quantity extracted in each period. Then the optimality condition which determines the rate of extraction is given by the so-called _Hotelling Rule_ which states: The right-hand side gives the opportunity cost of holding the resource in the ground. The left-hand side gives the net rate of return from holding it. If the left-hand side is less than the right-hand side, the firm will want to increase its rate of extraction, causing its marginal cost to rise until the two sides come into equality, and vice versa. Of course, this is a very stvlized way of looking at the extraction decision, but it does capture the fundamental forces at work.

# b. _Renewable Resources_

As an illustration of a renewable resource, consider a stand of trees which is harvested using clear-cut techniques. Slightly different expressions will be obtained for other types of renewable resources, such as a fishing ground. However, the basic principles involved will be similar. Let _F(T)_ be the output of a forest whose trees are all of age T, and _R(F(T))_ is the net revenue from the cutting and sale of the trees. At the beginning of the planning period, suppose that a crop of trees is planted at a cost of C. Suppose the revenue function and the planting costs are unchanging over time for simplicity. The only decision that the forester must take is the age T at which to clearcut the forest and replant. This is referred to as the _rotation period._ The future operation of the forest consists of an indefinite number of cycles of planting and clearcutting each of length T. Thus, he incurs an initial cost of C, and then receives a sequence of net revenues of _R(F(T)) -_ c and _T, 2T,_ 3T, and so on. Thus, the present value of the cash flows from the operation is: 26
Choosing T to rnaximize this yields the following optinmality condition: This equation has basically the same fortzi as that for the non-renewable resource. The left-hand side is the mnarginal value froni increasing the rotation period while the right-hand side is the financial cost associated frorn the pl)stponement in harvesting. The complicating feature is the fact that increasinig the rotation period affects each and every rotation into the indefinite fututre.

# c. _Inventories_

Suppose a firm has to decide how much of some good tc hold as inventory. The good can be a final product or an intermediate one. Suppose the price of thc good at time t _is_ Pt. There rnay also be a storage cost of ct per unit of inventory held. Then, the user cost of holding a tunit of inventory consists of the cost of financinig the inventory, any capital loss frorn hol(liing it, and the storage cost. The holding of inventories presumably gives rise to some benefit to the firm. The benefit could involve cost reductions from production smoothinlg, or reductions is risk. Let **tus** simply denote the mnarginal benefits frorn holding inverntories as _MBt_ withouit specifying their source. Then the optimal stock of inventory holdings will be that at which: Note that in this expression the user cost of inventories is evaluated at replacement cost rather than the cost at which any inventory hol(lings were originally acquired.

# 4. **Mechanisms for Taxation of Resource** Rents

The theoretical concept of remit, which is the primiary basis of Imiost resource taxes. is relatively clear. But the design and implementation of mechanisms for its taxation tends to be less than straightforward. In this section we deal with general<sup>types of</sup> such mechanisms and with some of the theoretical and practical difficulties involved in their implementation.

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Mec(hlianiismiis for **rent** colleCtioni differ in niariy rcsl)ects. One of the furidamenta' listinictioi's is l)btWeci ('Z **_ante_** _and( ex po.t_ rent taxatiori. _Ex antc_ **collection** is based **oni the** sale of **the** rights to the expected rents fromil a resource or a. site, **irn the** fornii of some sort of lease or concession arrangement. _ET po.st_ collection is soIe forll of taxation tilat is based on the actual rents that are derive(d as the resource is exp)loited. One interesting question concerns the ap)prol)riate milix between ci _ante_ and( it ex p)ost taxation of resource rents. In the followinig subscCtion we deal with the princil)al fortml of _ex_ ante rent taxationi the sale of leases for the exploitation of a resource. Th1e remaining sections (leal witli various nmeanis of taxing CY, _po.4t_ resource rents.

# a. _Auct0oni,s_

One way to capture the rent fromii a resource is to auction the rights to its exp)loitation. In _competitive_ b)idding for the right to extract an(l sell a givenl resource, a government shoIuil( exl)ect to be able to collect the fuill amouniit of the (x _ante_ rent from that resource. This wouil(d include the present value of all revenues less all costs, iIIcli(linlg risk and(i a norrrlal return to all investments, fromri its extraction; in other wor(ds, what we have called _1, C_ and(l £ al)ove sllital)ly corrected for expected tax p)ayments. This assumries, of course, that the government is willing to lease the resotirce-P)ro(ducing p)roI)erty for p,erp)etuity, or at least for as long as the resource has any econonImIc value.

There is a consi(lderal)le literature on1 the properties of different types of auctions seald(l-l)i(l first-price, sealed- bi(l secoi(l-price, Dutch, EnglishI, etc. While there arc illaily imlpo)Ortanlt lessOIs froin this literature. sonmie of the mio t b)asic mnessages ar( quite simpil)le. The first stresses thci iniportanice of coniUpetition ini the I)i(Idiig; p)rocess. Witholut competition, there can 1)be 1o assurancl that the government will sIi ceceel in (cap;turing a significanit share of the rents. Conmipetition iimiglit be dhifficuilt to achieve in mlianly ase's l)ecauisc of asymmuiet ries ini i nformniatioii al)out the size. quality, or other characteristics of the resouirce in question. This makes it even more impl)ortaant that the government riot restrict p)arti ci pationi **iii** other ways.

The sec ond is that nuder a set of reasonable assuirimptions. the above-mientioned four types Of auctions all yiel(d the samne price on average. The assumptions i ncludle risk-neutral and( syinuetric bidders. the valuc of the itei being bid for dependinrg lipon the charactteristics of the bidders. aii(i paymnctit being a fumnictionl of Ibidls alone. As the miuinbl)er of l)id(ders increases, the average reve(nic of thle seller increases. As the 1111111ler of bidders b)ecomnes in definitely large _(i._ .. the compel tive case). the price takes on it,s highest v-ue,. As nientioried . ini the case of resources flhis woildi bel the I)resent, vralue of rents. ()f course, if the assuinnJ,tionis (to nlot appJ)ly, tli(e different types of aiuctions will m!et be equivalenit. It wouildl tak(e IIs too far afield to c*onsid(Ier the opttiminal types of iaic(tions for different ('irc uiirstaticcs.

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For our purposes, the important conIsideration is that given sufficient cormlpetition in the bidding process, the government shoul(d be able to capture virtually all of the ex _ante_ or expected rents from the exI)loitation of any resource deposit. A perceived advantage to many governmrents from this way of collecting the rents is that the payrnerit would be made tup front, at the beginning of the extraction process. Only if the )rivate sector and the government had(l different dliscount rates would this be of any real significance. If the government had a higher discount ratc than the resource extracting firtm (whichi iright be the case with large transnatiorial firirrs working in developing countries), then the pre-paymnent feature of **ani** auction systerm rnight be of some bellefit to the host government. If the opposite were the case, thern aniy disadvantage to the government of the pre-payiment feature (due to a lower bid price by potential developers) could be eliminated by an arrangemnenit for postponement of payments.

One particular form of postponed payment systern is an annual land rent for the use of the site on which the resource is located. Any once-anid-for- all payment for the right to exploit a resource has an annual land rental fee to which it is equal in present value. Apart from the time pattern of payrnents, there are some other differences between land rental fees and pre-payment arrangements. First, the risk to the government is greater under the former arrangement. In the event that the resource turns out to be inuch less valuable than had been anticipated at the time of the rental agreement. the lessee woul(l find it relatively easy to renege on the agreernent by simply ceasing to pay the rent. There is little the government coul(d do to prevent this. Secon(d. **under an** annuiial rental arrangernent, the lessee would have an incentive to exploit the resource rriore quickly tharl under a pre-payinent system.l given the positive marginial cost of exploiting the deposit for one additional year. This inight also lead to under-exploitation of the resource since imarginlally ecornonlical deposits might not be financially attractive to extract if this requires extra time and( henice additionial rental payments at thc end of a lease.

_Ex ante_ rents, of course, are not the same as _ex post_ rents. An auction system. as opposed to mrost other systems discussed below, captures the former. Therefore, auction systemns differ from mnost other formns of resource taxation in that they shift the bulrden of risk from resource exploitation onto the developers. To the extent that social risk is less than the private risk of the developers, this lends sorne inefficiency to auction systerns as a mneans of collecting resource rents for the pIublic sector.

A lease auction coul(d be transformed into a, partial or full el _post_ paymnent system by making the bids somelhow contingent on the value or quantity of the resource actually extracted. For instance, lease payimernts could be of the fortm _R =_ a _+ bY_ where Y is the value or volumne of resources retrieved and sold from the dleposit. The standard pure cx _ante_ auction system is one in which b is set equal to zero and competitors bid on a. Ani alternative. however. would be for a to he 29
set equal to zero and to have potential leaseholders bid on b. This would be a pure royalty systeiii in which the royalty rate is set by a competitive bidding process. A miXe(l system woulld lbc one in which the governmiernt entertained bids on both a and _b,_ or in which it set a fixed positive value of one of these paranieters and asked for bids on the other.

Autction systerms also expose private resource developers to another potentially ilmportanrt forrn of political risk arising frorn time inconsistent behavior on the part of the governmnent. Having condlucted an auction and coliected substantial if not coniplete pre-l)aymnent of the negotiatedl lease price, the government miglht be temrpted at sonic later date to alter the ternms of the original lease. Such changes might range from breaking of the lease altogether (i.e. confiscating the previously negotiated exploitation rights) to the imposition of windfall income taxes when _ex post_ rents tuirn out to be grcater than ex _ante_ rents. In a world of fluctuating resource prices the imposition of such windfall taxes based on short-term rents would turn **out** to be a one-sided bet in favour of the government. Anticipation of this sort of political risk would reduce the ability of the government to collect ex _ante_ rents. Of course, an anticipated willingness of the government to entertain short-term rent-based argumiiernts made by lease-holders in times of low resource prices would work in the opposite direction.

In order for the governmient to nmaxirnize the proportion of the rents it is able to collect from an auctionl system, it is important that all the terms of the lease be spec;fied as clearly and( irrevocably as possible at the beginning. This applies especially to the conditions under which the lease might be altered or terminated, the nature of tax ami(l other obligations expected of the developer throughout the termr of the lease, and( the xicanis throuigh which any future disputes over these rrmatters mnight be settled. Regardless of the tightness of all such arrangements, reputation cffects, based oII actual behaviour of the host and possibly of other governments will be iimlportanlt in determining their effectiverness. It is probably because of this rmoral hazar(l prol)lenmn together with the general unwillingness of governments to enter into long-terrm lease arrangemiienits with private resource developers, that auctions and other forimis of _cx ante_ rent collection agreements are seldom observed as methods of taxing economic rents in developing countries.

Resource renits can also be lost throulglh inappropriate provision in long-term leases for external effects of the exploitation activity, such as environrnental pollution. These external effects might be an ongoing byproduct of the developer's extraction activities and/or they might be long-term costs that are imposed and felt primarily after the conclusion of the project. The latter might be especially imnp)ortant in conjunction with leases whose lives do not match the economic lives of the rcsource deposits. particularly in the case of renewable resources. Mine sites niight le left in a hazardous state after the expiry of a mining operation.

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Forest reserves might be "mined" with inadequate investment in to replenishment and/or replanting. A short-run revenue-maximizing view would be to collect all the "rents" that are possible without taking these costs into account. Such an approach might be favoured by boih short-run revenue-maximizing governments and profit-maxirnizing resource operators. Perrnitting mineral operators to mine a site without any restrictions on its condition at the conclusion of the operation would permit the government to maximize the bid it would receive for the rental of that site. But after account had been taken of the costs of site clean up after the operator's departure, the net rents received by the government would almost certainly be less than those that would have been collected if the bids had been rnade with the tunderstanding (and the incentive) that the operator would be responsible for the appropriate environmental management of the site. Similarly, a lease for a forest concession might bring in much more money to the government if there were no incentives or requirements for the concessionaire to invest in the long-run management of the reserve. But, once again, this would not be equivalent to maxirmizing the rent from the resource. Governme.it revenues would have been maximized at the sacrifice of long term rents and efficient resource utilization.

# _b. Cash Flow and Equivalent Cash Flow Taxation_

In our review of the concept of resource rent and its measurement we showed how the present value of t<sup>1</sup> ie net cash flows of a resource firm is equivalent to the present value of the rents from its activities. From this it follows that a tax equal to _x%_ of a resource developer's cash flow would be equivalent to an x% rent tax and, in the absence of capital market imperfections, would not distort the efficient allocation of resources in the market. Furthermore, if the tax rate were 100%, it would be equivalent to the outcome of a competitive bidding process for resource extraction rights except for the fact that the cash flow tax would be an efficient collector of _ex post_ rents, while an auction system would do the same for _ex ante_ rents. A cash flow tax shifts all the risks over actual rent manifestations to the government, whereas a lease auction places these risks on the resource developer.

The equivalence between a 100% cash flow tax and a competi6ve lease auction depends as well on several critical details of implementation. 1he most important of these is the treatment of tax<sup>1</sup> Dsses. Most resource ventures have the characteristic that cash flows are negative in early years and positive later. In order for a cash flow tax to be equivalent to a pure rent tax, negative cash flows must be a) subject to immediate refundable tax credits, or b) permitted to be written off against current taxable income from other sources, or c) allowed to be carried forward with interest at prevailing nominal market rates. Without such provisions, the base of a cash flow tax would exceed, in present value terms, that of a pure rent tax for a loss firm. Such a tax (i.e. without these provisions for tax losses) would no longer be non-distortionary: it would discriminate against investments with relatively long 31
gestation periods and those undertakecr in periods of relativelyI high niomiiial interest rates. It woul(l also discriminate against youing, growinig firrns at the explense of older estal)lished onIes. Anld, it wouil(l discriminate against risky investments and in favoutr of safe ones. Solving this problem withl alternative 1)), i.e. write-offs of tax losses agaiiist other cutrrenit ililCOiie sources. Wol(l bias the tax system inl favor of large establishe(l firmns aln(l against new ventulres witlhoiit otlicr ill(comlte souriices.

Caslh flow taxes are relatively uncommon. Instead, ianlay governiments impose taxes on bases which are, in principle, intended to be equivalent ( againi in present value termlls) to that of at cash flow tlx. As demiionstrate(l iii the l)reviois section, a tax on current net revenues less capital cost allowances equal to the suii1 of economic depreciation, interest costs on current capital stock and cal)ital losses (dtirinig the current period wouild be equivaleint to the same tax levied on current cash flows. The dlifference l)etween this and a cash flow tax l)ase is in the treatment of capital costs. Instead of b)eing written off at the time of their expenditure, capital costs are amortized am(i deducted fromi revenues according to their current user cost. This method tends to smooth out the( time patlh of taxab)le income for the firmn and, in particular, to miiake it rmiore likely tlaw there will be current revenues against which to write off tax-deductible costs that occur ini any time period. However, to the extent that discrel)ancies still (1o arise between current revenues and( allowable costs, ap)prop)riate methlo(ds mulst still be fouirnd for carrying forwar(d or backwar(l costs which are in excess of taxal)le revenues in anry time perio(d.

The principal problem that arises with cash flow equivalent taxes is in devisinig rules for defining the user cost of c;apital. This is especially so in the case of resource taxation. Trhere are not only the standard difficulties of defilliilg appropriate economic depreciation rates an(l rules for d(lelucti bility of interest expenses. but also those of deterrining the appropriate treatment of exploration expenses. "depletion" allowances and expenses i ncuirred **iII** the, maintenance and(l management of renewal)le re.sou)rces. The prinlcipal danger in the case of non-rernewable resources is that of dissip)ating the tax base by allowing excessive deductions for exp)loration and( depletion (as is often the case witli the use of generouis depreciationl allowances and/or investment tax credits with thei normIlal corporate tax). For example, firmiis are often allowe(d a separate ded(uctiorn for depletion over an(d above l)eing able to write off rmany of the costs of acquiring a resource property uii) front. This obviouis]y involves doluble-counting. In the case of renewable resources, suCh as forests. the more prevalent problem is that of overestimating rents by not allowing p)ropefr (leductions for rep)leniishiment costs. Deviations such as these fromn a pure rent tax will not only affect the tax base b)ut also (listort investment decisions in resource exploration, management and( extraction. We have outlined a general mnetho(d above for (desigIling a tax system which will have the property that it is equivalent to rent taxation. To date. no countries have taken advantage of it.

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Another type of cash flow equivalent tax ttlat is sormietirmies use(l in resource industries is a "rate of retuirn" tax or a tax on "added value." The purpose of this sort of tax is to avoid imiany of the ambiguities and arb)itrariness of atterripting to measuire the user cost of capital by a nore certain and( uniforrm measure. The measure employed for this purpose is simply the replacement cost of the current cap)ital stock of the firrmi times the current market rate of interest. While this avoi(ds soirie of the arbitrary (listiinctionis that iriiglht occur because of differences in debt-e(quity ratios **anl** (ldifferen(ces in historical values of investments **comnbi ned** with the effects of a(d hoc depreciation rules, it still faces important problems **in** the measurement of the rep)lacement value of the current cap)ital stock. The l)rol)lemts of determining economicl del)reciation and of valuing the firin's investrmients remain, albeit in a slightly different forrmi.

# c. _Royalties_

Another very commonly used formn of tax for (liverting rents to the p)ublic sector is a royalty or severance tax levied on resource extractions. A system of royalty p)ayments could be eq(uivalent to a pure _ex post_ rent tax if thc royalty were designed in such a way that it were equal or otherwise proportional to the ecorionic rents associated with the amouniits extracte(l. This would re(luire that it be b)ased oII the value of the extractions less all the econormnic costs associated with them. Very few royalty systems meet this re(luiremnent. A per UInit royalty systeirm takes account of neither the value of the resources sol(d nor the cost of their extraction. A per unit royalty where the size of the paymnent depends oni the gra(le or quiality of the resource extracted as well as its quality goes part of the way towar(ds the solutiorn of the first of these problems, but does not dleal with the second. AnI ad valoreim systerml based on the gross inarket value of resource p)roduction dleals more satisfactorily with the first problern, buit still does riot help with the secon(l. Ad valoremC systemis base(I oII net revenues generally consider, at best, only current costs of resource extraction and( henceI still overestimiate true economicii rents **iI** the tax base. The extent of the bias depends _o01_ tlhe im)ortance of capital costs in total costs.

Some royalties discriminate on the basis of the final use to which the resouirce is being put. The most comrmirionl levy of this sort is an export tax on resource products. Such export taxes differ from ipure rent taxes not only by generally ignoring extraction costs inI defiiiing the base, but also by exeniptinig resources which are sold in the domestic market. The **usual** reason for this forIm of tax is to subsidize dolnestic users of the resource p)ro(luct. As ntientioned earlier. this p)ractice ususally is associate(i with ind(uistrial poliicy goals of promoting downstreaim processing industries. A **coninionly ised(** tax structure in this regar(d is one in which the export tax ratc is negatively related to the extent of (lornestic value-added in processing activities. Whatever the justification for this sort of tax. it is (lear that it (liverges considerably froiin a tax oIt ecoIIOnmic relnts.

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Royalties, therefore, tend to be very imperfect mechanisms for the taxation of resource rents. We postpone to the following section a discussion of some of the adverse incentive effects arising fronm the use of imperfect rent taxes such as these.

d. _Production Sharing and Public Sector Equity Participation_ Many govcrnments atternpt to tax resource rents through some form of more direct participation in resource exploitation. Two of the most cormmon methods are production sharing and equity participation.

The simplest form of production sharing arrangement is one in which the government receives a certain proportion of the output or of the sales revenue from a resource deposit that they have leased to an operator. This is just like a type of crop-sharing which is commonly observed in agricultural production. It is formally identical to a crude (ad valorem) royalty described in the previous subsection and is a very imperfect rent tax. As with royalties, more complex produlction sharing agreements can be devised in order to correct for the obvious distortions of the crude form. For instance, a fixed amount of the initial production might be reserved for the developer in order to compensate for capital and exploration costs. Only after that initial amount would production sharing with the government begin. Of course, the extent to which this actually covered or exceeded capital costs would depend on the price of the resource at the time it was extracted. And the extent to which the production shares corresponded to economic rents (after capital costs) would depend on the value of the developer's share relative to current extraction costs. In order to properly reflect economic rents, the production shares would have to vary with the price of the resource and the actual value of current extraction costs. The latter would vary across resource deposits and over time with any given deposit. Production sharing agreements, therefore, will be generally a very poor substitute for taxes on resource rents.

Another form of direct government participation is through the purchase or granting of equity in a resource extraction operation. The extent to which such arrangements substitute for a tax on resource rents will depend on the terms under which the equity is acquired. Suppose the equity is acquired through governments coiitributing to the operation's capital investment in return for an equal share of the flow of net current revenues from the resource extraction operation. Then the returns that will accrue to the government could be thought of as comprising two parts: a) its share of the returns to capital investment, and b) an equal share of the resource rents. 100% government ownership would correspond to a 100% rent tax, 50% ownership would be equivalent to a 50% rent tax, and so on. The coexistence of other forms of income and resource taxes on such joint venture firms would complicate this simple relationship.

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Of course, if the price the government pays for equity participation exceeds its share of the capital investment of the firm, then it will end up collecting a smaller proportion of the rents by this method. In particular, if the equity price were the same as what would be paid by a new private investor, ari( hence included the capitalized value of expected rents, then no _(ex ante)_ rents at all would accrue to the governrment through its equity ownership. Any rents that were collected woul(d arise only because of differences b)etween actual ari( expected rents. These couldi be positive or negative.

Suppose, as is sometimes the case, that the governmnenit eqluity is obtained free of charge, i.e. without any contribi'tion to the firmn's capital. This free equity could be thought of as payment by the firm for the rights to resource extraction. If the equity share were on the same terrns as if the government had invested i.e. it gave the rights to a certain proportion of the flow of net current revenues of tlle firm -- then this would be equivalent to a tax on both resource rents andc private returns to capital. The only way to convert this into a pure rent tax would be to deduct from the governnment's revenue rights an imputed return to the firm's capital investment.

There are several other differences worth noting between such equity or joint venturing schemes and pure rent taxes. First, government participation is sornetimes seen to have additional advantages to other foriris of rent taxes by giving the government some voting power and hence direct control over the firm's activities and by giving the government "a window" which provi(dCs .lluable inforrmlatioii pertinent to both taxation and other forms of regulation of the rcsolurce sector. Second, it cannot be automatically assumned that revenues accruing to government resource companies are equivalent to tax revenues paid directly to the state treasury. Because of their greater indepen(lence fromii traditional government budgetary agencies, resource-rich state companies are notoriouis for the imlanly ways in whlich their spending patterns differ from those of these other agencies. In marny circIurllstances it is most realistic to treat state resource firms' profits just likc those of other private companies. Then state ownership makes no contribution to the government's efforts at rent taxation. In fact, the taxation of state companies is often more problematic than it is for private companies.

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# IV. THE COSTS OF IMPERFECT RENT TAXES

# 1. **Introduction**

Most taxes are levied on proxies or inmperfect substitutes for the bases at which they really are directed. This certainly tends to be true of those oni econonlic rents from the, exploitation and sale of resources. This has iml)licationis both for government revenues and for the allocation of a country's scarce resources (natural and other). A pure rent tax can be levied at rates of up to 100% without reducing the efficiency of resource allocation. However, if the tax base diverges from true economic rent, then any tax on that base will affect investment and other allocation decisions of private agents and cause inefficiencies in these decisions when viewed from the vantage point of aggregate econormic welfare. The nature arid extenit of these inefficiencies will depend on the form of the divergence of the tax base from true econornic rent. But in general the size of the efficiency cost will depend, among other things, on the rate of tax, or, rmore precisely, on the square of the tax rate. As long as tax revenues are increasing in the tax rate, there will then be a trade-off between government revenues and efficiency of resource allocation. This is not true of a paLre rent tax. In a world of imperfect taxes, therefore, it is important to understand the nature and the costs of inefficiencies arising from different methods of taxing resource rents. This will facilitate the design of tax systems that will best promote the government's revenue goals while minirmizing the efficiency costs imposed oIi the economy. The ideal tax system frorm this viewpoint might be expected to differ across countries and even within countries depending on the rmix of resource products and the specific circumstances of their exploitation.

Most countries (lo use a wide variety of mechanisms for taxing resource rents. Royalty formulas might differ considerably across resource products. Partially or comipletely pre-paid leasing arrangements might be used in some sectors and not in others. The same is true of governrnent participation through production sharing arid/or (tquity ownership. Arrangements sometiries differ across firms within the sarne indiistry. Furtherrnore, it is the normr rather than the exception for the same activity to be subject to a number of different types of taxes and royalties. Many of these differences in and mixtures of taxes are due to historical accidents and other reasons that have little or nothing to do with the design of an efficient or otherwise appropriate tax system. Nevertheless, the number of varieties and cornbinations of taxes that are possible for the collection of economic rents suggest the importance of understandiing some of these incentive effects and the deterrminanits of their significance as a guide to the design of resource taxation systems. The purpose of this section is to providc some insights into these questions. AIn exhaustive treatment of all these possibilities would be alnmost impossible and riot particularly useful. The alternativTe that we attempt here is to provide soine general principles for the understanding of these issues and some illustrations of some interesting types of 36
## cases.

Our perspective is generally that of looking at divergerices fror neuetrality in taxation. In the absence of other distortions frorn econormic efficiency, a neutral tax systern will also be efficient. When a particular resource extraction activity involves significant externialities, then offsetting non-neutralities in the tax treatmnent of thact activity might be appropriate. Of course, other types of regulation or institutional inrnovatiori imiight be rmuch rnore effective and less costly nmeans of achieving the same goals. In these cases, it is still iimportanit to un(lerstand(i the nature of the distortions that result from different types of taxes. Without such knowledge the designi of approp)riate non-neutral tax treatmrient of thalt activity woul(l not **be** possible; nor would a comparison of this with other forms of regulation.

# **2. Decisions Affected by Rent Taxes**

Resource exploitation involves a number of different types of activities. In the case of non-renewable resources these range from exploration to extraction to processing to marketing. Renewable resources involve all of these types of activities as well as those related to the long-term marnagexnent and replenishment of the resource. Taxes and other regulations might even determiiie whether a resource is renewable or non- renewable. The tax system can affect decisions at all points in the productioni process. The decisions which are affected at any stage mtlight involve the level of the activity in question, the input **mix** and/or the technology utilized. the disposal of the outputs (marketed and( non-i-narketed), and the timinlg of the activity. In the rernaining sections of this chapter we discuss some of these effects in relatior. to different types of resource taxes and illustrate a method by which one can measure their q,uantitative importance.

# **3. Royalty Structures**

Even the best designed royalty systems are very imp)erfect proxies for taxes on eco- **ormic** renit. Their basic difficulty is that they ignore all capital costs involved inI resource exploitation. In rmany cases they also ignore at least sorne comnponents of current costs and/or iniperfectly account for them. This means that royalties generally tend to overestimate economic rents, with the extent of the divergence depending on the importance of the underestimated and/or ignored elements of costs. This will discourage at least sorne resource-related investments. At low rates of tax this mnight not discourage **inany** socially desirable resource exploitation activities. But at higher rates of tax that might be necessary to collect significant public revenues, considerable amounts of **suclh** desirable investments might be discouraged.

Consider first the effect of ignoring capital costs in the definition of the tax 37
base. The general effect of tins (lefect in (iefining the base is to bias the tax systemn against capit al-intensive resource investrments. Consider two resource projects, both of which have the same net present value of cash flows over their lifetimrie, but onr of whicli has a much higher level of capital costs which are offset by higher sales revenues at the timne of marketing the product. The more capital-intensive of these l)ro)jects would( be subject to miiuclh higher royalty payments over its lifetime thai the other. Despite the fact that the projects are equally socially desirable (froml the efficiency viewpoint), the niore capital-intensive project wouldl be rmtuch iess likely to be undertaken. The royalty system creates a distortion by driving a wedge between the returns of marginal investments of (lifferent capital intensities.

In the case of nion-renewable resources, for instance, this woul(d discoutrage projects with relatively high exploration costs. With renewable resources, this would create a distortion against projects with high replenishment costs. It would bias forest activities in favor of imininlg of the natural forest and against cutting programns involving significanit silvicultural rnanagemnent or the developmlent of plantation forests.

The nono-deductibility of capital costs is especially harmiful when the effects of the royalty system are considered in conjunction with those of corporate taxes. The treatrnent of capital costs in royalty systems means that royalties are taxes not only on econormic rents, butt also oII capital income derived from resource exploitation activities. Corporate taxes are also levies on capital incomne. The combined effect of these two different taxes, therefore, is double taxation of capital income. Relative to other sectors, therefore, the imiipositioni of royalty paymiients discourages investment in resource proje(c(ts.

The effects of the inismeasurement of elements of current costs in a royalty systeIn can oc thought of in a sirmilar fashion. First, the exclusion of current costs, as is (lone in the crudest forrn of royalty system, also overestimates rents and, at least at higlh rates of tax, discourages socially desirable resource exploitation projects. Second, such systems create a distoitionl against projects which are relatively intensive in the use of currelnt inl)uts which are excluded firom considerationi in the base. Consi(dcr two projects or activities of the sarne pre-tax net present value and which are sirnilar in every other respect except that one is nmore intensive in some current **inpuit** whose costs are not taken into account in calculating the base of the royalty. Because the costs of that input cannot be deducted froni the tax base, this project or activity will be subject to higher royalty payments, and hence will be disfavoured by the tax systerm.

The most cornlllon manifestation of this sort of (listortion is the phenomlenon knowii as "high gra(iing" of a resource deposit. In the presence of a royalty system which provides a fixed (possibly zero) allowance for current costs in determination 38
of royalty payments, (wevclopecrs will extract only those resources with relatively high values and/or low costs an(d ignore high-cost and/or low-value deposits or parts of deposits that still **hav''** positive social value. Despite their positive social value, the royalty system discoureges their extraction by charging a tax in excess of the ret current revenues fromri their extraction. Such systems encourage forest concessionaires to cut only the high-vainid stems inI a stand and leave b(h *n(d and often even darnage or destroy smaller stems of significant social value. Similarly, mining operators are encouraged to close (lowrn rrines before all socially valuable deposits have been extracted.

# 4. Export Taxes

An export tax bears a ciose resemblance to a crude royalty and has all of the same efficiency costs, In addition, it discrimninates between resources marketed dormestically and those sold in the world market. If a resource has no outlet in the domestic market, there is no additional efficiency cost due to this form of discrimrination. However, this is seldom the case. When resources can be sold in the local market, an export tax induces them to be sold at a lower tax there than in export markets. Rents become dissipated by selling the resources at below world niarket prices to domestic users. The loss of governiment revenues arising from the use of an export tax rather than an equivalent royalty on all sales, export and domestic, is proportional to the size of the dornestic rnarket. The efficiency cost depends on the size of the tax and on the elasticity of domestic demand.

The only case in which this efficiency argument against export taxes might not apply is when the country is sufficiently large in the world market for the resource in question that it has some monopoly power in that market. **In** this case there is an optimal export tax which is inversely related to the elasticity of world excess dernand for the product. A general observation that is relevant here is that world markets for rnost resource products generally tend to be much more elastic than is claimed by the proponents of optimal export taxes. This is especially true in the longer run when other sources of supply become available and users are able to adapt to higher prices through various forms of substitution. The second observation is that an optimal export tax is riot a substitute for other taxes to collect economic rents. An ideal export tax facilitates the collection on.y of the rents arising from a country's monopoly position in world markets. The rents arising from differences between the competitive price of a resource and the costs of its extraction are left untouched by an optimal export tax.

A common reason for using an export tax rather than a uniform royalty is to promote the development of downstream processing industries. An export tax gives domestic processors access to the raw material at a price that is less than that faced 39
by foreign processors, with the gal) cqual not only to the cost of transporting the resource to the foreign plant, but also the size of the export tax. The aniotulit of the subsidy provided to (lornestic users depends on the rate of the export tax an(d on the importance of the resource in total processing costs. This formii of subsidy gives rise to several types of inefficiencies. First, to the extent that this effective protection is actuially necessary to encourage (lornestic processing oy imiarginal firms, it substitutes high cost ways of earning or saving foreign exchange (exporting locally processed raw mraterials) for lower cost ways of doing the same thiirg (exporting the unprocessed resource). Resource rents arnl government revenues, in effect, are (lissip)ated in the sul)sidization of inefficient marginal domestic producers. Second, b)y artificially lowering the domestic cost of natural resource inl)uts, export taxes induce local producers to l)e wasteful in the **use** of these raw materials. Plywood and saw mills in countrieF with significant exl)ort restrictions on logs, for instance, tenid to have much lower log recovery rates than do rnills in log importirig countries.

# **5.** Concessions **and Leasing Arrangements**

**Tlihe** leasing of concessions to a natural resource deposit can yield revenues which are identical to the ex ante rent froin that resource. As mrientioned earlier, however, it is important that the ler.gth of the lease correspond to the useful life of the deposit. Most governmerricts are reluctant to enter into sufficiently long-term leases for this purpose. This generally mcans that lease revenucs will be less than what could have been collected otherwise.

In the case of noil-renewable resources, the short term of the lease makes it difficult for operators 'to e:ctract all the usable resources from the project. This leads therm to offer a lower bid1 for the concession. It also induces them to Cagage in inefficieiit mining practices ainmed at speeding up the extraction process. This gernerally reduces the value of the deposit to potential future operators. Even if the currenit operators have a right of first refusal on future leases, political and other uncertainties will cause theim to discount this possibility and to shorteni their timne horizons in planning current activities. Therefore, short-term leases, even when offered consecutively, will generally yield less revenues than long term leases for iorn-rernewable resource deposits.

The sanc will generally be true in the case of renewable resouirces. However, in this case short-term leases rmight yield much greater revenues over the early years of exploitation than would be obtained from perpetuai leases. The rcason is that short-terrm I.ases give the operator very little incentive to engage in investments in replenishment or renewal of the resource. In these circumstances, the operator would sirnply rninc the first generationl or rotation of the resource stock (assumirng that this was the length of the lease) without regard for the consequences for future 40
generations or rotations. Therefore. short-terrn "rents" might be much greater than with a long-term lease holder, and renters might be willing to pay quite high prices for short-term leases. But, of course, what appear as rents to the short-term lease holder are largely postponed investments in replenishment ari(/or the destrtlction of much of the potential for longer term rents. The present value of the future stream of all rents that could be received would certainly be less with a successicon of short-term leases than with one perpetual lease in the **presence** of these sorts of incentives. The b)urden on other typtes of regulation of lease-holder behavior is very great when leases for renewable resources are relatively short.

# 6. Measuring the Distorting Effect of Taxes

Up to now our discussion of the effect of resource taxes has been largely qualitative in nature. For some purposes it rmay be desired to obtain iuarntitative measures of the extent to which different tax instruments distort decisions. A conventional tool for doing so is the use of _marginal effective tax rates._ These were initially devised as ways of measuring the size of the distortion irnposed by capital income taxes on the decision to invest in depreciable capital. However, they can be used to tax we(dge imposecl on virtually any capital decision, and have been applied to such things as inventory holding and non-renewable resource exploitation. Since the methodology for calculating marginal effective tax rates is somewhat technical, we have relegated it to an Appendix. It can be oInitted without loss of continuity. In the Appendix, we illustrate the use of marginal effective tax rates in the non-renewable resource context, concentrati., on capital investment ard extraction decisions. We do so for fairly simple examplc, ignoring **such** important comiplications as risk and the absence of full loss offsetting.

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# **V. POLICY IMPLICATIONS**

# **1. Introduction**

We conclude this review by summarizing some of its implications for resource tax policy. It is useful to begin by briefly recalling the role of resource taxes and their place in the system of taxes. Resource taxes are part of the overall system of taxe!s which impinge upon the incomes of businesses. The systerm usually includes direct taxes of a general natulre such as the corporation income tax and taxes on personal and uni corporated business income, indirect taxes of various sorts including sales and excise taxes as well as export and import duties, and taxes specifically designed for resource industries.

The system of income taxes is intended to tax capital and personal income of residenits and, where possibl, of non-residents earning income in the country of taxation. Such systems typically include both a personal tax system and a corporate tax system. The corporate tax system ought to be viewed as supplemnentary to the personal tax, that is, as a withholding tax on capital inicome earned in corporations. It essentially ensures that equity income earned in the corporation is taxed as it is earned, whether or not it is distributed. Many countries recognize this withholding role by integrating the corporate tax with the personal tax system through the use of rneasures such as dividend tax credits or dividend paid deductions from the corporate tax base. This essentially ensures that double taxation of equity income is rnitigated. In the case of foreign corporations, the corporate tax also facilitates a tax transfer from foreign treasuries in cases in which foreign governmnents offer foreign tax credits. Host country tax systems are often (or should be) designed with this in mnind. Interest income tends to be taxed at the personal level since withholding is not necessary here. Income taxes, if designed properly, tax all capital incorne on a uniform basis, including Loth the noimal return to capital and any rents. Of course, the design of many tax systems is imperfect in the sense that this uniforrnity is not achieved.

One of tlhe ways in which non-uniformity is evident is **in** the treatment of resource industries. In most countries the capital income tax system treats resource industries quiite favourably relative to other industries. This occurs mainly because of the favourable treatment afforded various capital expenses which are specific to the resource industrie~s. For example, scme items of a capital i,ature are given rapidA write offs in tax systems which are meant to be abiding by the accrual method of accounting. These incluide the costs of acquiring resource properties and exploration and development expenditures. Furthermore **do01ble** write-offs are often given by virtue of deletion allowances for resources used tip. And mnany developing countries have traditionally given generous incerntives in the form of tax holidays. investment tax credits. **(lity** exemptions on irnported equipment. an(d valuable loss carry for42
ward provisions. The consequence is that equity income in the resource industries is often undertaxed relative to other industries. Some corporate tax systenms also allow deductions for resource taxes paid. To the extent that this is the case, it vitiates the effect of the resource tax. To the extent that it is desirable to supplement general income taxes witb resource taxes, this is undesirable.

The case for special reso' -ce taxes is precisely to tax resource rents over and( above the levies that are implicit in general income taxes. There are two sorts of arguments for this. One is the efficiency-based argument that resource rents are non-distorting and therefore are an ideal source of revenue from an efficiency point of view. The other one, which is complementary, is that the property rights to resources ought to accrue to the public at large rather than to private citizens since they represent the bounties nature has bestowed on the economy rather than a reward for econiomic effort of some sort. This can be viewed as a sort of equiity argument. However, one must be careful in applying it. In an economy with, no resource taxes, the value of known stocks of resources will be capitalized into existing property values at least to some extent. If a government then imposes a new resource tax, the incidence of the tax will fall on the existing property owners or lease holders. Thus, there will be redistributive effects to b)e accounted for. If the government is the principal owner of the resource properties, this will be rnmlch less of an issue, except to the extent that they have leased the resources on a long term basis at a predetermined price that reflects the pre-resource-tax value of the rerts.

In our view, the main rcason for taxing resources over and above that of other general tax rneasures is .precisely to acquire for the public sector a share of the rents generated froml resources. In principle, special rent taxes could be irpi)osed on other sectors. However, the argument is strongest for resource indlustries sill(ce those are where economiic rents are imost likely to reside.

Given that the main purpose of resource taxation is to capture rents. the appropriate form of taxation is one whose l)ase is econorrmic rents. We reiterate b)elow the form that mighlt take. For now we sirnply note that actual resource taxes secIn to differ from rent taxes in signi.icant ways. Unlike with the gerneral income tax which includes provisions which allow the resource iII(lllstries to un(lerstate cap)ital income, resource taxes often overstate rents. This is becalise they frequently (io not offer full deductions for all costs, particularly capital costs. Somne systems tax revenues without giving any deduction for costs; others allow current costs to be deducted. As a consequence. they discourage investmneint activity in the resource industries, encourage the exploitation of highl gra(les of resources at the cxpense of low grades, and rnake it (lifficuilt to impose highl ta.i rates for fear of makirng the marginal tax rate greater than 100%/(.

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# 2. **Policies for Capturing Resource Rents**

As we have discussed earlier, there are three alternative ways for the governmernt to divert a share of rents to the public sector. They are as follows:

# _a. Cash Flow or Cash Flow Equivalent Taxes_

The ideal sort of rent tax is a tax oni the real cash flows of resource firims. For noiirenewable resource firims, the base would include all revenues oII a cash basis less all current and capital costs including costs of acquiring resource properties, exploration expenses, developmient expenises and any processing expenses incurred by the resource firm. For renewable resource firms, sirmilar costs would be deducted including costs of property rights, harvestiilg costs, any renewal costs such as replanting or restocking, as well as any processing costs done by the firm. There should be no deductions for other taxes paid. Of course, cash flow accounting should be done from a social point of view so any external costs should be included as costs on a cash basis. It may also be necessary to require the firm to cover the external cost associated with shutting down, though that may be done by forcing firrmls to post bonds and/or through other forms of regulation. Both corporations ard unincorporated firms should be subject to the tax. This is a relatively straightforward type of tax to administer, though there are likely to be incentives to evade. For example, there is an incentive to cngagc in transfer pricing for vertically-integrated firms as a way of passing rents forward to non-resource firmls. (Note, however, there is no (lisadvantage to extending the base as far forward as is necessary for a vertically-integrated firrm since if there are no X ts downstream, there will be no tax collected.) As well, there is an incentive to have capital income masquera(ling as wage and( salary payments to avoid the tax. These are inevitable consequences of a tax which applies differentially to sonle activities ani( not to others. In principle, the cash flow tax rate couldl be extremely high, approachilg 100%.

The public sector rnay balk at a full-fledged cash flow tax since it generally implies that tax liabilities will be negative for giowing firms. Althouigh the cash flow implications of these mrray be beneficial for the firms. governinents can raise tax revenues only with some welfare cost and they may prefer a system which smnooths tax receipts into the future. Such a compromiise is easily achieved with a imodified cash-flow tax base in which the firm caII capitalize cost deduictiorns ir a straightforward way. In particular. any costs which are capitalized receive a full noiminal interest (leduiction based on the full book value of the c)apitalized cost The rate of (lepreciatiorn used for capitalization purposes is arbitrary. It mlay well be chosern by the firimi sulbject to the constraint that tax liabilities caninot be negative. Suich a systemn is equivalent to oIne in which negative tax liabilities are carried forward at full interest. It is therefore equivalent to a straight cash flow tax base.

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# b. _Auctioning of Leases or Property Rights_

Rents may be transferred to the public sector by requiring firms to bid for the rights to exploit resources. In the case of rion-renewable resources, this would occur prior to the exploration stage. For renewable resources, the bid would be for a known stock of resources. As long as the bidding system were competitive and( all bidders were equally well informed, the value of the bid woul(l bte equal to expected future net rents (net of future expecte(d taxes) corrected for a risk factor. Furthermore, to exnsure that optirnal rents were obtained, the property rights obtained mrust be perpetual. If they were for a fixed terrm, there woul(l be an incentive for the operator to extract the resource inefficiently.

Even with a well-functiorinig auction, the consequences can differ from that under a rent tax. For one thing, the auction will yield 100% of the expected value of the rents to the bidder, whereas the tax rate may b)e less than that. Under an auction, the cash flow consequences are much different as well. Net rents rnust be entirely paid up front, whereas with taxes they are spread out into the future. If there are any capital market constraints, this will be reflected in the size of the bid. Also, the risk effects can be different. Under the auction system, the firm is forced to bear the risk associated with resource exploitation whereas with the cash flow tax the public sector shares the risk. To the extent that the public sector is better able to pool or spread risk, the outcorne may be more efficient. Of co Irse one important reason why the public sector may be better at dealing with risk is that some of the risk facing the operator is the risk of higher taxes in the fuiture. The time inconsistency which gives rise to this will be more severe under a system, such as an auction, which captures rents tup front. Thus while this risk makes it more approp)riate to use an auction system, it also reduces the price that bidders will be willing to pay for a long term lease.

The auction mnay be inefficient for various reasons. If bidding is not comnpetitive. it will not be efficient. Also, if the auctioni requires firnis to l)idl not only oII a once and for all payment but also onl a future royalty payment, the outcorne will not be efficient since the firm will be induced to behave inefficiently in the futuire.

# c. _Public Sector Equity Participatioz_

Finally, the public sector may obtain a share of the rents by taking on a share of equity in the firm in particular ways. **Onc** way of doing so is for the government to contribute to a share of the costs of exploiting a resource anr( claim an equivalent share of the equity of the firni. This woul(d be finaincial exactly the same as a cash flow tax, tholughl perhaps more difficult to implement. The public sector would have to identify both the cash costs and the revenues acctruing on the relevant operation 45
of the firm. On the other hand. unlike with a cash flow tax, if the public sector actually does become a full partner in the ownership of the firm, it presumably has a say in the decision-lakirng responsibilities that come with share ownership. As well, it may be privy to information that it would otherwise not obtain. This is in contrast with cash flow taxation where the government is a silent partner.

The above method involves the government providing cash up front and( obtairirig revenues in thc futulre. The governiment could become an equity participant while avoiding these cash flow consequences for itself. Instead of providing money up front, it could deduict its share of the costs later oIn against dividends. This is referred to as acquiiring free _equity._ As long as the costs were appropriately deducted with interest the schemne would be financially equivalent to the cash-flow equivalent schemes outlined earlier.

As with taxation but in contrast to auctions, equity participation schemes will divert less than 100% of the rents to the public sector. Furthermore, there may be an issue in the case of foreign firrmis of the extent to which foreign tax credits can be clairned against horrme country governrments. Of course, that may be an issue with resource taxes as well.

# 3. **How Actual Policies Differ frora True Rent Collection Devices**

Revenue-raising policies actually used differ from those outlined above in their designl. This implies that they are not pure rent collecting devices, but distort decisionmakinlg as well. There may be various reasons for this, some of which involve other policy objectives by the government (e.g., capital income taxation, protection, etc.). However. it is also possible that policy mnakers are ill-informed about the proper design of rent collecting devices, or that purely political factors are at work. Rather than secon(l guiessing the reasons, we sinmply discuss the ways in which actual measures deviate froml optima] rent-collecting instruments. We concenitrate largely on measiures sp)ecific to the resource industries.

## _a. Tax Mcasure.s_

Historically. it has been the exception rather than the rule that rent taxes have **bleen** used **in the** resource induistries. Indeed, there **are** very few examples of cash flow type taxes. We consider the various taxes in turn.

## i. _RIoyalties/St_ **_umpage_** _Feoes/Severance Taxes._

I)erhaps **the** rnost conimoni formn of resource charge has been a levy based on the 46
quantity extracted, variously referred to as a royalty or severance tax in nonrenewable resources and a stumpage fee in forestry. It is difficult to understand the attraction of this type of charge apart from simplicity. Sometimes these levies have been viewed less as a form of tax than as a fee charged by the public sector for removing resources from public or Crown lands. However, from an economic point of view, they are equivalent to a production tax. In their simple form, they tax revenues with no accounting for costs. As such, they act as a disincentive for investment and extraction of resources and coincidentally generate less revenue for the public sector than could be obtained by a rent tax. Furthermore, since no account is taken of costs, they discriminate against high-cost revenue sources at tlle expense of low-cost ones. This effect of crude royalty systems is generally known as high-grading of the resource. In the case of mines, socially valuable but high extraction cost deposits are left in the ground. In selective logging operations, lower value stems are left unharvested and are often damaged and left to rot in the forest. Also, since costs are not deducted, they do not serve as risk-sharing devices by the public sector, nor do they provide any assistance with the cash flow of firms as is the case with other measures. Against this must be set the fact that production taxes may have a role in correcting for externalities associated with resource production. However, this would not justify their use as primary revenue collection devices.

The effect of production taxes can differ according to whether the tax rate is based on quantity produced (per unit tax) or upon the selling price _(ad valorem)._ In principle, an _ad valorem_ rate can always be chosen such that it is equivalent to a given per unit rate. However, when prices are changing, maintaining that equivalence would require constantly changing the tax rate. If the tax rates remain fixed while prices change, the two will have different effects. In particular, when prices rise, the _ad valorem_ tax rate rises relative to the per unit and vice versa. This implies that the _ad valorem_ tax has some risk-sharing effect that the per unit does not have, and in periods of rising resource taxes, it discourages investinent inore. Similarly, when the quality of a resource varies within a given deposit (e.g. less rich ore seams in a mine, and different tree species within any part of a forest concession), maintaining equivalence between an _ad valorem_ and specific tax rate woi!ld require different per unit rates for different parts of the deposit which is extracted.

Several countries have moved away from simple per unit royalty systems and export taxes in recent decades. These include Bolivia and Indonesia for hard minerals, Colombia for oil, and Jamaica for bauxite. Sabah and Indonesia have also moved in a sinmilar direction in the case of tropical timber by varying the royalty rate by type of tree species.

Increasingly, royalty schemes have been designed to be more sophisticated than simple production taxes. There are two main ways in which this has been done. For 47
one, sorne royalty b)ases lhave been defined to be revenues net of current costs. Sabah has refined its tropical timber royalties by allowing a deduction mearnt to represent presumlptive logging costs. This goes part way towards rmaking royalties reflect rents. The other method is to mnake the royalty rate itself a sliding scale based on either resource prices (an _excess price tax)_ or on the quality of the resource. Thesc are sometimes referred to as _windfall taze.q_ reflecting the fact that purpose has **been** seen as a way of crearring off resource rents generate(l by p)rice increases. Such slidirng royalty systems have **been use(d** for oil (Peru and( Malaysia for examl)le) tropical timnber (Sabah) coal (Indonesia) and tin (Malaysia). Again, this is an imperfect way of taxing resource rents in general, although the procedlure of basing royalties on price can succeed **in** obtaininlg changes in rents frorn existinig resource firms who have benefited fromn all unexpected inicrease in price. However, this is donie at the expense of discouraging incremlental investrments. The latter can be mitigated in some instarnces by basing the royalty rate differentially on new and existing resource properties. Such a procedure will work only once.

# _ii. Income-Based Taxes_

Resource properties are usually subject to general income taxes. However, in some instances, taxes specific to the resource industries are also based on some measure of income. In such cases, the tax is often designed in simitlar ways to the general income tax and has built into it some of the same biases. That is, it affords rapid write-offs for ac(quisition costs, exploration and( development, and often gives a depletion allowance. Althouiglh this generates somlle revenues, it also has the effect of providing a sulbsidy to mlarginial projects. That is, average tax rates are positive while marginal tax rates are negative. Furthermore, the way such taxes have been irnplemrente(d in inost developing coluntries (e.g. for coal in Coloibia and hard minerals in Indoniesia) the rate of return to c(uity at which they becorne effective has tended to be extreiriely higlh. Thlus th(y have not been very effective collectors of (w.oCess profits or rents.

We have outlined earlier lhow incomne-based taxes could be designed to reflect economic rents. using a mo(lifie(d cash-flow approaclh. However, such systersl have not **been** used. E]lements of cash flow taxation have appeared in sorme developed countries. For exainpic. the mnininig tax regime in Alberta, Cana(la has the following features. It is basically a cash flow tax excc)t that a royalty is also applied until capital and start-ii) costs have all becn deducted. A sirmilar system is used by the Canadian government to tax oil an(l gas **oII** federal Crown lands. Thls, the principle of cash flow taxation has IIot1 **been** completely ruled ouit. However, these systerns are not fully efficicnt since they **deny** the full tax advantages of expensing all capital costs.

48
# iii. _Property Taxes and Leasing Fces_

Some tax regimes impose an annual rental fee or charge for the use of resource properties. This is often done in the case of tinmber concessions anid plantations in states of Malaysia. If their rates were such as to reflect the true capital value of the properties being used, they woutld be like a rent tax. However, they are typically set at arbitrary and more or less noriinal rates. It woul( l)c difficult to administer such a tax based on the true econornic value of the resource property in question since market values (1o not exist. Thlus, some ad(miniistrative discretiorl **would( be** required. If an **annual** rent tax is to be charged it **seeimis** preferable to use a proper rent tax.

# iv. _Export Taxes_

Export taxes are frequently used in developing countries as a source of revenue from primary resources. **In** primary product exporting countries, they have been a major source of government revenue. In the case in which the counitry is a price taker on international inarkets, an export tax has exactly the same effect as a production tax from the point of view of the pro(lucers. However, consumers pay a lower price under the export tax. There may therefore be sorne distribtutive reasons for preferring an export tax, though it may be rnore for reasons of administrative simplicity. However, countries have foun(d that export taxes on many resource products (e.g. rubber in Malaysia) have been quiite regressive and have tended to eliminate these taxes **in** favor of other iiiore general taxes **oII** spending and incorme. In maniy cases, domestic consumption is a small proportion of prodluction an(d so the differences in the revenue implicationis of production and export taxes rmay not be great. However, the efficiency costs arising froin diverting high value resources to lower value domnestic uses **d(epends** not on the absolute value of (lornestic use relative to exports, bLut rather on the resporisive of domestic dermiand(I to price changes cause(1 by the export tax. Taxes on exports to induce local (lowristrearli processing induistries can also he a very costly way of dissipating resource rents. Even in cases where the resource-exporting country mright lhave a lotne **terni** comparative advantage in further processing, the **use** of export taxes to speced **ui) the** process can be very costly.

The same shortcomnings of **production** taxes as rent collectors appl)y to export taxes. **OIn** the other hand, export taxes mnay **be** justified if **the** couniitry has some monopoly power in world markets by the usual optimial tariff argumnents. If so. that would be a separate nustificatiorn for export taxes over and( above rent collection devices.

_49_
# b. _Auction Systems_

We have listed auction systems earlier as one of the ways in which rents can be extracted from resource producers up front. However, they tend not to be used miuch, especially in developing countries. Presumably one reason is that the conditions do not lend themselves to competitive bidding procedures. Many resource projects are large and may not involve more than one different investor at the same time. For whatever reasons, individual deals are struck with resource producers involving different types of public participation. These can take various forms as discussed next. One feature of such contracts which distinguishes them from other arrangements is that they tend to involve a major element of administrative discretion. That may be viewed as a drawback from an economic point of view when compared with schemes for which eligibility and conditions are rnon-discretionary.

# c. _Production Sharing_

There are various non-tax ways in which governments acquire shares of the proceeds of resource projects. Two common methods are by sharing of the output of production and government acquisition of equity shares in resource firms. Variants of the first of these is considered here.

The simplest case is that in which the government imply takes a given share of the product. The analogy would be a system of share cropping in agriculture in which a landowner allows a tenant to farm a plot of land in return for a share of the crop produced. The basic scheme is identical to an _ad valorem_ production tax at the same rate. It differs from a tax on pure rent since no costs are deducted. Since it is _ad valorem,_ sonic risk-sharing is implicit in the scheme.

Since production sharing schemes are subject to negotiation, the proportion of sharing could vary from project to project. In this way some account can be taken of different potential rents. However, as long as costs are not explicitly deducted, such schemes will not reflect pure rents.

Some schemes account for costs partially by having the production sharing cut in only after some minimum guarantee level of revenues for the firm (e.g. oil<sup>in</sup> Indonesia). As well as allowing the firm to cover some part of initial costs before sharing its output, this provides an additional measure of risk-sharing. However, even if the mninimum were set such that total costs were covered, there would still be a marginal disincentive involved in such schemes once the production sharing begins to apply.

A variant on production sharing is a requirement that a certain proportion of production be "made available" to the domestic market. If such local market sales _50_
are at the prevailing world price, this does not transfer any rents. If the price is less, then some rents will be transferred, and it will be similar to a simple production sharing arrangement. Of course, if the sales at subsidized prices are to private traders, the rents will not accrue to the public sector. Lack of clear specification of the terms of such sales in the local rnarket (including the price and thc eligible buyer) can be a source of contention with resource investors (e.g. aluiriinlum in Indonesia).

# d. _Equity Participation_

Finally, governments mray negotia-te to adopt cquity positions in resource firims. Again, this can take various forms, and **the** ability to obtain rents depends upon the form taken. At one extreme, the governrment could siinply p)urchase shares of a resource firm on the open market. Divestiture of a given proportion of shares to local investors within a specified time period is a standard condition of foreign hard mnineral investments in Indonesia. The government has often put forward as an obvious investor in such circumstances. Since the market valuc of the firm should capitalize all expected future net rents of the firin, this would not be expected to yield any net revenues to the government. All it would do is to provide the government with whatever decision-making authority goes along with share ownership. To facilitate rent transfer to the government, the government mlst succeed ill obtaining share holding privileges at below the market value of the shares.

At the other extreme, the government may simply take "free equity" in the firm, thereby entitling itself to a share of future divi(lends of the firm. This will differ from a rent tax regime by the fact that no implicit deduction is given for the initial equity put in by the firm. This may approximate the initial capital costs incurred by the firm. It would then be similar to a royalty system with currcnt costs deducted. There are many instar!ces of such free equity arrangements, especially in hard minerals (copper in Panairia. copper an(d nickel in Botswana. and uraniullm inl Gabon).

Instea(l of taking free equity, the government may pay somen price for it. As mentioned, to obtain sorne share of the rents, the price would have to be less than the market price of the shares taken. The could be (lone up front or it coul(d be made later by reducing future dividends. Equity sharing schemes of this formn will be equivalent to rent taxes if the payment made by the government is cqual in present value ternms to an equivalent share of the cash costs of the project. If this payment is made up front, **it** would have the idcrntical financial cffect as a cash flow tax. The only real difference is that the government obtains voting rights. If the payment is spread out into tile futuire (e.g.. taken out of futulre dividernds). it should be carried forward with interest. In either case. the government will obtain only a 51
share of the rents rather tharn the entire rents under aII ideal auction syster.

# 3. **Other Design Issues**

There are a **numlb)er** of other (lesign **iSSU(eS** invol Ve(d in resource taxatioii which mIay cause them to (liffer froiri ideal reiit taxes. SonII of them are as follows.

# i. _The_ **_Time_** _Horizon_

As Imentione(l, arrangenients with thc l)rivate sector for sliarinig rents **may be** viewed as being for a hinited period of tille. This iray b)e because of conscious design, as in the case of forestry (on(e(CSSiOn. Or. it inay he because of the inevitable inability of governmenits to comrmiit to fixed policies for long perio(ls of tirne. In any case, the result is arn inefficiency which1 is har(d to avoi(l.

## ii. _Shlut-Down Costs_

Many non-renewa)lc resource operations face costs of shlut-downi such as clean-up costs to avoi(l environmental darmiage. Simnply requirinig firms to meet such costs rrlay be unenforceal)le since they imay be able to avoi(d theni b)y juist ablandornirng the site. Clean upj) could be enforced by re(quiring the firiim to post bonds against the cost of cleanpll). or, equivalently. by imposing a witlhlhol(linig tax **ill** respect of resource nianagemlient which is refundable once the clean uip is completed.

### iii. _Discretionar,y Polici.s_

Sone sorts of policies niav involve admtninistrative diiscretion. Econoniists generally view these Sor'ts of policies witlh soe suspici( on and p)refer those for which the terni.s of eligilbility are aiit mniatic. Discretioinary policies lend themselves to costly rent-seeking activitics as well as to possibilities for dishonest behaviour.

### iv. _.JuIrisdictional_ Issiies

In iiianiy countries jurisdiction over resources is dlecentralized at least partly to lower levels of goverunmenit. Examples include Malaysia and( Canada. This can give rise to problems of tax coordination amnonig various levels of government as well as to different fiscal capacities amlong lower levels of g-overnment. As the literature on fiscal federalism makes 1calr. the latter can cause ime(pli tics across the federation **and** inl(effi(ci('en('y in the allocation of mobile factors of produllction in favouir of the wealthier states, Many coumitries have institute(l mechanisms to etiable at least _552_
solne(( **shaie** of 1(ollres **ore** ret to be shared armoilg states.

v. _International Aspects_ Many of the firrnis that operate in less (leveloped (lcountries are foreign firtmls. This gives rise to variotus other issues. For one. (certaini tax measllres imay lbe p)Icferrcd to others to the extent that foreign tax **cre(litinlg** is facilitat d. Use of thle ii oluiie tax systerm rather tharn frec eq(uity or lproduction sh]ar'ilng arrangements iiiay have that property. As well, the ab)ility of foreign coihl)ailies to slhift profits throngh transfer pricing an(l other ni(als will liniiit the extent to whicli soni tyl)es of taxes **oxn** resource rents will be effective. This imiay help to accoinlt for the, growinig use of other imeasures such as royalties, equity particip)ation aii(l leasing of prop)erty rights.

# 4. **Conclusion**

Developing country governments have become increasingly conscious of thhe desirability of levying taxes on ccononIic rents arisinig fromIrl nattural resources **occurring,** withini their )ound(aries. At the same timle they have slhown increasing sophistication in modifying the crude fiscal instrmnients that have **1)een** traditionally usedl for this purpose in order to bOth decrease the efficieiicy costs arising froiii the use of imperfect rent taxes and increase the prop)ortioni of the rents that they are able to attach for pulblic purposes. The timili has now l)eeIl **reached** in iniany coulntries at which the gains frorrm further refinemnent of what are lbasically very **crudle** taxes such as royalties **an(I** export levies mlighlt be far exb ee(lc(l l)y replacing t hem w'tli **inicih** simpler fornms of pare remit taxes.

53
# **APPENDIX:**

# **Measuring Marginal Effective Tax Rates in Resource Industries**

The riargiinal effective tax rate measures the difference between the pre-tax rate of return on the mnarginal investmrient and( the after-tax return to savers. The latter can **be** inferred from observed market rates of return. The formner is rtmore problematic because the rmarginal investment project cannot be identified. In. tead, the return on the marginal investment project is inferred from the user cost of capital. Consider, for examplle, the case of (lel)reciable capital (discussed al)ove. The value of the rnarginal **prodilct** of one uniit of capital in real termils is given by (9'). To convert it into a rate of return expression, two steps rmiust be taken. First, the entire expression is divided through by **qt** so it represents the rnarginal product per dlollar of capital. Then, to make it a rate of return the economic depreciation rate _(6_ - _Aq/q)_ is suibtracted out. This leaves _r_ as the rate of return on the marginal investment. That is also the rate of return on saving, so the marginal effective tax rate is naturally zero in the absence of taxes.

Suppose now we take a very simple, but representative, corporate tax system. Let the rate of depreciation for tax purposes be a applied on an historical basis to unldepreciated capital. Suppose that interest deductions are allowed on debt, but no (leductions are allowe(d for the costs of equity. Also suppose that there is an investmyient tax credit in placc at the rate 0 based **oIl** gross investment. The tax rate is _u._ Then, it can be **sh0owI** that the expression for the value of the marginal pro(luct of capital (9') muiist be **amendcd** as follows: where r is the real cost of fund(ls to the firm. Sn rpose a proportion , of the firm is financedl by debt and( the rest by equity, and( the nomrinal costs of debt and equity are i **ani (** p respectively. Then. given interest deductibility, r is given by:

**In** interpreting eqUatioIn (9"), note that _ua/(r_ + _a)_ is the present value of future tax savings **dile** to depreciation. Thus, given the investmnent tax credit, the second bracketed term onl the right-lhanid si(le of (9") can be thought of as the effective price of nIew investment.

**The** p)re-tax rate of return **caan** be constructed as above. It is given by:

_54_
Given the tax parameters anxd cstimSites of the true depreciation rate and the cost of funds to the firm, r. can be calculated. To obtain the rnarginal effective tax rate, the after-tax rate of return rn must be subtracted from r.. The after-tay rate of return is given by _rn_ = _Ptit +_ (1 _- 0_<sup>_3_</sup> _)pt._ Next, we want to apply the saxne methodology to a non-renewable resource firm. We consider a firm which is simultaneously involved in exploration, investment in mining facilities, and extraction. Inventories are excluded sco that sales equal extraction; it would be relatively straightforward to add inventories. The taxation of resources is notoriously complex in practice. For illustrative purposes we consider a relatively simple scheme which incorporates most of the key issues.

In the exploration stage, the firm hires current inputs _L_ at a price W and produces a depletable asset according to the strictly concave function S(L). (We are deleting time subscripts for simplic-ity.) It then invests in mining capital K at a price Q to make the asset ready {or extraction. The production function is _Z(K, F)_ where _F_ is the current use of previously discovered asset. This is the only stage at which depreciable capital is used, though it weuid be straightforward to allow for it at either of the other two stagcs. Finally, the firm extracts an amount Y of the resource according to the strictly convex nomiLnal cost function C(Y) and sells it at a price P.

The tax regime facing the firm consists of two taxes -- a corporate tax and a simple royalty or severance tax based on total revenues. The corporate tax involves write-off provisions foc depreciation and interest costs dnd an investment tax credit as above, as above as well as some deduction for the use of the asset itself (a depletion allowance). We assume a royalty tax rate of g based olI total revenues. The corporate tax liability will be written:

# _Tc =-u[PY - C(Y) - WL - oA - R - iB] + fQI._

where A is the accounting value of the capital stock for tax purposes. Here, R is the depletion allowance and is defined to be: though most systems are more complicated than that. All other variables are the same as defined earlier.

Given this, the expression for the cash flow of the firm is defined to be: 55
_CF= PY(1-u(l-t)-g)-C(Y)(1-u(l-t))-WL(1-u)-Q(l-f)I+oAu(l-t)_ where the accounting capital stock is defined as in (6) and investment is<sup>related to</sup> the real capital stock as in (5).

The firm maximizes the present value of its cash flow discounted by the nominal cost of funds r '- 7r dcbfined by (10) and subject to the following two resource constraints: The nirst states that the total resource extracted cannot exceed the total developed, while the second states that the total resource developed cannot exceed the total found. (In a more general version of this problem, this constraint would have to hold at each point in time.) The solution to this problem yields the following marginal conditions to be satisfied: The first of these is simply the pre-tax marginal product of capital. To convert it to _rg_ simply subtract 6 - _Aqlq_ as before. The second equation is the social value of marginal product per unit of the current input L. An effective tax rate can be obtained directly by subtracting unity from it. The final equation is a form of Hotelling's rule. It gives the pre-tax rate of return to society from not extracting the resource. It can be converted to an effective tax wedge by subtracting rn. These can be used to calculate marginal effective tax rates for a given institutional setting. Notice that the corporate tax and the royalty system interact in each of the decisions of the firm - the current input decision. the depreciable capital input decision and the extraction decision.

56
# **Suggested Readings**

For a general treatment of the economics of both renewable and non-renewable natural resources see: Hartwick, John M. and Olewiler, Nancy D., _The Economics of Natural Resource Use_ (New York: Harper and Row, 1986).

A survey of the literature on taxes and other instruments for obtaining revenues from, and regulating, various types of natural resources (fisheries, forestry, mining, oil and gas, and hydro-electricity), see: Heaps, Terry and Helliwell, John F., "The Taxation of Natural Resources," in Alan J. Auerbach and Martin Feldstein (eOs.), _Handbook of Public Economics, Volume_ I (Amsterdam: North-Holland, 1985), 421-72.

A general outline of the special problems of taxing natural resources in developing countries may be fcund in: Gillis, Malcolm, "Evolution of Natural Resource Taxation in Developing Countries," Natural _Resources Journal_ **22,** July 1982 620-48.

A survey of the theory and calculation of marginal effective tax rates, including alternative approaches and applications, may be found in: Boadway, Robin W., "The Theory and Measurement of Effertive Tax Rates," in J.M. Mintz amd D.D. Purvis (eds), _The Impact of Taxation on Business Activity_ (Kingston, Canada: John Deutsch Institute), 60-98.

An application of the role of rent taxation and the concept of effective tax rates to non-renewable resources is developed in: Boadway, Robin W., Bruce. N., McKenzie. Kenneth. J., and Mintz, J.M., "Marginal Effective Tax Rates on Capital in the Canadian Mining Industry," Canadian _Jouyrnal of Economics_ **20.** February. 1987, 1-17.

Some general issues of taxation in developing countries arc surveyed in: Newbery, D.M.G. and Stern, N.H., _T'he Theory of Taxation for Developing Countries_ (Washington: The World Bank), 1987.

For a recent treatment of the effects of taxes on investment in developing countries see: Shah. Anwar (ed.), _Fiscal Incentives for Investment in Developing Countries_ (Washington: The World Bank). May 1992.

57
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