6.2 Key Fiscal Objectives

knowledge and the instruments it offers. Even if a single fiscal instrument could be described as “simple,” the fact is that at the extraction phase, oil, gas, and mining tend to be subject to a variety of fiscal terms that can include royalties, corporate income tax, windfall or additional profits taxes, production sharing (although not in mining) when selected, bonuses, fees or other contributions, and indirect taxes. Having too many different tax instruments under a given tax regime gives a wrong signal to potential investors on the effective tax severity and prevents a clear understanding of the interaction between the various taxes. A basic fiscal design rule is to try to minimize the number of fiscal instruments and to focus on the most important ones in terms of revenue capability.

Rewards and risk sharing derived from a fair fiscal regime

Designing a tax on rents from the extractive sector requires appreciation of some basic facts of EI life. In the vast majority of cases, foreign investment will be required (see chapters 1 and 3). The drivers to attract such investment are well established. Governments provide mineral or petroleum rights to private sector companies, with the expectation that the state will subsequently benefit from tax payments if commercial mines or fields are exploited. By receiving tax revenue, the government converts a resource in the ground into both social and economic capital (Sunley, Baunsgaard, and Simard 2003, 153). Correspondingly, private companies invest in exploration and development projects when a fair fiscal regime applies, with the expectation of making a profit commensurate with the risks involved and their cost of capital.

For both parties, there are potential rewards and risks, and the balancing of those will determine ultimately what EI sector development takes place and how beneficial it is to the government, the investor, and the local community (Stiglitz 2007; Date-Bah and Rahim 1987, 133n35). The fiscal regime is a key determinant of how EI sector income is shared between the investor and the government. There is no model that would immediately lead one to conclude what is a “fair” or “reasonable” share. However, there are recognized guidelines and best practices to be followed when a country designs a fiscal regime and selects its terms in hopes of establishing a regime considered fair by the parties. Even after initial agreement, there is no guarantee that this sharing of benefits will be sustainable over the long term, given the volatile and inherently uncertain investment life-cycle revenues.

Credibility and predictability of a fiscal regime

A recurring theme in the literature on fiscal design concerns the credibility of a fiscal regime.1 A fiscal regime must be credible to attract investment, but it also must be credible to the citizens of the country applying it. If not, it is likely to be challenged over the medium to long term. Linked to this credibility theme are the pressures on governments to demonstrate returns on publicly owned resources: they can act as a powerful incentive to adopt fiscal instruments that deliver early revenues from resource development. Reducing the frequency of changes to extractive fiscal legislation and other mining and petroleum legislation will increase their credibility for investors, who value stability. The fiscal regimes will also be considered more predictable for effective decision making.

Impact of different activities and contexts on fiscal regimes

Differences of approach and in fiscal regimes arise depending on whether the activity is oil, gas, or mining, even if they share similarities as “extractives.” Differences will also emerge according to the context in which a fiscal regime is designed (or updated). For some countries, the existence of active contracts inherited from the past will constrain the scope for change and force it to be incremental. (Examples can be found from mining in Guinea, Lao People’s Democratic Republic, Sierra Leone, and Tanzania.) These differences are highlighted in this chapter, along with the fiscal solutions to them.

Some understanding of comparable country settings and their tax regimes is also required, due to the number of areas and conditions in which exploration and production can take place and to the fact that investors favor those offering the more attractive tax treatment. Tax competition is a fact of life in the extractives sector, as in any sector. International tax issues can also be expected to play a part in other ways, even if many of these are not peculiar to the extractives sector.2 Treaty shopping and transfer pricing can have significant impacts, especially in the context of resource-rich economies.

Several web-based tools have been designed that have the potential to assist governments in addressing these fiscal design challenges. Some are mentioned at the end of this chapter.

6.2 KEY FISCAL OBJECTIVES

Ideally, the design of an EI sector fiscal regime should reflect objectives stated in a government policy document that sets

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out the overall strategic objectives for development and management of the sector. The proposed elements of any new fiscal regime or proposed changes to an existing fiscal regime should be presented clearly in that public document, offering stakeholders an opportunity to comment. Once a final decision is reached, it should be reflected in any resulting legislation. In practice, it is not usually the case that a fiscal regime can be designed with a clean slate, and some treatment of its predecessor in the policy document is likely to be necessary.

From the government’s perspective, the core objectives are likely to be focused on revenue raising: maximizing the estimated present value of net government revenues from EI. This is a goal best served by taxes, which are explicitly targeted on rents—defined as the excess of revenues over all costs of production, including those of discovery and development, as well as the normal return to capital, rather than on gross incomes (IMF 2012). There are, of course, various policy objectives that have implications for fiscal regime design, such as having broad-based sector development, ensuring that revenue arrives early and is dependable, limiting exposure to the risk of uncertainty and volatility in fiscal flows by designing a tax regime that is sufficiently progressive, ensuring the international competitiveness of the fiscal regime, minimizing opportunities for tax evasion, and having an administrative simplicity that is in line with the institutional capacity of the tax authority regarding the EI sector.3

The precise weight attached to these objectives will vary according to country-specific characteristics. These can include varying degrees of reliance (actual and potential) on extractive industry revenues as well as development needs, capital scarcity, and absorptive and institutional capacity. In many developing countries, capital stock is low, partly because investment has been low but also because there has been limited institutional capacity to transform investment into capital. Standards of governance vary considerably. Moreover, a change in resource reserves estimates could well extend the number of years during which natural resources can be expected to generate revenues (the resource horizon) and even the fiscal objectives themselves. Technological changes can also affect the market value of natural resources, making them easier to extract or increasing the portion that can be recovered. Different constraints can arise from past agreements made for existing projects, which make changes in fiscal objectives for those projects slow to implement— and further slowed by requiring mutual agreement.

From the investor’s perspective, key objectives are the maximization of profits and an early return on investment. Also important will be a positive indication that the fiscal regime remains stable over time. In resource-rich countries that have weak governance or that are perceived as having a low level of predictability, this consideration is likely to have a greater priority for investors.

Progressive rent capture

Rents are the excess returns from EI sector projects over and above what is required to justify investment, arising from the relative fixity in supply of the underlying resource, at least once it is discovered.4 Most governments take the view that the major share of these rents should go to the state, the owner of the resource—particularly for petroleum projects, but less commonly for mining. It is also widely accepted, and has increasingly become a political imperative, that as underlying project profitability increases, a state’s percentage share in rents or profits should also rise. However, the government share in the rents must leave private investors with an adequate incentive to explore, develop, and produce. An International Monetary Fund study concluded that in mining, governments commonly retained one-third or more of the rents, while in petroleum the share was higher at around 65 to 85 percent (IMF 2012, 6).

An increase in underlying project profitability is the result of an increase in market prices and production and/or a decrease in project costs. A fiscal system that produces these results—the share in rents rises as profitability rises— is called progressive. 5 It is positively responsive to changes in circumstances affecting underlying project profitability. So, a system with a zero share when profitability is low and a low share when profitability is high is progressive, as is a system with a high share where profitability is low and an even higher share when profitability is high. A system that produces the opposite result (a regime where a government’s share or “take” decreases as profitability increases) is called regressive. It is inversely responsive to changes in underlying profitability (see figure 6.1).

Promoting broad-based sector development and tax neutrality

While understandably interested in a high (but fair) rate of take from any one petroleum or mining project, governments are, at the same time, interested in their global take from the EI sector as a whole. This means that they are willing to promote exploration and development of mines and fields of different sizes and also are interested in maintaining a broad tax base. A government can maximize the tax base by, as far as possible, ensuring that new EI sector

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Figure 6.1 Progressive, Proportional, and Regressive Fiscal Regimes

Tax paid

0 Income

Progressive Proportional Regressive

Source: 11cresma 2010.

projects or ongoing resource-producing operations that are profitable before tax remain profitable after tax. A fiscal regime that accomplishes this is going to make the more profitable before-tax project less profitable but still attractive on an after-tax basis, in the sense that it does not impact or distort the decision to invest or produce (such a system never takes more than 100 percent of the rent or profit available before tax) (Tordo 2007, 14). Those neutral fiscal regimes can be expected to encourage new investment across a wide range of opportunities and extend the producing life of existing operations.6 Fiscal neutrality is achieved when the fiscal system does not distort investment decisions for a project evaluated on either a before- or after-tax basis.

Getting early and dependable revenue from a project

In the EI sector it is the prospect of substantial rents that makes these resources an especially attractive source of revenue. Particularly where their petroleum or mining sectors are either new or only narrowly developed, governments will place a premium (often politically driven) on early and dependable income from the EI sector. The emphasis on early revenue may be driven by urgent needs or may simply be driven by public expectation of revenues once a petroleum field starts production or a mine is opened. Dependable revenue (such as revenue that is ensured as long as a project is in operation) is clearly beneficial to budgetary planning, but it is subject to price volatility and other uncertainties. However, once an EI sector becomes more fully developed and a regular and steady stream of fiscal revenues is being generated from a variety of projects, this objective becomes less important.

International competitiveness of a country’s fiscal regime

Petroleum and mining companies operate on a global scale and compare fiscal terms among country projects when deciding, after a careful economic study of their portfolio of EI projects and opportunities, where to invest (Tordo 2007, 2). Governments, therefore, are greatly interested in how competitive their fiscal regimes are. At the same time, governments are mindful about not being more generous than the terms offered in comparable states. Such states are those with similar geological potential, cost and operating environments, track records, institutional capacity, and perceived and actual political risk. These elements can be as, or even more, important than fiscal regimes in determining the level of investor interest.

Fiscal competitiveness may depend on matters such as the level and behavior of the government take. This is normally measured by government revenues; rates of government take (see figure 6.2 for an example of a hypothetical project); responsiveness to production, price, and cost changes; the time and risk profile of the investor; and the investor’s internal rate of return.

Administrative clarity and simplicity

Administrative capacity is an issue in most developing states. Fiscal design in the EI sectors, often supplemented by insufficiently detailed fiscal rules, is not always tailored to a state’s capacity to administer a fiscal regime. This is one of the reasons that many states struggle to administer their regimes. There is an argument to be made in favor of simplicity in the design of a fiscal regime (Rio Tinto 2012). Above all, it is of paramount importance that the general tax rules applicable in the country be sufficiently tailored to the EI sector. Most difficulties in tax administration derive from the absence of sufficiently clear tax rules and guidance notes applicable to EI activities. Such rules should be incorporated in a specific part of the tax legislation or, alternatively, in sector-specific tax legislation, provided that it is made fully consistent with the general tax legislation.

Trade-offs among the objectives

In practice, it is not possible to achieve all of these objectives simultaneously. Trade-offs are almost always required. Many of these trade-offs will become more apparent when fiscal instruments are discussed in the following sections.

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Figure 6.2 International Fiscal Competitiveness

AETR, at 15% discount rate

100

90

80

70

60

50

40

Angola a. Oil, AETR for selected states and a given project

Namibia EquatorialGuinea Cameroon Timor-Leste Ghana 2008 Mozambique Australia Nigeria Madagascar Ghana 2006

AETR, at 15% discount rate

100

80

60

40

20

0

Tanzania Ghana Alternative b. Mining, AETR for selected states and a given project

Namibia ZambiaPapua New Guinea Malawi Botswana SouthAfrica GhanaCurrent Peru Zimbabwe

Source: IMF fiscal analysis of resource industries (FARI) model hypothetical simulations (IMF/Ghana Ministry of Finance Seminar 2010.) The use of 2006 and 2008 for oil for Ghana refers to fiscal terms at the time of the Jubilee discovery (2006), and terms suggested as more appropriate to the reduced geological risk following that discovery (2008). Similarly, for mining in (b), “current” refers to what was applicable at the time of the IMF review, and “alternative” suggests how terms might be improved. Note: AETR = average effective tax rate, the government’s share of the before-tax net present value, usually measured at the government’s assumed discount rate. IMF (2012, 26) research on 16 petroleum and 11 mining regimes for a given project suggests that most petroleum regimes have a higher AETR and include more progressive elements than do mining regimes. Panels (a) and (b) show standard international comparisons of AETR or “government take” for a hypothetical oil and mining project only. Ranking may differ with other projects.

The trade-offs that governments face derive not only from inherent conflicts among the state’s different objectives but also from the fact that investor objectives—in any fiscal regime—may be at odds with the government’s. For example, an investor will always want to maximize its return and minimize its risk, but the government may also be trying to do just that for itself. Fortunately, both parties are now beginning to recognize what constitutes a fair fiscal regime and that a well-designed regime can address each party’s concerns.

Stability of fiscal regime

An investor concern or objective that deserves particular attention is the stability of the government’s fiscal regime. A long-standing investor fear is that at the end of a long and

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