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A number of governments have recently imposed stiffer taxes on mining activities. While raising more revenue for the government in the short term, these taxes might discourage mining development over the longer haul. To what extent does it make sense on economic grounds for governments to tax mining, and at what level?
What’s the Optimal Tax on Mining?
John E. Tilton
July 9, 2010
Countries around the world impose royalties, corporate income taxes, excess profit taxes, and other imposts on companies mining coal, uranium, gold, copper, and other metals. While such tax regimes are complicated and difficult to compare, the tax burden on mining varies substantially among countries.
We also know that mineral commodity markets are highly volatile. When prices are high and mining companies are enjoying substantial profits, as has been the situation for much of the past decade, host countries often raise taxes in an effort to obtain a larger share of the wealth flowing from their mineral sectors. Australia, for example, has recently announced a substantial increase in taxes on mining, causing some companies to reassess their planned investments there. Australia, moreover, is not alone. Brazil, Chile, and other countries are also considering higher taxes on mining.
Arguments for Taxing Mining
Three common arguments are often encountered in the ongoing public debates over raising taxes on mining. First, some deposits, thanks to high grades and other factors largely associated with their geological formation millions of years ago, have particularly low costs. As a result, companies exploiting these deposits reap large profits—or what are often called economic rents—which governments should tax for the benefit of their citizens.
Second, mineral resources are inherently valuable due to their nonrenewable nature. For this reason, an opportunity cost—or what economists call a user cost—is incurred when they are exploited because they are now no longer available for future use. In many countries, mineral resources belong to the state by law, and higher taxes help ensure that the state and the public are properly compensated for the loss of valuable nonrenewable assets.
Third, higher taxes can provide a more equitable division of the wealth that mining creates between producing companies and the host country, particularly in light of the high prices and profits that the iron ore, copper, and other mineral commodity industries have enjoyed over the past decade.
A Closer Look
Upon reflection, however, none of these arguments for higher taxes on mining is particularly convincing. We know that the rents generated by low-cost mineral deposits provide the incentive for private companies to explore for new deposits. No exploration company is trying to discover a marginal mineral deposit (that is, one whose value reflects user costs but not any economic rents).
What drives the search for new mineral reserves is the hope of finding a world-class deposit with very low costs. For this reason, one can argue that there actually are no economic rents over the long run associated with mining because by definition a rent is a return the government can tax without altering the economic behavior of companies and other market participants. In any case, the important point is that governments that tax away what many think of as economic rents—that is, the profits associated with particularly rich and therefore low-cost deposits—will reduce and at some tax level completely eliminate exploration in the country. Over time this diminishes the viability of, and hence the potential returns from, its mineral sector.
The argument that mineral resources are inherently valuable because of their nonrenewable nature is similarly suspect. This is because empirical efforts to measure user costs have largely found them to be negligible. New discoveries and technological change apparently have offset the opportunity cost incurred in the future of using nonrenewable resources today.
The third reason for higher taxes—the need for a fairer distribution of the benefits from mining—suffers from at least two shortcomings. First, it requires the government to define what is fair, which is difficult to do in an objective manner. Reasonable people disagree over what is and is not fair, just as they disagree over what is and is not beautiful. In addition, it implies that governments in setting taxes should be concerned that all involved parties are treated fairly (however “fair” is defined), including the foreign shareholders of companies operating within the country. In well-functioning democratic societies, however, governments are elected by their citizens and ultimately expected to focus their efforts on promoting the welfare of their own citizens.
The Optimal Tax
As sovereign states, mining countries should set the goals and objectives they have for their mineral sectors so that the latter contributes as much as possible to the social welfare or the collective well-being of their citizens. While views may differ over the specific means needed to accomplish this general goal, one reasonable possibility is for the government to pursue taxation policies that maximize the net present value (that is, the value today, where future revenues are discounted for the time value of money) of the stream of revenues from the mining sector to the government over time. The government can then use these revenues to support education and other public services that improve the welfare of its people.
In this case, the optimal tax rate, measured as a percentage of mining profits, is clearly not zero, as this would produce no government revenues. As the tax rate increases from zero, the net present value of current and future government revenues rises, eventually reaching a peak. It then declines as the rising tax rate causes companies to cut domestic exploration, reduce the development of new mines, and at some point shut down existing mines. So pushing mining taxes beyond the optimal rate reduces the prolificacy and eventually kills the goose that lays the golden eggs.
Of course, governments may want to use their mineral sectors to promote job creation, regional development, and other public objectives in addition to generating mining taxes. If so, they should consider the net present value of all the social benefits flowing from the country’s mineral sector rather than just the net present value of its tax revenues.
In addition, governments may impose taxes on mining companies for the environmental damage they create in order to provide incentives for them to reduce such damage. In practice, however, most governments rely on command and control regulations rather than economic incentives to protect the environment from mining.
In any case, the critical question for Australia, Chile, and other mining countries is whether their current mining taxes are below or above the optimal rate. In practice, unfortunately, this is often difficult to determine. An increase in tax rates will almost always raise government revenues in the short run. As a result, it may be years before the adverse effects of higher taxes on exploration and new mine development become sufficiently clear to indicate that the tax rate is beyond the optimum.
Another difficulty arises from the fact that the optimal rate may shift over time in response to changes in mining taxes abroad. When a major mining country, such as Australia, sharply increases its taxes on mining, this increases the optimal tax rate in other mining countries. As a result, they too have an incentive to increase mining taxes. So higher Australian taxes could push the country’s tax rate on mining beyond the optimum initially. However, the new tax rate could subsequently become optimal as changes in mining taxes abroad, precipitated by the higher Australian tax, are completed.
Despite such complexities, the discussion above provides a logical and defensible rationale or conceptual framework for raising (or lowering) mining taxes. In contrast, most of the arguments that politicians and others are using today in advocating higher taxes on mining do not.
John E. Tilton (firstname.lastname@example.org) is a Research Professor of Economics and Business, Colorado School of Mines; Profesor de la Cátedra de Economía de Minerales, Centro de Minería, Escuela de Ingeniería, Pontificia Universidad Católica de Chile; and University Fellow, Resources for the Future.
This article is an update of his earlier study: Determining the optimal tax on mining. 2004. Natural Resources Forum 28: 144–149.