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SELECT COMMITTEE ON THE SCRUTINY OF NEW TAXES - 19/11/2010 - Mining taxes

CHAIR —The committee now welcomes Professor Ross Garnaut to the hearing. Professor Garnaut would you like to make a brief opening statement?

Prof. Garnaut —Thank you for inviting me here. I submitted to the committee two papers, One was a public lecture that I gave at the University of Melbourne in May a few weeks after the original government announcement of the resource super profits tax. Some of the points taken from that are being published in an article in the Australian Economic Review and I sent a copy of that. They are my two submissions. The submissions focus very much on the concepts, the ideas, of resource rent taxation and that is what I am most qualified to help you with.

Early in my career this was one of the issues that I used to do a lot of work on with my colleague then Professor of Economics at the University of Strathclyde, Anthony Clunies-Ross. I did what used to be thought of and might still be thought of as definitive text on mineral taxation—the Taxation of Mineral Rents which was published by Clarendon Press in Oxford in 1983.

CHAIR —Wasn’t Minister Craig Emerson around at the time as well?

Prof. Garnaut —Minister Craig Emerson was a very good PhD student of mine at the time.

CHAIR —He was looking at these resource rent taxes, so we might have a bit of a sense as to where government got their ideas from?

Prof. Garnaut —I do not know. If they got them from Dr Emerson, they got them from someone who is well informed. I make those background points simply to say that my expertise is really on the concepts, on the structures of taxes and the effects of them. I have been very busy on a lot of other things in recent years, so I am not right up to the minute on every detail of the current discussion in Australia, but I can probably be helpful in answering questions on the conceptual issues.

11:49:50

I start from the position that this is a very important issue in Australia. In Australia, more than in any other developed country, the resources sector is a major sector in the economy. Resource rents are larger in this economy than in any other developed country except Norway. A resource rent is potentially a source of taxation that has relatively little distortion of economic activity, so it is a lower cost form of taxation than most of the ways in which we raise taxation.

I also make the point that, under our Constitution where the mineral resources are owned by the Crown, resource rent taxation in one form or another—royalties or profits taxes or in other forms such as the payment of fees—can be regarded as the price a private party pays for receiving a piece of public property, the mineral resources, when it is given exclusive rights to develop them. Those exclusive rights given by government are necessary to give the resource value. If you did not have the government giving some company a monopoly right to develop a mineral resource—for example, a big hunk of iron ore like Mount Tom Price—then you would have a free-for-all, which is what we used to have in things like the gold rushes. So it is economically efficient to give some company a monopoly right to an area and for the government, to stop anyone else mining that, to hand over property rights for that. Resource rent taxation in various forms can be seen as the payment for that exclusive right that is granted by the government to use public property and to exclude other people from using that particular piece of public property.

Resource rent taxation in Australia is complicated by the fact that the mineral leasing powers lie with state governments and, in a compromise way, territory governments and with the Commonwealth only straightforwardly in offshore areas. So if you are thinking of resource rent taxation being a payment for the valuable piece of public property being handed over, it is actually state property that is being handed over. But the Commonwealth also has clear corporation taxation powers. I am not a lawyer but it would seem that this is a case where there are legitimate rights of taxation at the state and Commonwealth level and sorting out the potential for some unproductive interaction has to be an important part of the policymaking process.

The issue is a complex one with many dimensions. I have gone through those dimensions in the book of which you are aware, in quite a lot of articles, in the two papers that I presented to the committee. So maybe it is best for me to be guided by your questions.

CHAIR —Thank you, Professor. Before going into the conceptual issues, I might go to a matter of process because I did note in your submission that you concede that ‘the manner of public disclosure of such a new, large and complex policy was not world’s best practice’. Then you say that should not stop us from assessing the merits. Moving forward from the original disclosure, do you think the process improved after that, when the government decided to sit down with three taxpayers, to the exclusion of the remainder of the industry, rather than to go through a proper, open, consultative process on those concepts that you think may have merit?

Prof. Garnaut —It is best I be straightforward. I would think that the best process—world’s best practice, to which I refer there—would have been for the Henry review recommendations to have been made public and for there to have been a thorough public discussion with everyone with an interest—from a public interest point of view or a business or private interest point of view—putting views on that. I think we would have had a better discussion if it had been done in that way. Obviously, that was not done the first time and it was not done the second time.

CHAIR —We are now in a position where we are trying to assess the merits or otherwise. We have got the policy transition group process going with very narrow terms of reference and prescriptions that it has to be revenue neutral and it has got to respect the main features of the tax. Do you think that the policy transition group process is adequate to ensure that there is a proper discussion of the merits of specific features of the tax, so it gives enough flexibility for the government to properly take on board the public interest as well as the various stakeholder interests?

Prof. Garnaut —My views on policy process are well enough known for it to be no surprise for me to say that I think that a complicated public policy issue like this will be handled better if there is widespread public discussion of it. But that process that is going on now involving some consultation will not be the whole of the process. The process that you are going through is part of the process. What I would hope is that through all of the various ways in which this will be discussed we can get all of the important interests, especially public interests, properly represented in the discussion. But if all there was for us was the process as described, that would not be enough. Fortunately, there are some other—

CHAIR —So the policy transition group process on its own is not enough?

Prof. Garnaut —No, I think that the processes of this committee and of parliamentary discussion and the public discussion that could go on around whatever comes out of the transitional process are all important to good policymaking.

CHAIR —You mention in your submission when the petroleum resource rent tax was introduced for offshore production. That was a much more inclusive and lengthy process of public discussion, wasn’t it? You were involved at that time to some degree?

Prof. Garnaut —I was not involved in government. I was involved because Anthony Clunies-Ross’s and my ideas were really what were being embodied in the policy proposals. So I took an interest in it, of course. I see that whole policy process as including the public discussion of ideas early in the process, of which there was quite a lot and you have mentioned Craig Emerson’s work. There were quite a number of economists discussing these issues publicly and that was part of a wider public discussion. The government followed that up with a white paper for discussion. So, yes, there was quite a long process last time.

CHAIR —But this time, of course, the government has negotiated the design of the tax with three individual companies who have got a particular business model—and these are the BHPs, Rios and Xstratas—and they have excluded the FMGs and the iron ore ones and all of the other companies who in fact had a different business model. Can you see why those companies that were excluded from that tax design process feel aggrieved and why they think that BHP, Rio and Xstrata were given a competitive advantage?

Prof. Garnaut —I will make a more general response. I think that the public interest would be well served by a wide discussion in which the interests of particular companies are legitimate, so we can hear their voices but we need a wider public voice. And there is a very big public interest in this question; it is not just that of BHP and Fortescue and the other mining companies. So I hope that we will get enough public discussion.

CHAIR —I totally concede that point—there is a wider public interest question which has to be discussed—but I have a lot of discomfort with the Australian government negotiating a tax and the design of the tax with three companies, excluding the public, the parliament and other competitive stakeholders and not being prepared to share any of the information. What is your view? When the RSPT was announced, it was announced that there was $12 billion in revenue, and then it was going to be $10½ billion under the MRRT. The assumptions were changed. The original tax would have raised $24 billion; now the exchange rates have changed it is $7½ billion. There has been a lot of moving around in revenue estimates before the tax has even been introduced. Do you think that the government should be more transparent around the assumptions they are using so that we can have proper public debate about the impact of the tax on the budget, on the economy and on the public interest in general?

Prof. Garnaut —I agree that this is such an important issue that we would all benefit from wide discussion of effects on the budget and the economy, and I hope we will still get some of that.

CHAIR —But it is difficult to have wider discussion if we have not got the information, isn’t it? The people who were on the inside of the room have the information, but the public at large do not have the information. We, the parliament, have tried to get hold of the information. Do you think it is legitimate for the government to keep secret the commodity price, production volume and exchange rate assumptions that they have used to estimate the revenue from the tax?

Prof. Garnaut —I think best practice is to be as transparent as possible on all of these things.

CHAIR —Do you think the design of the minerals resource rent tax matches up better with the idea of a resource rent tax, or was the RSPT in your view a better tax in terms of the way you have assessed the structures of these taxes in the past?

Senator HUTCHINS —And in terms of your comment on royalties as opposed to the tax as well, Professor.

Prof. Garnaut —Okay. This is not unrelated to your earlier comment, Chairman, but I am not aware of every detail of the new proposal that is necessary to form an authoritative assessment, because in these matters some quite arcane things can have a very big fiscal effect. I do not know anything that the readers of Australian newspapers do not know, so—

CHAIR —Let me be more specific.

Prof. Garnaut —Can I answer—because you have both asked questions.

Senator HUTCHINS —I asked you about the coalition’s royalties and MRRT—

Prof. Garnaut —From an economic efficiency point of view, a profits based tax—or even better a cash flow based tax—like the MRRT or the resource super profits tax has many advantages over specific and ad valorem royalties. That drove the Commonwealth towards use of profits based taxes and the resource rent tax in offshore areas for petroleum. Back in history it even, in the end, led the Bass Strait joint venture partners to ask if they could come under the regime, because at the time mineral rents were judged to be very high in the Bass Strait. Under successive governments from both sides of politics, royalties rose to very high levels—in some fields around 85 per cent—and they have the effect of making it unprofitable to fully extract the mineral resource, whereas a profits based tax or, especially, a cash flow based tax does not have that effect. So there is a general superiority of the profit based taxes over the ad valorem and specific royalties from an economic efficiency point of view.

CHAIR —On that point, though, we had evidence earlier that in the Northern Territory, for example—where they have profit based royalties as well as paying company tax, which is a profit based tax—there are circumstances where the people in the Northern Territory do not get any return at all from the extraction of a non-renewable resource, because if there is no profit then the miners do not pay company tax and do not pay a price for the resources they extract. Isn’t a state royalty the only certain way for the community to get a certain return for the extraction of non-renewable resources?

Prof. Garnaut —It is more certain but if there is no profit from mining a mineral resource then there is no economic rent.

CHAIR —If there is no capacity for profit should there be any ongoing extraction at all? If a butcher cannot pay the price of his raw material he is not going to be able to run his business. If a restaurant cannot pay for the produce because they are not making enough money to run their restaurant they are not going to be able to run the restaurant. If a mining company cannot pay the cost of the resources that they are purchasing from individual states should they be able to continue to extract that resource without a return to the community? Or should we wait until it maybe becomes profitable again when prices go up for that return to continue?

Prof. Garnaut —There is always uncertainty about future prices and therefore about profitability. It is sufficient to leave judgments about that to the private sector. I do not think there is a general policy problem in receiving no revenue from a mine that turns out to have no profit. One can go through the economics of that and show overall that it will be part of a favourable outcome. That will be balanced by other cases where mines are more profitable than expected and in which the public revenues will get a higher proportion.

No mining company will enter the production of a mine in the expectation that it will get no profit, obviously. Its expectations would be disappointed for some reason or other if it does not make a profit. There are economic advantages in not placing a tax burden on it in those circumstances. The analogy with the butcher, I think, would be closer if we were considering putting a specific duty on some of the butcher’s inputs—

CHAIR —That goes to the person who is selling the product. Resources, as you mentioned earlier, are the properties of the states and it is the states on behalf of the people in those states who sell those resources, for royalties, to those mining companies. A butcher would buy it in a private market but the principle is the same. Why is it appropriate for this sort of tax to be applied to iron ore and coal but not to uranium, nickel or gold? Is there an economic argument in favour of picking those two resources and excluding others?

Prof. Garnaut —There is no economic reason. If two mines are equally profitable, are the same size, take the same length of time and the same amount of exploration to bring into production there is no economic reason to tax iron ore more heavily than uranium, for example.

CHAIR —So why do you think the government has picked them? I am not asking you to second-guess the government but what would be a public policy reason to pick iron ore and coal instead of some of the other resources?

Prof. Garnaut —That really is better directed at the government, because all I can do is second-guess the government.

CHAIR —Is it fair to say, then, that it is an arbitrary choice?

Prof. Garnaut —I think that is fair to say. In the public discussion there has been some suggestion that these happen to be very large and very profitable activities at the moment, but not every iron ore mine is large and profitable, and not every other kind of mine is small and unprofitable. So yes, I think you would be struggling to find an economic justification for the distinction.

CHAIR —I will again pursue this argument around state property and Commonwealth taxation powers. The Commonwealth does have corporation taxation powers and they impose company tax, and at present the states are imposing royalties. One of the distinctions between this mineral resources rent tax and the super profits tax is that the government have said that they want to bring the taxing point as close to the mine gate as possible. What has been said to us by mining companies and others is that when you extract it out of the ground it is hardly worth anything. The value comes in when you can take it to port and add value to it along the way. So the question is: when does a minerals resource rent tax that is applied as close to the extraction of the resource as possible become, in effect, a royalty rather than a profits based tax?

Prof. Garnaut —These are the difficult questions of administration. The closer you go to the mine gate to apply the tax, the more you have to attribute costs to the process whereby you get from there to a place where the resource has an independent market value. You do have an independent market value once you put something on a boat, because there is a global market for sea freight and for the final product. It is a question of the simplicity and straightforwardness of administration whether it is better to value the product at the first point at which the resource is independently saleable or at the mine gate. If you do the latter, then you will have to attribute a transport cost and therefore a return on investment, so you have to go through an additional process to calculate the resources rent tax.

CHAIR —So by calculating the resource rent tax that way you have got to go through a whole series of calculations and you have got to apply a whole series of processes and assumptions in order to essentially come up with a construct rather than what is a verifiable profit as such.

Prof. Garnaut —Yes. Well, you can do that on the basis of very clear principles and, if you have got very clear principles, it will lead you to a result. But, yes, you do have to go through that construction.

CHAIR —In the Henry review the resource rent tax proposal was based on the proposition that it would replace state royalties and the resource super profits tax initially was going to refund all royalties because the states were going to abolish royalties. But there is a limit to how much state royalties will be credited; any increases will not be credited and anybody not subject to the MRRT will continue to have to pay royalties. This is becoming rather complex, isn’t it?

Prof. Garnaut —My memory—and I might be wrong, because, as I mentioned, I am losing lots of things and this is not one of the main ones—is that the original Henry proposal capped the reimbursement of state royalties—

CHAIR —I think that was a conditional government proposal. I think the Henry proposal actually envisaged that a resource rent tax would replace royalties altogether. The problem the federal government had is that, because they wanted to introduce it quickly rather than going through a lengthy public consultation process they did not have agreement from the states to abolish royalties. In fact to this day, they have not spoken to the state government in Western Australia, for example, about any of this. So it goes again to the matter of process.

Going back to the question I wanted to ask earlier, about whether the MRRT is better or worse than the RSPT: one of the features of the MRRT is that it has removed the risk-sharing component that the RSPT included—having a share of the 40 per cent in profits but then taking on 40 per cent of the losses. That is what the government proposed as part of the RSPT, which is a Brown tax concept. What is the impact of this on the pace of new mining developments or incentives to pursue risky projects?

Prof. Garnaut —I described in my public lecture at the University of Melbourne the Henry review proposals as an ‘elegant response to a complex problem’. I did draw attention to concerns I had had about the Brown tax when I was assessing all the different ways you would tax royalties. The Brown tax is only neutral if the private parties have confidence that whatever the scale of their losses they will be paid by the government.

One can imagine some circumstances, especially if there are differences of views across the parliament and the chance of a change of government, where an investor would not feel certain that if it made a very large investment and, unfortunately for the company and for the community, it made a loss that it would not be fully reimbursed. So, the questions about the neutrality of the Brown tax are all about perceptions of the certainty with which you will get the cash.

CHAIR —Which then comes into the political domain as to whether public opinion would tolerate governments bailing out big mining companies.

Prof. Garnaut —That is a dimension of it, to which I drew attention in the discussion of these matters in the seventies and early eighties.

There is an additional complication in the version of the Brown tax that was proposed by the Henry review, and that is that the cash payments were not made immediately when the negative cash flows were incurred. They were somewhat delayed through two processes. Firstly, instead of negative cash flows being partially reimbursed immediately, there was in effect a depreciation regime. So there was some delay in the reimbursement. Secondly, even when the period of delay had passed there was not reimbursement in cash, it was in the form, effectively, of a government bond. That raised an additional question of certainty about whether the payment would actually be made in the future. It would not only be contingent on political circumstances but also because ‘in the future’ is contingent on the circumstance as well. There was also a question about whether recoupment of the costs of delayed payment at the Commonwealth’s borrowing rate did properly reflect the cost of capital. So there were these quite important questions that needed to be debated about the original Henry proposals.

CHAIR —The proposal of the RSPT said that it did not distort incentives for investment. Does the MRRT distort incentives to pursue new projects? What is going to be the impact on investment incentives of having it apply to iron ore and coal and not to other resources?

Prof. Garnaut —Again, bear in mind that I do not know all the details of the MRRT so I am speaking conceptually. But let us make it more concrete; let us talk about the sort of tax you have got for offshore petroleum, which in some ways is the prototype for the PRRT.

CHAIR —Except that there are no state royalties offshore.

Prof. Garnaut —Yes, apart from that complication. But abstracting from that issue—and it is a very important issue—let us just look at the structure of the tax.

The resource rent tax in the form of a petroleum resource rent tax does not have the problem that the Brown tax has, that you have to have faith that the government will pay up a large amount of money, and it does not raise that question about the appropriate rate of interest on delayed payment.

It raises another question: what is the appropriate discount rate that you should apply to negative cash flows before the tax comes into existence? It will not be possible to get that precisely right, but if it is set broadly right, as I think it is under the PRRT, then it will be less distorting than other forms of taxation. And if you have it broadly right it will be relatively undistorting in relation to new investment decisions. Companies will know that they will not pay anything until they have the whole of their investment back, with a rate of return substantially in excess of the return on riskless investment. They do not pay anything extra until then.

That has the effect of compressing the dispersion of the probability distribution of the outcomes. That has the effect of reducing risk for the company, and so it is therefore a way in which you can raise taxation with a minimal effect on investment decisions. You cannot say it has no effect.

Senator HUTCHINS —Professor Garnaut, I have just a few questions. Do you have a view on how successful resource rent taxes have been overseas?

Prof. Garnaut —Resource rent taxes come in many forms. Even the royalty is a form of resource rent taxes. Taken across the whole range, they have been very large sources of revenue in quite a few countries—not unimportant in Australia. Generally the resource rent tax in the form that Anthony Clunies Ross and I propose—in the form of the petroleum resource rent tax and I understand in the form of the MRRT—have, where they have been applied, tended to be stable and consistent with a healthy expansion of the minerals sector. That seems to have been the case with our petroleum resource rent tax in offshore areas.

Senator HUTCHINS —Is the $50 million threshold too high or too low?

Prof. Garnaut —There are some details of the way that will operate of which I am not—

Senator HUTCHINS —Would you mind taking that on notice.

Prof. Garnaut —Okay.

Senator HUTCHINS —Is the 22½ per cent rate too low as the OECD argues?

Prof. Garnaut —If you have the other parameters of the tax right, you could have a higher rate of tax without having a large distorting effect on investment. Cash flows of 22½ per cent are of course a very much lower imposition than a similar imposition on the value of production, and on many mines that 22½ per cent will apply to a relatively small cash flow because it will only apply to the cash flow after recruitment of the whole investment, with a rate of return that is not high enough to attract investors. So 22½ per cent sounds higher than it will seem if you apply it in practice to a lot of outcomes. But in general one could say that a 22½ per cent tax is not too high. And it could be higher without distorting investment. There is some trade-off between the rate of tax and the rate of return you allow before you apply the tax. If you have a higher rate of return, you might want to err in the direction of allowing a high rate of return, given that there are issues of judgment involved in setting the rate of return.

Senator HUTCHINS —The OECD in its recent review of the Australian government warned the government against spending the revenue the tax generates, and they suggested that a special reserve fund should be established. Some have suggested it should follow the Norwegian approach of investing offshore. Would this reduce the effect on the exchange rate and avoid the Dutch disease? Do you have a view on the effectiveness of special reserve funds?

Prof. Garnaut —I like to see this as part of a more general story of how we handle temporarily large revenues, above what one might think of as long-term average revenues, that come with a boom. I have been worried about the level of total expenditure in Australia—investment plus private consumption plus government expenditure—since the early stages of the current resources boom in 2005. I have actually been saying since 2005 that we should have been running bigger budget surpluses by sparely spending the revenue.

CHAIR — At least then we would have budget surpluses. That is a long history. We have not had one under this government.

Prof. Garnaut —I would qualify my general view for the circumstances of the great crash of 2008 and aftermath, Senator. There were circumstances there where, if we had tried to maintain a balanced budget then or a budget surplus, we would have sent the economy into recession. But, with the exception of that period, since 2005 we should have been running higher budget surpluses. The fact that we are spending the money as we go along, and still doing it, means the general cost level in Australia is rising more than it would otherwise. It means that other tradable goods industries are becoming less competitive. It means that parts of the economy other than the resources sector are not finding it easy to gain access to capital, given total capital availability in the Australian economy is to some extent limited. I set out some of these issues in a presentation I gave to the Australian Academy of Technological Sciences and Engineering last week.

The question about a special fund is whether it is easier to run bigger budget surpluses if you have a separate fund—politically easier. There is no reason in principle why you cannot run bigger budget surpluses through a boom like we have had without such a fund, but probably it is easier if you are making quite transparent the stabilisation purposes of the fund and putting some money aside.

CHAIR —The Future Fund?

Prof. Garnaut —I think the Future Fund probably made it easier for the government to run that bit of the surplus at that time, yes.

Senator HUTCHINS —What about the benefits of, say, a cut in the company tax rate? You were just talking about the uneven benefits through the economy, so I wonder if you would like to comment on that for us.

Prof. Garnaut —There was some discussion in the Henry tax review of the advantages of a higher rate of resource taxation, part of which would fund lower rates of company tax more generally. The general theoretical position of the Henry review on that was that there were economic advantages in taxing income from resources and other fixed factors of production and reducing the burden on parts of the economy where resources are mobile. Speaking purely from a theoretical point of view, in the current circumstance of our economy there would be advantages in shifting the balance of taxation from the general run of competitive business and more onto businesses operating in the resource sector and in other monopoly enterprises.

Senator HUTCHINS —You would be aware that at this stage the Commonwealth is looking at the benefits of this scheme going into increased infrastructure spending, superannuation savings and cutting the company tax.

CHAIR —And reducing the deficit?

Senator HUTCHINS —What sort of advantage do you see from that? Is that going to have a flow-on effect to the economy?

Prof. Garnaut —I think in current circumstances—again, I am just talking analytically or theoretically—to have a higher rate of tax on the resources sector that is funding a lower rate of tax on other sectors in general would reduce pressure on those other sectors, which are under very great pressure at the moment. They have quite extraordinary pressure, actually.

CHAIR —You are saying the resources sector should help the rest of the economy: let’s have less taxation on all other parts of the economy funded by the resources sector. That is essentially what you are saying?

Prof. Garnaut —Yes, and that is an idea from the Henry review. I think there is something to be said for that. But in current circumstances in Australia I would be cautious about spending all the revenue anyway because I am worried that right through this boom, now for five years with the exception of the financial crisis, we have been spending too much and that has made—

CHAIR —But most of the money to be raised by the mining tax is going to be spent, isn’t it?

Prof. Garnaut —Yes, but my understanding is that that expenditure is still subject to the two per cent per annum expenditure growth constraint.

CHAIR —That is about getting to surplus; to have a two per cent expenditure restraint from record levels of spending, at crisis levels, is not a very challenging expenditure restraint.

Prof. Garnaut —Yes.

Senator HUTCHINS —Superannuation is going to be savings, isn’t it?

Prof. Garnaut —Superannuation is a contribution to savings—

CHAIR —Will the mining tax increase superannuation funds?

Prof. Garnaut —I have explained that I have not tried to follow every detail—

CHAIR —I think Senator Hutchins is being very disingenuous because he knows that the mining tax will not be funding increased superannuation savings.

Prof. Garnaut —Let me make the general point again, this is an extraordinary boom. I think we would be in a less risky position as a national economy if on average we had been running bigger budget surpluses through this boom. What that is doing to the competitiveness of the other sectors is creating some problems for the future.

Senator HUTCHINS —Geographically, who do you think will be paying the MRRT? Will it be mostly Western Australia, where many of the mines are located, or Victoria, where many of the big mining companies have their headquarters, or overseas, where a large proportion of the shareholders reside?

Prof. Garnaut —In the end it will be mostly shareholders who carry the cost, and for mining companies where a majority of shareholders are overseas there will be a significant burden on them. Of course the proportion of foreign ownership varies quite a lot across the Australian mining sector.

CHAIR —The MRRT is supposed to be applied on a project by project basis, which means you can geographically isolate it. You mentioned earlier there is no economic reason why you would pick iron ore and coal and not the other resources—and 98 per cent of iron ore production happens to take place in Western Australia. Dr Henry has conceded that most of the MRRT revenue will come from iron ore and not from coal, because of the way the MRRT and state royalty credits interact, so coal is going to be a comparatively smaller proportion. Is it fair to pick a resource for what is an arbitrary reason, as you have described, when 98 per cent of that resource is located in one state? It is a national tax being essentially targeted at one state.

Prof. Garnaut —I said something about federal-state financial relations in the public lecture I gave. If the tax is a good one and it happens that the burden lies mainly in one or another state, I do not think the distributional issue is important. But I do think there are very big federal-state financial relations problems with two aspects of the arrangements. One is horizontal fiscal equalisation—this is a big subject in itself. I think it is very important for Australia that we come to grips with that. I say in the paper that that provided a disincentive for the states putting in efficient taxation arrangements of their own. Under the horizontal fiscal equalisation, if they took the big effort that was necessary Western Australia would lose most of the revenue anyway.

CHAIR —I was interested to read that part of it. So the way the Commonwealth Grants Commission process works at the moment, if Western Australia for example puts up their royalties on something, or even another state, their GST revenue just continues to go down. So, really, there is no incentive for a state to become less competitive in terms of attracting investment, just to send the money over to other parts of Australia anyway. Is that what you are saying?

Prof. Garnaut —Yes. It is hard work to put in place an efficient taxation regime, and there is not much incentive for a state government to do that and to take criticism for it if it is going to lose almost all of the revenue.

CHAIR —So do we have to revisit that whole Commonwealth Grants Commission process from a public interest point of view, to make sure that taxation arrangements, federal-state financial relations, are as efficient as possible?

Prof. Garnaut —That is my own view, and it has been for quite a long time. I think it is a big problem of our Federation. I have only mentioned one problem, the horizontal fiscal equalisation, but these days—and this has been happening gradually on both sides of politics for a long time—almost every state function has been turned into a joint function by tied grants, so there are really no purely state functions where states take full responsibility for what they do. I think that is the source of dreadful inefficiencies in our Federation.

CHAIR —To be fair, when you are responsible you should be responsible for both the revenue—

Prof. Garnaut —That is right, or else there should be clear lump-sum payments to handle vertical fiscal imbalance that do not—

CHAIR —Like the GST going to the states.

Prof. Garnaut —If the GST went to them on a lump-sum basis—but, unfortunately, it goes through the Grants Commission process.

CHAIR —And that distorts all of that again.

Prof. Garnaut —In my view it does, yes.

CHAIR —I think that is a very sound view. You talked about the PRRT before. Of course it was applied offshore, where there were no state royalties. The proposition is that it now be extended onshore. Why was the PRRT not extended to the onshore areas when it was introduced in the 1990s?

Prof. Garnaut —Simply because of the complexities of federal-state financial relations. There was a lot of discussion at that time about the advantages of profit based royalties like the PRRT and some of the states and territories moved in that direction. Western Australia did it for the Barrow Island onshore oilfield. The Northern Territory introduced a variation on the PRRT theme. From memory, South Australia went a bit in that direction with Roxby Downs, but I would have to refresh my memory to be sure. There were some adjustments in what the states did at the time but the reason the Commonwealth did not come onshore then was the complications of federal-state relations.

CHAIR —So the Commonwealth then had corporate knowledge of the complexities from the federal-state financial relations point of view of introducing a PRRT onshore, given the state royalty dynamics and, for that matter, an MRRT. Wouldn’t you expect that, before the government proceeded with something like this, there would be active engagement with state and territory governments about the merits or otherwise of this tax as opposed to the current arrangements? Wouldn’t you expect that there would be a discussion over a certain period of time rather than just having it dropped not just on the mining companies but also on the state and territory governments and the public at large?

Prof. Garnaut —I have no idea what discussions took place, but world’s best practice would suggest there was careful discussion of these matters.

CHAIR —The WA Treasury, which appeared before this committee, told us in July that there had been no discussions, and they told us again last week that, even since the middle of July, there has not been any meaningful discussion at all about any of these matters. They still do not know how the MRRT is supposed to interact with state royalties. But I think you have answered the question to the extent that you think that, under world’s best practice, the government should have engaged with those governments as well as with everybody else. You would not have any views or understanding about the likely revenues from the MRRT across individual commodities and things of that nature?

Prof. Garnaut —No. I do not know whether that is because I have not looked for all the information that is available or because it is not available.

CHAIR —I just thought I would check. Thank you so much for your contribution to the committee; it was most interesting.

Prof. Garnaut —Okay, good to be with you.

[12.39 pm]