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Economics Legislation Committee
21/02/2012

ERGAS, Professor Henry, Private capacity

Committee met at 9:02

CHAIR ( Senator Mark Bishop ): I declare open the first hearing of the Senate Economics Legislation Committee’s inquiry into the Minerals Resource Rent Tax Bill 2011 and related bills. The bill was referred to the committee on 10 November 2011 and the committee is due to report to the Senate on the bill by 14 March 2012. To date, the committee has received 31 submissions, which are available on its website.

These are public proceedings, although the committee may determine or agree to a request to have evidence heard in camera. I ask everyone to ensure that they have switched off their mobile phones. I remind all witnesses that in giving evidence to the committee they are protected by parliamentary privilege. It is unlawful for anyone to threaten or disadvantage a witness on account of evidence given to a committee and such action may be treated by the senate as a contempt. It is also a contempt to give false or misleading evidence to a committee.

If a witness objects to answering a question the witness should state the ground upon which the objection is taken and the committee will determine whether it will insist on an answer, having regard to the ground which is claimed. If the committee determines to insist on an answer, a witness may request that the answer be given in camera. Such a request may, of course, also be made at any other time.

I remind members of the committee that the Senate has resolved that departmental officers should not be asked to give opinions on matters of policy and shall be given reasonable opportunity to refer questions to superior officers or to a minister. This resolution prohibits only asking for opinions on matters of policy and does not preclude questions asking for explanations of policies or factual questions about when and how policies were adopted.

A witness called to answer a question for the first time should state their full name and capacity in which they appear and witnesses should speak clearly and into the microphones to assist Hansard to record proceedings.

I now welcome Prof. Henry Ergas. Would you like to make an opening statement to the committee?

Prof. Ergas : Yes, indeed, I would. First of all, thank you for the opportunity to appear before this committee. In an earlier paper; together with my co-authors, Mark Harrison and Jonathan Pincus; we argued that the initial Super Profits Resource Tax was confiscatory and inefficient. The Minerals Resource Rent Tax, which succeeded the Resource Super Profits Tax, was borne from negotiations between the largest mining companies and the newly installed Prime Minister.

As we explained in the paper I referred to, the result is a tax that has numerous distortions and inefficiencies. These include the use of a single threshold rate for a tax liability, which will distort investment in the taxable resources—coal and iron ore—away from risky projects and towards less risky projects. The fact of taxing those resources while not taxing others will distort investment as between coal and iron ore on the one hand and untaxed resources on the other. The tax invites state governments to increase royalty rates, thus exacerbating any inefficiencies those royalties cause, particular in terms of marginal projects.

Finally, as the tax amounts to the government acquiring an option on the relevant income streams, the revenues from the tax are likely to prove highly volatile, aggravating the pressures for increased public spending in good times and forcing potentially undesirable reductions in outlays in downturns.

We also noted that the MRRT was based on the assumption that it would be easy to identify the rents that were to be taxed. We stressed that identifying economic rents was by no means a simple undertaking, all the more so given the high degree of vertical and horizontal integration that characterises the major miners. Since then the legislation for the MRRT has been tabled and adopted by the House of Representatives. The legislation confirms our concerns with respect to the MRRT. Indeed, the legislation’s approach to identifying economic rents, resource rents in particular, raises additional problems above and beyond those that we suggested. These issues arise in the way the legislation requires income to be attributed within vertically integrated mining operations, as between upstream activities—that is extraction—which is where the tax is intended to apply, and the downstream activities of transporting and processing the resource.

Overall, the legislation appears to have moved away from the clearly stated intent of the MRRT, stated in the bill itself, to being the taxation of resource rents and from the recommendations of the Policy Transition Group report. The stated principle of leaving downstream revenue and profits out of the scope of the MRRT appears to have shifted, with the bill focused on costs that are actually paid or that would be paid in a competitive market and hence to the revenues that would be attributed in such a market to downstream operators, leaving the remaining revenues imputed to the resource and hence subject to the tax.

The Policy Transition Group report was very clear about the treatment of downstream profits and the scope of the MRRT. Page 13 of the PTG report states:

Profits derived from benefic ation or any other downstream processing are not intended to fall within the scope of the MRRT.

Section 110 of the bill reflects this overarching goal. However, in important respects the bill, in its detail, deviates from that objective. In particular, section 30.25.3 requires the use of an allocation method that ‘produces the most appropriate and reliable measure of how much of the revenue amount is reasonably attributable to the taxable resource’. That is, in itself, consistent with the overarching purpose of the bill that I noted above. However, section 30.25.4 then severely curtails the applicability and operation of section 30.25.3. That subsection states that in using such a method a number of assumptions must be made ‘to the extent they are relevant to the method’.

Paragraphs 4.91 and 4.92 of the explanatory memorandum appear to envisage a very wide application of those assumptions saying, ‘It would be expected that the assumptions would be relevant to any method that requires or takes into account, expressly or implicitly, evaluation of the downstream operations.’ Given that, the required assumptions are clearly of great importance. What those assumptions appear to do is to narrow greatly the scope of the transfer pricing methods that may be used.

Whilst the PTG report stated that in order to use the most appropriate and reliable method widely understood concepts and methodologies including OECD profit methods must be considered, the application of that section would seem to rule out most of the OECD profit methods that are usually accepted. The effect of this is to convert the downstream assets into what amounts to little more than a regulated utility that can and must be confined to earning a regulated rate of return. In turn, the effect of that is to shift to the upstream resource, and hence into the scope of the tax, income that is properly attributable to the efficient innovative operation of the downstream assets.

CHAIR: Professor, we have very limited time this morning. We have committee members from four or five different parties who would all like to ask you questions. We have all read your submission. Would you mind bringing it to a conclusion so we can go to questions please?

Prof. Ergas : Indeed, I will. The result of all of this is that it will deter efficient vertical integration. Where entities are vertically integrated, it will induce them to postpone investment in downstream assets as the risk involved in that investment will not be properly compensated and, as with other rate of return regulation, it will reduce the incentives for efficient operation of downstream assets which in turn will compromise the overall efficiency of Australian mining.

I am sure all of you remember the queues of ships off Dalrymple Bay and Port Waratah. This legislation creates a serious risk of those crippling queues becoming nationwide. Thank you.

CHAIR: Thank you. In the presentation you made to the Tax Institute’s Great Tax Debate on 31 August you stated, and I quote:

I think that the Minerals Resource Rent Tax is a very poorly designed tax which is likely to prove, in the long run, a very seriously distorting tax for decisions about investment in our natural resources.

I take it from your opening four principle criticisms that you stand entirely by that statement that you made in August or September of last year.

Prof. Ergas : Yes, I do.

CHAIR: In terms of principled opposition to this bill, it is not seriously different from your opposition to the bill that was first considered by the government when Mr Rudd was Prime Minister?

Prof. Ergas : Do you mean the Resource Super Profits Tax?

CHAIR: Yes, I do.

Prof. Ergas : I think there are a number of quite substantial differences between them, obviously both in design and effect, but they are both seriously flawed, albeit for somewhat different reasons.

CHAIR: So your opposition is maintained. In your review for the opposition, the policy document that you prepared for the opposition which you have discussed on the public record, did you recommend the use of resource rent taxes or did you come out against the use of resource rent taxes?

Prof. Ergas : I am not sure I have discussed the substance of the review, as such, on the public record. In fact, I do not believe that I have. What I have discussed are my views about tax and I am happy to answer your question in terms of my views. My views are that, in theory, resource rent taxes are a very good idea, but they pose many practical difficulties and when you get their implementation wrong that can have very serious consequences.

CHAIR: Do you believe in government’s applying tax to land, as opposed to non-renewable minerals below the land?

Prof. Ergas : Do you mean: do I think taxation of land is a good idea?

CHAIR: Yes.

Prof. Ergas : Yes. I believe there is a strong case for land taxes, but I would also note that whenever I have discussed that I have equally made it clear that there are substantial implementation issues associated with land taxes and, again, getting the design right is absolutely crucial.

CHAIR: So the design and the structure of the proposed tax is critical to your support?

Prof. Ergas : Yes, indeed.

CHAIR: You made some reference in your introductory remarks to four principle objections: effect on risky projects, distortion of investment between minerals covered by this tax and other minerals, encouragement to state governments to increase royalties, and the option on development of income streams for developers. Would you concede that investment into minerals, mining projects and ancillary development, some of which are proposed to be covered by this bill, are unprecedented in terms of investment going into those industries in this country?

Prof. Ergas : Yes, they are, indeed. We are in the midst of a mining boom.

CHAIR: Yes, we are. Do you agree some of the projects that investors are investing into have a significant degree of risk attached to those projects?

Prof. Ergas : Undoubtedly.

CHAIR: That risk could be sovereign risk, currency risk, infrastructure risk or wages cost risk. There are all sorts of risks.

Prof. Ergas : Yes, it is a broad number of risks.

CHAIR: Would you concede that projects that are at an advanced stage of consideration or where boards of companies have made commitments to the necessary infrastructure as part of the project have full information now about the proposed bill before the chair and its consequences?

Prof. Ergas : I am not quite sure what you mean, but they undoubtedly know about the bill.

CHAIR: I am asking the question in terms of risk for companies that are currently at an advanced stage of consideration of investment in coal, iron ore or coal seam gas attached to coal exploitation. Do you agree that they should have full information and knowledge of the risks that might be attached in terms of cost to this bill?

Prof. Ergas : Yes, but there is obviously substantial risk that they would have to estimate.

CHAIR: Yes, and they are in the business of doing that estimating?

Prof. Ergas : Yes, they are.

CHAIR: From the prices of the shares of the major companies, at least, in the iron ore and coal extractive industries, they seem to be relatively capable of examining and pricing that risk correctly.

Prof. Ergas : At least as correctly as anyone else.

CHAIR: That is a fair response. Your second point was that you thought that there would be a distortion in investment flows between mineral extraction covered by this bill and other minerals that might be the subject of investment not covered by this bill. Did I hear you correctly when you said that?

Prof. Ergas : Yes, that is correct.

CHAIR: Why is that the case when companies, suppliers and purchasers of, for example, coal or iron ore seek to purchase a particular product or indeed a particular grade or a particular fine usually for a particular purpose, firing in a particular way? How is there any comparison between investment in that range of projects and say copper, gold, zinc, oil or other crudely described extractive minerals industries?

Prof. Ergas : There obviously is in the sense that capital is fungible. It can go either into investing in iron ore or it can go into many other things in the economy, including other forms of minerals. If you tax iron ore and coal differently from the way you tax other minerals then, at the margin, you will distort those investment decisions in exactly the same way that if you have tax concessions for home ownership relative to the way you tax other assets in the economy, that will alter, for good or ill, the distribution of investment in the economy. From that point of view, when you impose a tax on one group of minerals but not on others, a consequence of that is that over time and at the margin you will distort the allocation of investment between them.

CHAIR: You have twice used the phrase ‘at the margin’. Given that the returns in iron ore, from the public statements of the major companies, the amount of investment flows going in there and the high degree of debt used by companies like Fortescue at high costs to develop their projects, I suspect that it is fair to conclude that the rate of return, or the absolute return, is extraordinarily high. Can I ask you: does that very high rate of return, to some extent, offset your concerns of projects perhaps not going ahead at the margin?

Prof. Ergas : No, it does not. It seems to me that you are first of all making an assumption which is that long-run rates of return are exceptionally high. Mining projects are very long lived.

CHAIR: They are.

Prof. Ergas : If you look at the ABS data on returns in mining over the long run, the long-run returns to Australian mining have been very close to the costs of capital for mining. That tends to be true worldwide for mining because mining is subject to very severe commodity price cycles and has extremely long-lived investment assets. When you look at it over the long period of time that encompasses the life of the relevant assets, rates of return on mining around the world have been pretty close to the cost of capital, and in some cases well below it. So I do not agree with your initial premise that properly calculated rates of return are extraordinarily high.

The second point, which is perhaps more important, is what happens in the economy is that even assuming that you have a commodity price boom and that that boom increases the attractiveness of a particular group of resources relative to others, then what happens is that investment flows into the areas that are now more attractive until rates of return at the margin, that is for the marginal dollar that is available to be invested, are equalised across projects. That includes investors taking on projects that are more risky in the normal state of things or inherently more difficult. When you impose differential taxation on projects that compete in the market for capital you inevitably affect those investment decisions in the long run. You affect those investment decisions so that even though projects which society would be better off were they undertaken could be undertaken absent the tax. With the differential tax on them they are no longer attractive and so in that sense there is a loss not merely to investors but to society as a whole.

CHAIR: I understand that response. I have one final question in that context. I come from Western Australia so I pay particular attention to matters relating to the mining industry of course, most of which is on the public record. You would be familiar with the huge ongoing projects there of what appears to be huge renewed investments in support services and ancillary services so the projects can be developed, whether it is port, rail, housing, towns or whatever. In the context of your earlier response, those major companies up there, and even some of the medium sized companies to a lesser extent, principally BHP, Rio, Fortescue and a range of the smaller to mid-size companies which are developing iron ore and like resources, appear satisfied that the long-term return for capital currently invested and proposed to be invested is adequate to satisfy their boards. Would you agree with that?

Prof. Ergas : I do not know. I am not a member of those boards and I am not really in a position to tell. What I can say, and this comes to an earlier point that you made which I agreed with, is that there is a great deal of investment underway. It seems to me that when we are looking at these issues of resource taxation, which are crucial issues for an economy such as ours that is so heavily dependent on and so well endowed with natural resources, so these are really crucial issues, that what we need to think about is not merely what is happening at the moment, that is the train that has already taken off, gathered pace and will continue likely along the path that it is now on, but to worry about what happens next, what happens in the long run, what happens when we have a period where circumstances are not so rosy, possibly followed by, one hopes, another upsurge in world demand for our commodities. We really want the next generation of Rios, Xstratas, BHP Billitons and Fortescues. Those are the people we need to worry about. My concern about this tax, as it is currently structured, is that it will defer efficient investment risk-taking and growth by that next generation and I think that would be a great loss for our economy.

CHAIR: If it occurred. Thank you. Senator Cormann.

Senator CORMANN: This whole process started, of course, with the Henry tax review which was supposed to deliver a simpler and fairer tax system. Do the MRRT and expanded PRRT changes make our tax system simpler and fairer?

Prof. Ergas : I do not believe they could be said to make it simpler. As I am sure as all of you have had, I have had the experience of reading through the legislation and trying to think in some detail about how it would be applied, and it seems to me that this legislation is both inherently complex—and I accept that any such legislation would have to be complex—but as well as being inherently complex it raises many issues of interpretation. It is extremely unclear in some places and simply incorrect in its use of economic concepts in other places, and all of that will, I fear, give rise to not only considerable litigation but also great uncertainty which will aggravate the effects this tax may have in chilling socially desirable investment.

In terms of fairness, it is rather difficult to say, but I do not believe that inefficient taxes do much to promote fairness, because fairness is best promoted by increasing the size of the pie and then using that greater pie so as to cater to legitimate concerns about fairness that a society such as ours should have.

Senator CORMANN: Given the way the MRRT originally was designed and the basis of it, the MRRT deal signed between the Prime Minister, the Treasurer, the Minister for Resources and Energy and the three big miners that we have ended up with, is the tax that is before us now competitively neutral or can it be said, as has been argued by some, that it provides a competitive advantage to the bigger miners and makes it harder for the smaller miners to compete with them?

Prof. Ergas : I do not believe this is a particularly good tax from the point of view of society as a whole, for the reasons that we touched on earlier. I am concerned about its overall effects on our long-term prospects for our mining industry as a whole, but what is also true is that within the mining industry it is designed in such a way as to have a differential effect on different types of miners. As my colleagues and I show in the paper that I referred to at the outset of my remarks, the effective tax rate on smaller, riskier projects and mining operations is many times the tax rate on large, mature operations. That is one of the reasons why this tax will be so distorting in the long run, because for mature operations it is not so onerous a tax but for the newer, riskier ones it has extremely high effective marginal tax rates.

Senator CORMANN: Much has been said in the context of this debate about the distorting effects of states’ royalties to justify the need for tax reform in general and the need for the MRRT in particular. Is the MRRT more or less distorting than the status quo?

Prof. Ergas : In my view it is more distorting than the status quo, essentially because in the status quo we have royalties. It is undoubtedly true that there are some efficiency issues associated with royalties, though in my view the AFTS report, the Australia’s Future Tax System report, the Henry review, did not quite get the economics right in respect of royalties. Nonetheless, there are some issues in respect of the economic consequences of royalties. With that said, with the MRRT it means that those miners who are not in a position to have their royalties refunded will still be affected by any distortions associated with royalties. For those marginal, smaller and newer projects you will still get the royalties distortion. Then on top of that you will get the distortions associated with the MRRT, so the aggregate distortion that this creates could be very significant indeed.

Senator CORMANN: In terms of the net fiscal impact of the mining tax package, that is the revenue the MRRT is expected to raise and the cost of the measures the government has attached to it, have you had a look at that? What is your assessment of the net fiscal impact of the mining tax package?

Prof. Ergas : Clearly, there are a number of uncertainties in that respect. I think the legislation has attempted to increase the likely revenue take essentially by taxing profits that under any traditional OECD transfer pricing method would be attributable to the downstream. What the legislation is intended to do is to capture those profits in the upstream and hence increase the effective tax take. How that will play itself out, especially given the starting base issues, is just very difficult to tell at the moment. But that said, I am still of the view that on balance the commitments the government has made on the spending side outweigh, or somewhat more than outweigh, the likely long-term revenues from the MRRT. In assessing that it is important to note the final point I made in terms of our concerns in the Ergas-Harrison-Pincus paper about the tax, and that final point was that mining profits as measured by this tax are going to be highly volatile and so the tax take is going to be highly volatile, yet the spending commitments do not have the same level of volatility and that will create pressure on expenditures in other parts of the budget over the longer term.

Senator CORMANN: You expect the revenue to be volatile. Given that we have records terms of trade at the moment, would it be fair to say that the revenue will also be downward trending all the time, as Treasury has indicated in its projections released on the FOI?

Prof. Ergas : Yes, that is correct. Again, it is difficult to tell because you have interactions with the starting base issue, but the important point to bear in mind is that, although at the moment of course our terms of trade are extremely good and resources prices are by and large very high, it is also true that as studies by the IMF and the World Bank have shown recently, commodity prices have not become less volatile. If anything, what has happened is that the volatility, as such, of commodity prices has risen. In particular, we seem to be going into a world where the booms are larger but the busts are also greater, though the duration of the busts may be shorter.

In a sense, what is happening in the world, if you think in terms of statistics as it were, you can think of a bell-shaped curve as having normal distribution, but commodity prices do not follow normal distributions over time. What has happened is that the skewness and the kurtosis of commodity prices over time have increased. That means that the volatility in terms of the severity of the swings has risen. Obviously, it is difficult to know what the future will hold—indeed, impossible—but if you accept that then the impact of this tax is that we have an increasingly volatile revenue source but it is effectively devoted to spending commitments which themselves do not have that degree of volatility.

Senator CORMANN: No. Obviously, when you have got high commodity prices what would normally be expected as a supply response and indeed Treasury, in its Mid-Year Economical and Fiscal Outlook, says that the medium-term outlook is for Australia’s terms of trade to decline as the global supply of iron ore and coal increases. As the global supply of iron ore and coal increases what would you expect to happen to commodity prices, all other things being equal?

Prof. Ergas : Commodity prices will decline, which is of course what happened in previous cycles. When Japan emerged as a major purchaser of commodities in the late 1950s and early 1960s, initially there was a strong price response. One consequence of that strong price response was that the Japanese buyers then naturally tried to react to that price response amongst other things by developing new sources of supply. That was to our great benefit. That was why they came to Australia. As their demand increased they found the existing sources of supply were supply constrained, so you had a steeply upward sloping supply curve and so, as demand increased, prices rose very rapidly. Ray Vernon, a great economist at Harvard—unfortunately now deceased—wrote a marvellous book about this process called Two Hungry Giants: The United States and Japan in the Quest for Oil and Ores. It is a marvellous study of exactly that process, and that process worked. On that occasion it worked to our great benefit. Now, we are, as it were, the incumbent suppliers, and we are trying to increase supply as much and as efficiently as we can. But the rest of the world is not simply going to stand by and accept that prices will remain at those levels without other countries also seeking to have, to put it very colloquially, a share of the action.

Senator CORMANN: In the mining tax deal, the government agreed to a request by the three big miners to provide for a market valuation method to determine the starting base in terms of effectively an upfront tax deduction which can be taken over a period of up to 25 years. What is the effect of that?

Prof. Ergas : I am not as critical of that as many other people are because it does seem to me that it is sensible to take account of the fact that the assets that the miners have were highly valuable assets that they had invested in over a very long period of time, and that is what the starting base does. The difficulty though is less with the consequences of that than with the fact of having both that and a single threshold rate for tax liability, because that threshold rate for tax liability, the rate at which the MRRT cuts in, is a rate that is reasonable from the point of view of a fairly mature, well-established operation but that is very low from the point of view of high risk operations. When you have both the starting base and that single threshold rate then, yes, there is a difference in the effective marginal tax rate and the effective average rate going forward for the incumbent larger miners and their operations compared to small, high-risk miners and those small, high-risk miners, the junior and mid-size miners will, in my view, face extremely high and very distorting marginal tax rates going forward.

Senator CORMANN: Effectively, the bigger miners will pay lower effective marginal rates.

Prof. Ergas : Yes, lower effective marginal rates.

Senator CORMANN: Because it can be depreciated over a period of up to 25 years, nothing would be stopping the BHPs, Rios and Xtratas from depreciating it over 10 years and effectively not paying any tax for an extended period of time.

Prof. Ergas : That is possible.

Senator BOB BROWN: You referred a while ago to those miners who are not in a position to have their royalties refunded; which ones are those?

Prof. Ergas : Those are going to be miners who broadly do not have net revenues that are sufficient for them to be subject to the MRRT and yet are producing output or, for instance, if they are in the final stage of mine life and are facing a decision about when to shut down, then royalties will affect that decision.

Senator BOB BROWN: Yes, but you are not contending that there are some miners who will pay the MRRT and then will not get their royalties refunded under the current proposal?

Prof. Ergas : No. The way the proposal would work is it allows the offset of the royalties.

Senator BOB BROWN: Do you understand what the formula or the process will be for having the royalties refunded?

Prof. Ergas : My understanding is that the royalties will be refunded effectively as an offset against the tax. Is that what you mean?

Senator BOB BROWN: Yes. More particularly, do you understand how then the arrangement with the states will be readjusted?

Prof. Ergas : I am sorry, do you mean in terms of the—

Senator BOB BROWN: The Commonwealth and the states for raising royalties which are involved in this—

Prof. Ergas : The horizontal fiscal equalisation?

Senator BOB BROWN: That is right.

Prof. Ergas : It is not entirely clear to me at the moment exactly what is involved, and that is subject to the review of horizontal fiscal equalisation which is currently underway. At the moment, what seems to be intended is that when a state government increases its royalties, the Commonwealth would effectively offset that through reductions in its transfers to that state or territory that had increased its royalties, in particular that some of the payments for infrastructure funding that would otherwise have been made as part of the MRRT would be reduced.

It seems to me that is an extremely inefficient way of dealing with the problem, because effectively what it does is it takes the funding notionally from the MRRT that would be available for state infrastructure projects. If you think of the MRRT as funding in part a pot that would go for state infrastructure projects and then, instead of allocating that pot on the basis of where the returns to infrastructure spending would be greatest, it allocates it on some other basis that offsets royalties, so you would get two distortions; you get the distortion from the royalty effect and then you get the distortion from the distortion to the method of infrastructure spending.

Senator BOB BROWN: It is not quite clear from what you said whether you think that royalties or a resource rent tax is the more efficient. Which one of those taxation options do you see as being more efficient?

Prof. Ergas : From the perspective of economics—and economics is like all other disciplines; people have different views and there is a robust debate out there as to the merits or demerits of the alternative views. But in theory if you were designing a system ab initio you would actually use a combination of taxes, so in theory you would use properly designed royalties, properly designed resource taxes and properly designed upfront auctions. You would set the rates in such a way as to, as it were, minimise the net costs in distortion that each of those types of taxes imposes per dollar of revenue that it raises. We are very far from that. For instance, we do not make enough use of upfront auctions of natural resources. We tend to have royalties that are perhaps at times a bit high, at other times, a bit low. Then we have a resource rent tax which, as I said in theory is not a bad idea but which, in the practice of this tax, is in my view at least very poorly designed.

As to your question, there is not an answer of the kind that says, ‘I like ice cream and I do not like cabbages.’ Rather, the answer to your question is a balanced diet, a balanced diet but well-designed and well-cooked. Whereas at the moment we have an unbalanced diet and one that to boot is very properly cooked in the process.

Senator BOB BROWN: All taxes are distorting, aren’t they?

Prof. Ergas : Yes, they are because all taxes affect behaviour. The consequence of that is that in reality all taxes have a cost that is somewhat greater than the revenue that they raise. That does not mean that you should not tax; it just means that you should tax sensibly and efficiently in such a way as to get, as it were, the revenue you need at the least cost to society.

Senator BOB BROWN: You said that you were concerned that the tax as proposed is on coal and iron ore but not on other minerals and this distorts investments. Would it be better if it were extended to gold, zinc, uranium and the other minerals?

Prof. Ergas : I do not believe that this tax would be improved by being extended because I believe that it is very poorly designed. I would hope that in future, including by sitting down with the states and working with them on a cooperative approach—I realise that involves great challenges of its own; it always has and always will—we could design taxes that would be better suited to the task and less costly and less distortionary, and in that context they should apply to natural resources as a whole.

Senator BOB BROWN: What about a sovereign wealth fund where you have got a big resource base? We have got Norway for example with a sovereign wealth fund which is there to help the economy now but also to have the rainy days, or the economic downturn days, better catered for. You spoke about that. What is your view on a sovereign wealth fund based on our natural resources wealth?

Prof. Ergas : Of course there are significant differences between our economy on the one hand and Norway and Chile’s on the other in the sense that both Norway and Chile are dependent to a much greater extent on a single resource, petroleum and natural gas in the case of Norway and copper in the case of Chile. In the case of Norway at least, not only is the petroleum resource a much larger part of the resource endowment—they do have hydro-power as an important resource, but it is secondary—but it is also a much bigger part of their economy and they have historically been very concerned about its non-renewability and the view that it would be depleted reasonably quickly. In that sense they, on that basis, therefore sought to achieve two objectives through their sovereign wealth fund. They sought to achieve an objective of macroeconomic stabilisation, as it were, using the sovereign wealth fund to insulate their economy to some extent from this massive amount of wealth that accrued to it as a result of the initial discoveries and then the subsequent developments of further resources so there was an insulation purpose. Secondly, there was an intergenerational equity purpose to it because they were understandably concerned that this resource would be depleted relatively quickly and then future generations of Norwegians would be much worse off.

Our situation is different from that in the sense that we have a much wider portfolio of resources. The prospects of depletion are much more limited than they at least initially were for Chile and for Norway. Of course, Chile is now embarking on a very major expansion of its resources, as is Norway, so those depletion prospects have, if anything, been shifted further out in time. Even with that wide portfolio it is a smaller share of our economy and hence the need for insulation is not all that great.

Senator BOB BROWN: So you do not favour a sovereign wealth fund?

Prof. Ergas : I do not. I do not believe that a compelling case has of yet been made out. I am also concerned that sovereign wealth funds can lead to distortions of their own. Governments can spend against them. That happened to both Chile and Norway at times. It is difficult to control their efficiency. There are better ways of investing for the future.

Senator LUDLAM: You have spoken at length of the complexity of some of the flaws in the proposed tax. Do you see potential, given that complexity which you have identified in your submission, for gaming of the system, particularly by the big miners, whether it be through cost shifting, transfer pricing or other accountancy tricks?

Prof. Ergas : When you impose a significant tax you are always going to provide incentive for people to minimise the tax that they pay. One of the ways in which they are going to do that is to try to shift income out of the taxed pool into the untaxed pool. To that extent, yes, this tax does invite that.

Senator LUDLAM: You have spent quite a bit of time thinking about the make-up of the tax and how it is drafted. If you were going to try to game it, how would you do it?

Prof. Ergas : Well, that is a very good question and I am sure there are much greater minds than mine, and much more highly-paid minds than mine—

CHAIR: You have got an excuse.

Senator LUDLAM: They all work for the companies—

Prof. Ergas : So they were dependent on precisely those issues at the moment—

Senator LUDLAM: What are the vulnerabilities—

Prof. Ergas : In all fairness I have not devoted all that much time to that. But I think the issues that will arise, even under the tax as it is currently proposed, will include timing issues, revenue recognition issues and particularly cost allocation issues; what the allowed rate of return on the downstream assets should be; how that allowed rate of return should be allocated; what the relevant asset base downstream is; and at what pace those downstream assets should be depreciated. All of those issues will doubtless arise in respect of this tax.

Senator LUDLAM: I take it you agree that there are substantial—it is obviously a bit unfashionable to call them super profits these days—resource rents out there at the moment in this part of the cycle over and above what it would take to get deposits into production, which is the basic premise of the tax in the first place?

Prof. Ergas : That is a good question—

Senator LUDLAM: One of our submitters has referred to them as ‘alleged resource rents’ I think. That was Fortescue. Do you think they are alleged or are they real?

Prof. Ergas : That is a very good question because, as I said earlier, part of the difficulty in this respect is that these assets are extremely long lived and very high risk. If you think back to when they were developed and take the assets that seem at the moment to be goldmines, so to speak—and I am referring to iron ore in the Pilbara—when the initial work was done on development of Hamersley, China was in the midst of the Great Leap Forward and suffered millions and millions of deaths as a result of the Great Leap Forward. Anyone who had said that China will emerge as a huge and hungry purchaser of Australian iron ore would have been regarded as pretty questionable and—

Senator LUDLAM: Sure, but Professor, if I can just drag you 40 years forward—

Prof. Ergas : if you go back—that is when those investments were made.

Senator LUDLAM: But the adjustments—

Prof. Ergas : If you go back over that it is not clear that there are those resource rents there.

Senator LUDLAM: You do not agree with the premise that there are pure economic rents at the moment, that with what has happened to commodity prices in the last five or 10 years, that we are in an environment of super profits?

Prof. Ergas : Let me put it this way. I believe that there are some resource rents. I think identifying those resource rents is extremely difficult and I think the problem is that if you tax what are not resource rents but the returns to risk-taking, the returns to investment and efficiency, thinking that you are taxing resource rents, that will have serious consequences for the economy.

Senator EGGLESTON: In your comments on economic issues related to this, in point five you say, ‘The public discussion, including government commentary, on the RSPT and now the MRRT has focused on the rivers of gold it is claimed these taxes will yield.’ But you then go on to say, ‘These claims are little more than fiscal illusion.’ Would you flesh that out a little bit for us because that suggests that, rather than providing a great stream of revenue which can be used for social purposes in the community and redistribution if you like and sharing the wealth of the mining boom, perhaps that is not going to be the outcome?

Prof. Ergas : The point we are making in the paper is that because the tax base is so volatile the value of that tax revenue to the community is less than the dollars it involves might suggest. The way to think about it is as follows: if you were given a choice between two revenue streams, one which had a relatively small number of dollars but was relatively stable and another which at times had a large number of dollars but was very volatile and unpredictable, then this might well not regard that riskier, more volatile income stream as quite as valuable as the more secure one. The error that is made when people look at big amounts but that are risky as if those were certain amounts, as if those were amounts that did not have risk, is a kind of illusion. It is an error. It is understating the cost of risk.

One point of view on that is to say, ‘Well, government is well placed to bear that risk.’ One point of view would be to say, ‘Government can bear those fluctuations.’ But what we have seen in recent years, rightly or wrongly, is that governments are highly sensitive, for many good reasons—sometimes for less good reasons—to budget outcomes, to relatively short-term budget outcomes. What that means is that they are not going to be well placed to bear the risks associated with highly volitive revenue streams, particularly when they are trying to use those revenue sources to fund non-volatile recurring expenses, and to think otherwise is a form of fiscal illusion. It is an illusion associated with taxation.

Senator THISTLETHWAITE: I guess you have written quite a bit on tax reform in Australia. It is true, is it not, that you have advocated in the past reform of our company tax system to implement a system that you would see as more efficient, one by which a resource rent tax model would be applied to all businesses throughout the country such that the ATO establishes an expected rate of return on capital in a particular industry and then there is a tax applied on the profits over and above that expected rate of return. That is something that you have advocated in the past; isn’t it?

Prof. Ergas : That is not quite right. What I have suggested is that in the long run there is merit in moving towards a form of cash flow taxation. Cash flow taxation is notionally similar to a resource rent tax; it is not exactly similar. One form of a cash flow tax is a resource rent tax, but what I have also said, and what everyone else who to the best of my knowledge have advocated such a move have said, including AFTS, is that there are very significant transition and design issues associated with that and that if you get those transition and design issues wrong then you will do more harm than good.

Senator THISTLETHWAITE: But that is something that you have advocated beyond the resources sector, in terms of an economy wide company tax, isn’t it?

Prof. Ergas : Yes, that is correct.

Senator THISTLETHWAITE: You have also advocated that stamp duty should be replaced with a land tax on all properties throughout Australia.

Prof. Ergas : Yes, that is correct.

Senator THISTLETHWAITE: Do you support the government’s proposal to reduce the company tax rate from 30 per cent to 29 per cent?

Prof. Ergas : I can see merit in it. I have some concerns about it, but I can see merit. I have sympathy with the argument that was put by AFTS, that is the Henry review, that currently our company tax rates—which when we moved to those rates were perhaps slightly lower, but broadly similar to rates in Europe—are somewhat higher. If you accept the logic that we compete in a world market for capital, then there is a case for bringing them down. I have two concerns about that, though, that I am not sure have been fully addressed. My first concern is where we are dealing with foreign investment and that taxation on that investment is subject to dual taxation arrangements. In those cases it may be that all that really happens is we lower our company tax rate and taxes payable overseas rise, so there is merely a shift in taxable income, not a net reduction in taxable income.

The second issue is that I get concerned, as I suspect do most others, when you have too large a difference between the top marginal, personal income tax rates and company tax rates, that you create undue incentives for income shifting and then add to compliance costs as you try to offset the effect of those incentives.

Senator THISTLETHWAITE: Thank you.

CHAIR: Thank you, Senator. Thank you very much, Professor. We are well over time. The questioning has been most interesting. Thank you for your courtesy in attending this morning. Would officers of the Institute of Public Affairs come forward to the table, please?