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Mining royalties

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Published on: Thursday, August 07, 2014

by Michael Knox - Morgans

In his first period as Prime Minister, Kevin Rudd introduced the idea of a new tax on mining profits. This was called the Resource Super Profits Tax. In introducing the idea for this tax, the Rudd government made three supporting claims.

The first was that resources were owned by all Australians. The second was that miners were making super profits after existing taxes and State royalties. The third was that royalties were very inefficient, so inefficient that the Henry Review of Australia’s future tax system recommended abolishing them.

These ideas of the Rudd government were supported by a report produced by consultants. Now, we have an article published in the academic journal Economic Papers, which does a very proficient demolition of that consultant’s report. The article is “Have Mining Royalties been Beneficial to Australia?” This article is written by Henry Ergas and Jonathan Pincus.

I don’t know Henry Ergas. I do know Jonathan Pincus. I encountered Jonathan when he was the President of the Economic Society of Australia (South Australian division). Jonathan is independent and fearless. He is amongst the most respected of Australian economists.

Jonathan’s paper swings off a point elsewhere referred to by Ross Garnaut in his book “Dog Days”. In our Economic Strategy of 10 July 2014, we noted that Ross Garnaut has a very poor view of the near term future of the Australian economy. The income from the mining construction boom is going to be paid to the owners of mining companies. Garnaut’s problem is that these mining companies are overwhelmingly foreign owned. This means that the income generated from mining will be mostly paid away to those outside the Australian economy.

First Dumb Assumption

Jonathan points out that the consultants have assumed exactly the reverse. They assume that the Australian mining sector is 100% Australian owned. Why have the consultants based a model on an assumption which was so dumb? I suspect that the terms of reference that resources were owned by all Australians led to the assumption that all of the resources were owned by Australians; same words, just a different order. The problem is this simple change in the order of words invalidates the whole consultants’ report.

Jonathan notes that “royalty payments are made by mining companies that are largely foreign owned. Therefore, Australians should benefit from royalties to the extent that foreign shareholders pay them; and to the extent that royalties push up the world prices of the relevant products and so improve Australian terms of trade.”

The consultants assume that Australian households own all the real assets used in Australian mining. In real life over 80% of the burden of royalty payments and company tax falls legally on non-resident shareholders of Australian based mining operations. Ergas and Pincus estimate that the final incidence on foreigners was around 80% of the public revenue derived from miners and their customers of which almost 70% fell on foreign shareholders. They say that the assumption that there are no foreign shareholders makes the consultant’s model “precarious”.

Because the consultants assume that mining is 100% foreign owned, this means that Australian households are simultaneously consumers and producers. However, if foreign ownership is taken into account, then the consultants’ estimates of the cost to Australian households of royalties would be overestimated by around 80%. Ergas and Pincus put this number at $2.8 billion. They say the net benefit to Australians from royalties and crude excise would be $1.1 billion.

Second Dumb Assumption

The consultants implicitly assume that the Australian mining industry would be just as productive if the Australian government had forbidden direct foreign investment. To anyone in the investment market, this is another dumb assumption.

Third Dumb Assumption

The consultants then assume that mining is using a costless renewable (inexhaustible) resource. Should this be true in practice, the Australian mining industry would not need an exploration sector. It would not need a finance industry to support that exploration sector. It would not need mining research or exploration research. It would never need to find new mines and develop them. To suggest this is dumb is an understatement.

However, if you make this dumb assumption, then it is pretty easy to come to the conclusion that the consultants come to that ‘excess returns were being earned by earners of non-land fixed factors of production eg. natural resources’. This is like assuming that the output of mines is like manna from heaven. In this case, the owners would gain excess returns. On the other hand, if they have to explore for the resources, find the resources and then mine them only for a finite period, then it is far less likely that the returns gained would be “excess”.

The consultants argue that the cost of living increases due to royalties and crude excise are larger than the public revenues that they generate. Ergas and Pincus point out that in 2007/2008, 85% of royalties came from black coal and iron ore. The shares of output exported were 83% for black coal and 90% for iron ore. They estimate that producers bore over 80% of the incidence of the $2.3 billion of royalties paid. That is to say $1.8 billion of the royalties paid were borne by producers.

Fourth Dumb Assumption

The consultants estimate that there is a big cost of living penalty to be paid by levying royalties. They estimate that Australian royalties increase the world price of minerals by 1.2%. This increases the CPI, according to the consultants, by 0.5%. Ergas and Pincus suggest ‘it seems implausible that the 1.2% increase in these prices would increase the CPI by 0.5%’. I can only agree. Mining is 8% of Australian gross domestic product. A 1.2% increase in mining prices should at most increase Australian prices by 0.1%. (8% of 1.2% is 0.096%). This is a fifth of the estimate provided by the consultants.

Ergas and Pincus begin their conclusion by saying “royalties are a traditional means by which the ultimate owners of exhaustible resources attempt to capture resource rents. To the extent that royalties perform this task well, they result in a relatively small reduction in output.”

“Foreigners owned over eight tenths of the equity in Australian mining companies”. The consultants “assumed that Australians owned it all. We estimate that the incidence of royalties on foreign owners of Australian mining equity provided excess benefits to Australia of 83 cents (black coal) and 89 cents (iron ore) per dollar of public revenue”. “When we ignore foreign ownership, we obtain an excess burden of royalties of a little under five cents per share of public revenue”.

They conclude “we are not claiming that royalties are superior to a practical rent tax: that comparison is yet to be made in a convincing way and is subject to the same considerations of foreign ownership that is raised here. We are, however, claiming that royalties, far from being prime candidates for complete abolition on our estimates are hugely beneficial to Australians. Moreover, an increase in royalty rates would have increased economic welfare, as well as boosting public revenue.”


The case mounted by the Rudd government for the resource rent tax was based on four erroneous assumptions.

The first was that the Australian mining sector is 100% Australian owned. The second was that the Australian mining industry would have been just as productive if the Australian government had forbidden foreign investment. The third was that mining resources are renewable and inexhaustible. Were this last assumption true, there would be no need to explore. The fourth was that the Rudd government assumed an implausibly high inflation effect for royalties.

Ergas and Pincus have exposed these errors and demolished the case for the resource rent tax. They show that the high level of foreign ownership of the resources sector means that mining royalties increase economic welfare.

The case for a Federal mining tax instead of State royalties no longer stands.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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