Taxes for the future

Raw material exports are a crucial source of income for most developing countries. Relevant goods include finite resources such as oil and gas but also renewables such as wood, biomass, cotton or food. In view of high global demand for resources, high commodity prices look certain for the years to come. Developing countries should take advantage of such opportunities.

On the other hand, development experts consider dependence on commodity exports a bad thing. Econo­mists like Richard Auty and Jeffrey Sachs speak of a “resource curse”, alluding to the observed paradox that economies with lots of natural resources tend to grow relatively slowly and, above all, perform poorly in terms of important indicators such as income distribution, employment or education. Accordingly, countries that depend on raw materials should implement prudent policies to avoid the pitfalls.

Non-renewable resources will one day run out, so policy-makers must take that into account. Exploitation of mineral resources should be geared to the common good and harnessed to promote national development. To safeguard society’s future welfare, any depletion of non-renewable resources must be offset by investments in other assets. This is known as “Hartwick’s rule”, named after the economist John Hartwick. It equally applies where the use of biological materials depletes nature – for instance, in species-rich rainforests.

Compensatory investments are not enough, however. In fairness to future generations, action also needs to address the environmental damage done by mining fossil or mineral resources or by cultivating large plantations. Therefore, even development strategies that rely on commodities must pay attention to minimising the use of resources like soil and water and boosting the efficiency of all relevant industries. Advanced sustainability concepts, such as the World Bank’s “Adjusted Net Savings”, for example, factor in greenhouse gas emissions, and thus provide the conceptual basis for taxing those who profit from environmental impacts.

Tax answers

Taxes are important instruments for tackling these challenges. Due to rising world market prices, tax revenues in many resource rich countries have increased in the past decade. Indeed, according to the IMF, the governments of sub-Saharan Africa trebled their commodity revenues to nearly 15 % of economic output from 1998 to the start of the global financial crisis in 2008. That surge needs to be put on a sustainable footing, with taxes providing the right incentives for sustainable resource management.

Taxes have an impact on issues like productivity, the provision of public goods, intergenerational just­ice and environmental consumption. These are core aspects of sustainable development. Taxation enables a government not only to finance public goods but also to influence behaviour.

Fiscal policy is also often used as a tool of distributive justice. It does not serve sustainability, however, to exempt fossil fuels from taxes or even subsidise them – as is the case in many developing countries. Governments that adopt such policies reward harmful behaviour and shift the cost of present consumption onto the shoulders of future generations.

Designing tax systems so that the general public gets a fair share of a country’s commodity wealth is a task with technical and political dimensions.

Technical options

In the case of many finite resources – and increasingly also cash crops – production is dominated by multinationals. Resulting challenges include double taxation and tax manipulation by transfer-pricing (see glossary). A high level of sunk costs, moreover, is typical of extractive industries along with initially uncertain profit prospects and long production periods. Therefore, appropriate taxation has to take account of the entire project cycle. Obviously, there is scope for progressively increasing taxes in the course of time, especially in the mining sector.

Countries as diverse as Venezuela, Kuwait and Norway set up public enterprises to administer national oil revenues and serve the public good. Where governance is weak, however, there is a high risk of such agencies mostly serving the interests of powerful elites.

Another option is to tax private companies’ profits or sales. But the legislation required for a targeted tax regime is difficult to draft. Implementation is challenging too. Loopholes for tax avoidance need to be eliminated.

A third option is to generate product-related government revenues. Most countries regard their underground assets as public goods and charge companies a fee (royalty) for the right to exploit them. Such levies generate revenue for the state as soon as production starts, regardless of whether the company makes a profit. However, they also reduce earnings prospects for investors, who can thus be deterred.

Other fiscal tools include “production sharing agreements” for oil and gas extraction as well as auctions for exploration or extraction rights. In most cases, it makes sense to mix various instruments. Governments with weak capacities, however, may struggle to find the right balance.

Political obstacles

It is not uncommon for developing countries to have the government and private-sector companies negotiate the rules for commodity sectors behind closed doors. The latter are often large multinational corporations. Because governments do not always monitor and enforce their regulations, moreover, there often is scope for unlawful conduct. The flexibility of bilateral negotiations serves private actors more than it does public authorities.

At the same time, unpredictable institutional and regulative environments push up the cost of financing and insuring projects. In difficult circumstances, private companies will demand special safeguards for their investments.

To ensure that investors can calculate their tax burden and that the public good as well as interests of affected parties are duly considered, it makes sense to pass comprehensive rules for entire economic sectors. The process of regulating and controlling the exploitation of natural resources is an issue of public relevance. It involves legislators, public administrators and the judiciary.

Most OECD nations have put in place such rules a long time ago. They command the political power and administrative capacity needed. Many developing countries, however, do not do so. Therefore, development cooperation should be geared to supporting developing country governments to implement overarching sector rules and develop long-term sector strategies along with transparent tax regimes. This is not only about reforming tax laws and tax administration; it is also about reviewing bilateral investment and double taxation agreements.

At present, the chances for reform are good. Thanks to the massive surge in demand for raw materials, developing countries tend to be in a stronger bargaining position today than they were in the past. The re-negotiation of contracts can thus swiftly result in sharp increases in government revenue. Countries like Bolivia, Ecuador and Zambia have gone down this route recently; Peru is preparing to follow suit. Talks of this kind, of course, must be geared to long term success. Financial speculation in commodities, however, tends to hamper long-term policies.

Value of transparency

Ultimately, transparency benefits all parties involved. Where things are not clearly regulated, financing costs will rise, investment activity decrease and tax revenues eventually decline.

Transparency needs to be guaranteed by both sides. Companies must disclose their profits and payments in each country they operate in (country-by-country reporting), and governments need to declare what they use tax revenues for. Apart from revenues, prudent allocation of funds is a crucial component of any credible fiscal policy.

Where the public has a say in budget matters, the acceptance of extractive activities is likely to rise. In many resource-rich countries, only a small group of national elites and multinational corporations profit from the exploitation of natural resources. It may be difficult to widen the circle of beneficiaries and reach out to broader sections of society, but it is not impossible.

Governments have several options. A reasonable step, for example, would be to compensate local communities for damages caused by the expansion of extractive operations. Alternatively, tax income can be used to fund ecological restoration projects. It matters particularly to use extraction revenues for improving development opportunities in the future, when society will have run out of finite resources to export. Investing in education, for example, serves that purpose.

Investment in resource sectors often has an international dimension. So the question of fair and effective taxation needs to be discussed in international forums and in direct dialogue with multinational corporations. Other policy fields such as foreign trade, investment promotion and environmental protection need to be covered too. In most cases, bilateral action alone is unlikely to result in appropriate tax policies and sustainable development of the extractive industries.