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Fiscal systems
Fiscal systems
Keith Brewer, Gilles Bergevin and Robert Dunlop
This article compares mining taxation in Canada, the USA, Australia, Brazil, Chile, Indonesia, Papua New Guinea, Peru, South Africa and Zambia. It calculates the effective tax rates experienced by a hypothetical mining project and the sensitivity of tax rates to changes in profitability, inflation and product price cycles. The study assesses the advantages and disadvantages of various tax treatments and also examines the direction of tax reform in the USA and Canada and what implications reform would have for the mining sector. The authors are employees of the Department of Energy, Mines and Resources, Canada, Ottawa, Ontario, Canada KlA OE4. The opinions expressed herein are those of the authors and do not necessarily represent the position of the Department. The authors would like to acknowledge the contribution of other members of the Economic and Financial Policy Analysis Branch in the completion of this paper. Roberta Albert was instrumental in collecting information about mineral tax regimes, developing tax models and undertaking the preliminary analysis of tax systems. Lise Hubert was responsible for much of the computer work. Charts and figures were designed by Jacques Savard. The bulk of the typing was capably handled by Renelle Leger and Moira Dussault. Of course, any errors or discrepancies in the paper are solely the responsibility of the authors.
This study is designed to provide an evaluation of certain fiscal systems in place, as at March 1986, in a number of major mineral producing countries. The focus is on income based taxes and how these taxes perform under a variety of conditions. Income based taxes are not the only taxes paid by mining companies, but are generally important in terms of public policy. These taxes are frequently used as a tool of based taxes are often used by industrial policy: that is, income governments to influence the development of the economy in certain directions. Even in countries without an explicit industrial policy, income based taxes are generally a significant government intervention in private business. They have an important impact on an economy’s allocation of resources through their complex distributional effects. To understand the complete impact of taxation on the competitive position of an industry, we would also have to consider the effect of other types of taxes, including sales taxes, excise taxes, capital taxes, tariffs and others. Such taxes are important but they are not considered in this study. This study is primarily concerned with identifying and examining the structural causes of certain types of behaviour of tax systems under specific economic circumstances. For example, which tax systems produce an increase in effective taxation during inflation and why? How do tax systems deal with problems such as the cyclical nature of mining; are these measures successful? Absolute comparisons of the tax burdens in various countries are avoided, as they are extremely difficult to interpret and are often misleading. The tax treatment of mineral income is a complicated and sensitive issue. Relatively minor income tax changes may have a significant impact on the viability of a given project or class of investment. The amount and type of mineral exploitation in a country can be significantly influenced by the tax system. Accordingly, extensive revision of income tax provisions in several countries may result in major changes in the development of mining. The process of tax reform in the USA had been largely completed before similar movements took place in Canada and other countries. The US experience had a major effect on the others. As the USA’s largest trading partner, Canada was particularly influenced by US reforms. The Canadian Minister of Finance observed in Guidelines for Tax Reform in Canada: Recent developments
0301-4207/89/020131-18$03.00
0
1989 Butterworth
outside of Canada provide further impetus for our review
& Co (Publishers)
Ltd
131
Fiscal systems
of the tax system. In particular, personal and corporate tax rates in the United States have been lowered. Our close economic ties underline the need to ensure that our tax system allows Canadian producers to remain competitive with our major trading partner.
Given the need to reduce rates, the general direction of tax reform in Canada and other countries is relatively clear. The tax base was broadened, as it was in the USA. Nevertheless, the Minister of Finance also noted that ‘. . . the Canadian and American tax systems are not identical. Tax reform in Canada is not a matter of duplicating changes in the US.’ Thus, while it is generally acknowledged that Canadians now face a tax system with lower rates and a broader base, the specific steps taken to reach these ends were designed to best suit the specific needs of the Canadian economy.
Methodology The approach taken is to apply the tax system of various countries to the financial results generated by a mine model. The assumptions underlying the model are changed so that the sensitivities of taxation to differing economic conditions can be investigated. The mine model was developed in consultation with several private Canadian mining companies. It is based on the cost conditions of an open pit copper-gold mine of the type that is found in British Columbia. (Some work has also been done using an underground copper-gold mine model based on northern Quebec conditions, but the results of these simulations are not presented in this article.) The base case simulation of the mine model assumes general price stability; metal prices are set so that the project will yield a 15% pretax internal rate of return (IRR) over its life. The project is assumed to be developed on a stand alone basis ie it is not developed by a large company with income from sources other than the project. It is also assumed that the project is entirely equity financed. The study also uses computer models of mineral income tax legislation. The choice of legislation to include was made difficult by the number of levels of government involved and the resemblance of many royalty schemes to income taxes. In general, however, royalties (ie taxes based on production volumes or other similar variables) are not included in the study. The tax laws modelled for the study are: Canada
Federal income tax Quebec corporate income tax Quebec mining duties Ontario corporate income tax Ontario mining tax Manitoba corporate income tax Manitoba mining tax British Columbia corporate income tax British Columbia mining tax USA
Federal income tax Alaska state income tax Alaska state mining tax Utah state income tax Utah state mining tax
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Australia Federal income tax Queensland state royalty Company) Brazil Corporate income tax Chile First category tax Housing tax Additional tax Indonesia Corporate income tax Papua New Guinea Corporate income tax Peru Corporate income tax South Africa Corporate income tax Lease tax Zambia Corporate income tax Mining tax
(applicable
to the Mount
Isa Mining
The mine model is subjected to the provisions of each of these tax acts to produce detailed tax calculations. The impacts of individual components on the tax base are grouped and compared. For example, the impact of capital cost recovery provisions on the size of the tax base is compared for the various countries in the study. This stage focuses on the structural differences between taxation regimes, by comparing deductions and exemptions allowed by different tax acts. The results of this analysis are used to explain the differences in behaviour observed in subsequent sections of the study. The next step is to calculate the effective tax rate for the simulations. The effective tax rate is defined as the net present value (NPV) of tax payments, divided by the NPV of net project cash flows. The measure shows the proportion of the cash generated by the project that is paid out as tax. This measure was chosen because it is an important variable for investors and could be applied in all of the simulations contemplated. The effective tax rate is used to measure changes in the tax burden that are introduced by changing the parameters of the underlying mine model. For example, changes in the price assumptions are made to examine how effective tax rates would change under different profit conditions. Similarly the impacts of inflation and product price cycles are examined.
Tax rate and tax base Special attention is paid to the size and composition of the tax base. Systems differ more in the size of the tax base that they define (that is, in their definitions of taxable income) than in their rates of taxation. Furthermore, the structure of the tax base can explain the wide divergences in the behaviour of systems under different operating conditions. Thus the first step is to provide a basis of comparison between tax bases and isolate the factors which differentiate them.
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Fiscal systems Table 1. Mineral income tax structures to marginal tax rates).
“Calculations based on 15% pretax FIR mining project over a period of 20 years. Cash flow and tax bases are discounted. bThe PNG tax svstem features a top marginal rate of 70% which is triggered only at a very high profitability level. Because the top marginal rate did not come into effect under the range of profitability considered in the study, the marginal tax rate applicable is 35%. ‘Arithmetic average of results for states of Utah and Alaska. Only federal and state income taxes are considered. dArithmetic average of results for Quebec, Ontario, Manitoba and BC. Only federal and provincial income taxes are considered.
‘PNG actually has a top marginal rate of 70% but this is only triggered at project rates of profit higher than were analysed in this study.
134
2. 3. 4. 5. 6. 7. a. 9. 10.
in national jurisdictions (jurisdictions ranked according
Tax base as % of operating cash floti
Peru USAC Australia South Africa Canadad Indonesia Brazil Zambia Chile Papua New Guineab
Top marginal rate (%) 57 54.2 49 46.2 45.3 45 45 45 40 35
Mean Standard deviation Deviation as percentage of the mean
46.2 6.0 +1-13%
31 .o 10.0 +1-32X
35.5 22 27.2 37.3 27 26.4 23.6 16.4 40.6 52.0
One approach taken is to compare the provisions of tax regimes by listing the top marginal rates and the sizes of tax bases defined. Table 1 demonstrates that the tax base rather than the tax rate is the primary source of diversity between systems. The tax base ranges from 52% of operating cash flow in Papua New Guinea to 16.5% in Zambia, whereas the top marginal rate ranges from 57% in Peru to 35%’ in Papua New Guinea and shows much less relative variation. For each of the national jurisdictions studied (that is, all levels of income taxation considered) the table shows the top marginal tax rate and the tax base as a proportion of operating cash flow. Operating cash flow is defined as revenues from operations less all those expenses which are treated identically under accounting conventions and all income tax acts. For example, salaries, wages, energy and other such costs are all fully deductible for tax and accounting purposes. Thus, these items are deducted from revenues in the calculation of operating cash flow. In contrast, capital cost allocation, exploration and development and taxes levied by other levels of government receive a variety of tax treatments; these items are not deducted from revenues in calculating operating cash flow. Both the theoretical tax payments and operating cash flows are discounted so that the impact of timing differences is manifested in the results. The tax base is determined by many factors such as the rate at which capital items are allowed to be written off, the value of investment related incentives provided and other such items. Consequently, it is useful to provide a more detailed breakdown of the determination of the tax base. The information in Table 1 is expanded in Table 2, to show the impact of specific incentives and deductions on tax bases. Deductions and incentives have been grouped together into three categories: capital cost recovery, investment related incentives and other incentives and deductions. Capital cost recovery refers only to the claiming of amounts actually invested in the mine. Since the same mine model is used in the simulation of all tax systems, the amount invested and the timing of this investment is the same in all cases. The difference in the numbers in the first column is due entirely to the timing of deductions allowed. Given that the numbers are discounted a deduction made earlier will be more valuable than one made later. For example, in countries with provisions f or rapid write offs (such as Chile, South Africa and Zambia), the value of capital cost recovery may reach 53% of discounted operating cash flows. In contrast, the value of the same item in a more restricted regime
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Fiscal system Table 2. Tax incentives and deductions as a percentage (values discounted to net present value).
of projects
Accounting
rules
cash flow
incentives
Total deductions and incentives
Tax base
incentives and deductions
%
%
%
%
52 52 48
8 8 30
15 11 0
75 71 78
25 29 22
48 49 38
7 2 0
25 21 31
80 72 69
20 28 31
4% 49
7 0
23 27
78 76
22 24
51
0
22
73
27
49
27
0
76
24
53 53 53
0 0 0
0 4 7
53 57 60
47 43 40
51
8
13
72
28
48
0
0
48
52
52
0
12
64
36
53 53
6 5
4 0
63 58
37 42
53 53
14 32
17 0
84 85
16 15
44
0
22
66
34
Jurisdiction
Canadian average Federal income tax Provincial income tax Provincial mining tax USA Alaska Federal income tax State income tax State mining tax Utah Federal income tax State income tax Australia Queensland Federal income tax Brazil Corporate income tax Chile First category tax Housing tax Additional tax Indonesia Corporate income tax PNG Corporate income tax Peru Corporate income tax South Africa Corporate income tax Lease tax Zambia Corporate income tax Mining tax
operating
Capital cost recovery
Investment
%
( such as US federal income tax) may be only 48% of operating cash flows. (Note that the Alaska state income tax allows the smallest depreciation allowance, but this is because some capital expenditures made by the modelled mine are not claimable for state income tax purposes.) Investment related incentives provided by a tax system are those directly tied to the amount of investment made. For example, investment tax credits are generally a fixed proportion of capital expenditures. Other items included in this category include investment allowances, adjustments to undepreciated capital bases and supplementary depletion deductions. The use of these incentives varies widely among jurisdictions. Several countries such as Australia, Chile, PNG and Peru offer no such incentives. In contrast, incentives are a major component of the tax systems in Brazil and Zambia. The Canadian system is perhaps the most complicated, with relatively small incentives offered for federal and provincial income taxes, but with major incentives at the mining tax level. The ‘Other incentives and deductions’ category includes a variety of items, the most important of which are deductions of other levels of taxation. In most of the countries studied mines are subject to several levels of income taxation. In computing taxable income, some national government level tax systems treat income taxes levied by regional or local governments as deductible expenses. Most confusingly, in the USA, state income taxes are fully deductible for federal purposes and
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Fiscal systems
federal taxes are fully deductible for state purposes. More commonly only one level of taxes is deductible. In Canada, provincial taxes cannot be claimed for federal tax purposes but a notional deduction, the resource allowance, is permitted instead. A variety of small incentives and deductions allowed by other regimes is also included in this omnibus category. For example, the deduction equivalent to the tax rate concessions offered under the Indonesian system is included in this group. The last row in Table 2 is labelled ‘Accounting rules’ and shows the value of financial accounting defined deductions as a proportion of the operating cash flow of the project. Almost all tax systems are based on the idea that accounting income (with a few modifications) is an appropriate base upon which to levy taxes. The ‘Accounting rules’ row shows the relationship between taxable income and accounting income and isolates the differences between them. Using standard Canadian accounting rules, the accounting income of the project is calculated and the expenses are grouped in the same manner as the tax incentives and deductions. The value of capital cost recovery deductions under all tax rules is of course greater than that provided by accounting rules (with the exception of Alaska, for reasons described above), reflecting the fact that all tax systems allow for some accelerated claiming of capital costs. Such treatment could be interpreted as a preference granted by almost all systems. Alternatively, it could be seen as an almost universal recognition that accounting depreciation is not an appropriate expense for tax purposes. The major sources of difference between accounting income and taxable income are investment incentives. As these are artificial deductions and credits created by tax systems, they have no counterparts in the accounting model. Consequently, the systems with the largest investment related incentives produce the greatest differences between taxable and accounting income. It will be recalled that the major item in the ‘Other incentives and deductions’ category is provision for other levels of taxation. The ‘Accounting rules’ row includes an amount equivalent to the highest discounted value of taxes paid to a regional government (the Queensland state royalty). Thus comparisons between accounting income and taxable income are best made at the national level. That is, as the accounting income shown takes account of regional government taxation (but not national government taxation), it is best compared with the taxable income defined at the national level. Still, in all cases except Chile, Peru and Papua New Guinea, the national government level tax base is smaller than accounting income. In total, taxable income is considerably smaller than accounting indicating that most tax systems incorporate significant income, divergences from the accounting model. Time structure of the tax base The information in Table 2 is convenient to deal with because it has been discounted back to the date of first production. The process of discounting is useful as it allows for direct comparisons of series with different time horizons. Some information is, however, lost through discounting, so the composition of tax bases is also shown on a year to year basis (Figures 1 to 4). For example, several systems effectively
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Fiscal systems
I
70
Depreciating
assets
65 Exploration
60 55 50 4s
m
Other
0
Taxable
and
development
deductions income
I
40
1
35 30
I
25
II
20 15 10 5 0 1985
I
,
19a9
1987
1991
1993
1995
1997
1999
2001
Figure 1. Canada (BC, Ontario, Quebec): federal income tax, impact of incentives mine (OCM) mine project, 15% rate of return base case, stand alone.
2003
2005
2007
on the tax base, open pit copper-gold
70 65 _
m
6Ot-
g
55-
‘.
50-
.z
45-
2
40-
”
35-
:
30-
9
25-
:
20-
$
15-
Exploration
and
development
10St-
ow
i
1985
Figure 2. Utah: federal income tax, impact of incentives case, stand alone. 75 [
on the tax base, OCM mine project, 15% rate of return base
I i
70 -
Depreciating
65 60 -
m
Exploration
m
Other
assets and
development
z -. g
5055-
I
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25-
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20-
$
15-
income
/
5101985
Taxable
deductions
I
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?
1987
Figure 3. Chile: additional stand alone.
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tax, impact of incentives
POLICY June
1989
on the tax base, OCM mine project, 15% rate of return base case,
137
Fiscal systems 75 70 65
I 1987
Figure 4. Zambia: corporate
income tax, impact of incentives
on the tax base, OCM mine project, 15% rate of return
base case, stand alone.
allow for an extended tax free period at the commencement of production and this cannot be ascertained from discounted summaries of the size of the tax base. Figures 1 to 4 show the calculation of the tax base schedules for the Canadian federal income tax, US federal income tax as it would apply in Utah, the Chilean additional tax and the Zambian corporate income tax, for each year of the project’s life. Operating cash flow for each year is shown and the various shaded areas represent different classes of categories: depreciable assets, exploration and development and other deductions. The depreciable assets category includes all deductions associated with capital investment, such as capital cost recovery and investment related incentives. The exploration and development category includes the claiming of exploration and development expenses and ‘Other deductions’ is composed primarily of the any related incentives. deduction of other levels of taxes. The residual area, left blank, represents the taxable income of the project. The figures illustrate that the model project has operating cash flows of $71 million each year during its first 10 years of operation. This rate falls to $27 million for the subsequent 10 years of operation as a result of a simulated reduction in ore grades. This feature of the model is designed to recreate the increase in costs that is typical of older mines. It should also be noted that tax minimizing routines have been used to generate the schedules of tax incentives and deductions claimed. That is, where choices exist, tax payers are assumed to make the choices that result in the lowest possible effective tax rate. The tax systems illustrated in the figures were chosen to show a range of treatments. For example, in Figures 1 and 2, the Canadian federal income tax and its US counterpart (for a mine in Utah) are shown. These taxes are chosen because they define similar tax bases (25% and 22% of discounted operating cash flow respectively). But Canadian rules allowing rapid claiming of exploration, development and capital costs mean that a Canadian mine may pay no federal income tax for its first three years. In contrast, the mine in Utah would claim these items over a longer period and therefore is not able to benefit from a tax free period. Of course, in later years the Canadian mine will have greater taxable income than its Utah counterpart as tax pools become depleted more rapidly.
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Fiscal systems
Figures 3 and 4 contrast a broadly based tax system with a narrowly based one. The Chilean additional tax defines a tax base that is close to accounting income. Some acceleration in the claiming of capital costs is allowed, but there are no investment related incentives. The result is a tax base equal to 40% of operating cash flow. In contrast, the Zambian corporate income tax combines accelerated claiming of capital costs and significant investment related incentives, to define a tax base equal to only 16% of discounted operating cash flow.
Sensitivity of effective tax rates to changes from base case assumptions In this section the focus of the study moves from the structure of the tax systems to an examination of the impacts these structures have on effective tax rates under different economic circumstances. Effective tax rates are calculated in the base case simulation, but these results have little information content. Base case conditions are inherently unrealistic and the tax systems included in the study are not chosen in order to make a direct comparison of tax burdens. The base case results are useful, however, as a basis for sensitivity analysis. In this section, analysis proceeds by systematically relaxing the unrealistic base case constraints and comparing the resulting effective tax rates. Results are analysed for policy implications of variations in profit rates, inflation and product price cycles.
Sensitivity of effective tax rates to changes in projectprofitability One important criterion for evaluating the behaviour of a tax system is its response to changes in profitability of a firm or industry. Whether a corporate tax system is progressive, regressive or neutral with respect to profitability can have a major effect on the way in which resources are allocated in a society. Increasing economic efficiency and encouraging .an optimal allocation of resources are both major goals of tax reform movements around the world. Achieving these goals is closely linked with the way a tax system treats projects that yield different levels of profit. A progressive tax system is one in which the effective tax rate varies directly with the rate of profit. That is, the more profitable the firm, the greater the proportion of its cash flow that is taken as tax. Conversely, the tax burden (as measured by the effective tax rate) is lighter for firms with lower profits. At first glance, such a system appears appealing because it links the tax burden to the ability to pay. But while this may be a valid goal in personal taxation, there are important questions about the economic effects of corporate income being taxed on a progressive basis. A major criticism of progressive taxation is that in good times it can prove to be a disincentive to economic efficiency. Since a greater proportion of funds are removed from firms that have the best returns, the ability of these firms to expand is reduced. For the economy as a whole this means that the adoption and development of new technologies and industries may be retarded. A progressive tax system also tends to equalize the after tax returns between highly profitable and marginally profitable firms. This, too, may reduce the incentive for productivity improvement or for investment to be directed to new or promising areas.
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Fiscal systems _-----
Australia (-hj,e
---
Indonesia
---
Papua
-----
Peru
New
Guinea
100 -
50 -
Figure 5. Effective various profitability
tax rates under assumptions.
‘At a seminar at the East-West Institute, Honolulu, Hawaii in November 1987, it was pointed out that the PNG system is generally thought to be progressive. On the other hand, the results shown here indicate a regressive structure. The explanation is given in note b of Table 1. PNG would be considered progressive if the project profitability were high enough to trigger the very high top marginal tax rate. However, under the circumstances of the model tested here, we never reached that high profit rate which would have triggered progressive behaviour by the PNG tax system.
140
I
0 LOW
Base
case
profitability
The principal immediate advantage of progressive taxation accrues to governments. Under this type of regime taxes rise automatically on firms that are doing well, allowing government revenues to increase without the need to formally introduce tax changes. On the other hand, companies performing relatively poorly also have an interest in a progressive tax system because their effective tax rate is lower than would be the case in either a neutral or regressive system. In a regressive system of taxation, effective tax rates vary inversely with profitability. That is, the effective tax rate rises as profitability falls and vice versa. There are several structures that can result in regressive taxation, but the most common is a pure production royalty: a fixed charge that does not vary with profitability. Theoretically, a regressive tax system has the advantage of providing a stable source of revenues for government. Taxes payable do not depend on company performance and therefore the same amount should be forthcoming regardless of business conditions. Firms performing well will favour such a system as it means a lower effective tax for them than would otherwise be the case. In fact, however, the supposed benefits of a regressive taxation may be difficult to realize. Instead of stable revenues, even greater variations in tax collections may occur. The fixed burden of taxation may force companies to cease operations during periods of reduced profitability. Such taxation increases the downside risk of any project. A project that is marginal on a pretax basis may be wholly uneconomic on an after tax basis, given regressive taxation. Increased riskiness of investment may also result in lower levels of capital expenditures. This may be especially true for sectors such as mining which are subject to significant price variations. A series of simulations is undertaken to investigate how mineral tax regimes respond to changes in company profitability (Figures 5 and 6). For each national jurisdiction, results of a low profit and a high profit simulation are compared to the base case. Recall that, in the base case, the model mine yields a pretax IRR of 15%. By manipulating ore grades, low and high profit cases are developed that yield 5% and 25% IRR respectively. Figure 5 shows the outcome in terms of effective tax rate declines for Australia, Chile, Indonesia, Papua New Guinea’ and Peru. The base case effective tax rate is indexed to 100. The alternative profitability cases are shown in relation to the base case. For example, the Queensland (Australia) effective tax rate under low profitability conditions is more than three times what it is under base case conditions, In the high profitability scenario, effective tax rates are 23%
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various profitability assumptions.
profitability
lower than under the base case. The Queensland system is the most extreme of the regressive systems studied. (It will be recalled that Queensland is the only jurisdiction in which a royalty is included among the taxes studied, so this result is not surprising.) All the tax systems illustrated in Figure 5 are regressive, although to varying degrees. Figure 6 shows the relationship between effective taxation and profitability for the remaining jurisdictions. The Zambian system is the most strongly progressive. A mine in that country would pay no income taxes if it had a 5% IRR, but its effective tax rate in the high profit simulation would be 75% higher than the base case. Brazil also has a noticeably progressive tax system. The US systems would have been progressive had they been modelled completely. Canada and South Africa have relatively neutral systems by comparison, although none of the systems could technically be called neutral. It is difficult to design a neutral tax system. Among the systems studied none has a truly neutral system. The different types of behaviour demonstrated by tax systems are traceable to specific structures. Regressive taxation generally occurs when components of the system are not sensitive to profit. This includes the Queensland state royalty, although other structures may produce similar results. For instance, the Indonesian tax rate concession acts to promote regressivity. This feature reduces the marginal tax rate for mines during their first ten years of operation. A profitable mine can benefit greatly from this provision, but a less profitable mine which may not have taxable income for some period during the ten year concession would be less affected. Thus, the result is to lower the effective tax rate on profitable operations without greatly affecting less profitable mines. Sensitivity of effective tax rates to changes in the rate of inflation The second series of simulations undertaken is designed to isolate the impact of inflation on the performances of the national tax jurisdictions. The simulation chosen allows all prices and costs to rise by 5% per year over the life of the project. In this way, real IRR is maintained at 15% and the simulation is directly comparable to the base case. As all prices and costs move together, only capital items are affected. Under such conditions inflation will have a greater impact depending on the capital intensity of the project. (The arguments made in this section are equally applicable to capital-intensive sectors other than mining.) Figure 7 shows the results of this simulation, again in relation to the base case. The base case effective tax rate for each jurisdiction is indexed to 100 and the inflation simulation is shown relative to that
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Fiscal systems
20 0 Indonesia
Figure
Australia
7. Comparison
Peru
Papua New Guinea
Chile
South Africa
Alaska
Brazil
of effective tax rate indices, base case versus 5% inflation scenario,
“Effective tax rates measured by tax payments as a percentage of pretax cash
flows, discounted
Canada
Zambia
base case index = 100.
at 3%.
outcome. Thus, the introduction of 5% inflation has virtually no impact on effective taxation under Indonesian rules, but raises effective tax rates by some 70% under the Zambian regime. With the exceptions of Indonesia and Australia, the introduction of low levels of inflation significantly raises real effective tax rates in all systems; this would probably have been true of the US system if this had been modelled. The sensitivity of tax systems to inflation is primarily a result of the use of historical cost based accounting as a reference system for the tax treatment of capital items. The real cost of capital per se is not allowed as a deductible expense in any of the tax systems examined, as all systems use the historical acquisition cost of capital assets as their base. That is, firms record the purchase price of capital assets and are allowed to claim that amount over a number of years as a deductible expense. Inflation normally increases both revenues and costs but has no effect on historical cost based deductions such as depreciation. Thus, the higher the rate of inflation, the smaller depreciation becomes relative to income. Clearly, as the value of this deduction falls, effective tax rates increase. Of course, inflation has a greater impact on capital-intensive firms, because a larger proportion of the expenses claimed by these firms is capital related. To prevent this erosion in the real value of deductions, a tax regime would have to be based on cash flows rather than on income, or else have structures that adjust capital cost allowances for actual inflation conditions. None of the systems studied has such structures, although most contain some sort of compensation for inflation. To the extent that protection is provided, it is in the form of ad hoc, arbitrary adjustments rather than ones sensitive to inflationary conditions. For example, the Zambian tax provisions allow for 10% compounding of any unclaimed capital costs, whether inflation rates are 2%, 20% or 200%. A more common measure, which has among its several purposes the lessening of the effects of inflation, is the provision of investment allowances and/or tax credits.
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Fiscal systems The impact of these types of adjustments is to reduce the rate of effective taxation and, somewhat paradoxically, to make tax systems more sensitive to inflation. Notice that in Figure 7 the systems with the greatest inflation protection, namely Zambia, Brazil and Canada, are the most affected in the model by the introduction of 5% inflation. Inflation sensitivity is related to the proportion of total tax deductions that are invariant with respect to inflation. By providing ad hoc incentives, a tax system decreases the tax base, which naturally lowers the effective tax rate - other things being equal. But, the remaining tax base (although smaller because of the existence of ad hoc incentives) is, relatively, more dependent on historical cost based items, such as depreciation. This makes the system very sensitive to inflation, and it is not surprising to see the effective tax rate being levered up significantly in the inflation simulation. Note, however, the tax systems with the greatest leverage to inflation also have among the lowest effective tax rates at 0% inflation. Systems with ad hoc inflation protection and investment incentives are designed to function optimally at a given rate of inflation, whether intentionally or not. This is another reason why tax burden comparisons of the base case (or any other simulation for that matter) are misleading. When a tax system is designed in the context of a certain rate of inflation, it will perform differently when another rate is forced on it. The base case simulation assumes no inflation and under these conditions several tax regimes, notably Zambia, produce very low effective tax rates. With the introduction of inflation into the simulations, however, the ranking of tax burdens changes markedly.
Sensitivity
of effective tax rates to product price cycles
One of the most distinguishing characteristics of mining is that mineral products are subject to significant price cycles. Price changes, up and down, of 30% a year are not uncommon for many mineral commodities. The overall profitability of mining may be comparable with other but the variation in year to year sectors over a period of years, profitability tends to be much greater. This is an important factor because the variability in earnings results in greater effective tax rates in many jurisdictions for mining and may put the sector at a disadvantage relative to other sectors. This final simulation is designed to isolate the impact of price cycles on the effective tax rates for the countries studied. The base case scenario assumes that output prices are stable. The change introduced is meant to simulate a well timed investment. The mine is brought into production as prices begin their cyclical rise and is therefore extremely profitable in its first years. Prices then fall, before levelling off. The cycle is designed so that the project’s IRR would be unchanged from the base case, and thus the two simulations are directly comparable. The price cycles introduced are shown in Figure 8. Several other cycles were investigated, but the results from these simulations are less interesting from a policy perspective. The results of the simulation are shown in Figure 9. For each jurisdiction the change in the effective tax rate is shown, given the introduction of the price cycle scenario. Thus, for example, the introduction of price cycles reduces the effective tax rate for Alaska by 10% from what it would have been under base case conditions. In
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Fiscal systems
0.58
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1 1
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, 12 lifespan
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(years1
x-x-x-x-x-x-x-x-x-xzT)
360
tn :
340
.-u”
320 -
X
X
a’
Figure 8. Copper and gold price assumptions, OCM mine model, cyclical price scenario.
300.
1 0
1
I 4
I
,
\,/
8
,
I
I
12
Project
lifespan
I
I
1
I
20
16
24
[years]
1(
(
til 6
u’
-1c
cw
-20
Zambia
Alaska
Brazil
Canada
Peru
South
Indonesia
Africa
Figure 9. Sensitivity
Papua New
Chile
Australia
Accouni
Guinea
‘9
rules
of effective tax rate indices to cyclical price scenario.a
aEffective tax rates measured by tax payments as a percentage of pretax cash flows, discounted at 3%.
144
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1989
Fiscal systems
contrast, the Australian system produces somewhat higher effective taxation. In general, the impact of price cycles on effective tax rates is relatively small, compared with the sensitivities seen in the other simulations. (The Zambian case is special because of an unusual interaction between the corporate tax and mining tax. As a result of loss carry back provisions, a large amount of taxes are deferred, thereby reducing the effective tax rate significantly.) Nevertheless, it is important to understand the performance of a tax system under cyclical conditions because of the types of changes that are being introduced in many countries as part of tax reform. These changes may introduce a bias against industries in sectors subject to above average cyclical variations. The key variable in determining a tax system’s response to changing prices is the treatment of capital assets. Systems that have rigid depreciation schedules for tax purposes tend to produce higher effective tax rates under unstable price conditions than systems that have more flexible rules. In this context, rigidity and flexibility refer to the ability of tax payers to vary the amount of depreciation claimed for tax The best example of a rigid system is that defined by purposes. conventional accounting rules. That is, a specific depreciation charge is mandated each year according to the estimated service life and historical cost of the firm’s assets: the amount of expense recorded is independent of the company’s revenue or income. To illustrate the impact of a rigid depreciation system on effective taxation, Figure 9 includes the results of a simulation in which income defined under Canadian accounting rules is used as the tax base (labelled ‘Accounting rules’ in the figure). The mine model is simulated in both the base case and the cyclical prices case, and accounting income results are produced. A uniform tax rate is applied to both sets of results to produce two series of taxes payable. These series are used to generate effective tax rates. It will be noted that the cyclical prices case produces a project effective tax rate that is 10% higher than the base case, even though the project IRR is the same in both cases. The reason for this has to do with the timing of deductions. A rigid system allows little discretion in the timing of deductions. For a company in a cyclical sector this means that during periods of falling markets the full amount of depreciation to which it is entitled may not be claimable. There is no compensation during the next period of rising markets, however, because the amount of income claimable remains fixed. The net effect is to extend the claiming period for depreciation, which necessarily reduces the value of the deduction and increases the rate of effective taxation. In contrast, the firm with stable income will generally be able to claim the full amount of deductions to which it is entitled in each year and, therefore, not have to extend claiming periods. Thus two projects that have the same IRR may have significantly different effective tax rates due to the timing of the income. A remedy for this situation may be to permit accelerated claiming of depreciation. This allows companies to make increased claims during profitable periods. Claims may be reduced during slow downs, but the net effect will leave cyclical industry firms and other firms on a more equal footing. Another possible solution would be to allow firms to carry their losses forward indefinitely; but there are serious practical problems associated with this approach. The treatment of cyclical price sectors has become an issue because of
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POLICY June 1989
145
Fiscal systems
the current direction of tax reform. Capital consumption rates have been moderately reduced in the USA and similar changes are being contemplated in Canada. The reason given for this action is that accelerated depreciation is a subsidy to capital-intensive investment that introduces bias in economic decision making. This may be the case; but removing accelerated depreciation may introduce another level of bias against cyclical, capital-intensive sectors such as mining.
Direction of tax reform taken in Canada and the USA After several years of intense debate, the process of reforming the Canadian and US income tax system now appears largely complete, at least at the federal level. Although many radical plans were discussed, the final outcome was relatively moderate. The major provisions of tax reform for mining are: 0 0 0
the reduction of the top corporate tax rate in Canada and the USA; the repeal of the US and Canadian investment tax credit and the Canadian earned depletion; enhancement of the corporate minimum tax system in the USA.
Changes made to depreciation schedules and the treatment of exploration and development in the USA are not themselves expected to have a significant impact on mining, although there had been considerable concern by the industry about earlier proposals concerning these areas. In addition, percentage depletion was retained. The major impact, however, may be felt in an increased tax burden as a result of the changes to the corporate minimum tax. These changes will complicate the tax system, making an overall evaluation of the impact of tax reform on US mining difficult. In Canada, the loss of earned depletion and the reduction in capital cost allowance rates are also not expected to have a significant impact in view of the reduction in nominal tax rates. The accelerated capital cost allowance for new mine assets and major expansions was retained, as was the fast write-off for exploration. The US and Canadian mineral income tax regimes before tax reform were generally similar in structure and performed accordingly. They had significant investment incentives, were mildly progressive and were relatively sensitive to inflation and price cycles. In policy terms, what are the implications for mining of the changes made in the USA and Canada? Many profitable mines may have lower effective tax rates than had been the case under the former systems. These mines will benefit from the reductions in tax rates and will not be as severely affected by the loss of incentives. Effective tax rates on less profitable operations in the USA, however, will probably rise, primarily because of the changes made to the minimum tax systems. Thus, the net effect of the changes should be to make the system less progressive with respect to profitability. Second, the removal of the investment tax credit eliminates a significant incentive whose value falls with inflation. The reformed system, therefore, will be less sensitive to inflation in both Canada and the USA. Third, because the capital cost recovery system has not been changed significantly, the mineral income tax systems will generally retain their capacity to deal with price cycles, although the minimum tax may have an effect in this regard in the USA. There are several important advantages to the new system. Rewarding success rather than effort, by reducing the progressivity of the
146
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system, is consistent with stated economic policy objectives. It is generally conceded that a policy which promotes a more efficient allocation of resources within and among industries enhances the prospects for economic growth. The loss of fixed investment incentives, such as the investment tax credit, is seen as less important given the current low rate of inflation. These incentives provided compensation to industry at a time when inflation created a strong tax bias against capital-intensive investment. With inflation low, however, the same incentives could have produced very low effective tax rates for capital-intensive ventures. There are disadvantages to the reformed systems as well. Because they provide no inflation adjustments, the US and Canadian systems remain intrinsically unsuited to inflationary conditions. Any resumption of inflation would produce strong pressures for the reinstatement of lost incentives.
Conclusions The tax reform debate in various countries has renewed interest in alternative tax systems and the impact that taxation has on the economy. In this study a variety of mineral income tax systems are investigated to examine how these systems are constructed and what policy implications they contain. This is accomplished by modelling the system and then subjecting the model to different mine operating conditions and comparing the results. The variables chosen for simulation are: profitability, inflation and product price cycles. In examining the relationship between effective tax rates and profitability it is found that most of the systems studied are progressive, although to varying degrees. That is, the rate of effective taxation rises or falls with the rate of profit. For a smaller number of jurisdictions, the tax system is found to be regressive. In this case, the rate of effective taxation moves contrary to the direction of profit (the higher the rate of profit, the lower the rate of effective taxes and vice versa). No system was found to be neutral (with the rate of effective taxation constant regardless of the rate of pretax profit), although some approached neutrality. The relationship between effective taxation and profitability is important because of its impact on a society’s allocation of resources. A progressive system may impede the movement of investment to new or fast growing sectors of the economy and may, therefore, impair overall economic growth. A regressive system may appear attractive to a government concerned about the stability of its tax revenues, but could lead to problems. First, such a system may, in fact, increase the variability in tax revenues by increasing the likelihood of temporary mine closures. Second, a regressive tax system increases an investor’s risk and may, therefore, reduce the amount of investment. One of the major causes of progressivity is the provision of investment incentives and these are being pared back in many jurisdictions. The narrowing of income tax rate scales will also be likely to have an effect. Inflation is a less important problem in developed economies than it was in the recent past. Thus, there has been a move to remove the measures that protected companies from the tax effects of inflation. Tax systems based on historical cost based accounting generally produce high effective tax rates during periods of inflation. Mining, which is a
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147
Fiscal systems
relatively capital-intensive sector, is particularly susceptible to inflation. This is demonstrated in the simulations undertaken in the study. While the reduction of inflation protection in a low inflation environment may be appropriate, sectors such as mining may be especially vulnerable to a sudden, sharp increase in real effective taxes should inflation increase. Thus, a corporate tax system that treated all sectors similarly at a low level of inflation may introduce significant distortions at higher levels of inflation. Mining differs from many other industries because the prices for its products are especially subject to significant price cycles. The study demonstrates that these price cycles may result in higher effective tax rates for mining than for comparable sectors that do not have price cycles. The structural cause of this relationship is shown to be the treatment of capital cost recovery. Price cycles have a greater impact on effective tax rates when the claiming periods for capital costs are extended. In most tax reform debates there have been calls for the extension of capital cost claiming periods. Should these measures be adopted for mining, the industry may be put at a disadvantage relative to other sectors.
148
RESOURCES
POLICY June 1989
Keith Brewer, Gilles Bergevin and Robert Dunlop
This article compares mining taxation in Canada, the USA, Australia, Brazil, Chile, Indonesia, Papua New Guinea, Peru, South Africa and Zambia. It calculates the effective tax rates experienced by a hypothetical mining project and the sensitivity of tax rates to changes in profitability, inflation and product price cycles. The study assesses the advantages and disadvantages of various tax treatments and also examines the direction of tax reform in the USA and Canada and what implications reform would have for the mining sector. The authors are employees of the Department of Energy, Mines and Resources, Canada, Ottawa, Ontario, Canada KlA OE4. The opinions expressed herein are those of the authors and do not necessarily represent the position of the Department. The authors would like to acknowledge the contribution of other members of the Economic and Financial Policy Analysis Branch in the completion of this paper. Roberta Albert was instrumental in collecting information about mineral tax regimes, developing tax models and undertaking the preliminary analysis of tax systems. Lise Hubert was responsible for much of the computer work. Charts and figures were designed by Jacques Savard. The bulk of the typing was capably handled by Renelle Leger and Moira Dussault. Of course, any errors or discrepancies in the paper are solely the responsibility of the authors.
This study is designed to provide an evaluation of certain fiscal systems in place, as at March 1986, in a number of major mineral producing countries. The focus is on income based taxes and how these taxes perform under a variety of conditions. Income based taxes are not the only taxes paid by mining companies, but are generally important in terms of public policy. These taxes are frequently used as a tool of based taxes are often used by industrial policy: that is, income governments to influence the development of the economy in certain directions. Even in countries without an explicit industrial policy, income based taxes are generally a significant government intervention in private business. They have an important impact on an economy’s allocation of resources through their complex distributional effects. To understand the complete impact of taxation on the competitive position of an industry, we would also have to consider the effect of other types of taxes, including sales taxes, excise taxes, capital taxes, tariffs and others. Such taxes are important but they are not considered in this study. This study is primarily concerned with identifying and examining the structural causes of certain types of behaviour of tax systems under specific economic circumstances. For example, which tax systems produce an increase in effective taxation during inflation and why? How do tax systems deal with problems such as the cyclical nature of mining; are these measures successful? Absolute comparisons of the tax burdens in various countries are avoided, as they are extremely difficult to interpret and are often misleading. The tax treatment of mineral income is a complicated and sensitive issue. Relatively minor income tax changes may have a significant impact on the viability of a given project or class of investment. The amount and type of mineral exploitation in a country can be significantly influenced by the tax system. Accordingly, extensive revision of income tax provisions in several countries may result in major changes in the development of mining. The process of tax reform in the USA had been largely completed before similar movements took place in Canada and other countries. The US experience had a major effect on the others. As the USA’s largest trading partner, Canada was particularly influenced by US reforms. The Canadian Minister of Finance observed in Guidelines for Tax Reform in Canada: Recent developments
0301-4207/89/020131-18$03.00
0
1989 Butterworth
outside of Canada provide further impetus for our review
& Co (Publishers)
Ltd
131
Fiscal systems
of the tax system. In particular, personal and corporate tax rates in the United States have been lowered. Our close economic ties underline the need to ensure that our tax system allows Canadian producers to remain competitive with our major trading partner.
Given the need to reduce rates, the general direction of tax reform in Canada and other countries is relatively clear. The tax base was broadened, as it was in the USA. Nevertheless, the Minister of Finance also noted that ‘. . . the Canadian and American tax systems are not identical. Tax reform in Canada is not a matter of duplicating changes in the US.’ Thus, while it is generally acknowledged that Canadians now face a tax system with lower rates and a broader base, the specific steps taken to reach these ends were designed to best suit the specific needs of the Canadian economy.
Methodology The approach taken is to apply the tax system of various countries to the financial results generated by a mine model. The assumptions underlying the model are changed so that the sensitivities of taxation to differing economic conditions can be investigated. The mine model was developed in consultation with several private Canadian mining companies. It is based on the cost conditions of an open pit copper-gold mine of the type that is found in British Columbia. (Some work has also been done using an underground copper-gold mine model based on northern Quebec conditions, but the results of these simulations are not presented in this article.) The base case simulation of the mine model assumes general price stability; metal prices are set so that the project will yield a 15% pretax internal rate of return (IRR) over its life. The project is assumed to be developed on a stand alone basis ie it is not developed by a large company with income from sources other than the project. It is also assumed that the project is entirely equity financed. The study also uses computer models of mineral income tax legislation. The choice of legislation to include was made difficult by the number of levels of government involved and the resemblance of many royalty schemes to income taxes. In general, however, royalties (ie taxes based on production volumes or other similar variables) are not included in the study. The tax laws modelled for the study are: Canada
Federal income tax Quebec corporate income tax Quebec mining duties Ontario corporate income tax Ontario mining tax Manitoba corporate income tax Manitoba mining tax British Columbia corporate income tax British Columbia mining tax USA
Federal income tax Alaska state income tax Alaska state mining tax Utah state income tax Utah state mining tax
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Australia Federal income tax Queensland state royalty Company) Brazil Corporate income tax Chile First category tax Housing tax Additional tax Indonesia Corporate income tax Papua New Guinea Corporate income tax Peru Corporate income tax South Africa Corporate income tax Lease tax Zambia Corporate income tax Mining tax
(applicable
to the Mount
Isa Mining
The mine model is subjected to the provisions of each of these tax acts to produce detailed tax calculations. The impacts of individual components on the tax base are grouped and compared. For example, the impact of capital cost recovery provisions on the size of the tax base is compared for the various countries in the study. This stage focuses on the structural differences between taxation regimes, by comparing deductions and exemptions allowed by different tax acts. The results of this analysis are used to explain the differences in behaviour observed in subsequent sections of the study. The next step is to calculate the effective tax rate for the simulations. The effective tax rate is defined as the net present value (NPV) of tax payments, divided by the NPV of net project cash flows. The measure shows the proportion of the cash generated by the project that is paid out as tax. This measure was chosen because it is an important variable for investors and could be applied in all of the simulations contemplated. The effective tax rate is used to measure changes in the tax burden that are introduced by changing the parameters of the underlying mine model. For example, changes in the price assumptions are made to examine how effective tax rates would change under different profit conditions. Similarly the impacts of inflation and product price cycles are examined.
Tax rate and tax base Special attention is paid to the size and composition of the tax base. Systems differ more in the size of the tax base that they define (that is, in their definitions of taxable income) than in their rates of taxation. Furthermore, the structure of the tax base can explain the wide divergences in the behaviour of systems under different operating conditions. Thus the first step is to provide a basis of comparison between tax bases and isolate the factors which differentiate them.
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133
Fiscal systems Table 1. Mineral income tax structures to marginal tax rates).
“Calculations based on 15% pretax FIR mining project over a period of 20 years. Cash flow and tax bases are discounted. bThe PNG tax svstem features a top marginal rate of 70% which is triggered only at a very high profitability level. Because the top marginal rate did not come into effect under the range of profitability considered in the study, the marginal tax rate applicable is 35%. ‘Arithmetic average of results for states of Utah and Alaska. Only federal and state income taxes are considered. dArithmetic average of results for Quebec, Ontario, Manitoba and BC. Only federal and provincial income taxes are considered.
‘PNG actually has a top marginal rate of 70% but this is only triggered at project rates of profit higher than were analysed in this study.
134
2. 3. 4. 5. 6. 7. a. 9. 10.
in national jurisdictions (jurisdictions ranked according
Tax base as % of operating cash floti
Peru USAC Australia South Africa Canadad Indonesia Brazil Zambia Chile Papua New Guineab
Top marginal rate (%) 57 54.2 49 46.2 45.3 45 45 45 40 35
Mean Standard deviation Deviation as percentage of the mean
46.2 6.0 +1-13%
31 .o 10.0 +1-32X
35.5 22 27.2 37.3 27 26.4 23.6 16.4 40.6 52.0
One approach taken is to compare the provisions of tax regimes by listing the top marginal rates and the sizes of tax bases defined. Table 1 demonstrates that the tax base rather than the tax rate is the primary source of diversity between systems. The tax base ranges from 52% of operating cash flow in Papua New Guinea to 16.5% in Zambia, whereas the top marginal rate ranges from 57% in Peru to 35%’ in Papua New Guinea and shows much less relative variation. For each of the national jurisdictions studied (that is, all levels of income taxation considered) the table shows the top marginal tax rate and the tax base as a proportion of operating cash flow. Operating cash flow is defined as revenues from operations less all those expenses which are treated identically under accounting conventions and all income tax acts. For example, salaries, wages, energy and other such costs are all fully deductible for tax and accounting purposes. Thus, these items are deducted from revenues in the calculation of operating cash flow. In contrast, capital cost allocation, exploration and development and taxes levied by other levels of government receive a variety of tax treatments; these items are not deducted from revenues in calculating operating cash flow. Both the theoretical tax payments and operating cash flows are discounted so that the impact of timing differences is manifested in the results. The tax base is determined by many factors such as the rate at which capital items are allowed to be written off, the value of investment related incentives provided and other such items. Consequently, it is useful to provide a more detailed breakdown of the determination of the tax base. The information in Table 1 is expanded in Table 2, to show the impact of specific incentives and deductions on tax bases. Deductions and incentives have been grouped together into three categories: capital cost recovery, investment related incentives and other incentives and deductions. Capital cost recovery refers only to the claiming of amounts actually invested in the mine. Since the same mine model is used in the simulation of all tax systems, the amount invested and the timing of this investment is the same in all cases. The difference in the numbers in the first column is due entirely to the timing of deductions allowed. Given that the numbers are discounted a deduction made earlier will be more valuable than one made later. For example, in countries with provisions f or rapid write offs (such as Chile, South Africa and Zambia), the value of capital cost recovery may reach 53% of discounted operating cash flows. In contrast, the value of the same item in a more restricted regime
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POLICY June 1989
Fiscal system Table 2. Tax incentives and deductions as a percentage (values discounted to net present value).
of projects
Accounting
rules
cash flow
incentives
Total deductions and incentives
Tax base
incentives and deductions
%
%
%
%
52 52 48
8 8 30
15 11 0
75 71 78
25 29 22
48 49 38
7 2 0
25 21 31
80 72 69
20 28 31
4% 49
7 0
23 27
78 76
22 24
51
0
22
73
27
49
27
0
76
24
53 53 53
0 0 0
0 4 7
53 57 60
47 43 40
51
8
13
72
28
48
0
0
48
52
52
0
12
64
36
53 53
6 5
4 0
63 58
37 42
53 53
14 32
17 0
84 85
16 15
44
0
22
66
34
Jurisdiction
Canadian average Federal income tax Provincial income tax Provincial mining tax USA Alaska Federal income tax State income tax State mining tax Utah Federal income tax State income tax Australia Queensland Federal income tax Brazil Corporate income tax Chile First category tax Housing tax Additional tax Indonesia Corporate income tax PNG Corporate income tax Peru Corporate income tax South Africa Corporate income tax Lease tax Zambia Corporate income tax Mining tax
operating
Capital cost recovery
Investment
%
( such as US federal income tax) may be only 48% of operating cash flows. (Note that the Alaska state income tax allows the smallest depreciation allowance, but this is because some capital expenditures made by the modelled mine are not claimable for state income tax purposes.) Investment related incentives provided by a tax system are those directly tied to the amount of investment made. For example, investment tax credits are generally a fixed proportion of capital expenditures. Other items included in this category include investment allowances, adjustments to undepreciated capital bases and supplementary depletion deductions. The use of these incentives varies widely among jurisdictions. Several countries such as Australia, Chile, PNG and Peru offer no such incentives. In contrast, incentives are a major component of the tax systems in Brazil and Zambia. The Canadian system is perhaps the most complicated, with relatively small incentives offered for federal and provincial income taxes, but with major incentives at the mining tax level. The ‘Other incentives and deductions’ category includes a variety of items, the most important of which are deductions of other levels of taxation. In most of the countries studied mines are subject to several levels of income taxation. In computing taxable income, some national government level tax systems treat income taxes levied by regional or local governments as deductible expenses. Most confusingly, in the USA, state income taxes are fully deductible for federal purposes and
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135
Fiscal systems
federal taxes are fully deductible for state purposes. More commonly only one level of taxes is deductible. In Canada, provincial taxes cannot be claimed for federal tax purposes but a notional deduction, the resource allowance, is permitted instead. A variety of small incentives and deductions allowed by other regimes is also included in this omnibus category. For example, the deduction equivalent to the tax rate concessions offered under the Indonesian system is included in this group. The last row in Table 2 is labelled ‘Accounting rules’ and shows the value of financial accounting defined deductions as a proportion of the operating cash flow of the project. Almost all tax systems are based on the idea that accounting income (with a few modifications) is an appropriate base upon which to levy taxes. The ‘Accounting rules’ row shows the relationship between taxable income and accounting income and isolates the differences between them. Using standard Canadian accounting rules, the accounting income of the project is calculated and the expenses are grouped in the same manner as the tax incentives and deductions. The value of capital cost recovery deductions under all tax rules is of course greater than that provided by accounting rules (with the exception of Alaska, for reasons described above), reflecting the fact that all tax systems allow for some accelerated claiming of capital costs. Such treatment could be interpreted as a preference granted by almost all systems. Alternatively, it could be seen as an almost universal recognition that accounting depreciation is not an appropriate expense for tax purposes. The major sources of difference between accounting income and taxable income are investment incentives. As these are artificial deductions and credits created by tax systems, they have no counterparts in the accounting model. Consequently, the systems with the largest investment related incentives produce the greatest differences between taxable and accounting income. It will be recalled that the major item in the ‘Other incentives and deductions’ category is provision for other levels of taxation. The ‘Accounting rules’ row includes an amount equivalent to the highest discounted value of taxes paid to a regional government (the Queensland state royalty). Thus comparisons between accounting income and taxable income are best made at the national level. That is, as the accounting income shown takes account of regional government taxation (but not national government taxation), it is best compared with the taxable income defined at the national level. Still, in all cases except Chile, Peru and Papua New Guinea, the national government level tax base is smaller than accounting income. In total, taxable income is considerably smaller than accounting indicating that most tax systems incorporate significant income, divergences from the accounting model. Time structure of the tax base The information in Table 2 is convenient to deal with because it has been discounted back to the date of first production. The process of discounting is useful as it allows for direct comparisons of series with different time horizons. Some information is, however, lost through discounting, so the composition of tax bases is also shown on a year to year basis (Figures 1 to 4). For example, several systems effectively
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Fiscal systems
I
70
Depreciating
assets
65 Exploration
60 55 50 4s
m
Other
0
Taxable
and
development
deductions income
I
40
1
35 30
I
25
II
20 15 10 5 0 1985
I
,
19a9
1987
1991
1993
1995
1997
1999
2001
Figure 1. Canada (BC, Ontario, Quebec): federal income tax, impact of incentives mine (OCM) mine project, 15% rate of return base case, stand alone.
2003
2005
2007
on the tax base, open pit copper-gold
70 65 _
m
6Ot-
g
55-
‘.
50-
.z
45-
2
40-
”
35-
:
30-
9
25-
:
20-
$
15-
Exploration
and
development
10St-
ow
i
1985
Figure 2. Utah: federal income tax, impact of incentives case, stand alone. 75 [
on the tax base, OCM mine project, 15% rate of return base
I i
70 -
Depreciating
65 60 -
m
Exploration
m
Other
assets and
development
z -. g
5055-
I
.E 2
4540-
I
” ;
3530-
I
.$
25-
I
z
20-
$
15-
income
/
5101985
Taxable
deductions
I
I
?
1987
Figure 3. Chile: additional stand alone.
RESOURCES
tax, impact of incentives
POLICY June
1989
on the tax base, OCM mine project, 15% rate of return base case,
137
Fiscal systems 75 70 65
I 1987
Figure 4. Zambia: corporate
income tax, impact of incentives
on the tax base, OCM mine project, 15% rate of return
base case, stand alone.
allow for an extended tax free period at the commencement of production and this cannot be ascertained from discounted summaries of the size of the tax base. Figures 1 to 4 show the calculation of the tax base schedules for the Canadian federal income tax, US federal income tax as it would apply in Utah, the Chilean additional tax and the Zambian corporate income tax, for each year of the project’s life. Operating cash flow for each year is shown and the various shaded areas represent different classes of categories: depreciable assets, exploration and development and other deductions. The depreciable assets category includes all deductions associated with capital investment, such as capital cost recovery and investment related incentives. The exploration and development category includes the claiming of exploration and development expenses and ‘Other deductions’ is composed primarily of the any related incentives. deduction of other levels of taxes. The residual area, left blank, represents the taxable income of the project. The figures illustrate that the model project has operating cash flows of $71 million each year during its first 10 years of operation. This rate falls to $27 million for the subsequent 10 years of operation as a result of a simulated reduction in ore grades. This feature of the model is designed to recreate the increase in costs that is typical of older mines. It should also be noted that tax minimizing routines have been used to generate the schedules of tax incentives and deductions claimed. That is, where choices exist, tax payers are assumed to make the choices that result in the lowest possible effective tax rate. The tax systems illustrated in the figures were chosen to show a range of treatments. For example, in Figures 1 and 2, the Canadian federal income tax and its US counterpart (for a mine in Utah) are shown. These taxes are chosen because they define similar tax bases (25% and 22% of discounted operating cash flow respectively). But Canadian rules allowing rapid claiming of exploration, development and capital costs mean that a Canadian mine may pay no federal income tax for its first three years. In contrast, the mine in Utah would claim these items over a longer period and therefore is not able to benefit from a tax free period. Of course, in later years the Canadian mine will have greater taxable income than its Utah counterpart as tax pools become depleted more rapidly.
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Fiscal systems
Figures 3 and 4 contrast a broadly based tax system with a narrowly based one. The Chilean additional tax defines a tax base that is close to accounting income. Some acceleration in the claiming of capital costs is allowed, but there are no investment related incentives. The result is a tax base equal to 40% of operating cash flow. In contrast, the Zambian corporate income tax combines accelerated claiming of capital costs and significant investment related incentives, to define a tax base equal to only 16% of discounted operating cash flow.
Sensitivity of effective tax rates to changes from base case assumptions In this section the focus of the study moves from the structure of the tax systems to an examination of the impacts these structures have on effective tax rates under different economic circumstances. Effective tax rates are calculated in the base case simulation, but these results have little information content. Base case conditions are inherently unrealistic and the tax systems included in the study are not chosen in order to make a direct comparison of tax burdens. The base case results are useful, however, as a basis for sensitivity analysis. In this section, analysis proceeds by systematically relaxing the unrealistic base case constraints and comparing the resulting effective tax rates. Results are analysed for policy implications of variations in profit rates, inflation and product price cycles.
Sensitivity of effective tax rates to changes in projectprofitability One important criterion for evaluating the behaviour of a tax system is its response to changes in profitability of a firm or industry. Whether a corporate tax system is progressive, regressive or neutral with respect to profitability can have a major effect on the way in which resources are allocated in a society. Increasing economic efficiency and encouraging .an optimal allocation of resources are both major goals of tax reform movements around the world. Achieving these goals is closely linked with the way a tax system treats projects that yield different levels of profit. A progressive tax system is one in which the effective tax rate varies directly with the rate of profit. That is, the more profitable the firm, the greater the proportion of its cash flow that is taken as tax. Conversely, the tax burden (as measured by the effective tax rate) is lighter for firms with lower profits. At first glance, such a system appears appealing because it links the tax burden to the ability to pay. But while this may be a valid goal in personal taxation, there are important questions about the economic effects of corporate income being taxed on a progressive basis. A major criticism of progressive taxation is that in good times it can prove to be a disincentive to economic efficiency. Since a greater proportion of funds are removed from firms that have the best returns, the ability of these firms to expand is reduced. For the economy as a whole this means that the adoption and development of new technologies and industries may be retarded. A progressive tax system also tends to equalize the after tax returns between highly profitable and marginally profitable firms. This, too, may reduce the incentive for productivity improvement or for investment to be directed to new or promising areas.
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Fiscal systems _-----
Australia (-hj,e
---
Indonesia
---
Papua
-----
Peru
New
Guinea
100 -
50 -
Figure 5. Effective various profitability
tax rates under assumptions.
‘At a seminar at the East-West Institute, Honolulu, Hawaii in November 1987, it was pointed out that the PNG system is generally thought to be progressive. On the other hand, the results shown here indicate a regressive structure. The explanation is given in note b of Table 1. PNG would be considered progressive if the project profitability were high enough to trigger the very high top marginal tax rate. However, under the circumstances of the model tested here, we never reached that high profit rate which would have triggered progressive behaviour by the PNG tax system.
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I
0 LOW
Base
case
profitability
The principal immediate advantage of progressive taxation accrues to governments. Under this type of regime taxes rise automatically on firms that are doing well, allowing government revenues to increase without the need to formally introduce tax changes. On the other hand, companies performing relatively poorly also have an interest in a progressive tax system because their effective tax rate is lower than would be the case in either a neutral or regressive system. In a regressive system of taxation, effective tax rates vary inversely with profitability. That is, the effective tax rate rises as profitability falls and vice versa. There are several structures that can result in regressive taxation, but the most common is a pure production royalty: a fixed charge that does not vary with profitability. Theoretically, a regressive tax system has the advantage of providing a stable source of revenues for government. Taxes payable do not depend on company performance and therefore the same amount should be forthcoming regardless of business conditions. Firms performing well will favour such a system as it means a lower effective tax for them than would otherwise be the case. In fact, however, the supposed benefits of a regressive taxation may be difficult to realize. Instead of stable revenues, even greater variations in tax collections may occur. The fixed burden of taxation may force companies to cease operations during periods of reduced profitability. Such taxation increases the downside risk of any project. A project that is marginal on a pretax basis may be wholly uneconomic on an after tax basis, given regressive taxation. Increased riskiness of investment may also result in lower levels of capital expenditures. This may be especially true for sectors such as mining which are subject to significant price variations. A series of simulations is undertaken to investigate how mineral tax regimes respond to changes in company profitability (Figures 5 and 6). For each national jurisdiction, results of a low profit and a high profit simulation are compared to the base case. Recall that, in the base case, the model mine yields a pretax IRR of 15%. By manipulating ore grades, low and high profit cases are developed that yield 5% and 25% IRR respectively. Figure 5 shows the outcome in terms of effective tax rate declines for Australia, Chile, Indonesia, Papua New Guinea’ and Peru. The base case effective tax rate is indexed to 100. The alternative profitability cases are shown in relation to the base case. For example, the Queensland (Australia) effective tax rate under low profitability conditions is more than three times what it is under base case conditions, In the high profitability scenario, effective tax rates are 23%
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various profitability assumptions.
profitability
lower than under the base case. The Queensland system is the most extreme of the regressive systems studied. (It will be recalled that Queensland is the only jurisdiction in which a royalty is included among the taxes studied, so this result is not surprising.) All the tax systems illustrated in Figure 5 are regressive, although to varying degrees. Figure 6 shows the relationship between effective taxation and profitability for the remaining jurisdictions. The Zambian system is the most strongly progressive. A mine in that country would pay no income taxes if it had a 5% IRR, but its effective tax rate in the high profit simulation would be 75% higher than the base case. Brazil also has a noticeably progressive tax system. The US systems would have been progressive had they been modelled completely. Canada and South Africa have relatively neutral systems by comparison, although none of the systems could technically be called neutral. It is difficult to design a neutral tax system. Among the systems studied none has a truly neutral system. The different types of behaviour demonstrated by tax systems are traceable to specific structures. Regressive taxation generally occurs when components of the system are not sensitive to profit. This includes the Queensland state royalty, although other structures may produce similar results. For instance, the Indonesian tax rate concession acts to promote regressivity. This feature reduces the marginal tax rate for mines during their first ten years of operation. A profitable mine can benefit greatly from this provision, but a less profitable mine which may not have taxable income for some period during the ten year concession would be less affected. Thus, the result is to lower the effective tax rate on profitable operations without greatly affecting less profitable mines. Sensitivity of effective tax rates to changes in the rate of inflation The second series of simulations undertaken is designed to isolate the impact of inflation on the performances of the national tax jurisdictions. The simulation chosen allows all prices and costs to rise by 5% per year over the life of the project. In this way, real IRR is maintained at 15% and the simulation is directly comparable to the base case. As all prices and costs move together, only capital items are affected. Under such conditions inflation will have a greater impact depending on the capital intensity of the project. (The arguments made in this section are equally applicable to capital-intensive sectors other than mining.) Figure 7 shows the results of this simulation, again in relation to the base case. The base case effective tax rate for each jurisdiction is indexed to 100 and the inflation simulation is shown relative to that
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20 0 Indonesia
Figure
Australia
7. Comparison
Peru
Papua New Guinea
Chile
South Africa
Alaska
Brazil
of effective tax rate indices, base case versus 5% inflation scenario,
“Effective tax rates measured by tax payments as a percentage of pretax cash
flows, discounted
Canada
Zambia
base case index = 100.
at 3%.
outcome. Thus, the introduction of 5% inflation has virtually no impact on effective taxation under Indonesian rules, but raises effective tax rates by some 70% under the Zambian regime. With the exceptions of Indonesia and Australia, the introduction of low levels of inflation significantly raises real effective tax rates in all systems; this would probably have been true of the US system if this had been modelled. The sensitivity of tax systems to inflation is primarily a result of the use of historical cost based accounting as a reference system for the tax treatment of capital items. The real cost of capital per se is not allowed as a deductible expense in any of the tax systems examined, as all systems use the historical acquisition cost of capital assets as their base. That is, firms record the purchase price of capital assets and are allowed to claim that amount over a number of years as a deductible expense. Inflation normally increases both revenues and costs but has no effect on historical cost based deductions such as depreciation. Thus, the higher the rate of inflation, the smaller depreciation becomes relative to income. Clearly, as the value of this deduction falls, effective tax rates increase. Of course, inflation has a greater impact on capital-intensive firms, because a larger proportion of the expenses claimed by these firms is capital related. To prevent this erosion in the real value of deductions, a tax regime would have to be based on cash flows rather than on income, or else have structures that adjust capital cost allowances for actual inflation conditions. None of the systems studied has such structures, although most contain some sort of compensation for inflation. To the extent that protection is provided, it is in the form of ad hoc, arbitrary adjustments rather than ones sensitive to inflationary conditions. For example, the Zambian tax provisions allow for 10% compounding of any unclaimed capital costs, whether inflation rates are 2%, 20% or 200%. A more common measure, which has among its several purposes the lessening of the effects of inflation, is the provision of investment allowances and/or tax credits.
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Fiscal systems The impact of these types of adjustments is to reduce the rate of effective taxation and, somewhat paradoxically, to make tax systems more sensitive to inflation. Notice that in Figure 7 the systems with the greatest inflation protection, namely Zambia, Brazil and Canada, are the most affected in the model by the introduction of 5% inflation. Inflation sensitivity is related to the proportion of total tax deductions that are invariant with respect to inflation. By providing ad hoc incentives, a tax system decreases the tax base, which naturally lowers the effective tax rate - other things being equal. But, the remaining tax base (although smaller because of the existence of ad hoc incentives) is, relatively, more dependent on historical cost based items, such as depreciation. This makes the system very sensitive to inflation, and it is not surprising to see the effective tax rate being levered up significantly in the inflation simulation. Note, however, the tax systems with the greatest leverage to inflation also have among the lowest effective tax rates at 0% inflation. Systems with ad hoc inflation protection and investment incentives are designed to function optimally at a given rate of inflation, whether intentionally or not. This is another reason why tax burden comparisons of the base case (or any other simulation for that matter) are misleading. When a tax system is designed in the context of a certain rate of inflation, it will perform differently when another rate is forced on it. The base case simulation assumes no inflation and under these conditions several tax regimes, notably Zambia, produce very low effective tax rates. With the introduction of inflation into the simulations, however, the ranking of tax burdens changes markedly.
Sensitivity
of effective tax rates to product price cycles
One of the most distinguishing characteristics of mining is that mineral products are subject to significant price cycles. Price changes, up and down, of 30% a year are not uncommon for many mineral commodities. The overall profitability of mining may be comparable with other but the variation in year to year sectors over a period of years, profitability tends to be much greater. This is an important factor because the variability in earnings results in greater effective tax rates in many jurisdictions for mining and may put the sector at a disadvantage relative to other sectors. This final simulation is designed to isolate the impact of price cycles on the effective tax rates for the countries studied. The base case scenario assumes that output prices are stable. The change introduced is meant to simulate a well timed investment. The mine is brought into production as prices begin their cyclical rise and is therefore extremely profitable in its first years. Prices then fall, before levelling off. The cycle is designed so that the project’s IRR would be unchanged from the base case, and thus the two simulations are directly comparable. The price cycles introduced are shown in Figure 8. Several other cycles were investigated, but the results from these simulations are less interesting from a policy perspective. The results of the simulation are shown in Figure 9. For each jurisdiction the change in the effective tax rate is shown, given the introduction of the price cycle scenario. Thus, for example, the introduction of price cycles reduces the effective tax rate for Alaska by 10% from what it would have been under base case conditions. In
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Fiscal systems
0.58
-
0.54.
1 1
1
I
0
1
4
r’
I 8
%&c/X
Project
, 12 lifespan
I 16
1
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1
I
20
24
(years1
x-x-x-x-x-x-x-x-x-xzT)
360
tn :
340
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320 -
X
X
a’
Figure 8. Copper and gold price assumptions, OCM mine model, cyclical price scenario.
300.
1 0
1
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,
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8
,
I
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12
Project
lifespan
I
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[years]
1(
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til 6
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Alaska
Brazil
Canada
Peru
South
Indonesia
Africa
Figure 9. Sensitivity
Papua New
Chile
Australia
Accouni
Guinea
‘9
rules
of effective tax rate indices to cyclical price scenario.a
aEffective tax rates measured by tax payments as a percentage of pretax cash flows, discounted at 3%.
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contrast, the Australian system produces somewhat higher effective taxation. In general, the impact of price cycles on effective tax rates is relatively small, compared with the sensitivities seen in the other simulations. (The Zambian case is special because of an unusual interaction between the corporate tax and mining tax. As a result of loss carry back provisions, a large amount of taxes are deferred, thereby reducing the effective tax rate significantly.) Nevertheless, it is important to understand the performance of a tax system under cyclical conditions because of the types of changes that are being introduced in many countries as part of tax reform. These changes may introduce a bias against industries in sectors subject to above average cyclical variations. The key variable in determining a tax system’s response to changing prices is the treatment of capital assets. Systems that have rigid depreciation schedules for tax purposes tend to produce higher effective tax rates under unstable price conditions than systems that have more flexible rules. In this context, rigidity and flexibility refer to the ability of tax payers to vary the amount of depreciation claimed for tax The best example of a rigid system is that defined by purposes. conventional accounting rules. That is, a specific depreciation charge is mandated each year according to the estimated service life and historical cost of the firm’s assets: the amount of expense recorded is independent of the company’s revenue or income. To illustrate the impact of a rigid depreciation system on effective taxation, Figure 9 includes the results of a simulation in which income defined under Canadian accounting rules is used as the tax base (labelled ‘Accounting rules’ in the figure). The mine model is simulated in both the base case and the cyclical prices case, and accounting income results are produced. A uniform tax rate is applied to both sets of results to produce two series of taxes payable. These series are used to generate effective tax rates. It will be noted that the cyclical prices case produces a project effective tax rate that is 10% higher than the base case, even though the project IRR is the same in both cases. The reason for this has to do with the timing of deductions. A rigid system allows little discretion in the timing of deductions. For a company in a cyclical sector this means that during periods of falling markets the full amount of depreciation to which it is entitled may not be claimable. There is no compensation during the next period of rising markets, however, because the amount of income claimable remains fixed. The net effect is to extend the claiming period for depreciation, which necessarily reduces the value of the deduction and increases the rate of effective taxation. In contrast, the firm with stable income will generally be able to claim the full amount of deductions to which it is entitled in each year and, therefore, not have to extend claiming periods. Thus two projects that have the same IRR may have significantly different effective tax rates due to the timing of the income. A remedy for this situation may be to permit accelerated claiming of depreciation. This allows companies to make increased claims during profitable periods. Claims may be reduced during slow downs, but the net effect will leave cyclical industry firms and other firms on a more equal footing. Another possible solution would be to allow firms to carry their losses forward indefinitely; but there are serious practical problems associated with this approach. The treatment of cyclical price sectors has become an issue because of
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the current direction of tax reform. Capital consumption rates have been moderately reduced in the USA and similar changes are being contemplated in Canada. The reason given for this action is that accelerated depreciation is a subsidy to capital-intensive investment that introduces bias in economic decision making. This may be the case; but removing accelerated depreciation may introduce another level of bias against cyclical, capital-intensive sectors such as mining.
Direction of tax reform taken in Canada and the USA After several years of intense debate, the process of reforming the Canadian and US income tax system now appears largely complete, at least at the federal level. Although many radical plans were discussed, the final outcome was relatively moderate. The major provisions of tax reform for mining are: 0 0 0
the reduction of the top corporate tax rate in Canada and the USA; the repeal of the US and Canadian investment tax credit and the Canadian earned depletion; enhancement of the corporate minimum tax system in the USA.
Changes made to depreciation schedules and the treatment of exploration and development in the USA are not themselves expected to have a significant impact on mining, although there had been considerable concern by the industry about earlier proposals concerning these areas. In addition, percentage depletion was retained. The major impact, however, may be felt in an increased tax burden as a result of the changes to the corporate minimum tax. These changes will complicate the tax system, making an overall evaluation of the impact of tax reform on US mining difficult. In Canada, the loss of earned depletion and the reduction in capital cost allowance rates are also not expected to have a significant impact in view of the reduction in nominal tax rates. The accelerated capital cost allowance for new mine assets and major expansions was retained, as was the fast write-off for exploration. The US and Canadian mineral income tax regimes before tax reform were generally similar in structure and performed accordingly. They had significant investment incentives, were mildly progressive and were relatively sensitive to inflation and price cycles. In policy terms, what are the implications for mining of the changes made in the USA and Canada? Many profitable mines may have lower effective tax rates than had been the case under the former systems. These mines will benefit from the reductions in tax rates and will not be as severely affected by the loss of incentives. Effective tax rates on less profitable operations in the USA, however, will probably rise, primarily because of the changes made to the minimum tax systems. Thus, the net effect of the changes should be to make the system less progressive with respect to profitability. Second, the removal of the investment tax credit eliminates a significant incentive whose value falls with inflation. The reformed system, therefore, will be less sensitive to inflation in both Canada and the USA. Third, because the capital cost recovery system has not been changed significantly, the mineral income tax systems will generally retain their capacity to deal with price cycles, although the minimum tax may have an effect in this regard in the USA. There are several important advantages to the new system. Rewarding success rather than effort, by reducing the progressivity of the
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system, is consistent with stated economic policy objectives. It is generally conceded that a policy which promotes a more efficient allocation of resources within and among industries enhances the prospects for economic growth. The loss of fixed investment incentives, such as the investment tax credit, is seen as less important given the current low rate of inflation. These incentives provided compensation to industry at a time when inflation created a strong tax bias against capital-intensive investment. With inflation low, however, the same incentives could have produced very low effective tax rates for capital-intensive ventures. There are disadvantages to the reformed systems as well. Because they provide no inflation adjustments, the US and Canadian systems remain intrinsically unsuited to inflationary conditions. Any resumption of inflation would produce strong pressures for the reinstatement of lost incentives.
Conclusions The tax reform debate in various countries has renewed interest in alternative tax systems and the impact that taxation has on the economy. In this study a variety of mineral income tax systems are investigated to examine how these systems are constructed and what policy implications they contain. This is accomplished by modelling the system and then subjecting the model to different mine operating conditions and comparing the results. The variables chosen for simulation are: profitability, inflation and product price cycles. In examining the relationship between effective tax rates and profitability it is found that most of the systems studied are progressive, although to varying degrees. That is, the rate of effective taxation rises or falls with the rate of profit. For a smaller number of jurisdictions, the tax system is found to be regressive. In this case, the rate of effective taxation moves contrary to the direction of profit (the higher the rate of profit, the lower the rate of effective taxes and vice versa). No system was found to be neutral (with the rate of effective taxation constant regardless of the rate of pretax profit), although some approached neutrality. The relationship between effective taxation and profitability is important because of its impact on a society’s allocation of resources. A progressive system may impede the movement of investment to new or fast growing sectors of the economy and may, therefore, impair overall economic growth. A regressive system may appear attractive to a government concerned about the stability of its tax revenues, but could lead to problems. First, such a system may, in fact, increase the variability in tax revenues by increasing the likelihood of temporary mine closures. Second, a regressive tax system increases an investor’s risk and may, therefore, reduce the amount of investment. One of the major causes of progressivity is the provision of investment incentives and these are being pared back in many jurisdictions. The narrowing of income tax rate scales will also be likely to have an effect. Inflation is a less important problem in developed economies than it was in the recent past. Thus, there has been a move to remove the measures that protected companies from the tax effects of inflation. Tax systems based on historical cost based accounting generally produce high effective tax rates during periods of inflation. Mining, which is a
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relatively capital-intensive sector, is particularly susceptible to inflation. This is demonstrated in the simulations undertaken in the study. While the reduction of inflation protection in a low inflation environment may be appropriate, sectors such as mining may be especially vulnerable to a sudden, sharp increase in real effective taxes should inflation increase. Thus, a corporate tax system that treated all sectors similarly at a low level of inflation may introduce significant distortions at higher levels of inflation. Mining differs from many other industries because the prices for its products are especially subject to significant price cycles. The study demonstrates that these price cycles may result in higher effective tax rates for mining than for comparable sectors that do not have price cycles. The structural cause of this relationship is shown to be the treatment of capital cost recovery. Price cycles have a greater impact on effective tax rates when the claiming periods for capital costs are extended. In most tax reform debates there have been calls for the extension of capital cost claiming periods. Should these measures be adopted for mining, the industry may be put at a disadvantage relative to other sectors.
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