The energy sector attracts a special tax regime in the form of the Resource Rent Tax due to;

the need to compensate society for the use of its natural resources; the fact that the economic
nature of some operations means there is an economic rent to be taxed; and finally, because a
number of studies over the last few decades have concluded that this is the most effective and
equitable tax system for extracting society’s compensation from the economic rents produced.

Natural resources are generally considered to be the property of the community as a whole,
with governments mandated to administer the rights to the exploitation of these resources, and
to extract appropriate compensation on the behalf of the community. This paper will discuss
the advantages and disadvantages of the Resource Rent Tax applied by the federal
government to petroleum exploitations in Australia. A sound knowledge of such existing tax
regimes is essential in order to be able to design and implement tax systems which encourage
the development of ecologically sustainable energy systems.

According to the Western Australian Department of Industry and Resources (2008), a

successful system will; adequately compensate the community for the loss of a finite resource
(eg fossil fuels); provide producer, consumer and intergenerational equity; provide stable
revenue; be simple to administer; and be transparent. From an economic point of view, the
most important criteria is that the system leads to an efficient allocation of resources
according to consumer’s tastes and preferences, and that externalities are taken into account
so that that the system does not distort the market.

The spectrum of taxes and royalties used to recuperate the community’s share of revenue
from the sale of natural resources ranges from ad valorem and well head production royalties,
to resource rent profit based taxes. Both taxes and royalties in this context have a similar
definition, which is that they are the compensation to society for the use of a finite resource.
This is worth noting, as a tax is usually defined as a government revenue raising measure,
such as the excise on liquid fuels.

The increase in the 1970’s of crude oil prices, as well as the prices of substitute goods coal
and uranium, led to the implementation of a federal excise which gathered 22 billion dollars
in a ten year period, prompting states to question the adequacy of their own revenue raising
measures. The current resource rent framework in Australia was formed out of the wealth of
research conducted throughout this period, and in the wake of the ‘70’s oil shock. (Rodgers,
2007).

The concept of economic rents is founded on the work of David Ricardo (1817), with work by
Brown (1948) leading to the idea of the ‘Brown Tax’ on economic rents. The idea of taxing
these economic rents on mining projects in Australia was developed by Henderson (1971),
who proposed auctioning of mining tenements. This was followed the work of Garnaut and
Clunies-Ross (1975), who developed the idea of a Resource Rent Tax as a way of keeping
economic benefits of natural resource projects in developing countries. They also argued that
this would be a less distorting way of taxing resource development, which could theoretically
have a neutral effect on investment decisions.

Criticisms by Swan (1976, 1978) and Dowell (1978) led to Garnaut and Clunies-Ross (1979)
elaborating on the need for balancing investment promoting and investment deterring effects
of resource rent taxes using fiscal parameters (ie, the threshold rates for profit, rate of tax and
tax deductibility of expenses). Fraser (1993,1998) uses simple models of a mining company,
in both risk averse and risk-neutral scenarios, in an attempt to demonstrate the potential

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 neutrality argued by Garnaut and Clunies-Ross. But Smith (1999) argues that in the real world
outside of such simple models, the fiscal parameters are simply too complex to be able to
design a truly neutral resource rent tax, and that the best that can be done to avoid distortion is
to avoid threshold and tax rates which are too high.

This wealth of research has resulted in the energy sector in Australia attracting a special tax
regime at the Federal level, known as a Resource Rent Tax (RRT), implemented by the
Commonwealth government in 1987. Although a tax in name, the RRT really operates as a
royalty, as it is designed to compensate society for the use of resources which incur an
economic rent, without distorting relative prices in the market. This tax differs from the ad
valorem tax or specific rate royalty, common at the state level, which unlike the RRT do not
take into account whether there is economic rent to be taxed in a particular operation. This
feature of these state taxes can discourage investment in marginal resource exploitations.
Neither do these taxes take into account the amount of economic rent, which can lead to
under-compensation of the community. Figures 1,2 and 3 below illustrate the differences
between specific rate, ad valorem and resource rent systems.

Figure 1: Specific royalty – Source: ABARE.

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 Figure 2: Ad valorem royalty – Source: ABARE

Figure 3: Brown tax – Source: ABARE.

The concept of economic rent depends upon the idea of normal or abnormal profits. A normal
profit occurs when the costs of production (including opportunity costs of capital and labour)
are equal to the sale proceeds of the product. The opportunity cost of capital refers to the next
best investment of capital that has been foregone in order to invest in a particular project, and
can be equated to what is considered a normal profit for an enterprise.

Economic rent is thus a surplus over and above economic costs of production and occurs
wherever the profit is above normal. Enterprises compete to capture this surplus, whilst
governments can obtain some of this surplus in the form of taxes. In theory, taxing this kind
of surplus will not discourage the firm from operating, as it will still make anormal profit,
i.e., it is still making the best possible use of its labour and capital resources.

The Petroleum Resource Rent Tax (PRRT) which is applied by the Commonwealth
government in Australia, works on the assumption that a normal profit is 25%, with any
surplus above this being considered economic rent, which is then taxed at a rate of 40%. This
is considered to be the ideal mechanism for obtaining compensation for the use of community
resources without distorting market signals. The advantage of only taxing where a resource
rent occurs is that marginal operations are not discouraged from starting or continuing. The
disadvantages include the fact that government revenue can be delayed for very long periods,
or may not even eventuate at all in some cases.

The PRRT works on an assumed normal profit of 25%, due to the fact that to calculate the
actual normal profit of each company on a yearly basis would simply be too complicated. The
tax rate over this normal profit is applied at 40%, even though all above normal profits could
theoretically be extracted by the government without distorting the market. In reality though,
this would lead to a reduced incentive for companies to innovate and reduce costs.

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 A resource rent tax allows the government to participate in the profit sharing on a resource
project, without having the risk of directly investing in the project. The risk undertaken by the
government is that the project will not produce above normal profits, and that society will
thus not be compensated for the use of their finite asset. The trade-off is that under this
system, at least society will have benefited from the economic activity of these more marginal
projects having taken place, whereas as under a well-head tax system, they might not have
entered production. The possible side-benefits are known as positive externalities, and include
increased employment and scientific knowledge gained from exploration of remote areas.

The special tax regime applied to the energy sector must compensate society for the use of
finite natural resources, whilst encouraging (or at least, not hindering) economic development.
This delicate balance is met in Australian commonwealth waters (excepting the North West
Shelf) by the Petroleum Resource Rent Tax, which after decades of study has been refined to
the point where it allows society to share in the profits from the development of common
energy resources, whilst giving companies a level playing field in which to develop even
marginal projects.

References:

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Garnaut R and Clunies-Ross A (1975). “Uncertainty, Risk-aversion and the Taxing of Natural
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 http://ageconsearch.umn.edu/bitstream/10396/1/cp07ro02.pdf - accessed 7/5/2009.

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