7.1 Fiscal Objectives

The design of an EI sector fiscal regime should reflect stated objectives. Ideally, proposed elements of a new fiscal regime or proposed changes to an existing fiscal regime should be clearly presented, offering stakeholders an opportunity to comment. Once a final decision is reached, it should be reflected in any resulting legislation.

From the government’s perspective, typical fiscal objectives might include: (1) a significant share of project rents that increases as profitability rises; (2) broad-based sector development; (3) early, dependable income; (4) limited exposure to risk; (5) international competitiveness; (6) minimized opportunities for tax evasion; and (7) an administrative simplicity (or complexity) that is in line with the institutional capacity of the tax authority regarding the EI sector.

From the investor’s perspective, a key objective will be the stability of the fiscal regime.

Rent Capture. Rents are the excess returns from EI sector projects over and above what is required to justify investment.[3]  It is generally agreed that the major share of these rents should go to the state: the owner of the resource. It is also widely accepted, and has increasingly become a political imperative that, as underlying project profitability increases, a state’s percentage share in rents should also rise. A fiscal system that produces these results – low share when profitability is low, high share when profitability is high – is called progressive. It is positively responsive to changes in circumstances affecting underlying project profitability. A system that produces the opposite result, (a regime where a government’s share or ‘take’ decreases as profitability increases) is called regressive. It is inversely responsive to changes in underlying profitability (see Figure 7.1 below).

 

Source: Manon's Econ Blog website. (last accessed 1 April 2012).

Broad-Based Sector Development. While understandably interested in a high rate of take from any one petroleum or mining project, governments are at the same time interested in their overall take, from the EI sector as a whole. This means that they are also interested in maintaining a broad tax base. A government can maximize the tax base by, as far as possible, ensuring that new EI sector projects or ongoing resource-producing operations which are profitable pre-tax, remain profitable post-tax, albeit at a lower rate of profitability. A fiscal regime that accomplishes this is known as neutral, in the sense that it does not impact or distort the decision to invest or produce (such as system never takes more than 100 percent of the rent or profit available pre-tax).[4] Neutral fiscal regimes can be expected to encourage new investment across a wide range of opportunities and extend the producing life of existing operations (see Figure 7.2 below).[5]

Early and Dependable Revenue. Particularly where their petroleum or mining sectors are either new or only narrowly developed, governments will place a premium (often politically driven) on early and dependable income from the EI sector. The emphasis on early revenue may be driven by urgent needs, or may simply be driven by public expectation of revenues once a petroleum discovery is announced or a mine is opened. Dependable revenue (such as revenue that is assured as long as a project is in operation) is clearly beneficial to budgetary planning. However, once an EI sector becomes more fully developed and a regular and steady stream of fiscal revenues is being generated from a variety of projects, this objective becomes less important.

In terms of the above Figure 7.2, the socially optimal level of production is Q, where price just equals cost.  Neutral tax regimes encourage production towards Q.

Source: Ajayi, O. (2009). Resource Taxation as a Tool for Development. International Energy Law Review, Vol. 2, p. 60.

Limited Exposure to Risk. Governments are, not surprisingly, adverse to uncertainty and volatility in fiscal flows (as suggested in the preceding paragraph), and to the risk of loss or failure where public funds are involved. 

International Competitiveness. Petroleum and mining companies operate on a global scale and compare fiscal terms in deciding where to invest.[6] With this mind, governments show a great interest in how competitive their fiscal regimes are in terms of attracting investor interest. That said, they will also be mindful about not being more generous than need be based on the terms offered in comparable countries. Comparable countries are those with similar geological potential, cost and operating environments, track record, institutional capacity and perceived and actual political risk.[7]

Fiscal competitiveness may depend not only on matters such as the level and behavior of government take, measured by rates of take (Figure 7.3), responsiveness to price and cost changes, the time and risk profile of investor and government revenues, etc., but also on legal constructs which determine the availability or not to investors of foreign tax credits,[8] i.e., home country tax credits for taxes paid in host countries. (See Foreign Tax Credits under Special Fiscal Topics, Section 7.3 below)

Standard international comparisons of average effective
tax rates or ‘take’ for hypothetical oil and mining projects.

Source: IMF FARI Model Hypothetical Simulations.

Mitigation of Adverse Environmental and Social Consequences. While other provisions in laws, contracts, or regulations may more importantly and directly address environmental and social concerns related to resource operations, fiscal terms play a role as well (see Chapter 9).

Administrative Simplicity. Administrative capacity is an issue in most developing states, and fiscal design in the EI sectors is often tailored to the perceived capacity to administer a fiscal regime; hence the interest, ceterus paribus, in administrative simplicity.[9]  

Trade-Offs. In practice, it is not possible to achieve all of these objectives simultaneously. Clearly, trade-offs are almost always required. For example, efficient rent capture mechanisms may not satisfy a government’s objective of limiting exposure to revenue volatility, or of administrative simplicity. Many of these trade-offs will become more apparent when fiscal instruments are discussed below.  

The trade-offs, which governments face, derive not only from inherent conflicts among the different objectives established by government, but also from the fact that investor objectives – with respect to any fiscal regime – may be at odds with government’s own objectives (for example, an investor will always want to maximize its return and minimize its risk, while the government is trying to do the same on its own behalf). Fortunately, both parties are now beginning to recognize what constitutes an equitable fiscal regime, and that a well-designed regime can go a long way towards addressing each party’s concerns.

One investor concern or objective that deserves particular attention relates to the stability of the government’s fiscal regime. A long standing investor fear is that at the end of a long and expensive exploration period, and after the expenditure of very significant sums on EI sector development, it will become a ‘captive’ of the host state and vulnerable to unfavorable renegotiation of fiscal terms, especially where circumstances have unexpectedly changed in the investor’s favor through resource price increases or discovery of unanticipated large or rich reserves.[10]  

This concern has been addressed not only through legal or contractual assurances of stability (see Chapter 5), but also through fiscal design itself:  a responsive fiscal system (for example, a fiscal regime that automatically adjusts the government take to actually achieved profitability tends to reduce pressures to renegotiate).[11]

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  • Prof Philliph Crowson: The following statements from Chapter 7.1 on Fiscal Objectives are unduly simplistic: 'Rents are the excess returns from oil, gas, or mining projects over and above what is required to justify investment. It is generally agreed that the major share… read more