70309 The Political Economy of Natural Resource Taxation: Building Credibility and Investing in Tax Administration Capacity* Tuan Minh Le and Lorena Viñuela . A tax regime that is progressive and based on profits This note presents policy choices available to natural- is considered best practice for natural-resource- resource-endowed countries that focus on both design endowed countries. These regimes promise to capture and implementation. The literature provides the bulk of resource rents from the sector while extensive policy guidance in the area of natural ensuring the required investment associated with resource taxation, which builds on an extensive high-risk, capital-intensive exploration and public finance tradition (see, for example, Daniel, extraction. But developing countries often find this Keen, and McPherson 2010; Otto and Andrews model challenging and even impossible to enforce. 2006). Yet most of this work deals separately with Instead, underlying political economy drivers and the technical, economic, and institutional aspects of resulting institutionally weak and fragmented oil and taxation. The objective of this note is to illustrate mining revenue administration often lead to how particular policy choices regarding resource excessive reliance on regressive indirect fiscal taxation policy and administration can be better regimes or those based on proxies to profits. High understood in the context of the prevailing political uncertainty, price volatility, and political pressures economy and institutional endowments. The message make fiscal regimes prone to change and instability, is that policy choices are invariably and predictably impairing further prospects of attracting investments conditioned by a set of dynamics for given country needed to develop the sector. contexts. This note provides guidance on how different starting points shape the prioritization and Governments face challenges committing to stable sequencing of certain policy designs to enhance both taxation policies as a result of the interaction between overall rent-capture by the state and successful and these distinctive sector features and the lack of sustained extractive industry investment in the sector. mechanisms for credible enforcement of intertemporal policies and commitments, both between domestic forces and between governments Policy Issues in Design and and investors. Developing countries facing time Implementation of Fiscal Regimes consistency problems need to design country-specific ―good enough‖ or ―best fit‖ fiscal regimes, defined as typically simple, transparent, and politically feasible, Policy issues related to the design and to conform to a certain set of core objectives and the implementation of fiscal regimes for nonrenewable levels of risk that the state is willing to take. resources generally fall into three areas of recurrent concern that illustrate the paradoxes observed in the Suboptimal, complex, and contradictory design of third stage of the natural resource management value fiscal regimes chain. These policy issues include selection of fiscal regimes in developing countries that are apparently Paradoxically, developing countries often have more too complex to implement, suboptimal instability in complex regimes than countries with higher capacity. fiscal regimes, and pervasive weaknesses and In recent years developed countries have strived to apparent neglect of administrative capacity in this simplify their tax systems (Otto and Andrews 2006; area. van Meurs 2008), whereas resource-rich, low- capacity, and weak-governance countries do just the Perpetuating time inconsistency opposite, or at least refuse to follow the trend. The latter have tended to introduce relatively complex Fiscal regimes for nonrenewable resource in many regimes (particularly in their royalty base, which developing countries often seem erratic and myopic. mimics one based on profitability). Resource-rich, For companies, investments in the mineral sector are low-capacity, and low-governance poor countries risky, capital intensive and long term, and there is often find it overly challenging to administer a fiscal always high uncertainty and unpredictability in both regime centered on progressive direct income taxes. demand and production of the output (Osmundsen Therefore, they rationally front-load revenues using 2010). For host governments, operation and market production-based royalty as the major fiscal risks render the revenue flow highly variable and instrument. Preference for steadier revenues, short- cyclical by nature. It is clear that both investors and term horizons, and risk avoidance explains the fact the government would benefit from stable fiscal that royalties or other regressive instruments are most policies. Nevertheless, the absence of cooperation commonly used to tax mineral extraction. While mechanisms, the high discount rate for the royalty is economically inefficient, it is simpler to incumbent, substantial payoffs for deviating from administer and has lower variability. agreements, and political exchanges taking place in largely informal, uncertain, and nontransparent Low incentive to invest in revenue administration arenas—as commonly observed in resource-rich reforms developing countries—all contribute to the ubiquitous time consistency and commitment Many low-income, resource-rich countries have problems (Kydland and Prescott 1977; Persson and notably low capacity and poor governance in revenue Tabellini 2000). The paradox is that time administration. The typical problems in revenue inconsistency is exogenous to investors but administration range from inadequate organizational endogenous to the domestic political economy. structuring, low human resource capacity, perverse incentive systems for revenue collection and taxpayer Sectoral characteristics interact with institutional service, and cumbersome processes, to lack of constraints, intensifying the commitment issues.i Past information technologies and infrastructure support. tax increases are associated with lack of credible In addition, the collection of revenues from the commitments by the government. Investors will mineral sector spreads across multiple institutions, expect it to behave opportunistically after their which generally do not have incentives or are legally investments are sunk. In order to attract new bound to cooperate. As revenue administrations have investments, governments need to signal investors insufficient staffing and training to deal with that they are willing to compensate them for the multinational mineral corporations, self-assessment additional risk (and even lock in their ability to becomes a mere formal acceptance of returns filed by change the regime, for example, by introducing corporations, subject only to desk audits. stability clauses). However, when investments are completed, especially in the context of high prices, Prevailing institutional and political incentives, governments have difficulties enforcing such however, discourage investment in this area. First, commitments (because of voracity, rent-seeking, and revenue reforms are both resource-intensive and long social demands) and consequently tend to increase term; they are highly politically driven, and success is taxation. In response, companies generally reevaluate impossible without broad and sustained political future investments and increase production at the support. Second, incumbents with short-term time expense of the long-term productivity of reservoirs. horizons—and therefore a high discount rate—and Thus, the repeated interaction between governments management of revenue administrations have high and investors leads to a suboptimal equilibrium of incentives to retain the status quo (Fjeldstad and underinvestment and an unstable procyclical taxation Rakner 2003). Third, fragmentation in administration regime (Boadway and Keen, 2010; Osmundsen of revenues from the mineral sector, including the use 2010). of a state-owned corporation as a regulatory and 1 revenue-collecting institution, without institutional the multiple interactions between these and incentives or enforcement mechanisms for institutional and political constraints. coordination, inhibits successful tax administration reforms. Fourth, the lack of transparency in upstream Table 1. Economic Impacts of Alternative Tax contracting and signing of development agreements Regimes is a major constraint on effective revenue administration. Extracti Grade Adminis Revenue on Selectio Cutoff tration Variabilit Type of Tax Profile n Profile Grade Cost ya Revenue Mobilization and Accountability Per unit Present Present Increase Low Low royalty on to future to future s While many low-governance countries have output significant room for improvement in tax collection, (nominal) because of the concentration of ownership and the Ad valorem Function None Increase Interme Interme high profitability in extractive activities, mineral royalty of s diate diate discount wealth provides a combination of surplus and relative ed price administrative ease, reducing pressures for path accountability (Chelliah 2006). To the extent that Variable Function Function Increase Interme Interme governments derive large mineral rents or control the royalty of rate of rate s diate diate of of production directly, they may be in a position to growth growth avoid the politically sensitive task of taxing their of prices of prices and tax and tax population (Dunning 2008) and also may be able to rates rates make transfers to large segments of the population to Profits tax None None Unchan High High secure the legitimacy of the regime (Anderson 1987; ged Crystal 1995). These political incentives reduce the urgency to diversify the tax base (Ross 2001) and to Profits tax Future Future Decreas High High with cost to to es make long-term investments in institutional capacity depletion present present for tax administration, which often results in poor Profits tax Function None Decreas High High resource mobilization and can trigger the revision of with of es fiscal terms. Additionally, a weak tax administration percentage discount depletion ed price can easily be manipulated by the incumbent path administration or captured by private interests. Property tax Future Future Increase Interme Low Taxation is an important aspect of citizenship and to to s diate governance. Individuals who do not pay taxes are less present present likely to demand transparency and quality in government spending and hold it to account. Source: Shukla and Le 1999. Governments that do not derive a substantive part of their resources from their citizens are less likely to Governments mix instruments to overcome the trade- pay attention to their demands (Karl 1997; Moore offs between efficiency and effectiveness in revenue 2004). Overall, the tendency will be greater to use raising or between revenue adequacy and variability particularistic rewards rather than produce public implied by the different instruments. On the one goods (Bueno de Mesquita et al. 2004). hand, governments resort to fiscal and nonfiscal instruments to collect natural resource rents. The most commonly used fiscal systems are tax/royalty in mineral-rich countries (Otto and Andrews 2006) and Fiscal Instruments for Mining and Oil concessions and production-sharing contracts in oil and Gas producers (Tordo, Johnston, and Johnston 2009). Nonfiscal alternatives include auctioning exploration This section briefly discusses alternative fiscal and extraction rights, production sharing, and equity regimes. There are multiple fiscal instruments participation.ii Yet they are generally associated with available for taxing extractive industries, each with revisions of the terms throughout the project cycle its own benefits and disadvantages along economic, (Blake and Roberts 2006). On the other hand, the administrative, and revenue-enhancing dimensions. fiscal instruments that are most commonly used for The inherently complex process of policy design extractive industries include royalty (specific and ad becomes even more challenging in the minerals valorem), corporate income tax, presumptive income sector owing to the distinctive technical and tax, resource rent tax (RRT), and property tax, as economic characteristics of oil, gas, and mining, and well as other taxes such as value added tax (VAT), and import and export duties (Boadway and Flatters 1982; Nellor 1987; Otto 2001; Otto and Andrews 2 2006; Sunley, Baunsgaard, and Simard. 2003). The understood tax system is typically associated with incentives created by the various tax and royalty less risk and higher compliance. A clear and simple instruments are summarized in table 1 (for a more fiscal regime prevents tax collectors from taking it extensive discussion, see Barma, Kaiser, Le, and upon themselves to interpret tax laws and regulations, Viñuela 2012, chapter 4). and also prevents companies from taking undue advantage of loopholes or exemptions. The alternative taxes not only create different Standardization of tax procedures in administration incentives for extraction, grade selection, and can also prevent companies from using bribes as a differences in terms of deadweight loss, but they also means of avoiding a lengthy and complicated process affect the variability or uncertainty of government to determine tax liability. Regarding specific fiscal revenues (Shukla and Le 1999). The uncertainty in instruments, unit or value-based royalties are least revenue streams flowing to the government imposes a susceptible to fiscal corruption, given that they cost on the economy. In other words, taxes that create require a relatively low level of administrative higher uncertainty are less desirable than those with capacity and are usually straightforward to calculate less variability in government revenues. From this from a company’s total production. This point of view, output-related taxes are preferable to recommendation is also consistent with studies that income-based taxes. Taxes such as a resource rent tax show that corruption impacts direct taxes more than create a great deal of uncertainty and therefore indirect taxes (Ghura 2002; Tanzi and Davoodi impose higher costs on the economy. A unit, or ad 1997). Profits-based taxes, on the other hand, allow valorem, royalty on output is dependent only on the more room for corruption and therefore require more quantity and price of the output, and it creates a monitoring from the government. revenue stream that is least variable or uncertain. Moving to a variable royalty, clearly the extent of variability or uncertainty increases. Income tax Centrality of Tax Administration revenues not only depend on the quantity extracted and price of output but also on the prices of inputs, To a large extent the quality of implementation and cost overruns, and so on. The revenue stream from enforcement of the regimes determines the income taxes has a higher variability; the variability effectiveness and efficiency of instruments and the of a combination of income tax and royalty lies in variability of the revenues as much as their design. between and is moderate compared to a pure income Implementation can also create delays and distortions tax. When an additional profits tax or resource rent that will affect investment and production decisions. tax is employed, the result is multiple rates and the Tax administration is one of the areas most revenue stream becomes more variable. The property vulnerable to corruption. In most low-income tax is a function of revenue from the extraction of the countries, there is much room for improving the tax resource, and its variability is similar to that of an ad administration capacity, which can yield substantial valorem royalty. increases of public revenues from natural resources. Most resource-dependent countries have an overall The various taxes also have different administration low to moderate state effectiveness at collecting taxes costs, which have two components. One is the cost of or other forms of government revenue, and their collection or administrative cost, representing the performance falls behind that of countries with public sector cost incurred by the revenue department similar levels of gross domestic product (GDP) (Karl of the government in administering tax laws. It 1997; Knack 2008). The number of tax includes wages and salaries, cost of accommodation administration agents per thousand inhabitants is and transportation, expenditures on investigation of lower on average in these countries, but the cost as a tax evasion/tax avoidance and enforcement, and percentage of the revenues collected is also lower on maintenance of a legal system for adjudication of average (Rozner 2009). These figures are disputes. The other is the compliance cost—the cost symptomatic of the relative ease that rents offer, but borne by the taxpayers or the private sector in in the long run, rents reduce the need for other taxes meeting the legal requirements of the tax system. It and lower domestic tax effort. Nonetheless, they includes the expense of keeping records, accounts, require sustained investment in tax administration, and other necessary data; cost of acquiring the which is often at odds with short-term time horizons knowledge of legal obligations and penalties; and the prevailing political economic incentives. payments for professional tax advice; and other incidental costs. The main challenge that many developing countries and donors that provide technical assistance face lies Moreover, while preventing fiscal corruption is in attracting and retaining qualified professionals. always a challenge, the simpler and more easily Salaries are generally low and noncompetitive, and as 3 a result turnover is high. Many of the more objectives, governments from scarce-capital countries experienced agents are routinely hired by the same also need to create incentives that attract foreign companies they monitor. Taxing extractive industries investment to develop the sector. Political economy involves multiple actors, including sector ministries, scholarship suggests a number of country mineral commissions, customs, and tax collection characteristics that are likely to (1) condition the agencies. The specific features of each country, such overarching policy motivations and (2) shape the as the form of government and the formal and fiscal regime choices resource-rich countries make. informal distribution of functions, will determine Figure 1 presents a stylized overview of this how fragmented the implementation of taxation will sequence. Unlike geological endowments, be. In settings where interagency coordination and technological and institutional factors are likely to be alignment of incentives are poor, revenue collection endogenous to the country setting and will change is lower. Institutional duplication and fragmentation over time. increase the cost of controlling and scrutinizing adherence to rules by tax agents. At the same time, The political economy context has been characterized lack of coordination between different agencies and along two dimensions: the tendency and ability to between levels of government often reflects the enforce agreements over time and the extent to which noncooperative nature of the political system the political system is broadly inclusive (see Table 2). (Haggard and McCubbins 2001). Regarding the first dimension, understanding how well political forces or elites coordinate regarding In many cases in which the lack of independence and policies and whether there are formal or informal capacity has compromised the effectiveness of mechanisms at their disposal to ensure that those revenue collection, governments have resorted to agreements are upheld allows us to assess the length state-owned enterprises, such as Yacimientos of governments’ time horizonsiii and risk Petrolíferos Fiscales Bolivianos (YPBF) in Bolivia orientations.iv Settings with high discount rates or and Petroecuador in Ecuador, that are generally better short-term horizons are likely to see greater endowed than tax agencies, to mobilize taxes from instability in the fiscal regime, which in turn is likely extractive activities However, this dual role often to affect investors’ perceptions of risk. Furthermore, compromises the performance of such entities domestic political forces that cannot sustain (McPherson 2003; Marcel and Mitchell 2006) while agreements tend to mobilize fewer resources from the further reducing the resources available for tax sector and are associated with a more informal (and administration. In extreme situations, governments front-loaded) rent extraction. In turn, these with weak capacity resort to bundled deals that instruments affect the production time profile of completely bypass tax collection and public mines and oil fields. In sum, short-term horizons are expenditure management. While reducing the associated with faster rates of resource extraction and transactions costs for the government, these contracts front-loading of taxes (Robinson, Torvik, and Verdier create additional risks because mining and oil 2006) and underinvestment in the long run. companies become engaged in operations that are not covered by the mining or hydrocarbon legislation, Price and production changes aggravate cooperation such as the development of major infrastructure problems by generating strong incentives to change facilities (roads, railways, power generation), as well fiscal terms as social expectations and political costs as processing plants and local community of taxing other sectors or individuals rise during development. boom times. In contrast, in environments where cooperation is possible, policy change tends to be incremental and done through compromise. Repeated Political Economy Settings and interactions in institutionalized arenas extend time horizons and create incentives to invest resources in Dynamics creating policy capabilities, such as tax administration capacity (Stein et al. 2008). In turn, As expressed by Bates (1989, 479), ―taxation professional bureaucracies can limit the scope of inherently implies politics.‖ When selecting fiscal opportunistic policies and enhance trust in instruments, governments face competing objectives. commitments, because they implement them over On one hand, governments seek to reduce revenue time (Huber and McCarty 2001). They can reduce the variability and the associated political costs. On the incentives to change fiscal regimes by efficiently other hand, they want to maximize their share of maximizing revenues within the framework of resource rents over time and to internalize the social existing regimes. They also increase the strength of and environmental costs associated with these the government in relation to other actors. activities. While pursuing these sometimes rival 4 Figure 1. Determinants of Fiscal Regimes • Geological and that affect Institutional Context • Fiscal Regime Outcomes • Features of natural resources • Level of stability of fiscal regimes • Institutions enforcing • Choice of tax instruments agreements • Incentives in Decision • Level of investments in tax • Distribution of power Making administration capacity • Policy rigidities • Priotization of objectives • Time horizons/discount rates • Risk profiles interact and determine level of investment rate of extraction Source: Authors. Table 2. Political Economy Contexts Credibility of intertemporal commitments Political inclusiveness Weaker/less enforced Stronger/more enforced Less inclusive Patrimonial rule Hegemonic government Individualized political authority, crony hierarchy, Institutionalized one-party regime, either few restraints on power predatory or benevolent High discount rate, risk averse, and narrow Low discount rate, risk taking, and narrow distribution of rents distribution of rents  Extremely short time horizons create  Longer time horizons create a relatively more pressures to revise fiscal regimes, front-load stable fiscal environment. It is in the best revenues, disincentivize investments in interest of the ruling elite to maximize income institutional capacity, and reduce risk-sharing over time and therefore share the risk in the to the detriment of long-term fiscal stream. development of extractive industries.  Limited inclusiveness reduces the space for  Limited inclusiveness leads to a narrower collective action and demands for good distribution of rents, which are used to secure governance. supporters and discourage opponents. More inclusive Clientelist pluralism Programmatic pluralism Political competition based on extensive use of Electoral competition based on programs; patronage horizontal and vertical accountability High discount rate, risk averse, and broader Low discount rate, risk-taking, and broader distribution of rents distribution of rents  Short time horizons due to low  Longer time horizons create a stable fiscal institutionalization and electoral cycles create environment leading to long-term investments pressures to revise fiscal terms and front-load and contracts. revenues, creating suboptimal outcomes in  Nonetheless, broader political inclusiveness investment and production. creates a greater space for collective action for  Revenues are more broadly distributed, but good governance and mitigating informational patronage and earmarking remain significant. asymmetries. Source: Authors. Regarding the other dimension, political make greater use of voluntary tax compliance for inclusiveness, fiscal regimes distribute resources and nonresource taxes, since the government’s legitimacy generate winners who actively mobilize to sustain is higher because the distribution of revenues is wider those creating positive feedbacks or roadblocks for (Alm 1996; de Juan, Lasheres, and Mayo 1994; Feld reforms that constrain the political space. More and Frey 2002; Levi 1988; Pommerehne and Weck- inclusive systems and competitive systems also tend Hannemann 1996). In these cases the tax base is broader, administration cost is lower and, mechanisms to determine succession in power and consequently, total revenues are higher (Kenny and enforce intertemporal agreements, such as Angola Winter 2006; Winer and Hettich 2006). and Lao People’s Democratic Republic (PDR), are better placed to provide a stable fiscal environment Political systems in which there is fair electoral for investors, chose tax instruments that maximize competition, but where political forces do not engage revenues over time, and attract foreign capital to in long-term agreements, are generally associated explore new areas. Nonetheless, the concentration of with the extensive use of clientelism to mobilize power in the executive often implies that rents are support. Patronage links are strong and embedded in diverted downstream or extracted through informal political parties, regional networks, and business channels. Part of the rents is distributed to key groups conglomerates. Parties are weakly institutionalized that support the ruling government, such as Luanda’s and rely on personalistic strategies, rather than urban classes and the Angolan military, or the party competing on the basis of programs. Electoral rules cadre in Lao PDR. are often the object of choice and manipulation, as seen in Bolivia, Ecuador, and Mongolia. Legislative Finally, countries with politically competitive coalitions are generally short-lived and imply systems, where institutional technologies are significant costs that create pressures to expand fiscal available to enforce policy agreements, provide the spending. In these countries, sudden changes in most stable fiscal environment for the development revenues can have significant political costs. As time of extractives activities and a greater level of horizons are relatively short, discount rates are high efficiency in public spending. Fiscal and electoral and incentives to invest in institutional capacity are rules in countries such as Chile and Trinidad and low, while formal regulation is often ignored. Tobago are stable and provide incentives for political Politicians in such countries frequently use populist groups to enter into agreements and sustain them promises and sovereignty narratives to increase across political cycles. taxation or nationalize companies during boom times. In other cases, such as Mexico, parties face credibility problems in committing to a politically Implications, Options, and costly reform of the national oil company (in Mexico, PEMEX). The problems of time consistency are Interventions: Building Credibility as common to these settings. a Reasonable Tax Collector The Democratic Republic of Congo (DRC) and Niger As Bird (2008, 2) emphasizes, fiscal regimes are are examples of countries with noninclusive political shaped by ―changing economic conditions, systems in which cooperation among political forces administrative constraints and technological is weak. In such countries, policy makers have short possibilities, and especially, the political institutions time horizons and systemic instability is prevalent, as within which these factors are at play.‖ The specific power continues to be highly contested. As a result, characteristics of the extractive sector and the volatile decisions in the sector lead to front-loading revenues price environment create a time consistency problem through signing bonuses and bundle deals as well as between long-term investments and short-term the renegotiation of contracts. In these contexts, price political commitments. In the absence of strong shocks generate additional instability. For example, institutions and capable bureaucracies, low- and since independence in 1960, Niger has had four middle-income countries that lack formal or informal coups and five constitutions, which closely followed institutional mechanisms to sustain policies over time the uranium boom-and-bust cycles. Because of face the greatest challenge in building credibility as fragmentation, power holders needed to balance reasonable tax collectors. The policy swings that coalitions from different regional and ethnic groups result from price volatility, electoral and political while securing the support of the military. Sharp cycles, and the absence of executive constraints price and production changes have reshaped the increase the perceived risks for investors. Policy distribution of power and destabilized coalitions. In instability requires governments to offer lower takes DRC, the ruling coalition derives its support from the and compensate for the higher risk to attract eastern provinces in a context of regional and ethnic investment, which are difficult to uphold. fragmentation and frequent interference from neighboring countries. The smuggling of mineral Consequently, policy recommendations need to resources has contributed to regional conflict. consider the use of instruments along with the level of taxation of the industry. Governments should Noninclusive political systems in which one political initially tailor rates commensurate with economic, force is hegemonic and there are established geological, and technological conditions, and then 6 gradually change to a neutral and stable tax system such increases would prevent further adjustments or (Osmundsen 2010). Once credibility has been changes in the model of ownership. established, the government could incrementally increase its take and adjust the instruments to make Box1: Responses to the Mineral Price Boom them neutral or progressive. Figure 2 charts a During the last mineral price boom (2004–08), Chile, credible path in fiscal reform. The policy and Mongolia, Peru, and Zambia increased their levels of administration interventions along the 45-degree line taxation, as their existing fiscal regimes did not allow them would allow governments to obtain a fair share of the to capture part of the windfalls. However, their responses rent and at the same time create a favorable and levels of success varied. Chile introduced a profit- environment for investment. A hypothetical ideal related royalty in 2005, after many years of imposing only path begins with a low equilibrium (low government a flat income tax. Unable to increase investment in state- revenue intake and low investment), where countries owned CODELCO, the Chilean government started allocating unexplored areas to private investors. For years may start adjusting the level of revenue intake. As this country offered below-average tax rates to private countries learn more about taxing resource rent, they investors. Because Chile had built credibility as a restrained introduce more neutral or progressive elements in tax collector, private companies did not resist the measure. their fiscal regime, creating the path parallel to the Peru sought to avoid modifying its mining legislation by 45-degree line. The distance between the fiscal path creating a ―voluntary contribution‖ scheme related to prices and the 45-degree line represents the ―credibility in 2006. All companies adhered to the scheme, as it gap‖: once it is ―filled,‖ countries may safely uptick represented a preventive measure against more aggressive their revenue intake through deepening tax policy and tax reforms, while the government was able to placate administration reforms without sacrificing the robust popular demands. level of investment. Mongolia’s parliament passed a law that created a windfall tax in 2006, but its stability clauses effectively restricted its Figure 2. Path to Building Credibility application to only one mine. However, such tax is likely to negatively affect future investments. In a similar manner, Risk/low credibility Zambia introduced a ―windfall tax‖ in 2008, but withdrew it in 2009. After two decades of low investment in the copper industry, Copperbelt was privatized in the mid- 1990s. At that time, buyers used their leverage to obtain low tax rates and a broad stabilization clause. As copper Formal rent- prices quadrupled from 2003 to 2008, the Zambian capture (tax government came under domestic and international and non- pressure to raise tax rates. In 2008, it increased tax rates, tax) annulled stabilization agreements, and introduced a windfall tax. Nonetheless, soon afterward, the government reversed the measure in response to pressure from international investors. Source: Navia (2009) and Finch (2009). Extractive investment ‘Good Fit’ Fiscal Regimes Source: Authors This section presents some the policy In the absence of third-party institutions that penalize recommendations proposed in the volume Rents to governments for changing tax rules, a country can Riches that provide minimally acceptable government improve its reputation as a reasonable tax collector performance without significantly hindering only by accepting a reasonable tax burden and short- economic and political development (Grindle 1997) term losses of tax revenues while engaging in long- given the country-specific political economy context. term reforms. Ultimately, the main constraint on The underlying rationale is that in each of these rulers’ pursuit of wealth for themselves is the threat settings are fiscal instruments that can help minimize of declining revenue caused by capital flight or corruption risks and maximize revenue, given the reduction of economic effort. However, leaders will existing tax administration capabilities and incentives weigh the political and electoral costs associated with to invest in strengthening capacity and the degree of tying the government’s hands. Box 1 shows that geological maturity. However, improving the fairness countries have been able to successfully adjust their of the country’s share and building in mechanisms rates in the context of high prices, but doing so that allow both investors and government to regularly required incrementalism and signals to investors that revise agreements in light of major shifts in the 7 market environment will disincentivize unilateral have a say in the decision-making process. In revisions of the tax regimes, which hurt the country’s addition, the degree of certainty about geological credibility and prospects of attracting new prospectsv is considered (Mazaheri 2010). Table 3 investments. displays the recommended fiscal and nonfiscal instruments for natural-resource-dependent countries These recommendations are based on the country’s along these three dimensions, with the assumption that ability to sustain commitments over time in tax ―high administrative capacity‖ is likely to be the exception policy and how it is reflected in its overall credibility, rather than the norm and that even advanced countries and the degree of inclusiveness of the political face numerous challenges in the collection of system, that is, how many groups or political parties receipts.vi Table 3. ‘Good Enough’ Fiscal and Nonfiscal Instruments for Natural Resources Credibility of intertemporal commitment Political inclusiveness Less credible/weaker enforcement More credible/stronger enforcement Less inclusive/ Patrimonial rule Hegemonic government less collectively oriented Individualized political authority, crony hierarchy, Institutionalized one-party regime, either few restraints on power predatory or benevolent With certain geological prospects: With certain geological prospects: • Production-based royalties combined with • Production-based royalties combined with windfall royalties income tax and windfall royalties or sliding- • Use of stability clauses with built-in regular scale royalties, production sharing revisions With uncertain geological prospects: With uncertain geological prospects: • Production-based royalties combined with • Production-based royalties combined with windfall royalties or sliding-scale royalties windfall royalties • Use of stability clauses with built-in regular • Use of stability clauses with built-in regular revisions revisions • Targeted tax incentives More inclusive/ Clientelist pluralism Programmatic pluralism more collectively Political competition based on extensive use of Electoral competition based on programs; oriented clientelism/patronage horizontal and vertical accountability With certain geological prospects: With certain geological prospects: • Production-based royalties combined with • Auctions, progressive income tax, or profit- income tax and windfall royalties, sliding- based tax scale royalties • Use of stability clauses with built-in regular With uncertain geological prospects: revisions • Auctions, progressive income tax, or profit- With uncertain geological prospects: based tax • Use of stability clauses with built-in regular • Production-based royalties combined with revisions windfall royalties, production sharing, • Targeted tax incentives equity sharing • Use of stability clauses with built-in regular revisions Source: Authors, adapted from Mazaheri 2010. Variation along each of these dimensions yields clauses—which take a variety of forms, including the different recommendations for resource-rich fixation of tax rates over a given period or a rule- countries. The government’s ability to credibly based guarantee of the fiscal terms under signed commit to policies and contracts over time is of development agreements—are the most commonly special concern to companies and investors. When used instruments to signal to companies that their countries have the reputation of breaking investments are secure and that contracts will be commitments and reversing policies, companies will honored. Transparent stability clauses, especially need governments to signal commitment. Stability 8 when subject to third-party arbitration, tend to be the Linking Transparency to Credibility and Reputation most credible. and Signaling Similarly, governments may need to provide extra Increasing the transparency that surrounds policy reassurances to investors when geographical making and revenue flows can also contribute to prospects are uncertain. Uncertainty is defined here building credible commitments and solving the time- in terms of the expected value of a country’s natural consistency problem. For governments whose power resources. For countries that recently discovered is not formally limited and for which the use of third- natural resources and have not proven their reserves, party enforcers is not feasible, increasing or whose resources exist in hard-to-reach regions transparency can correspondingly increase the surrounded by poor infrastructure, investors will be perception of government credibility. In general, assuming greater financial risk and thus expect to be transparency allows agents to better understand better rewarded. A range of targeted tax incentives whether deviations from expectations are the result of can help governments compensate for this risk, such opportunism or stochastic shocks, a central concern as accelerated depreciation in combination with in models of accountability (Alt 2002). Policy makers prolonged loss, carried-forward allowance, or who support reform can create new institutions to reinvestment tax credits. signal commitment or to lock in policies against future incumbents. Politicians can be persuaded to On the other hand, when geological prospects are undertake reforms that signal commitment if they more certain, a government may resort to auctions as believe that investors will react positively, as a way to allocate resources and generate revenues institutional change can take place when actors with (Cramton 2007). However, auctions are typically power perceive that their interests can be better recommended only when the government has some achieved through alternative sets of rules (Geddes degree of credibility, because auctions need to be 1994). conducted in a transparent and accountable atmosphere where clear, formal rules are honored and Governments can improve their credibility by where corruption is not endemic. To maximize their creating institutions to give various interests a say in take, governments will need to invest in gathering policy making and increase the constraints on their sufficient geological data to draw blocks and mining power. Institutions that introduce checks and areas and set the terms of the auction. Although using balances and mechanisms to enforce agreements auctions when geological prospects are unknown can between domestic actors can create those constraints. be a way for poor countries to obtain revenue up Constraints on rulers give investors more confidence front and to reveal the true value of reservoirs and that the policy environment will not change radically basins, there are risks in both collusion and investors once they have made specific and irreversible capturing a higher share of the actual value of the investments. Longer investments tend to increase resources over time. On the other hand, there is the investors’ attention to political stability. Political risk that a resource project will not be profitable over constraints are expected to reduce rent-seeking and time, in which case royalties or production-sharing the diversion to private individuals of resources that arrangements can be used alongside auctions to help could be used to finance growth-promoting governments obtain a certain amount of revenue investments in infrastructure and human capital while sharing part of the extraction and production (Heinsz 2000). As well, democratic institutions can risks. Note, however, that this is very much indirectly reduce the compliance and enforcement dependent on the specific country context and the costs associated with taxation, and increase revenues relative bargaining power between government and as a consequence (Levi 1988). Building a reputation investors. of abiding by contracts has positive externalities for other sectors and can attract foreign direct investment Production-sharing or equity-sharing arrangements into nonmineral sectors. should be considered when the government has low administrative capacity but some degree of If institutions benefit both the government, by credibility. The government’s credibility is important increasing revenues, and the investors, by increasing in this regard because production-sharing and equity- productivity or welfare, then the bargain is self- sharing arrangements necessitate stable contracts and enforcing and thus credible (Acemoglu and Robinson predictable policies from the government over time. 2001; Escriba Folch 2003; North and Weingast The benefits of these arrangements are numerous, 1989). In addition, governments can use contractual most significantly that the government retains devices, such as stability agreements, to reduce ownership of the resources being extracted. investors’ perceptions of risk: more than two-thirds of developing countries offer such incentives 9 (Baunsgard 2001; Boadway and Keen 2010; Daniels, that benefit from the status quo. Tax administration Keen, and McPherson 2010). Nonetheless, their improvements have the potential to create positive effectiveness may be reduced when prices surge spillovers in addition to increasing revenue collection beyond the normal range of variability and when by creating the basis for broadening the tax base, in there is no third-party arbitrator. turn triggering beneficial strengthening of accountability links. Investing in Tax Administration To raise both revenue and credibility and the related Conclusion transparency in the tax system, some countries apply tax farming or privatization of revenue collection. Defining and practicing a ―good enough‖ fiscal While the concept is sensible for a country such as regime for the mineral sector are most critical to Timor-Leste, which just recently gained ensuring that governments obtain a fair share of independence and is still in the beginning of the state- revenue while creating a favorable environment for building process, donors may be cautious about investment. The interaction of a number of technical, spreading it among countries without weighing its economic, and political factors leads to the three key costs and benefits. The recent experience of paradoxes observed in resource-rich, low-income, Mozambique, where crown agents were delegated the and weak-governance countries: suboptimal, collection of customs duties, gave rise to concern complex, and contradictory conceptual frameworks about the sustainability and costs—both financial and for the design of fiscal regimes; low incentives to opportunity costs—of fundamental domestic revenue invest in revenue administration reforms; and administration reforms. While revenues collected perpetuating time inconsistency and lack of were increased, the contract proved to be highly commitment. Given the maze of paradoxes, the costly and the transfer of skills was very limited authors make the following recommendations: (Fjeldstad and Rakner 2003). Fiscal regimes should be designed to best fit the Tax administration reforms are central to specific political economy context. appropriately implementing tax policy and signaling the government commitment that in turn enhances Progressive profit-based taxes, in theory, are the credibility. A number of countries, particularly in best—helping achieve revenue efficiency and Africa and Latin America, have embarked on flexibility. But underlying political economy drivers, fundamental organizational restructuring by creating weak revenue administration capacity and semiautonomous revenue agencies. The reforms aim governance, and institutional fragmentation in sector to improve transparency, integrity, and efficiency. regulation and revenue collection indicate that one International experience indicates that the success of size does not fit all. Thus good-enough fiscal regimes such innovative institutional formation and tax are called for, with recommended broad guidelines administration reforms in general depends primarily based on three dimensions: political inclusiveness, on political will (see, for example, Bird 2008; Das- the credibility of commitments and policies over Gupta and Mookherjhee 1998; Kidd and Crandall time, and the certainty or uncertainty of geological 2006; Lledo, Schneider, and Moore 2004; prospects. With the caveat that these are helpful but Osmundsen 2010, Thirsk 1997). But political will is still indicative, the design of a detailed good-enough either lacking or nonsustainable in resource-rich regime must be commensurate with the country- countries. specific political, economic, and institutional setting. 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Oxford UK: geological data, the size of prospective areas, and the history of Oxford University Press. resource extraction in the country. vi For example, in the United States, the Report to the Royalty Policy Committee, Mineral Revenue Collections from Federal and About the Authors Indian Lands and the Outer Continental Shelf, submitted by the Subcommittee on Royalty (December 17, 2007), pointed to the numerous challenges faced by the Department of Interior’s Tuan Minh Le is Senior Economist at the Africa State Minerals Management Service (MMS) in collecting royalties and Reform and Capacity Building Unit of the World other nontax revenue derived from the extraction of minerals. The problems described are related to the collection and management Bank. of information to select companies for audit and determine how much royalty is owned, as well as inadequate policies to protect Lorena Viñuela is a Consultant at the Public Sector whistleblowers who reported incidents of corruption. Governance Anchor of the World Bank. Notes This note is the third in a series of four notes on the natural resource paradox based on Naazneen H. Barma, Kai Kaiser, Tuan Minh Le, and Lorena Viñuela, Rents to Riches? The Political Economy of Natural Resource-Led Development (Washington DC: World Bank, 2012). This note summarizes key messages from chapter 4 of the volume, which provides additional country- specific examples to support the analysis. The authors thank Philip J. Daniel, Nimah Mazaheri, Raúl Junquera, Mick Keen, and other project peer reviewers for their input on the book chapter on which this note is based. i Australia’s recent efforts to increase revenue mobilization from its mining sector suggest that this type of negotiation is also very much part of the ongoing relationship in more developed economies. As the pronouncements by the government indicate, the country clearly sees the pressures for capturing a fair share of rents for the country while at the same time safeguarding the long- term sustainability of the industry. Some extractive-rich countries, such as Zambia, have been under tremendous pressure from civil society organizations and communities to review their contracts with firms while prices boom. In Tanzania, as the mining sector becomes more prominent in the economy, election year politics drive mining code changes. President Jakaya Kikwete promised to review the mining sector immediately when he took power in 2005. He initiated a review process in 2006, and despite lengthy delays in drafting and negotiating the new mining code, the Mining Act of 2010 was passed by the parliament in April 2010 and is awaiting the president’s signature. Prominent in the new act is a sharp increase in the rate and the base of royalty as well as application of the rate to the gross value of minerals instead of the netback value. ii Production-sharing agreements are equivalent to different tax and nontax instruments (Brosio 2006). Production sharing of physical output is equivalent to a unit royalty. As a share of the value of production, it functions similarly to an ad valorem royalty and, when costs are deducted, to an income tax. The government’s discount rate indicates the degree to which it iii cares about the future. Governments are said to have high rates of discount when the risk of being removed from office is high. The implication for the level of taxation is that governments that are guided by short-term considerations will raise taxation of the sector in the short term using the available mechanisms. 13