Tax, tax havens and the extractive industries

May 24, 2012 Citizens for Tax Justice: to know the gas tax is to love the gas tax here

Nov 22, 2011 - CMI report: Extractive sectors and illicit financial flows: What role for revenue governance initiatives? Original here

Sept 20, 2011 - Piping Profits: Mapping the Extractive Industries corporations. Original here.

Dec 2010 - Friends of the Earth on tax evasion, tax and climate change

October 2008: Direct distribution: TJN link in Foreign Affairs >

July 2008: Direct distribution: AABA workshop paper + slides >

June 2008: carbon audit the tax code  >

May 2008: see this new initiative involving US legislation for country-by-country reporting in the extractive industries. See also the section on the IASB in the TJN A-Z archive .>

The Resource Curse

Awareness of  a “Resource Curse” affllicting mineral-dependent nations has grown fast since the emergence of new research in the 1990s. The Resource Curse thesis is simple, and contains a paradox: countries that depend on natural resources like oil tend not to be able to use that money effectively for the benefit of their general populations, and in some cases development outcomes seem to be even worse than if they had not discovered those natural resources. Resource-dependent states tend to be more prone to conflict, more authoritarian, more unequal, in some cases they suffer greater poverty, and greater corruption, than those states that are not dependent on natural resources. What is more, the weaker its internal governance is in the first place, the more likely it is that a country will perform poorly. Angola, Bolivia and Kazakhstan are cases in point.  

TJN will not explore all the reasons for the Resource Curse, which are amply covered elsewhere. Instead, this section will highlight a few issues relating to minerals and taxation. This involves the following main components:

Minerals, accountability, and taxation without representation

American colonists rebelling against British rule in the late 18th century famously rallied around the slogan: “No taxation without Representation.” When governments tax citizens, and especially when they tax them directly, citizens are empowered to bargain: they demand accountability in return. (Read more about this here.) When a country depends on mineral resources like oil, however, it taxes the energy companies, not the citizens – so the citizens are in a weaker bargaining position. The government can consequently ignore them – and if the citizens don’t like it, governments can use oil revenues to pay for the police forces and armies to keep them quiet.

This is one reason why countries that depend on natural resources tend to be more authoritarian (think Aliyev’s Azerbaijan, for example, or Angola.) The U.S.-based columnist Thomas Friedman was right to popularise this idea with his “first law of petropolitics”: The price of oil and the pace of freedom always move in opposite directions in oil-rich petrolist states. The higher the average global crude oil price rises, the more free speech, free press, free and fair elections, an independent judiciary, the rule of law, and independent political parties are eroded, and the less rulers leaders care about what the world thinks or says about them. The point here is that normal taxation builds links of accountability between rulers and citizens; mineral taxation does not seem to have that effect. (We discuss possible responses to this problem in the last section on this page.)

The Dutch Disease, rent-seeking, financial services and financial secrecy

One of the recognised problems with mineral-dependent states is the so-called Dutch Disease – an economic problem that afflicted the Netherlands when it discovered large gas reserves in the 1960s. What happens is that large inflows of money into an economy from these sectors cause local prices to rise relative to imported goods. (This either happens through appreciation of the exchange rate, or through inflation, or both.) Higher prices make it more difficult for local productive sectors (such as agriculture or manufacturing) to compete against imports, and as a result these sectors wither. Nigeria’s agricultural sector, for example, collapsed during the 1970s oil boom. (Foreign aid, as it happens, can have a similar effect.)

The Dutch Disease is not automatically disastrous: if the inflow of money comes from a sector that generates huge numbers of jobs, then this will compensate for job losses elsewhere. The problem is that oil production, for example, produces lots of money, but few jobs. (For example, Angola’s planning minister estimated in 2007 that the oil industry, which accounts for around 97% of Angola’s exports, only employed 0.2% of the economically active population.) The result is that a small number of people become very rich, whilst large numbers of people grow poorer. In theory, mineral-rich countries could transfer some of the oil taxes to benefit the poor. In practice, they usually don’t: instead, the money tends to get dissipated in corruption, or channelled offshore into private bank accounts.  The mineral wealth is squandered without generating long-term growth, and inequality worsens.

Financial services industries can, in some cases, share some of these “Dutch Disease” problems. Countries need financial systems, of course, to match savings with investment, and to channel money around the economy and abroad. But what happens when a country’s financial system expands to become far bigger than what would be required for normal operation of the economy? Take the City of London, for example. As a global financial centre it attracts money from all over the world, including from developing countries. This has caused the UK’s real exchange rate to appreciate significantly. As a result, other productive activities in the British economy find it harder to compete with imported goods, and they wither. (China has done the opposite: it has built up large foreign exchange reserves; the resulting outflow of money has depreciated the currency, making Chinese goods extremely price competitive on world markets.)

As in oil-dependent economies (and Britain is an oil producer too), the financial inflow results in Britain being a much more unequal society. In theory, the British government could counteract this through increased taxation of upper income earners in the City, using the revenue to pay for schools and hospitals, turning what one might call a “financial services curse” into a blessing. In practice, it is tax-dodging that attracts the money to London in the first place – so this money cannot be taxed properly. The result is very large concentrations of wealth and extreme inequality in Britain -- which, as this IMF paper illustrates, is among the highest in the rich world.

(It should be noted here that certain aspects of financial services activities – such as financial secrecy -- have a very wide variety of other malignant effects, which are covered elsewhere: such as erosion of other countries’ tax systems; the promotion of capital flight from poor countries; and fostering international corruption.)

Excess liquidity in mineral-rich nations leading to destabilising cross-border flows

In the current global context, high oil prices have led to destabilising cross-border financial flows adding to imbalances in world markets, leading to an excess of borrowing in some countries such as the United States. Taxation of oil consumption is one source of reducing excess demand for fuels. Read more here.  

Responses to the problems?

As discussed above, and elsewhere, proper co-operation on tax matters, and better transparency in taxation, are essential.

The Resource Curse literature and the work of the transparency NGO Global Witness, in particular, have led to an initiative known as Publish What You Pay – seeking country-by-country reporting by companies in the extractive industries. This is a welcome development – although the more recent Extractive Industries Transparency Initiative (EITI) has to a fair degree overshadowed it. What TJN would like to see is country-by-country reporting being extended beyond the extractive industries to all companies. This would lead to an explosion of transparency worldwide. Read more about this here (on page 6).
 
One unusual tax proposal for oil-rich countries would be to do what happens in Alaska, where each citizen receives a portion of oil revenues, paid directly to them each year. Direct distribution of oil revenues would have two effects. First, if the government wanted to tax this money, it would then have to bargain with newly empowered citizens, thus promoting accountability.

However, it also illustrates another problem with natural resource revenues: dividing these revenues within a country is a thorny political problem, and becomes a “fight for a share of the cake.” First, one must decide how to divide revenues between states and regions. (Nobody will ever be happy how this is done, for it is a zero-sum game: more for one region means less for the others.) Once this division is made, however, the same problem emerges when decisions must be made as to how to divide within each region: how to share it between sub-regions or municipalities or whatever. And so on, down to village and even household level, as is evidenced by the seething turmoil in the Niger Delta. This problem of dividing the national cake exacerbates ethnic and other tensions, increases lobbying and other political games to gain access to state revenues, and lies at the heart of the high corruption that tends to afflict mineral-dependent governments more than most. If the taxes on mineral companies were paid equally to citizens, not to governments, this would entirely change the political dynamics of mineral-dependent societies. This has been advocated for Iraq in articles in Foreign Affairs and the Financial Times , and in an IMF working paper on Nigeria. The biggest problem, of course, would be in getting such a scheme up and running: politicians who currently benefit from the current set-up would oppose it hugely, while implementation in poor countries would be extremely hard too. 

Whether or not this controversial proposal could be achieved or is desirable, it does illustrate some of the negative tax-related effects of mineral dependence.

 

Addendum: Tax, fuel consumption and climate change

Another tax justice issue relating to natural resources concerns global warming and the taxation of energy consumption. This is clearly of paramount importance. European countries levy relatively high taxes on fuel, while the United States has found fuel taxation politically very difficult, and consequently U.S. fuel consumption relative to gross domestic output is far higher than in Europe.  In other words, the U.S. is a less efficient user of energy because its fuel is relatively underpriced.

Fuel taxation has a rival scheme for tackling global warming: emissions trading. Under this approach, a government sets a cap on the total amount of fuel emissions, and issues energy users, for example power generators or steel manufacturers, with allowances to emit a certain amount of pollution. These allowances are tradeable – and the companies involved consequently have a strong incentive to curb their emissions in order to sell their emissions quota to less efficient energy users.  Over time the cap set on total emissions can be lowered, increasing the incentives for companies to adopt more energy efficient processes, and raising the costs of those that don’t. The European Union has already set up a carbon market of this kind, though the scheme has not yet demonstrably contributed to a reduction in carbon dioxide emissions.

Carbon trading does have some advantages over carbon taxes, primarily because it is politically easier to implement than to introduce a new tax. It also makes the problem of transferring money internationally to reward carbon reductions easier, as it is in the form of a trading mechanism, rather than in a government-to-government transfer.

However, most economists would say that carbon taxes are a better way to reduce greenhouse gases than cap-and-trade schemes, for several reasons.

Carbon taxes are transparent and simple, while emissions trading systems are complicated and opaque, making them prone to corruption – for example, through companies lobbying to be allocated a greater share of allowances than they deserve. Even without corruption, however, carbon trading schemes are vulnerable to misjudgements by policy-makers – and experience has shown that relatively small errors in judging the right cap can send the price of permits skyrocketing, or falling to the floor. Fixing the number of permits make no adjustment for the business cycle, and it exacerbates volatility: the United States has had a scheme for trading sulphur dioxide since the mid-1990s, and the price of the tradable permits has fluctuated by an average of 40% a year since then. Given the importance of energy in most economies, this volatility could cause great harm.

People have proposed reforming carbon trading schemes to iron out these problems – but as The Economist points out, the more tinkering of this kind, the more the schemes will resemble a carbon tax. As the Economist put it:

If cap-and-trade schemes are to be reformed so that they look more like carbon taxes, why are politicians so reluctant to impose carbon taxes in the first place? . . . Taxes are also more prone to ideological caricature, particularly in America, where many conservatives argue instinctively that all taxes are bad.

Even the Greg Mankiw, former chairman of U.S. President George W. Bush's Council of Economic Advisors, supports carbon taxes. He put it like this :

Economists recognize that a cap-and-trade system is equivalent to a tax on carbon emissions with the tax revenue rebated to existing carbon emitters, such as energy companies. That is, Cap-and-trade = Carbon tax + Corporate welfare.

Carbon taxes also potentially have a much broader reach: while it may be feasible to get companies trading emissions, getting all of a country's citizens to participate in an emissions trading scheme is rather more difficult. Taxing carbon-based fuel would be far easier.    

Furthermore, carbon taxation presents a neat free lunch. If western governments tax fuel, this would lower the price of oil by reducing demand. This would not only make environmentalists happy, but it would please policy-makers in energy-consuming countries who are worried about energy security and about the dependence of their economies on countries like Saudi Arabia and Russia. But there is another thing: when oil prices fall, not only do consumer countries benefit – but the majority of citizens of producer countries in countries like Nigeria are likely to benefit too. Think back to Friedman’s first law of petropolitics, and to the notion of the resource curse: the more a country – especially a poor country – depends on natural resources like oil, the worse their citizens’ standard of living is likely to be. Less dependence on oil revenues will increase the links between governments and citizens, and give governments more leeway and incentive to promote economic diversification.Finally, carbon taxes also raise revenue. Governments can spend this on better public services, or if their citizens think taxes are high enough already, they can fund tax cuts in other areas.

Now there is a big fly in this ointment: carbon taxes tend to be regressive – that is, they often hit the poorer sections of society hardest. The solution to this problem lies with making other elements of taxation systems more progressive to counter this. But tax havens and the offshore infrastructure, as we have demonstrated elsewhere, make this much harder to achieve, by widening inequality and thereby increasing political resistance to the notion of environmentally beneficial measures like a carbon tax. The higher inequality already is, the stronger will be the political resistance to new regressive taxes. (Or, looking at it another way, cracking down on tax havens would generate new taxes that could be used to fund urgent measures to tackle climate change.)

Tax competition, of which tax havens are the most pernicious agents, is another reason to worry about carbon taxation. Tax competition makes it harder for countries to tax fuel – because they know that if they do, many industries and actors will move elsewhere. Taxes on aviation fuel are notoriously hard to implement for just this reason. A similar problem occurs with shipping fuel. The same harmful dynamic also works with fuel-intensive industries – which threaten to relocate on the basis of fuel taxation. For these reasons, tax havens and tax competition are throwing sand in the wheels of international efforts to combat global warming. This provides another powerful argument why the world urgently needs to wake up, and confront, the terrible harm caused to the world be tax havens and tax competition.