I have updated this substantially to address feedback received following its original publication...
The RSPT as we know it is a dead-policy-walking. The principles and logic underlying it are sound, to be sure: the concept of an RSPT is a huge improvement over ‘production-based’ royalties. But the practical execution of the RSPT’s announcement, and the government’s implementation strategy, leave a lot to be desired.
One of Australia’s most respected corporate leaders, John Ralph, rubbished the RSPT in a recent op-ed in The Australian. The main problem I have with Ralph's arguments is that he implicitly claims that the 40 per cent tax offset for losses under the RSPT will have no impact on expected profits and hence investment. His logic goes that if the imposition of the tax cuts future returns, it must, by definition, also reduce the attractiveness of prospective investments and therefore the willingness of miners to dedicate cash to new projects.
But this is wrong. Investing in new mining opportunities is an inherently very risky activity. Any decision by a company to commit capital to a project will always be 'risk-adjusted'. By risk-adjustment, I mean that the executives in question will examine the distribution of positive and negative outcomes that are expected to be generated by the investment. They will then likely attach probabilities to the range of possible payoffs. Crudely put, if the probability-weighted payoff exceeds their weighted average cost of capital, which is fancy language for 'required rate of return' and varies on a company-to-company basis, they will proceed with the project.
Critically, the government’s RSPT offers to significantly boost the payoffs associated with negative outcomes via the availability of the 40 per cent 'offset', which is a cash contribution from taxpayers to investors.
If you can picture a bell-curve, which you might have created to illustrate all conceivable future profits and losses that could be produced by an investment, the 40 per cent tax offset reduces the magnitude of the losses you bear. It changes the way an investment's bell curve looks: in short, it truncates the left-hand-side of the return distribution by alleviating the magnitude of the losses the company incurs. Of course, the RSPT will also trim the right-hand-side returns as well.
Another way of thinking about the RSPT is that taxpayers are effectively becoming synthetic 'equity' investors in the projects that resources companies undertake—they will share both the risks and returns realised by new investments. This is why the RSPT is not really a tax, at least in the popular sense of the term. It might be better understood as the nation's cost of equity for providing an exclusive licence to the monetisation of our non-renewable resources. And the nation has evidently decided that in lieu of a higher share of the upside returns (above a fair hurdle) it will very reasonably offer to bear its pro-rata proportion of the losses.
There is no other conclusion to draw but that Ralph is mistaken when he alleges that by cutting miners’ expected returns above a hurdle the RSPT will immediately result in lower levels of investment. Assuming that new projects have significant risk, which we know to be the case, it is entirely plausible that the ‘risk-adjusted’ expected returns are no less than they were before the introduction of the RSPT. And if the application of the RSPT does not reduce risk-adjusted returns, nor push raw profits below a miner's required rate of return, it is hard to see how it should have any negative influence at all.
Of course, there are several 'riders' here. In reflecting on these qualifications, we move from the general to the specific, which is where the problems begin to emerge. In the real world, the devil is truly in the detail.
First, a credible point Fortescue has made is that the government’s proposed 40 per share of the losses does not, in fact, serve its purpose. It has been suggested that this is in part because there is too much uncertainty attributable to miners actually getting the tax offset, which means that it may not provide the symmetrical downside protection that was originally intended. If this is correct, the RSPT could be in serious trouble.
In particular, Business Spectator’s Stephen Bartholomuez has questioned whether debt and equity funders will accept the miners’ tax offset at face value, or discount it due to the political risks associated with future governments changing their mind about how the RSPT should work, which is, ironically, what they are doing right now. Bartholomeusz opts for the latter interpretation.
It was worrying to hear Twiggy Forrest report to Alan Kohler on Inside Business that most of Fortescue’s bankers had withdrawn from its outstanding projects. Perhaps these bankers have just iced their finance until they get better visibility on the results of the industry’s lobbying process. But Twiggy seems to be genuinely of the view that the RSPT will have a profoundly adverse impact on Fortescue's ability to carry out both current and new investments.
Second, there is a legitimate criticism about the retrospective nature of the tax. The argument made by many officials and economists—two good friends of mine, Nicholas Gruen and Rory Robertson, being the latest—that government should be permitted to vary its taxes retrospectively given the current imperfections in the royalty regime, does not cut the mustard.
In his latest note to clients, Rory recycles the Treasury’s rationale that the retrospective application of the RSPT to existing projects is justified because the share of profits accounted for by royalties and taxes has plummeted over time. Rory correctly argues that the RSPT is just the price paid by companies to extract and sell a non-renewable resource. But any defence of retrospectivity involves flawed logic.
Putting the shoe on the other foot, how do you think we would feel if, say, China, turned around after a big fall in commodity prices and said, Sorry guys we made the mistake of paying you too much for your iron ore in the past. And we are going to unilaterally redact the prices in our old contracts to compensate us for this error. I don’t think so—there is something called 'the rule of law'.
The private sector has to be able to assume that the fundamental tenets of the legal and regulatory framework under which it operates will not retrospectively change to its material detriment. It is inequitable to punish companies in one sector in hindsight for making commitments that were correct at the time given the information available to them. And claiming that they should have been aware of the risk of retrospective tax changes is nonsensical. On that basis it would be hard to do any business.
It is increasingly clear that the incidence of the burden imposed by the RSPT affects companies in different ways depending on their cost of capital, leverage and the life-cycle profile of their investment activities (eg, whether they are merely harvesting existing projects or betting on a portfolio of new ones).
In this context, it is also not acceptable for government to tell us that the 'theoretical company' represented in their models is indifferent to the RSPT, or that retrospective application is justifiable on the grounds that the prices of Australian resources have risen rapidly over time.
The fact of the matter is that the absence of the RSPT, and any shortcomings in Australia’s tax architecture, are the failings of government, not the private sector. In effect, the government is saying, Forgive us guys, but we stuffed up. If we were a bit smarter, we would have always had an RSPT in place. We are now going to pretend that we can travel back in time, and simply assume that the RSPT has always been there. Oh and tough luck if like Fortescue you would never have carried out these projects in our parallel universe.
Nicholas Gruen disagrees with this line of thinking and claims that the RSPT is not retrospective, and should be considered no different to a change in company or personal tax rates.
My response is that this is not an economy-wide tax, which both personal income and corporate taxes obviously are. Changing the latter two taxes affects all folks in all sectors at the same time, and does not, therefore, materially affect the ‘opportunity cost of capital’. You are still going to go to medical school and become a doctor, or train to be a lawyer, whether your marginal tax rate is 20, 30 or 40 per cent. These variations are also, one would think, less likely to be subject to design error given the ramifications of such.
In contrast, the RSPT is a sector-specific tax, if it can actually be called that, which, if applied to existing projects under the current design, would have resulted in different decisions being made. Fortescue is a classic case in point.
It is an interesting legal question whether State governments are permitted to make unilateral changes to the contractual terms of the exclusive licences they grant to companies to extract and develop non-renewable resources. I am guessing not. If this is true, there is presumably a legal argument that the RSPT is a constructive breach of contract by the Commonwealth, or perhaps ‘tortious interference’ in contracts held by the States.
The case about sovereign risk is also credible. At worst, the government is breaching its implicit contract with the entire resources industry. Contrary to what Gruen and Robertson have alleged, companies should be able to assume that once they agree a price with governments under an exclusive contractual licence to commercialise resources, government does not then have the ability to unwind that contract in hindsight if for some reason they get the price wrong.
Employing this logic, companies should have the price they pay retrospectively cut if the value of commodities fall through the floor. Yet it is hard to see government embracing the same silly logic if circumstances were to change.
Indeed, the risk is very much the opposite—that future governments will decide to renege on part, or all, of their obligation to bear the losses associated with these projects.
