The fiscal regime governs the way in which mineral rents are shared between the state and the investor. A well-designed fiscal regime is essential to attract investment for the development of the resource, while ensuring a robust source of revenue for the state. This blog draws on discussions at a regional workshop organized by the Green Fiscal Policy Network in December 2016 in Bangkok which explored the role of fiscal regimes, revenue management, and sovereign wealth funds in the extractives sector to finance the Sustainable Development Goals (SDGs).

Oana Luca is an Economist in the Tax Policy Division of the Fiscal Affairs Department at the IMF. She specializes in extractive industries taxation, the fiscal modeling and analysis of mining and petroleum, and resource revenue forecasting and management. Oana has worked on a large number of resource-rich countries in Africa, Europe and Asia. Prior to joining the IMF in 2009, she was part of the Development Economics group at the World Bank and responsible for analytical and regional macroeconomic studies. She is a graduate of the John Hopkins University’s School of Advanced International Studies (SAIS).

Mineral extraction offers a one-time opportunity to raise revenues for development

For many countries, mining can be an important source of export revenues, a tax base for the government, driver of economic activity, and financing for development. Such revenue can be channeled to finance needed infrastructure and sustainable development projects, build buffers on which to draw during economic shocks, and/or accumulate savings for future generations. Importantly, minerals can provide countries with an important source of financing to help deliver the SDGs, estimated to require US$ 5-7 trillion annually.

Getting the fiscal regime right is key ….

A well-designed fiscal regime is essential to attract the investment necessary to develop subsoil resources while ensuring a robust stream of revenue for the state. In the case of non-renewable resources, several considerations influence the fiscal design. Here, the potential for economic rents is larger than elsewhere, but so are exploration costs and the risk of unsuccessful discovery. In some countries, the involvement of multinational companies generates complex international tax considerations, while in others, the involvement of state-owned companies has led to complex governance structures and economic inefficiencies.

Around the world, mining can contribute to as much as 40 percent of total government revenue. Such dependency often leaves public finances exposed to the whims of volatile commodity prices. Social and environmental externalities of mining activities add to these challenges and complexities. But perhaps the most important consideration of all is the recognition that minerals in the ground are exhaustible – once extracted, if not valued properly, they are lost forever.

… and requires sector-specific fiscal instruments

Because of these characteristics, the fiscal regime for mining has evolved to include mechanisms rarely found in other industries. It usually consists of a combination of direct and indirect taxes, at times accompanied by forms of state participation. The most prevalent elements include:

  • Royalty, usually an ad-valorem tax on production, ensures revenue from the first day of production. The royalty serves as a minimum payment to the state as the owner of the resource in the ground, and as an economic threshold for project development. If the project is not profitable enough to pay a minimum tax, then it may be preferable to postpone its development until economic conditions improve. On the downside, high royalties increase the cost of production and may deter the development of otherwise viable projects.
  • Profit/rent-based taxes ensure that the state takes a share of rent when it is realized. In addition to the standard income tax, which applies to normal business profit, some countries charge supplementary taxes on what is considered above “normal” profit (as in Chile). In other countries, the income tax rate varies with profitability (as in Botswana, or in South Africa for gold mining). Unlike royalties, such instruments usually yield revenue for the state later in the life of the project, but respond better to underlying profitability.
  • State participation can take place in the form of unpaid equity (the government receives a share of dividends without contributing to costs) or carried equity (the government’s share of costs are met by the investor and later recovered from the government’s share of dividends). While fiscal revenue can be raised through alternative, often more efficient tax instruments, countries favor state participation on account of traditions and national sentiment. Lesotho, Botswana and Ghana use forms of state participation in their mining sectors.

Evaluation, administration, and transparency must reinforce the fiscal regime

In deciding the appropriate mix of instruments, complex objectives must thus be taken into consideration. The fiscal regime must be designed so that it remains robust in the face of changing circumstances, it is easy to administer by the tax authority and comply with by companies, fosters stability and transparency, attracts investment, and ensures that the state receives an appropriate share of revenues.

Usually, the combination of a small royalty with standard income tax and a simple rent tax mechanism provide a flexible, yet robust design for taxation.  To address negative externalities associated with the extraction activity and to mitigate environmental risks, fiscal provisions must also include mechanisms for mine closure and site rehabilitation as well as environmental insurance schemes. Economic evaluation is essential – the fiscal instruments must be evaluated as a package and tested for robustness under various project development and price scenarios. Ultimately, resource revenues must be integrated with the country’s broader macro-fiscal strategy to support its sustainable development.

Note: This blog draws on discussions at a regional workshop organized by the Green Fiscal Policy Network in December 2016 in Bangkok which explored the role of fiscal regimes, revenue management, and sovereign wealth funds in the extractives sector to finance the Sustainable Development Goals (SDGs). For further information about the workshop, visit the event web page.