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Ken Henry's fallacious resource rent tax and the mining industry's failed response
Gerard Jackson
The mining industry has got to be its own worst enemy. Atlas Iron's CEO David Flanagan was reported to have stated: "I like the idea of a resource rent tax which takes the place of a state royalty — but I don't want both". To an informed observer this makes as much sense as saying that I like the idea of taking strychnine rather than arsenic. Both taxes are toxic but without a doubt the rent resource tax is the most lethal of the two, something that mining executives and CEOs clearly do not realise.
The first thing to note about the theory of economic rent is that no sooner had David Ricardo promoted it than his extremely able contemporaries went on the attack, successfully demolishing it. A few years after Ricardo's death in 1823 there was scarcely a person left in Britain who adhered to the doctrine so thorough were the assaults. Yet some 180 years later we have the head of the Australian Treasury promoting this financial monstrosity and a leading mining CEO embracing it.
To understand why this tax is so toxic one must first understand it. According to Ricardo and his disciples economic rent is a surplus created by the emergence of marginal or what he would call zero-rent land. Therefore rent is a differential, the return in excess of the marginal activity. In other words, the higher returns are determined by the differential. But as his critics pointed out, the price of any unit of land is, like any other product, determined by supply and demand. The existence of marginal land is irrelevant.
Moreover, what any potential buyer is prepared to offer is determined by the productivity of the land. Hence land that commands a higher price than marginal land does so because it is more fertile. (This is clearly the germ of a productivity theory.) One contemporary critic wittily observed that according to the theory that Ken Henry is thirsting to impose on the country
men of six feet exist because there are men of smaller altitudes, and would not have existed without them. (Thomas Perronet Thompson, The TrueTheory of Rent, Westminster Reviews, 1826, p. 6.)
Now the mining industry has swallowed the line that there exists a theoretical level above which a resource rent tax would apply. Not so. The theory emphatically states that the level is always set by the marginal operation. John Stuart Mill made this point absolutely clear when he categorically and correctly stated:
The rent of land consists of the excess of its return above the return to the worst land in cultivation. (Principles of Political Economy, University of Toronto Press, Routledge & Kegan Paul, 1965, p. 419.)2
What this means in practise is that if the country had only two mines, with one earning $1000,000 and the other $100,000,000 then the second mine should be taxed $99,000,000. And this is exactly what James Stuart Mill proposed. Never a man to shy away from the logic of his own arguments he not only called for the government to impose a 100 per cent tax on all agricultural economic rents he also suggested that the East India Company do the same in India. The company wisely ignored his suggestion.
Whether Mill was junior was merely exercising filial piety in basically making the same proposal is neither here nor there, the fact remains that he fully understood that the logic of the concept of economic rent leads directly to a 100 percent tax on the alleged surplus. (The Mills are excellent examples of a certain type of personality that can be blinded by its own intelligence.) It follows that if Ken Henry really believes in the theory of economic rent he will not hesitate to not only demand that mining companies be fully taxed but that the tax be extended to agriculture.
After all, according to the logic of this theory the existence, for example, of marginal wheat farmers determines the return (surplus) to supramarginal wheat farmers and that taxing this difference will have absolutely no effect on investment and output. And why stop there? Why not do the same to supermarkets, factories, milk bars, etc?* So why doesn't he? Is it because somewhere is the deep recesses of his bureaucratic mentality there is the dim realisation that the theory is indeed false and that if it were fully applied — as its logic demands — it would in fact destroy the mining industry?
Henry has argued that a resource rent tax on the offshore oil and gas industry did not affect investment and therefore the same would go for the mining industry. What Henry and his supporters — none of whom appear to fully comprehend the nature of economic rent — have obviously missed is that at the very best it was only a partial tax on 'rent'. A full-blooded resource rent tax would have destroyed these industries.
In addition, the facts do not support Ken Henry's contention that the tax is costless. When the Queensland Government decided it needed to raid even deeper into Mount Isa Mines' profits it dropped its then-royalty scheme in favour of imposing a royalty on the mine's tonnage. The result was the locking up of resources. By raising the tax burden these greedy politicians raised the company's cost curve thereby restricting output by locking up valuable resources.
A sufficiently large partial resource tax would have the exact same effect. (If Henry thinks otherwise, perhaps he would care to explain why). This is what Andrew Forrest, chief executive of West Australian iron ore miner Fortescue Metals Group, was getting at when he said that a rent resource tax would reduce investment in Australia while boosting it in countries like Brazil. Then again, maybe Henry thinks Brazil doesn't have any iron ore.
What CEOs like David Flanagan need to understand is that if you want to discredit a proposal you really should start by attacking the premise upon which it is based. In the case of Henry's tax the premise is utterly false. No matter what some of our 'rightwing' economists say the theory of economic rent is pure fiction and there is nothing "problematic" about it. I suggest that Mr Flanagan and similar-minded CEOs start seeking out informed opinion if they wish to protect their industry against predatory politicians and activist leftwing bureaucrats.
A final note: It is argued that Henry's tax will reduce taxes elsewhere. These people are overlooking the obvious fact that the real problem is government spending. This means that even if other taxes are cut, when the mining boom ends Australians will be facing increased taxes and increased government borrowing in order to maintain government spending. Moreover, one has to be incredibly naive to think that Henry's tax would not lead to even greater government profligacy.
*Some readers have complained that this is a dishonest attack on Henry because "... you know that strictly speaking these are profits and not economic rents". But my point is that there is no such thing as an economic rent and hence Henry's rent tax can be logically extended to the profits of any enterprise.
The question of quasi-rents was also raised. It should be obvious by now that if economic rent is a fallacy then so is the concept of quasi-rent. As a rule it is taught that quasi-rents are a short run phenomenon because the supply of factors can be increased and this is why these 'rents' ought not to be taxed. However, it ought to be clear that the 'quasi-rent' obtained, for example, by a musical genius cannot be eliminated by increasing the supply of geniuses.
After all, there was only one Tchaikovsky. Hence, according to the current orthodoxy, this 'rent' is unearned and can therefore be taxed with impunity and in the name of equity. I mean to say, who gave people like Isaac Newton, Peter Tchaikovsky, van Beethoven, etc., the right to be immensely talented and therefore earn vastly more than their contemporaries?
The phenomenon of so-called economic rent and quasi-rent is easily explained by marginal productivity theory. This is why Professor Fetter called the concept of economic rent "a garbled marginality theory". In addition, he pointed out that "quasi-rents, involving the idea that no income, of share, enters into market prices in short periods, cannot stand". Rents are in fact time payments that every factor receives, whether they are payments for capital goods or wages. Moreover, in the case of land and capital these payments, as Alfred Marshall himself explained, are capitalised.
Henry's misbegotten tax is a classic example of what happens when a bad idea goes unchallenged. Unfortunately this is par for the course in Australia. Now that the Institute of Public Affairs has endorsed an utterly fallacious opinion on the origins of the economic rent doctrine it has made it clear that no alternative view, no matter how accurate, will be tolerated.
No wonder so many people have been misled.
Gerard Jackson is Brookesnews' economics editor
BrookesNews.Com
Monday 3 May 2010