WA Iron Ore Royalty Analysis - Minerals Council of · PDF fileii Commercial-in-Confidence Deloitte Access Economics Executive Summary Raising royalties on some iron ore miners would

WA Iron Ore Royalty Analysis Minerals Council of Australia

7 November 2016

Liability limited by a scheme approved under Professional Standards Legislation. © 2016 Deloitte Access Economics Pty Ltd

James Sorahan Director – Tax Minerals Council of Australia Level 8, 10-16 Queen Street Melbourne VIC 3000

7 November 2016

Dear James

Western Australia iron ore royalty analysis

This report outlines the broad economic and budget effects of increasing a volumetric tax on iron ore production in Western Australia.

Specifically, this report finds that:

Different taxes cause different degrees of damage to the economy. The type of tax under review here would lift the production costs of some Australian iron ore producers without affecting their domestic and foreign competitors. Its impact would see the Australian economy eventually shrink by $2.9 billion a year as a result of a tax that raised $2.3 billion.

That said, because the tax would initially hit lower cost mines, some of that damage would appear over time rather than immediately. If any higher cost mines were to be affected, the effect on them could be more notable: the global iron ore market remains under pressure.

Moreover, while the damage to the economy would tend to ultimately be concentrated in the Pilbara – Australia’s key iron ore producing area – the process of ‘horizontal fiscal equalisation’ would adjust the distribution of Good and Services Tax (GST) to account for WA’s additional mining revenue. The net effect would leave WA with something less than a net $300 million of the total extra of $2.3 billion raised every year.

That is, the State hardest hit by the tax would eventually see little benefit from the revenue it raised: over the longer term, Western Australia would ultimately suffer the majority of the economic cost, while receiving only a small share of the benefit from additional government revenues.

The amount of tax and royalties paid by miners as a share of their income has increased steadily in recent years. This share reached 46.8% of income in 2013-14 as falling mineral prices led to an increasing share of royalty payments.

Yours sincerely,

Chris Richardson Director Deloitte Access Economics Pty Ltd

Deloitte Access Economics Pty Ltd ACN: 149 633 116

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Tel: +61 2 6263 7000 www.deloitte.com.au

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Contents Glossary ..................................................................................................................................... i

Executive Summary ................................................................................................................... ii

1 Background ..................................................................................................................... 1

2 Setting the scene ............................................................................................................ 2

2.1 What does the literature say? ................................................................................ 2

2.2 The global iron ore market ..................................................................................... 3

2.3 Tax rates are rising – with royalties the key reason ................................................. 4

3 Royalties and additional rentals ...................................................................................... 7

3.1 The background ..................................................................................................... 7

3.2 The CGC effect – budget benefits get spread .......................................................... 9

4 CGE modelling ............................................................................................................... 10

4.1 The headline numbers.......................................................................................... 10

4.2 Computable general equilibrium modelling .......................................................... 11

4.3 Inputs to the modelling ........................................................................................ 12

4.4 The economy-wide impacts of the tax .................................................................. 13

Conclusions ............................................................................................................................. 16

Limitation of our work .................................................................................................... 17

Charts Chart 2.1 : Marginal excess burdens of taxes for Australia ........................................................ 3

Chart 2.2 : WA iron ore export volumes and values ................................................................... 4

Chart 2.3 : Share of income paid in taxation – all minerals......................................................... 5

Chart 2.4 : Contribution of iron ore royalties to WA Government Budget .................................. 6

Chart 3.1 : 2015 royalty receipts ............................................................................................... 7

Tables Impact on economy and jobs (relative to where they’d otherwise have been) .......................... ii

Table 4.1 : Impact on economy and jobs (relative to where they’d otherwise have been) ....... 10

Figures Figure 4.1 : The components of DAE-RGEM and their relationships ........................................ 12

Figure 4.2 : Decomposition of the change in real GRP ............................................................. 14

i Commercial-in-Confidence

Deloitte Access Economics

Glossary

CGC Commonwealth Grants Commission

CGE Computerised general equilibrium

DAE Deloitte Access Economics

DAE-RGEM DAE – Regional General Equilibrium Model

DMP Department of Mines and Petroleum

FIFO Fly-in-fly-out

GRP Gross regional product

GST Goods and services tax

MCA Minerals Council of Australia

MEB Marginal excess burden

RSPT Resource super profits tax

WA Western Australia

ii Commercial-in-Confidence


Executive Summary Raising royalties on some iron ore miners would initially generate a net increase in revenues for the Western Australian State Budget of around $2.3 billion a year.1

However, Australia is a federation, and under the Intergovernmental Agreement on Federal Financial Relations the process of fiscal equalisation would gradually adjust the distribution of the Goods and Services Tax (GST) to account for WA’s additional mining revenue. Western Australia would still earn a share but, after allowing for the resultant loss in GST grants, the net impact would be something less than a net $300 million a year.

That is, the budgetary benefit earned by Western Australia wouldn’t last. Yet whereas the extra budgetary dollars would flow to the nation as a whole, the economic costs of poor taxation would mostly hit WA – indeed, they’d disproportionately hit the Pilbara – and they’d grow over time rather than shrink:

The tax take ratio, the amount of tax and royalties paid by Australian miners as a share of their income, has increased steadily in recent times. This share reached 46.8% of income in 2013-14 due to the increasing share of royalty payments. Royalty payments now account for around half (22.8% of the 46.8%) contribution of mining companies to Australia’s Federal and State government coffers (with the rest made up by company taxes), having risen from 17.3% in 2007-08.

The nation had a tumultuous mining tax debate in 2010, but one of the few points of broad consensus among economists was that royalties prematurely shortened the life of otherwise viable mines, and discouraged investment in new mines that were otherwise worthwhile to both miners and to society as a whole.

In fact most models of the relative efficiency of taxes – how much damage they do to the economy – rank royalties as among the worst taxes in terms of the damage that they cause to economies.

The net outcome is that, measured in today’s dollars, the modelling spelled out in this report estimates that the annual cost to the economy of $2.9 billion is in excess of the amount of revenue raised ($2.3 billion).

Impact on economy and jobs (relative to where they’d otherwise have been)

Pilbara WA Australia

GRP deviation (% deviation) -4.8 -1.1 -0.17

Employment (% deviation) -4.3 -0.5 -0.06

Employment (persons) -2,900 -3,400 -7,200

Source: Deloitte Access Economics

In particular, the type of tax under review here would lift the production costs of some Australian iron ore producers without affecting their domestic and foreign competitors, and the modelling shows that the proposed changes would have a significant impact on the

1 Assuming an extra $4.75 a tonne charge on iron ore production from affected mines.

iii Commercial-in-Confidence


Pilbara. Relative to where it would otherwise have been by then, the Pilbara economy would be 4.8% smaller, with a 4.3% reduction in employment (some 2,900 jobs).

In fact the only part of the Australian economy that would be even harder hit than the Pilbara is the iron ore mining sector itself. Once the impact of this additional tax was mature, then iron ore mining would be 6.3% smaller than it would otherwise have been.

With lower returns, fewer projects would become viable, and marginal deposits in existing mines may remain untapped – causing those mines to close sooner than they’d otherwise have done. Over time, the imposition of this type of tax reduces the amount of iron ore production relative to where it would otherwise have been, with flow on effects for the sector and the economy more broadly.

Accordingly, a policy to raise royalties would lead to:

an improvement in net revenues available to the WA Government that wouldn’t last (because Australia’s Federation would hand most of the extra taxes raised to the other States, and also because such policies would – over time – lead more mines to close and fewer to open, thereby slowly reducing the taxpaying potential of the sector being taxed relative to what it would otherwise have been), but

costs that would last, with the relative burden of those costs rising over time, and being felt most on the Pilbara.

To be fair, some of these costs would be slow to be felt. This tax would hit longer established mines first, and longer established mines typically have the best iron ore deposits – which means they also tend to be more profitable than average. That position on the cost curve means this tax would initially mimic some of the effects of a higher profit tax, transferring some profits from more profitable miners to taxpayers across Australia.

Yet today’s low cost deposits eventually become tomorrow’s marginal mines. It is at that point in time that this tax would cause most damage.

And this is a tax on successful mines instituted after they became successful. That raises issues of sovereign risk, because it leads to an effect on incentives:

On the one hand the perception of increased sovereign risk would weigh on future investment potential.

On the other hand it would weigh on efficiency: if the best mines become the mines most likely to be hit by an after-the-fact tax, then that blunts commercial incentives for miners to be the best that they can be.


1 Commercial-in-Confidence


1 Background The Minerals Council of Australia (MCA) commissioned Deloitte Access Economics to prepare a report which outlines the broad economic and government budget effects of increasing a volumetric tax on iron ore production in Western Australia (WA).

The rest of the report is as follows:

Chapter 2 sets the context for the report. It provides a brief overview of the academic literature on the effect of export taxes on the economy. It also outlines the current state of the global iron ore market and the current contribution of WA’s iron ore miners to the WA Government Budget.

Chapter 3 outlines the proposed change to the iron ore production rental charge and its expected effect on government revenues.

Chapter 4 presents CGE modelling which details the range of effects arising from increasing the iron ore rental rate applied to ore mined in WA from 25 cents to $5 per tonne on each of the Pilbara, West Australian and Australian economies.



2 Setting the scene

2.1 What does the literature say?

Economists have long known that taxes create distortions that hurt the economy – that each dollar of revenue raised comes with a cost. Economists also know that some taxes generate more harm than others2.

This understanding has underpinned previous periods of tax reform, and it forms much of the narrative around the current broader reform debate.

At the heart of those reform attempts was the preference to move from ‘bad taxes’ to ‘good taxes’ – from taxes which do more damage to the economy to those which do less. The aim is to raise the revenue required for government to achieve its goals while doing the least damage to the economy.

While much can be said about the 2010 mining tax debate, there was a broad consensus among economists that mining royalties cause relatively more economic damage than most other types of taxation.

Royalties raise the cost of production, and they do not respond to changing profitability. That creates a deadweight loss – benefits which are now unable to be claimed by society.

The resultant higher cost structure means that fewer projects are viable and marginal deposits in existing mines may remain untapped. Over time, the imposition of this type of tax reduces the amount of iron ore production relative to where it would otherwise have been, with flow on effects for the sector and the economy more broadly:

Mining firms would hire fewer employees than they’d otherwise do because not as many people are needed to operate the mines or to build additional production capacity.

Less activity in the mining industry would have flow on effects for other industries which provide it with inputs such as the construction, manufacturing and business services sectors.

This would also spread the pain across Western Australia (and the rest of Australia), as many of these other affected businesses are located in other areas, as are some of the workers operating in Pilbara mines.

Estimates for the size of this effect (known as the marginal excess burden (MEB)) were prepared for the Henry Tax Review. They are shown in Chart 2.1. That modelling found that the MEB for this tax is a relatively high 0.70. This means that for every additional dollar of tax raised 70 cents of consumer welfare (a measure of household wellbeing) is lost.

(Chapter 4 presents the results of our own modelling of this, which shows a loss of 75 cents of consumer welfare for every dollar that this tax would raise.)

2 Both the Henry Tax Review and Treasury’s Re:Think paper provide estimates for just ‘how bad’ certain taxes are in the Australian context.

http://taxreview.treasury.gov.au/content/content.aspx?doc=html/pubs_reports.htm

http://bettertax.gov.au/publications/discussion-paper/



For some context, we have also included estimates for MEBs for labour and capital income taxes. The MEBs for both these taxes are 0.24 and 0.40 respectively, both considerably lower than the estimates for mining royalties.

Chart 2.1: Marginal excess burdens of taxes for Australia

Source: KPMG Econtech

2.2 The global iron ore market

The global market for iron ore is exactly that – global. Foreign capital is needed to invest in building the mines, while the production from the mines is sold onto a world market almost entirely to foreigners.

This meant that, when global trends moved in our direction through the 2000s thanks to China, this nation benefited from historically high prices and the significant investments in increasing capacity in the sector.

More recently times have changed. Iron ore prices averaged US$162 a tonne at the top of the cycle in 2011, but since then spot prices have declined notably.

Falling prices reflects the fact that, while Australia is a large player in the market, our iron ore producers are largely price takers in a global market.

The fall in global prices reflects the twin negative forces acting in the market:

The substantial investments made in increasing capacity (both in Australia and overseas) have lifted the supply of iron ore to the market.

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At the same time, global demand – China – has not increased by a commensurate amount.

China’s development model has relied heavily – and overly – on construction. But now it has built too much, and it has relied too much on debt in doing so.

Acknowledging this, the Chinese Government is attempting to transition the economy away from heavy industry (which relies on a lot of iron ore) towards a consumption growth model, leaving the outlook for iron ore prices under pressure.

The chart below reflects how the changes in the global market are affecting WA. The chart shows substantial increases in the volume of iron ore exports from WA (green bars). However, while the amount of ore being shipped out has increased, the value of those exports has actually fallen (blue line).

Chart 2.2: WA iron ore export volumes and values

Source: WA Department of Mines and Petroleum

In summary then, prices are already low and global pricing is competitive – a challenging backdrop into which to boost an already inefficient tax.

2.3 Tax rates are rising – with royalties the key reason

Falling prices (and hence profits) have not translated to lower rates of tax. As Chart 2.3 shows, the converse is actually true.

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The tax take ratio, the amount of tax and royalties paid by Australian miners as a share of their income, has increased steadily in recent times. This share reached 46.8% of income in 2013-14 due to the increasing share of royalty payments.

Royalty payments now account for around half (22.8% of the 46.8%) of the contribution of mining companies to Australia’s Federal and State government coffers (with the rest made up by company taxes), having risen from 17.3% in 2007-08.

Chart 2.3: Share of income paid in taxation – all minerals

Source: MCA Tax Survey

Note: Data is for all of Australia, and covers all minerals.

The rising share of iron ore royalty payments can also be seen in the WA Government Budget figures.

The amount of iron ore royalties paid to the WA Government has increased from $465 million in 2004-05 to be around $4.0 billion in 2014-15 (as seen in Chart 2.4).

As a result, iron ore royalties accounted for 14.7% of all WA revenue in 2014-15, up from 3.3% in 2004-05.

In 2014-15 the WA Government received around $1,550 in iron ore royalties for each resident of the State. This is almost seven times the $231 per resident received a decade ago in 2004-05.

Overall, WA’s iron ore miners have contributed more than $27 billion in royalties to the WA Budget over the last 10 years.



Chart 2.4: Contribution of iron ore royalties to WA Government Budget

Source: WA Department of Treasury; WA Department of Mines and Petroleum

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3 Royalties and additional rentals

3.1 The background

An 8 September 2016 release from the WA Department of Mines and Petroleum (see http://www.dmp.wa.gov.au/News/Iron-ore-royalties-and-19354.aspx) headed Iron ore royalties and additional rentals set out some useful background to the issues explored in this report.

A full extract follows:

“Recent media reports have placed considerable focus on WA’s iron ore royalties and additional rental payments.

In 2015 the Department of Mines and Petroleum (DMP) collected $5.2 billion in royalties from mineral and petroleum producers in Western Australia, and almost three-quarters of this was from the iron ore industry.

Western Australia has a three-tiered royalty system. The royalty rate depends on the level of processing and the form in which a mineral is first sold – 7.5 per cent for ore, 5 per cent for concentrate and 2.5 per cent for final form. All iron ore companies pay royalties at 7.5 per cent. However, if the iron ore is concentrated, the rate is 5 per cent. Based on recent prices of A$60 per tonne, iron ore royalty payments equate to $4.50 a tonne or $3 a tonne for concentrate.

Chart 3.1: 2015 royalty receipts



“Iron ore producers are also required to pay an additional rental of 25 cents per tonne on their mining lease after 15 years of production on a mining lease. This charge is specific to iron ore producers and originates from the 1960s when State Agreements were introduced for operations in the Pilbara. The additional rental provided a mechanism for the Government to recoup some of its investment in infrastructure in the region. It was later incorporated into the Mining Act and now applies to all iron ore producers after 15 years. At present three companies, Rio Tinto, BHP Billiton and Cliffs Natural Resources Pty Ltd, pay the additional rental.

In 2015 DMP collected $120 million in additional mining lease rental from iron ore producers in Western Australia.”

That is, under the Mining Act 1978, iron ore miners are required to pay a production rental charge of 25 cents for each tonne of iron ore produced from mines once the mine has been in operation for at least fifteen years.

One potential policy which has received publicity of late would see this charge increase from 25 cents to $5.00 per tonne. Given that the Department of Mines and Petroleum (DMP) indicates that the current charge of 25 cents a tonne raised some $120 million in 2015, Deloitte Access Economics estimates that this change would raise an additional $2.3 billion a year in revenue3.

To the extent that the mines affected are lower cost, some of the effects of this would initially mimic a rent tax, transferring some profits from miners to taxpayers without a major impact on behaviour.

However, the type of tax under review here would lift the production costs of some Australian iron ore producers without affecting their domestic and foreign competitors.

Moreover:

The quality of mineral deposits tends to decline over time as the mineral is mined, making any given mine more marginal. That means this tax would tend to become more damaging over time for any individual mine (as that mine ages and its relative costs rise).

And, over time, more and more mines will be covered. This would see the additional charge placed on more marginal mines, thereby increasing costs.

It would also lift the production costs of some Australian iron ore producers without affecting their domestic and foreign competitors.

Ultimately, the imposition of this additional tax would reduce mining production and with it the number of jobs required to operate the mines.

Finally, because of the Commonwealth Grants Commission (CGC) process, Western Australia will not actually benefit all that much from the additional revenue.

3 The proposal sees an additional $4.75 a tonne charged only on mines operated by BHP Billiton and Rio Tinto. Deloitte Access Economics has assumed that this additional charge would apply to all other iron ore producers in WA when their mines meet the criteria currently set out in section 28(A) of the Mining Regulations 1981. As of today, Cliffs Resources is the other producer who pays this additional rental charge. That said, the specific operations affected would depend on the detail of any legislation that were to ultimately pass Parliament.



3.2 The CGC effect – budget benefits get spread

That last point is worth setting out more fully.

Australia is a federation founded on the basis that citizens across the nation should have access to the same level of government services irrespective of where they live. This system is maintained through the distribution of revenues from the goods and services tax (GST) with States that have greater means to provide services for their citizens receiving a lower share of the GST funding pool than States with less capacity to provide services.

As part of this system of fiscal equalisation, any increase in revenues obtained by the WA Government from raising taxes on iron ore production would effectively be distributed across the other States and Territories by reducing the amount of GST funding that WA receives and increasing the GST provided to other States.

This process of horizontal fiscal equalisation already sees the WA Government receive a fraction of the GST payments it would otherwise receive on a per capita basis, in large part due to the additional revenue raising capacity of the State from mining royalties.

The CGC is the body which makes this assessment each year based on the revenue raising capacity (and cost of providing public services) of each State and Territory over the previous three years in its determination.4

When the combined effect of the additional revenue raised under this type of proposal and GST distribution are considered, then the total revenue impacts are not large.

In net benefit terms, WA would only be better off by about 11% of the additional tax it raised (the difference between the State’s share of national iron ore revenue and its population share). That would be something less than $300 million a year.

So whereas the previous section noted the long-lasting economic costs of such a policy change, this section notes that the benefits – mostly a share of extra tax revenues – would fade over time.

Western Australia could try to avoid such an outcome through two different channels:

Within the ordinary processes of the CGC, it could try to argue that – as effectively the only State in Australia with iron ore mines – it was increasing its “revenue effort”, and so should be allowed to hold onto more of the revenue in question.

Or it could appeal directly to the Federal Government, arguing that the revenue from the increase in this tax should be quarantined from the ordinary processes of the CGC.

That said, the expected outcome would be that Western Australia would bear the ongoing economic cost of the policy, but ultimately would not receive all (or even most) of the increase in revenue.

4 2017 GST Distribution Model.

https://cgc.gov.au/index.php?option=com_docman&view=document&Itemid=514&layout=default&alias=884-cgc-the-gst-distribution-model-pdf&category_slug=update-processes



4 CGE modelling

4.1 The headline numbers

This chapter presents the results of Deloitte Access Economics’ CGE model which has been used to examine the economy-wide impacts of the proposed tax change on the Pilbara region, Western Australia, and Australia.

These impacts are evaluated over the medium to longer term – that is, the phase in which the mines affected by this tax are broadly representative of iron ore mines across the Pilbara as a whole. That could occur either because those mines first caught up in the new tax become marginal over time, or because other iron ore operations pass the 15 year threshold for coverage by the tax.

The modelling shows that the proposed changes would have a significant impact on the Pilbara. Relative to where it would otherwise have been by then, the local economy would be 4.8% smaller, with a 4.3% reduction in employment (some 2,900 jobs).

In fact the only part of the Australian economy that would be even harder hit than the Pilbara is the iron ore mining sector itself. Once the impact of this additional tax was mature, then iron ore mining would be 6.3% smaller than it would otherwise have been.

The contraction in the Pilbara’s economy is much starker than that seen in the rest of the State but, on the whole, Western Australia is also worse off. Over the medium to long-run, Gross State Product (GSP) is 1.1% lower and employment is 0.5% lower than it would otherwise have been (some 3,400 jobs).

Much like the rest of Western Australia, the impact on the Australian economy is smaller- iron ore is huge for the Pilbara, but less so for the nation as a whole. Australian output is projected to be 0.17% smaller, while there would also be 0.06% fewer employed persons (some 7,200 jobs).

Table 4.1 below shows the headline results from this modelling.

Table 4.1: Impact on economy and jobs (relative to where they’d otherwise have been)

Pilbara WA Australia

GRP deviation (% deviation) -4.8 -1.1 -0.17

Employment (% deviation) -4.3 -0.5 -0.06

Employment (persons) -2,900 -3,400 -7,200

Source: Deloitte Access Economics

Measured in today’s dollars, that says the annual cost to the economy of $2.9 billion is in excess of the amount of revenue raised ($2.3 billion).

The cost arises due to the reduction in production and investment related to the higher tax (section 2.1). Deloitte Access Economics estimates that for every dollar of additional revenue



raised from the proposed increase in iron ore rentals, consumer welfare (consumption) falls by 75 cents.

(Chart 2.1 earlier presented estimates for the MEB associated with mining royalties prepared for the Henry Tax Review. That modelling found that the MEB for royalties was a relatively high 0.70. Our modelling finds a slightly higher impact, at 75 cents.)

Because consumption accounts for around 60% of the Australian economy, this translates to a loss in output in excess of the amount of revenue raised.

(That is, $2.3 billion in revenue raised multiplied by the MEB of 0.75 divided by the share of the economy made up by household consumption of 0.6 equals an output loss of $2.9 billion.)

The fall in national income is smaller, at $1.2 billion a year.

Importantly, the results presented in this chapter reflect the estimated impact of the policy change over the medium to long-run.

The initial impacts of this tax are more like a resource rent tax, because the additional charge is mostly applied to lower cost iron ore deposits. This means that the increase in the rental rate would be less harmful in the short term than in the longer term results presented here.

4.2 Computable general equilibrium modelling

A change (or shock) in any part of the economy has impacts that reverberate throughout the economy as a whole. For example, in the current context, the proposed changes to Western Australia’s taxes (the shock) would result in a reduction in mining output and a reduction in economic activity in associated sectors in Pilbara, as well as lower consumer spending associated resulting from lower wages and less employment.

The project utilises the Deloitte Access Economics’ – Regional General Equilibrium Model (DAE-RGEM). DAE-RGEM is a large scale, dynamic, multi-region, multi-commodity CGE model of the world economy with bottom-up modelling of Australian regions. DAE-RGEM encompasses all economic activity in an economy – including production, consumption, employment, taxes and trade – and the inter-linkages between them. For this project, the model has been customised to explicitly identify the Pilbara economy, including some of its unique economic characteristics.5

Figure 4.1 is a stylised diagram showing the circular flow of income and spending that occurs in any particular region of DAE-RGEM, excluding inter-regional interdependences:

To meet demand for products, firms purchase inputs from other producers and hire factors of production (labour and capital).

Producers pay wages and rent (factor income) which accrue to households.

5 Australia has been divided into three regions: Pilbara, Rest of Western Australia and Rest of Australia. With Rest of the world and these three Australian regions, the DAE-RGEM divides the world into four regions and solves like any other dynamic, multi-sectoral global CGE model. The model is calibrated using Deloitte Access Economics’ in-house database developed from the GTAP database v9 and ABS data.



Households spend their income on goods and services, pay taxes and put some away for savings.

The government uses tax revenue to purchase goods and services, while savings are used by investors to buy capital goods to facilitate future consumption.

As DAE-RGEM is an open economy model, it also includes trade flows with other regions, states, and foreign countries.

Figure 4.1: The components of DAE-RGEM and their relationships

The model compares a baseline scenario where the proposed tax change doesn’t occur with a counterfactual scenario where in addition to what happens in the baseline scenario the tax change does occur.

That is, as noted above, the losses to the economy and to jobs don’t mean – for example – that there is a loss of 4.3% of all the jobs in the Pilbara, but that there are 4.3% fewer jobs in the Pilbara compared to what is projected to occur in the absence of the tax increase.

The difference between outcomes of the two scenarios gives the projected impact of the policy change. It is assumed that the proposed tax applies to all iron ore mining activities irrespective of their ages.

More detail on the modelling framework used is provided in Appendix A.

4.3 Inputs to the modelling

The key difference between the scenario discussed here and the baseline is the proposed tax change. This is initially modelled as a $2.3 billion increase in the revenue collected by the Western Australian government through changes to a production-based royalty on the output of the iron ore mining sector. That then converts to an equivalent cost per unit of natural resource production thereafter.



The majority of West Australian iron ore operations occur in the Pilbara, and so the modelling assumes the majority of the revenue comes from this region.

Yet there would also be effects in other regions in Australia:

The use of fly-in-fly-out (FIFO) workers in the mining sector would spread the effect of reduced employment over other regions in WA, as well as to some other States.

Additionally, headquarters for the affected companies are located elsewhere in Australia such as in Melbourne. This would also spread some of the economic cost to other States.

4.4 The economy-wide impacts of the tax

As highlighted in Chart 2.1, royalties are among the more damaging taxes to the economy. This is borne out by the CGE modelling discussed here, which shows strong negative impacts from raising production-based royalties.

But it is worth stepping through the logic of this and what is driving these changes, because doing so showcases some of the key issues to consider with this tax change and how taking different views on these issues can produce quite different outcomes.

As a back-of-the-envelope calculation, economists use MEBs and multiply them by the revenue raised to get a dollar loss in consumption (or GDP, if that is how the MEB has been measured).

Relying on MEBs alone, however, may understate the potential economic impacts, because they are primarily concerned with what economists call ‘allocative efficiency’.

This is fine in a static environment. In a dynamic environment, however, you also need to be aware of the possible impact the policy change can have on the supply of factors (labour, capital and natural resources)) and the productivity environment in which the (additional) factors will be employed, including the possible impact on the terms of trade and other international transfers.

Figure 4.2 (below) shows how the impact on both the Pilbara and WA as a whole is apportioned between allocative efficiency, factor supply and technical change.



Figure 4.2: Decomposition of the change in real GRP

Note: This is the total effect over the medium to long-term. In the short term, the allocative efficiency effect dominates but this effect diminishes over time and the factor supply effect dominates the total effect of the policy change.

As has been highlighted in Chapter 3, the tax change will drive up the cost of producing iron ore but, in the short term, the increased cost of production for the affected operations may not be significant enough to shift the aggregate cost of production in the Pilbara or WA. It could simply reduce the rents of those mines.

Unfortunately though, iron ore is in relatively fixed supply, and as production goes on the operations will become more marginal, meaning the tax will increasingly start to ‘bite’.

Two further factors are worth noting:

World buyers of our iron ore would bear a small share of the pain of the tax: Australia’s terms of trade increases slightly due to the imposition of the tax. This is because Australian producers have a minor impact on pricing in the iron ore market.6 A portion of the higher domestic price of production is transferred onto the world market, which shifts up the price of iron ore and with it the price of Australia’s exports relative to imports. However, the income effect is less than the volume effect, which results in an overall loss.

Foreign shareholders bear some of the pain of the tax – though this would have a dampening impact on future investment: Additionally, foreigners lose out as well, as they have a stake in Australia’s mining assets. While this cushions the impact on

6 Remember that our results reflect the mature case – when the mines affected by the extra tax are representative of the sector in WA as a whole. That could occur either because those mines first caught up in the new tax become marginal over time, or because other iron ore operations pass the 15 year threshold for coverage by the tax. Accordingly, a portion of the world’s marginal mines would – by that stage – be hit by the tax. Because miners have to make sufficient return on their capital for it to be worthwhile for them to be in business, then prices have to be higher. After all, costs (in this case, taxes) are higher.



domestic incomes initially, there is some risk in increasing taxes on foreigners as in the long term this may impact on future investment decisions, leading overseas investors to invest elsewhere.

The shock results in less foreign investment than would otherwise be the case. This is part of the reason for the loss in gross regional product (GRP); as there is less capital to work with, meaning lower potential output. Also, less capital per workers means they are less productive and will receive lower wages. However, lower foreign investment also means lower foreign debt and lower interest (or dividend) payments to overseas.

Consequently, the loss in gross national income (GNI, at $1.2 billion a year in today’s money) is less than the loss in GDP (at $2.9 billion a year in today’s money) resulting from the proposed increase in the production tax rate applied on iron ore mining.

That said:

Given how large the reduction in the economy is, there is still a very large loss of national income relative to the size of the tax.

And, looking ahead, there’s further damage that the model doesn’t pick up. As the proposed tax simply gathers some existing mines up into the tax base straight away, that sees the tax taking an additional share of existing successes.

Like most taxes with a retrospective impact, this latter feature of the proposed tax would boost perceptions of ‘sovereign risk’ in Australia.

In turn, that would tend to reduce foreign investment over the longer term by more than the model is assuming.



Conclusions This report outlines the broad economic and budget effects of increasing a volumetric tax on iron ore production in Western Australia.

It finds that:

Different taxes cause different degrees of damage to the economy. The type of tax under review here would lift the production costs of some Australian iron ore producers without affecting their domestic and foreign competitors. Its impact would see the Australian economy eventually shrink by $2.9 billion a year as a result of a tax that raised $2.3 billion.

That said, because the tax would initially hit lower cost mines, some of that damage would appear over time rather than immediately. If any higher cost mines were to be affected, the effect on them could be more notable: the global iron ore market remains under pressure.

Moreover, while the damage to the economy would tend to ultimately be concentrated in the Pilbara – Australia’s key iron ore producing area – the process of ‘horizontal fiscal equalisation’ would adjust the distribution of Good and Services Tax (GST) to account for WA’s additional mining revenue. The net effect would leave WA with something less than a net $300 million of the total extra of $2.3 billion raised every year.

That is, the State hardest hit by the tax would eventually see little benefit from the revenue it raised: over the longer term, Western Australia would ultimately suffer the majority of the economic cost, while receiving only a small share of the benefit from additional government revenues.

The amount of tax and royalties paid by miners as a share of their income has increased steadily in recent years. This share reached 46.8% of income in 2013-14 as falling mineral prices led to an increasing share of royalty payments.

Limitation of our work

General use restriction

This report is prepared solely for the internal use of Minerals Council of Australia. This report

is not intended to and should not be used or relied upon by anyone else and we accept no

duty of care to any other person or entity. The report has been prepared for the purpose of

providing the Minerals Council of Australia with analysis and modelling of the global market

for iron ore and the effect of increasing iron ore rentals from 25 cents to $5 on the Pilbara,

Western Australian and Australian economies. You should not refer to or use our name or the advice for any other purpose.

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WA Iron Ore Royalty Analysis - Minerals Council of · PDF fileii Commercial-in-Confidence Deloitte Access Economics Executive Summary Raising royalties on some iron ore miners would