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Neutrality
EXCERPT FROM: "Extractive Resources and Taxation"
9. A tax on mineral rents may be made neutral as to discovery as well as to conservation.
Herfindahl and Vickrey have expounded the intertemporal neutrality of a tax on net realized mineral rent. Their exposition has been in terms of a net value above costs, where revenues and costs were assignable to individual years. Steele has intimated the difficulties &f this concept where heavy initial capital costs must be spread over many years, and McDonald has brought out the central importance of the tax treatment of capital investment.
Figure C.3 above helps solve those difficulties. If a cycle of mineral investment and recovery be evaluated as a whole, the optimal time-distribution maximizes present net value of the resource. A tax taking a fixed percentage of the net would not change the life which yields maximum net present value, and so would be substantially neutral. Such a tax might best be levied as an annuity whose PV equals the tax rate times the PV of the mine, and whose life approximately equals the life of the mine.[13]
The neutrality of this tax extends further than its effect on the timedistribution of use of the known stock. It is also neutral on the timing of discovery and development. These two decisions are also critical in their timing, and the criterion is the same as for conservation of the known stock, to wit, maximization of present value (as of any given year). That is, the time to begin developing a proven reserve is when the value in situ stops rising faster than the interest rate, so its PV is a maximum. Again, the time to begin prospecting lands with suspected reserves is when their leasable value stops rising faster than the interest rate. This is the same principle, but with discovery costs added to development costs.
This is an important extension of the principle of the neutrality of proportional taxes on mineral rent. Not only do they not affect timedistribution of use of the stock which is known and already tapped; not only do they not affect the time of beginning the removal; but they also leave unchanged the timing of discovery itself.
There remains the possibility that they may reduce the optimal exploratory outlay, even while preserving the timing. But the presumption of temporal neutrality is that discovery costs be fully deductible when laid out — i.e., be expensed —either directly or by the device suggested above of making the tax an annuity whose present value is the tax rate times the PV of the mine. The same presumption preserves their quantity. The quantity that maximizes rent before tax also maximizes rent after tax.
There are two ways to tax rent: the base may be realized rent, as with an income tax that expenses capital outlays; or putative, assessed rent, as with a property tax that exempts improvements. The suggested annuity tax has features of both modes. It would let the federal income tax take on a bit more of the character of a property tax, for the level of the annuity, at least at the start, would have to be based on some sort of advance appraisal of the mine. Later, like an income tax, it might be readjusted to reflect experience with the mine.
Another approach to taxation of mine rent is simply to allow full deduction of all non-land costs, including capital outlays in full in the year of outlay.[14] The practical problem here is that, if the tax rate were high, the government would first have to contribute a large share of the initial capital investment, which would count as negative income in year o; and later have to take a large share of gross income to recoup its investment, impairing taxpayer incentives. At a 100 per cent rate the government would supply the entire capital outlay and recover zoo per cent of the later cash flow above current costs —if there were any. But then why would a private investor care if there were or not? To avoid such a problem, the annuity approach is better. Under this regime the miner pays a steady constant yearly tax, a percentage of yearly rent, and keeps everything above that to motivate him.
In application, the annuity approach might give the income tax some of the levering character of a property tax based on presumptive rather than realized income. Constitutional lawyers may frown at such a use of the Sixteenth Amendment, but waiters and gamblers are already taxed on presumptive income and it might make more economic sense to extend the precedent to landowners.
As a final caution, note that the in situ income tax, as discussed here, implies the absence of any depletion deduction. The taxpayer's capital recovery is handled by setting his tax rate as though he were allowed to expense capital outlays when incurred. Any depletion deduction above that would be double counting and simply leave rent in private hands.
Depletion and expensing are substitute approaches to capital recovery, not complements.
The considerations of what unit to use to assess the value of depletion, therefore, would apply only where expensing is not or has not been allowed.
As between the two approaches to capital recovery — expensing and depletion — expensing (or its annuity equivalent) is more compatible with the taxation of economic rent. Expensing real costs enables us to distinguish between actual capital formation and lease acquisition.
Thirty years later the two kinds of outlays have merged into the market value of a mine, and depletion is likely to cover both, without, however, exempting from tax the interest return on productive outlays as expensing does.
If we must use the depletion approach, then the methods suggested for assessing the value of depletion for income tax deduction should be useful. They might also have a place in a transition period. But on balance the expensing approach with an annuity tax seems an interim goal toward which to move; and a property tax based on an accurately assessed putative value net of discovery costs seems an ultimate goal.
Policy Conclusions
Forearmed with the formal analysis, we may now draw policy conclusions and in a more relaxed and literary mood explore several points in more depth. Like the points made above, these are individual conclusions of the editor and do not purport to express any consensus among the conferees. The editor acknowledges a deep debt to the contributors, however. Their thinking and criticism improved his mind and directed him to many of the issues whose significance he did not previously hold in proper perspective. Correspondence from Professors Vickrey and McDonald has been especially deep and provocative.
Beyond Neutrality. "Neutrality" is a good norm of tax policy, but not the best. Some taxes may be better than neutral; that is, they may positively improve on the pre-tax allocation of resources by helping to make imperfect markets less faulty, by countervailing biases that characterize some markets, etc.
For example, severance taxes might be used as price surrogates to limit demands on open-access resources like fisheries. Conversely, taxes may be used to improve access to or allocation of resources which the private market has partially frozen or removed from commerce. Taxes on the capability or rentability of land may tend to weaken monopoly. More generally, they and other taxes on rent lower the financial requirements for land acquisition, letting people pay for access to resources one year at a time, instead of in one lump sum, thereby short-circuiting the otherwise serious economic barrier of credit rationing. These taxes also may stimulate economizing behavior by reducing the liquidity and the total holdout power of sleeping landowners too affluent or diverted to be concerned with making the most of the assets at their command. They apply leverage, sharpening the incentives of the market and sharpening the definition of maximum profit positions.
Marginal Resources and Neutrality. We may recognize neutral and better taxes (given perfect tenure) by their lack of effect on marginal resources, and marginal decisions on all resources. (In the absence of tenure protection over resources, better-than-neutral taxes would be user charges and would affect marginal decisions.) Taxes falling on the net income or rent or value of resources meet that test, because on marginal resources the tax base equals zero, and there is no tax, hence no destruction of marginal output. Tax bases other than natural resources generally lack this virtue because there is no free marginal supply. Taxes on gross output lack this virtue because they hit producers on marginal land. (I am indebted to David Ricardo for pointing this out a hundred and fifty years ago in Chapters 10 and 11 of his Principles.) Minnesota's recent taconite amendment, for example, guaranteeing upper limits on taxes on the production of taconite, was followed immediately by several commitments to build new plants in northeastern Minnesota, a graphic example of the impact of unneutral taxation on marginal decisions. Any severance or excise or royalty or other tax based on gross output (or gross input) will hit marginal land and render it submarginal.[15]
Neutral and better taxes may be increased to per cent rates without worsening allocation or incentives. That simple reductio ad absurdum forces us to face up to distortions we are tempted to overlook as negligible or undemonstrable when rates are very low. At per cent rates, taxes on gross receipts or value added, for example, would close down production completely.
Taxes on the net income of extractive resources are better, but at 99 per cent would leave no effective incentive to realize the taxable income. High rates would put a heavy premium on uses yielding untaxed psychic income to the owner, so the tax is not really neutral. Unpleasant extractive resources such as coal mines, that yield little psychic income,[16] might be taxed effectively on the net money income. Similar taxes, however, on forests or fisheries or farms would motivate the owners to devote the entire resources to personal recreation and subsistence farming. Untaxed residential and recreational land use would be expanded, commercial and industrial uses choked off. Trade and specialization would give way to self-contained subsistence economies, and the Treasury would be empty.
In addition, any tax based on realized cash income invites deferment of realization to defer tax liability, a form of tax avoidance that has become so universal one might fairly call it the single most pronounced allocative effect of income taxation.
To avoid those problems at high tax rates we have to resort to a tax based like the property tax on the assessed market value or "rentability" of resources. Those elusive leprechauns called implicit, imputed, psychic, and accrued undistributed income are firmly capitalized into the price of land, and may be taxed through the traditional propertytax mechanism. This tax may be better-than-neutral, as mentioned above. Here, however, we meet the problem of exhaustibility.
ENDNOTES
[13] "Applying that to equation (3) and Figure C.3, the tax annuity would have the value:
(4) where T is the yearly tax, t the tax rate. (Costs in years after o should be discounted to time o and included in Co.) (4) is derived by two steps: first, subtract Co from (3), giving present value net of capital costs; second, convert the lump sum to an annuity by multiplying by
__T__ = __A__ -- Co ______i_______ t L 1 - ( 1 + i )-L (4) converts the lump sum PV to an annual net rent, the cash flow
____i____ 1 - ( 1 + i )-L less the "capital recovery factor"
__A__ L times capital cost. Note that the annuity (4) is not something to maximize by changing L. A higher annuity is possible by shortening L, but it would have a lower PV0 because of there being fewer total annual payments.
____i____ 1 - ( 1 + i )-L [14] Treasury thus lends the taxpayer a tax deferment that grows at compound interest to equal the value of the taxes when due. See also McDonald's discussion of expensing in Chapter 11 of this book.
[15] The profession proved remarkably perceptive of this point in its reaction to one mistake in an otherwise excellent paper by Professor Paul Davidson. He analyzed percentage depletion like a negative excise tax — a sound analogy — but then minimized its influence on exploration and extension of the margin by saying the emergence of rent on previously submarginal land would absorb all the surplus — again correct—and thereby completely offset the incentive to develop new land. The last is a basic error. New rent only absorbs the gain above Costs, it does not prevent the outlay of the Costs themselves. Davidson's analysis would have made any tax neutral by denying its effect on marginal lands and by implication on marginal production on all lands. In fact, excise taxes on marginal lands make them submarginal, and negative excises do the reverse. See Paul Davidson (8), and Campbell's (7), Steele's (6), Comments" and Davidson's reply thereto (9); McDonald (30, p. iso, n. '43); and A. E. Kahn (26). On p. io of his reply, Davidson seems to agree in principle that a negative excise may encourage exploration. See also Allyn Lockner (28).
[16] Masochistic personalities may get psychic relief from coal mining. They may even enjoy paying taxes. I do not think, however, that most of us would prefer to live in a society geared to their needs.
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