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EXCERPT FROM: "Extractive Resources and Taxation" (Madison: U of W Press)

by Mason Gaffney, 1967

How to Tax Mineral Rents. It is a curious commentary on our times that the former notion of taxing earned (wage) income at lower rates than unearned (property) income we have not only abandoned but reversed. It is the style to pooh-pooh the quaint notion that high income-tax rates might dilute the incentive to work. On this topic the modern policy-maker produces a backward-bending supply curve of labor and explains that "income effects" of lower after-tax labor income more than offset "substitution effects" so labor may very well work longer for less money. But when it comes to oil royalties, that's different.[44] Here the incentive argument comes back to life and we hear that what we thought was a gift of Nature is the work of men —men who will stop work unless they receive large financial rewards! In the modern idiom, labor income has become mostly rent, and land income is a necessary incentive to call forth supply.

In truth, the older idea had merit. If indeed our institutions overmotivate prospecting it makes sense to tax mineral rents not just as highly as other land income, but higher. And if it makes sense to tax economic rent, then some mineral income can be completely socialized without any excess burden whatever.

The question that remains is simply how to do it. A modified income tax, a modified property tax, and government ownership are the major instruments for the purpose. Let us sum up our conclusions about each:

Given perfect tenure, perfect competition, perfect knowledge, international amity, and neutral public-works investment policies —i.e., given the absence of the nine biases toward premature prospecting — a business income tax could tap the rent of mineral land and exempt the income of productive investments in exploring and developing it by a fairly simple, straightforward device: let the taxpayer deduct his investment costs fully in the year expensed, except lease purchase, royalties, and other payments for land.

On the whole, I conclude that an income tax so modified, while a great improvement over present practice, is less desirable than a modified property tax. Income taxation with expensing poses a number of problems.

1. Given the nine biases for prospecting, an income tax fails to offset the overmotivation because all prospecting is expensable, even on public land. Conceivably the law might allow expensing on private land but not on public. However, the matter is too subtle and many-sided to be handled by any such simple formula, and in practice it is hard to see how an income tax can discriminate among degrees of tenure (a property tax does so discriminate, and very precisely).

2. Expensing is hard to administer equitably, because there are many new, small, marginal firms with no outside income from which to deduct their capital outlays. How to treat such firms? None of the options is wholly satisfactory: If we deny them any tax credit, then only giant diversified firms can benefit. If the Treasury advances them cash, it must lend without security and to almost anyone as a matter of legal right, a dubious prospect. If we let them carry forward their deductions until they have other income, we are denying them interest on their investment, which is the essence of the expensing feature. If we let them carry forward deductions with interest, the rate would be the same for all taxpayers, an advantage to the stronger firms whose insular individual rates (i.i.r.) are lower. Worse, we would be guaranteeing a fixed tax-free return on all investments, however ill-advised, however filled with graft for the taxpayer.

3. At high tax rates a serious incentive problem arises after the taxpayer has recovered his capital tax-free, with or without interest, because all income above that base would pay a high rate The overage is supposed to represent economic rent, but when we tax even economic rent on a realized-cash basis we motivate taxpayers to convert cash income to psychic income. The critical value, the maximum economic rent, is much less sharply defined when the taxpayer keeps only a small fraction of it.

A bumbling manager on superior land would show little net income over costs, including his and his nephew's inflated salaries and overpriced supplies from his brother-in-law. Thus land rent, which we set Out to tax, would be diverted to private pockets or dissipated by incompetence; while the high tax rate, aimed at rent, would instead capture the fruits of superior management. The leverage is applied backwards.

If a tax is to motivate men it must let them, and not the Treasury, retain most of the marginal cash flow above a fixed basic charge.

The proposal would in effect amount to an original lump-sum grant, to encourage prospecting and developing, followed by a stiff tax on gross income (net of operating costs, usually minor compared with capital costs). Following initial investment, the taxpayer would suffer under all the defects of a severance tax, or Ricardo's "tithes." Only the rate would have to be much higher than a tithe: even higher than the present o per cent, to compensate for the loss of revenue by permitting expensing.

To avoid demotivation, the annuity approach outlined earlier might contain the germ of an answer. In ef