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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 effect, it could put the income tax partly on a putative basis and give it some of the quality of the property tax, based on expert and free-market appraisal of resource capacity.

4. The personal income tax hits labor and management income, of course, as well as property income, and it would require much more than expensing of capital costs to convert it into a tax on land rent.

The corporate income tax hits only property income, since management is salaried and deductible. But it fails to tax unincorporated owners, however wealthy, and it also exempts -the income of corporate bondholders.

5. If payments for land are not deductible, and productive investments are expensable, taxpayers will seek to disguise the former as the latter. To overcome that, Treasury agents would have to show more insight than they do today in the analogous case of preventing urban real estate owners from assigning most of the value to depreciable buildings when it is really non-depreciable land value.

6. Changing the income-tax basis for going mines would pose a formidable transition problem because of all the old records of capital outlay that would be required to establish the investment history.

The major advantage of the income tax over the property tax is jurisdictional, thanks to the Sixteenth Amendment. The federal government can also tax property, and actually has done so at least five times in American history, but the levy must be apportioned among the states by population, a weakening limitation. The income tax may also capture some income from foreign holdings of United States nationals and corporations, but the deductibility of foreign taxes limits that, perhaps completely, perhaps more than completely. It may even be that United States firms lower their United States taxes by deducting overseas costs destined to generate foreign taxes — a pregnant topic for future research.[45]

A modified property tax has a better chance of being administered so as to be neutral or better. The modification from present practice is to exempt capital improvements, leaving the pure in situ resource value as the base. Based on resource capacity rather than the performance of individual men, this tax avoids demotivating post-discovery production as an income tax, however well-intended, will. The present question is, will it demotivate discovery itself?

Under conditions where discovery creates tenure by closing previously open access, discovery creates taxable property where there was none — from primordial chaos, so to speak. A property tax is then a tax on discovery. But that is a virtue because under conditions of open access discovery is otherwise overmotivated, as we have seen. The property tax discriminates among forms of tenure exactly in the manner that is needed, and does it inherently because the tenure instrument itself is the tax base. Thus it solves a problem which baffled us under the income tax.

Given perfect pre-discovery tenure, on the other hand, the property tax may be made substantially neutral in most circumstances by imposing it on pre-discovery "leasability" values, previously discussed. Perhaps "pre-" and "post." discovery are oversimplified concepts. "During" discovery is more meaningful, for discovery is usually a gradual process.

The tax assessor, by following the simple rule of keeping up with market values, administers a tax that rises gently with the prospects of a field during a protracted period of study and revelation of its detailed anatomy.

As experience brings ever sharper detail of a field into ken, the property tax on the barren properties drops and on the fertile ones rises, keeping the total about the same. That kind of administration of assessment would make the property tax virtually neutral towards prospecting. No doubt it will fail to be perfectly neutral, but no tax should be compared to perfection for that is not a real alternative. Other taxes are the alternative, and none other is so likely to approach neutrality.

The sum of experience in a field, the production and prospecting of many independent people, may raise or lower the earlier opinion of its capabilities and so raise or lower the value of the tax base. The effect is so diffused and remote from the activity of any one person, however, that it would not normally deter exploration. To the extent that it would, in special circumstances, it merely introduces into the propertytax a small element of fiscal risk- and profit-sharing to temper its high leverage effects. Some people seem to prefer that in any event.

It may no doubt occur that random prospectors on land of no known mineral content will strike rich minerals. Should these finds then pay a property tax? There is no easy answer nor is any perfect solution likely. But as a general rule, the biases toward excess exploration work strongest on fringe or marginal lands, so taxing such strikes may do less harm than good.

So the in rem property approach to resource taxation has a basic soundness lacking in the realized cash income approach, and warrants heavier reliance. In addition to its basic merit it offers several advantages.

First, it applies leverage prompting landowners to behave more economically, somewhat as would the interest on a heavy mortgage.[46]

Unlike the tax on realized cash income which blurs critical values at high tax rates, the property tax accentuates and sharpens their definition to the taxpayer. Let us note some of the ensuing benefits:

1. Leverage on surface landowners, where mineral rights go with the surface, overcomes the resistance that backward-looking traditionalists sometimes offer to any change of land use. Under an equally high tax rate on cash income, landowners might frequently prefer the psychic security of their older ways. In less-developed countries, and anywhere where much of the land is closely held by absentees too affluent or dissipated or military to be enterprising, this factor can be crucial.

2. Applying leverage will result in more compact fields and lower collection costs. Lease values have a strong location element.[47] Forcing development in existing fields served by existing lines, and near markets cheaply reachable by new lines, will save large line costs.[48]

To the extent that mineral location determines community location such savings are multiplied in all community costs of overcoming space. The isolation that curses many mining camps and towns will be considerably relieved.

3. Marginal resources will pay little tax —only the amount necessary to offset and neutralize post-discovery taxes — and feel no leverage, which is desirable.[49] That lets their owners wait while the resources ripen. The leverage to produce bears on owners of superior resources, prompting fructification of stagnant reserves whose value has stopped rising by a large annual percentage.

Were it not for the leverage effect, the margin of resource use would probably be extended by the exemption from taxes of improvements on marginal land. That is, present tax policies hit marginal land and thereby make submarginal some lands that will be marginal or better under a neutral tax like the one here proposed. But the leverage of the tax on superior resources might well be such as to supply the market so well that presently marginal resources become submarginal, regardless.

If present markets were perfect the leverage effect would be nil and the net effect would be some extension of the margin, due to untaxing of improvements on and cash flow from marginal land. In my judgment present markets are so far from perfect that the leverage effect will on balance predominate, raising the margin.

Second, in rem property taxation of the value of mineral deposits tends to promote competition. To the extent that it succeeds it opens the door to great savings not just to consumers but to the industry.

For a free market in ores releases each firm and other unit of interest from the need to protect its individual resource base through vertical integration, and spares all the waste and duplication that entails. It opens the way to free-and-easy interfirin cooperation and specialization of the kinds that man, the social animal, works out in an environment where survival and security are the fruits of constructive cooperation rather than avaricious or defensive acquisition.

The modified property tax promotes competition in these ways:

1. It falls heavily on the firm which seeks to control a market by cornering the ore deposits. As these are monopolized their market value rises and the speed of intended use falls. If the tax rises with the value it becomes a tax on monopoly, in effect.

One may object, the property tax has not worked that way in the past. In fact it probably has, in many jurisdictions and industries, to the extent that it has fallen on in situ values. But remember that we are now analyzing a property tax modified to exempt mine improvements.

Today's property tax falls heavily on improvements and so hits the competitor who fructifies reserves more than the monopolist who sterilizes them. The modified tax would do the reverse, and so force the monopolist to sell to competitors, not just to get rid of direct tax liabilities but to lower the taxes on property it retains by reducing the value given it by the monopolist's artificial scarcity.

2. Small, new, marginal firms with weak credit would benefit. The tax would bring down the market price of leases to explore superior land, lessening the financial burden of entry, opening the door to large numbers of small firms.

The income tax tends to do the same, but is less effective. The immediate impact of the property tax is on landowners, holdouts who have not yet signed leases. Lease prices fall thanks to increased supply more than reduced demand. The income tax, on the other hand, lowers lease prices by lowering what buyers will pay, a less stimulating process.

With expensing of exploration costs, it might take some time for the depressing effect of higher anticipated post-discovery taxes to work its way through to lease prices. Some of the gain intended for prospectors might leak away to landowners.

Either tax, however, ranks high in this respect and is preferable to no tax at all, even if the taxes be not needed for public spending —if inflation, for example, be the alternative mode of public finance.

3. Large mineral owners would lose much of the differential value of their holdings as a credit base. It is through the mechanism of credit rationing that the land giants gain much of their market power.

Focusing taxes on superior lands tends to equalize credit ratings. Owners who create real capital to speed the rate of recovery would enjoy better credit with taxes removed from real capital.

4. Giant landowners would lose much of their power to engage in extinction pricing. A tax on rent tends to remove the cushions of surplus income and assets from supramarginal firms and lessen the differences of reserve power among firms. Thus the giants lose their power to discipline competitive firms by losing some of their superior power to absorb losses. The giants also lose much of the high rental income which they plow back into expansion, something which modern income taxation prompts them to do as a primary method of tax deferment.

5. The tax hits old and new firms impartially, in contrast to the income tax, which is hard on new firms which lack outside income from which to deduct early losses.

A third advantage of the property-tax approach is greater ease of transition. There is no need to reconstruct histories of past outlay. The tax is based simply on present value capitalized from anticipated income. The evidence is always at hand.

The problem of hyper-accelerated liquidation during a period when voters are debating tax increases should not be severe under the modified property-tax approach. On marginal land, where acceleration would be most uneconomical, no tax is to be levied so there should be no effect.

On superior land, acceleration over a few years would very likely boomerang on the owner by giving the assessor an inflated idea of a mine's capacity. Remember, too, that acceleration would entail heavy irreversible investments in mine improvements, which improvements and their cash flow would themselves be taxable in the event the present proposal to limit the tax base to in situ values be rejected. Remember, finally, that acceleration would lower spot prices and brake itself. All told, it is neither a likely nor a disastrous outcome.

A difficulty in property taxation is assessment. The details of that art warrant another volume and cannot be elaborated here, but to observe that most of the art is simply to follow the market, which sets values in the course of business.

A great disadvantage of the property tax is jurisdictional because, as mentioned, federal use of the tax is constitutionally unwieldly. It is available to states wishing to accelerate their economic development, but on the whole in recent years state governments have proven cartel minded. In oil and gas it is especially obvious that state governments are active and essential partners in the cartel. Their property-tax policy of focusing on improvements what little tax there is appears as simply another arm of a set of policies to restrict output.

A solution to that is at the federal level, however, and analytically quite simple. The cartel of mineral-producing states of the Union needs to be relieved of its privileged control of the American market by free import of foreign minerals — crude oil, tungsten-molybdenum, silver, or what have you. In the revival of competition that would result, state governments would find economic development more to their advantage than cartel deportment and would break ranks, to the benefit of consumers, workers, investors, and the overall health of the economy. If the suggestion seems too large-minded for American politics, recall that mercantilism, surely a small-minded philosophy, traditionally welcomes the import of crude raw materials. It is their export which stamps one a colonial.

On the principle that rank-breaking is cumulative, all policies helping to promote competition might be enlisted. Citing oil as one example, another obvious federal move is to repeal the Connally "Hot Oil" Act whereby federal power undergirds state restrictions on free oil in interstate commerce — one cannot but recall the Fugitive Slave Law and the Dred Scott Case — and in its place to subject state governments and their agencies to the antitrust laws. The 1943 Supreme Court declined to interfere with state prorates,[50] but dropped a broad hint: "...Congress could, in the exercise of its commerce power, prohibit a state from maintaining a stabilization program like the present[51] because of its effect on interstate commerce" (36 at 350). The 1943 Court was perhaps passing the buck. Injunction of illegal acts is a judicial function. The modern Court has acted more decisively in several fields when the public was ready.

The pace at which state and federal lands (primarily offshore) are released to commerce should also be subject to the scrutiny of the FTC and the Antitrust Division. Without extensive evidence it seems a reasonable inference that states which limit private production to market demand (at the seller's price) must also hold back state lands;[52] and a Congress which restricts imports and supports the Hot Oil Law and excessive stockpiling would hold back federal lands and stifle Bureau of Mines research. In fact it is Interior Department policy, based merely on the Secretary's discretion, to abide by state-decreed allowables for production from offshore oil lands! A voter-supported demand for investigation and reconsideration of our disposal policy could illuminate the matter brilliantly, and get results.

By this time it is obvious that I conclude on the whole that outright government ownership is less desirable than property taxation. Governments own so much that they almost always administer their holdings monopolistically, however enlightened they may be in other ways.

Alberta is the supreme achievement and the supreme disappointment of government ownership of minerals. It is just another member of the world cartel, limiting production to market demand at its price. The Dutch Government; which also owns mineral rights, is equally or more disposed to restrict output. The Organization of Petroleum Exporting Countries (OPEC) is currently trying to prevent private oil companies from cutting prices. The historical record of governments as landowners is such as to lead us to expect no better future performance, unless some revolution in economic education fundamentally improves the behavior of administrators and legislators.

Where public lands are mixed with private, owners of the latter bring pressure to underutilize the former and maintain artificial scarcity.

Another common weakness is that of setting rents below the market for the benefit of politically influential lessees, as on the federal domain.

A third weakness is that of falling under the spell of irrational ideologies and slogans related to conservation, with overbalanced emphasis on one aspect. Thomist-Marxist-Keynesian anti-usury bias often takes sway. It dovetails nicely with the needs of monopolists, and makes the slowest, least enterprising policy seem the height of "efficiency" while an economical sense of urgency appears the most unseemly myopia and greedy fast-buck profiteering.

Minerals in the earth have some unique economic traits. Unlike other land they disappear with use into the sink of time. And they originate in the limbo of future time, unknown and unowned.

Each trait poses tax problems and has solutions. Countervailing taxes on property value and on severance assure an economical timing of extraction; countervailing pre- and post-discovery taxes on in situ property values assure a correct timing of discovery. Even the political problem will be soluble when economists arrive at a working consensus among themselves and offer the world consistent counsel.


ENDNOTES

[44] Professor Kahn has earlier noted this irony (26, p. 297).

[45] President Kennedy's budget message of January sg6 urged blocking "the deduction of foreign development costs . . . to reduce the U.S. tax on their domestic income," Foreign taxes are credited in full against U.S. taxes —i.e., not simply deducted from taxable income but from the taxes themselves. See Philip Stern (40, p. 30).

[46] Unlike a mortgage, the tax involves no repayment of principle. It corresponds to the interest on a perpetual loan.

[47] "One hundred years ago, land at the heart of the Comstock Lode sold for $10,000 a foot, but dropped off sharply. 'The remarkable descent in value of mining land was attributed to the fact that the Gold Hill miners recognized that the bonanza ore body's chances for extension into adjoining ground became increasingly less likely with greater distance from the center'" (Milwaukee Journal, November 15, 1964, citing the Appraisal Journal [34].)

[48] "In difficult territory like Holland a gas feeder line averages $250,000 per mile (5 p. 97). In the Louisiana swamps it is $350,000 per mile (4). The Gulf of Mexico and the North Sea are also difficult territory. In the aggregate, line and other hauling costs are comparable to exploration costs. An important social cost of pipelines in settled areas is their propensity to leak and explode. The FPC attributes 64 deaths and 222 injuries to this cause from 1960 to 1965. As higher safety standards are enforced the monetary cost per mile will no doubt tend to rise.

[49] "The precise detail of how to administer this policy is not supplied here, and needs to be worked out. From Figure C.4B it is evident that some of the detail could be interesting, because resources assume a value even when still submarginal for present use.

[50] See Parker v. Brown 317 U.S. 341, 6 S. Ct. 307 (1943) (36). I am indebted to Stanley Hack, Attorney, for calling this to my attention.

[51] The program at bar was the California Agricultural Prorate Act, originally of 1933.

[52] California's East Wilmington field off Long Beach was held back until 1965, by which time it had become "the richest known untapped field in the world, and by all odds the most handily situated..." (Business Week [5, p. 36]). There were special reasons — but aren't there always? In Alberta, which owns most of its own mineral rights, land-disposal policy and production limitations are completely integrated into one system.



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