Why taxing gas profits is harder than it looks

Australia is one of the world’s largest producers and exporters of liquefied natural gas (LNG). But in the years since the LNG boom some projects have generated enormous revenues while paying little or no tax via the Petroleum Resource Rent Tax (PRRT).

This has led to calls from across the political spectrum for reforms to how Australia taxes gas – from changes to the PRRT, to a 25 per cent export levy, a windfall profits tax, and even a government equity stake in gas producers.

For all the salience of gas specifically, much of this debate is really about a broader question: how should governments tax profits from natural resources?

That question, in turn, boils down to two narrower ones – should we tax revenues or what economists call ‘rents’, and if rents, how? These questions don’t have easy answers, but understanding why they matter, and what each possible answer entails, is critical to having a productive debate about the way we tax gas.

A useful starting point is to understand why we tax gas in the first place.

From an economic perspective there are two distinct motivations for taxing gas (over and above normal corporate taxation).

The first is ownership and rents. Australia’s natural resources belong to all Australians. Companies that extract and sell them should compensate the public for their use.

Some of what these companies extract is what economists call ‘rents’. In theory, the return on any investment includes both a ‘normal rate of return’ (the return that investors require to compensate them for deferring profits and holding risk), as well as a return above this rate. Economists call this surplus above the normal rate an ‘economic rent’. Tax theory suggests taxing rents is an efficient approach to raising revenue as it doesn’t distort behaviour.

The second motivation is negative externalities. Gas combustion imposes climate costs that aren’t reflected in its price. However, in a market where gas is exported at a world price, an Australian-specific tax would do little to change what users pay, so it functions more to capture rents than address this externality.

This brings us to how Australia taxes gas production – royalties and rent taxes.

Historically Australia has taken two main approaches to taxing gas. The first is via royalties – a fixed cut of every dollar of gas revenue (or unit of output). This is how states tend to tax onshore gas and is similar in spirit to the proposed 25 per cent export levy.

If the goal is to compensate taxpayers for ownership, a revenue-based royalty appears a natural choice. The problem is that in the long run this would give Australians an inefficient return on their resources. By taxing only project upside, royalties deter some projects that would have otherwise gone ahead.

This forgoes both the private investment, and the public share of whatever profit it would have generated. Some may welcome this on climate grounds, but royalties are a blunt tool for this purpose, with a carbon tax or the Safeguard Mechanism better placed to deal with this concern.

This raises the question of whether there’s a more efficient way to tax gas, which is where rent taxes come in. The idea is that by just taxing the ‘rent’ component of profits, the public gets a return for its gas while not affecting investment decisions.

This sounds simple in theory, but it turns out to be difficult in practice. This leads us to the second question of how to tax rents.

Currently, the Federal Government taxes offshore gas projects via the PRRT (in addition to company tax). Understanding how the PRRT works helps reveal the challenges with taxing rents.

How does the PRRT work?

The PRRT is designed to tax unusually high profits from oil and gas projects (the rent component), while leaving companies with a normal rate of return to not dissuade investment.

In practice, it works by allowing companies to carry forward their unrecouped costs for a particular project (the teal bar in the chart below) – and to compound these costs at an ‘uplift rate’ (light blue). The idea is that the uplift rate mimics what the company could have earned by investing that capital elsewhere.

Initially, when the project starts earning positive profits (yellow bar), these are offset against the outstanding cost base. Once a project has earned enough to fully offset the uplifted cost base, a tax rate of 40 per cent applies to all further revenue (the red line).

In theory, this complicated setup achieves three things simultaneously:

1. 1. no distortion to the investment decisions
   2. genuine capture of economic rents including windfall profits
   3. no downside risk to the taxpayer.

But the PRRT has some issues – both perceived and real.

A key perceived issue with the PRRT is that tax revenue doesn’t always increase in line with gas profits, as we’ve seen over recent years. This is true, but by design.

The PRRT waits until a project’s profits have offset the uplifted economic cost of capital before taxing the surplus. This means that profits may spike before tax revenue does. Likewise, windfall gains increase the PRRT’s total take but do so by reducing the cost base faster and bringing forward tax revenue, rather than by the tax spiking in the year of the windfall.

Aside from concerns about which costs gas producers include in the base, a real issue with the PRRT is how the uplift factor is set (how big that light blue part of the bar should be).

In theory, it should represent a project’s true opportunity cost of capital. Get this right and the PRRT taxes only the component of profits representing economic rents. Set it too low and the tax dissuades investment. Set it too high and the cost base compounds faster than warranted, meaning the government collects too little tax revenue.

There’s some evidence that Australia’s uplift rates have historically been set too high. Currently, the uplift factor is set at the long-term government bond rate (LTBR) plus 5 per cent for the first 10 years of a project’s life, then a GDP factor afterwards. Prior to 2019 it was the LTBR plus 15 per cent for the first 10 years (with the changes in 2019 grandfathered for existing cost bases).

The problem of setting the uplift too high compounds, literally, as the size of the accumulated cost base grows. Large cost bases mean that even significant revenue increases can be absorbed against prior deductions without triggering tax.

Are there other options to tax rents?

An ideal rent tax would do what it says on the tin – tax rents, as simply as possible. In theory, this ideal is what’s called a symmetric cash flow tax, where the government takes a share of all net cash flows. At the start of the project, they subsidise upfront costs. When companies start making profits, they share in the benefits. This is the approach taken by countries like Norway.

In effect, the government becomes a silent equity partner in each project: sharing in both the upside and the downside. This symmetry means that the tax doesn’t change whether projects go ahead. In good years, taxpayers capture a share of the profits, and in bad years the government absorbs a share of losses.

The strength of this approach is that it lets the government tax rents without distortion, and without having to ever guess at an uplift rate. But this doesn’t come for free, and there are two concerns worth taking seriously.

The first is political. A government even appearing to take a stake in gas projects might look uncomfortably like playing business partner – not unlike the recent memes casting the Prime Minister as a cofounder. But in the case of a symmetric cash flow tax, the government would be a pretty appealing partner to many businesses, providing equity without any say in how the project is run.

The second concern is that symmetry means taxpayers are on the hook for two things: first, (a share of) upfront costs, and second, some exposure to the downside risk of project failure.

Ultimately, the key point is this: for a rent tax to raise revenue without distorting investment decisions, it must adequately deal with risk, rather than simply taxing the upside once it arrives. It can do this by the government sharing in the risk (via a symmetric tax). Or it can do this by compensating investors for bearing that risk alone via an uplift factor, which is difficult to accurately set.

So where does this leave us?

Any tax on gas production must choose between three things: distorting investment decisions (e.g. via royalties or export taxes), having the government bear downside risk (e.g. a cash flow tax), or finding a way to compensate investors for holding that risk instead (e.g. the PRRT’s complicated uplift factor).

Policies that appear to sidestep this trade-off usually don’t. The recently announced east coast gas reservation, to the extent it binds, is effectively an export tax combined with a subsidy for domestic gas consumers. Likewise, a windfall profits tax faces the problem of defining where normal profits end and the windfall begins (analogous to setting the PRRT’s uplift rate).

So how do we tax gas? The boring answer is that there’s no free lunch. If we decide simplicity matters more than efficiency, royalties may be a reasonable choice. If efficiency matters and we’re willing to accept downside risk, a symmetric cash flow tax is the better instrument. And if we want efficiency without that risk, we’re left holding the PRRT’s challenge over choosing an uplift rate.

Ultimately a productive debate is well served by being clear about which of these objectives is most important, rather than pretending we can have all three at once.