Taxing non-renewable resource extraction: for more transparency, fairness and sustainability
Essay submitted in October 2014 for the 2014 Amartya Sen Prize Contest on how illicit financial flows relate to global poverty and inequality.
Illicit financial flows are one of the symptoms of unharnessed globalisation. While trade and finance have become more and more international, with an accelerated rhythm since the end of the Cold War, governance has not kept pace and all states, including the most powerful, face the consequences of non-cooperative behavior and free ride, from other state entities as well as from non-state actors whose influence can exceed that of entire countries.
In the case of illicit financial flows, defined here as “all unrecorded private financial outflows involving capital that is illegally earned, transferred, or utilized, generally used by residents to accumulate foreign assets in contravention of applicable capital controls and regulatory frameworks” , they disproportionately impact poorer states with weaker administrative capabilities to enforce legislation or lead an equal dialogue with corporations that represent an overwhelming share of national income.
According to Global Financial Integrity , in 2011, about one trillion dollars escaped from developing countries in the form of illicit financial flows and since 2002, the total amount of outflows reached almost six trillion dollars. By comparison, for the same year 2011, official development aid (ODA) provided by all the members of the Development Assistance Committee (DAC) of the Organisation for Economic Co-operation and Development (OECD) was worth 134.6 billion dollars , a sum grossly six times smaller than estimated illicit financial outflows – which are by nature difficult to assess precisely.
Global Financial Integrity also states that 80 percent of illicit financial flows come from trade misinvoicing, i.e. the under-invoicing of exports or over-invoicing of imports in order to move money out of a country and escape local taxation or acquire safer or more profitable foreign assets. Considering the dominant weight of this technique, in search of a practical solution to diminish illicit financial flows, we shall, in the framework of this essay, limit our investigation to trade misinvoicing and therefore, focus on actors involved in international trade in developing countries.
The French economist Thomas Piketty, widely acclaimed for his book Capital in the Twenty-First Century, suggests that a solution to put an end to rising inequality within nations as well as between them could be the introduction of a global tax on wealth. Although he recognizes himself that such a move is at the moment “a utopia” , we shall see that a watered-down version of this tax lies within the realm of possibility and would be an effective instrument to curtail illicit financial flows.
Yet we shall first set some hypotheses for our proposal. One is that developing countries have a clear interest in fighting illicit financial flows and in consequence, they are ready to take necessary measures in this direction. Illicit financial flows are hard to tackle in isolation from other phenomena like corruption and some businessmen or government officials certainly benefit from the current situation. Nevertheless, we expect that pressure exerted by donor countries on the one side and local civil society on the other can force governments to act in the interest of the nation as a whole and not only of a few.
Second, the strong commitment of donor countries is essential. We have just mentioned that they can influence governments of nations damaged by illicit financial flows, but as they can be themselves the destinations of such flows and the countries of origin of multinational enterprises engaged in trade with developing countries, they have a role to play domestically. Because of their relative power on the international scene, they can also reach a third category of states that heavily rely on illicit financial flows at the expense of both donor and developing countries: tax havens.
Concerning multinational corporations based in state members of the DAC, we do not assume here that they are the main source of illicit financial flows – although some of them have probably been taking a active part in the process – but we argue that by disclosing more information about their economic activities in developing countries, they can make government officials and local business partners more accountable in front of their public opinions. Local communities may indeed legitimately wonder why payments declared by multinational enterprises sometimes do not match with government revenue.
For the purpose of this essay, we must consider the second condition as fulfilled because it is impossible to enforce any solution without the active support of donor countries. However, the first hypothesis needs to be further narrowed down to be possibly validated. The list of countries most hit by illicit financial flows actually shows a great variety in size and power with at its top China and Russia, representing together a third of the total (in flow for 2011 as well as cumulatively), and then states like Mexico, Iraq or Poland.
It would be very difficult to find a single solution which would be equally workable in such different countries and furthermore, having in mind the strength of governments in China and Russia, we can question whether in these states, illicit financial flows primarily result from weaker administrative capabilities. By way of compromise between feasibility, impact relative to GDP and nonetheless critical mass, we accordingly choose to limit our study to the top eleven countries of the list (with cumulative illicit financial flows exceeding 100 billion dollars) minus China and Russia which should be treated in a separate manner.
We shall therefore focus on Mexico, Malaysia, India, Brazil, Indonesia, Iraq, Nigeria, Thailand and South Africa, which stand together for another third of total illicit financial flows, calculated for 2011 or cumulatively. A common feature of these economies is the relatively high share of raw materials in their overall exports, with an average of 40% if we only take into account fuels and minerals for the year 2012 (see table 2 below). This element is important for our proposal because we declared earlier that we would focus on actors involved in international trade, and the relatively high level of concentration in extractive industries makes it an easier case for enforcement.
Our suggestion consists in introducing, where it does not exist, a tax on the extraction of non-renewable natural resources, in particular oil, gas and minerals. As Thomas Piketty convincingly argues, a tax is not only a way to raise revenue but also to gather and disclose information: calculating the tax base shows how much wealth is generated, collecting the tax shows how much of it goes to the community and redistributing its proceeds gives clues on the quality of governance and the level of fairness in a given society. Moreover, in the case of natural resources, taxes can improve sustainability by reducing the rate of depletion – higher costs of extraction will make part of the production unprofitable at current selling prices – or encouraging producers or consumers to seek more cost-efficient alternatives.
The extraction stage is probably the most appropriate for four reasons. First, as we have assumed that developing states have weaker administrative capabilities, taxes calculated at the moment of extraction are easier to monitor and less vulnerable to fraud  than for instance profit taxes, which by definition are calculated after transactions having taken place, with an increased risk of trade misinvoicing in the meantime. Second, depending on the mode of calculation – especially if volumes are considered instead of value –, they can provide more stable revenue for public authorities as they are less directly affected by the variability of world markets. Third, extraction activities alone, not to mention further steps along the value chain, create a lot of negative externalities with global and local impact, from greenhouse gas emissions (GHG) to increased exposure to toxic substances . Therefore, there is an economic and political ground for introducing a special tax regime for this sector. Last but not least, taxation at an early stage is more likely to be neutral between export and domestically oriented production, so that it is compatible with the rules of the World Trade Organization (WTO).
How should the tax be calculated? specific taxation seems to be a better option not only because it tends to make proceeds more foreseeable, but having in mind the compensating function of the tax for social and environmental costs, which rather result from production itself than from sales, it is more logical to retain a volume-based method. Ideally, the exact amount would integrate a GHG-related component, in a similar way as the European Commission tried – unsuccessfully – to reform the Energy Taxation Directive a few years ago . This would contribute to global efforts to fight against climate change while at the same time not overburdening developing countries since additional costs would be passed on to industries and eventually to Western consumers.
Scholars and experts from international organizations could advise national governments on how to determine an adequate level of taxation, taking into account market power of the exporting country and international competition, negative externalities and effects on other sectors of the economy – dimishing margins in extractive industries may help the country avoid the so-called “Dutch disease” and diversify the economy.
Although we have already largely reduced the geographical scope of our analysis, it remains nonetheless still too wide for us to be able to provide concrete figures since market conditions significantly differ for each commodity and some of them even show regional peculiarities. In any case, according to the International Monetary Fund (IMF), there is still a lot of potential to harness in raising revenue from extractive industries, especially in developing countries .
Tax collection, while facilitated by the proximity to the source and the physical nature of extraction, can still be challenging for states with weaker administrative capabilities. Here again, technical cooperation in partnership with more experienced national administrations and international organizations has an important role to play in exchanging and implementing best practices in the realm of resource production and export audit and more generally tax administration. Strengthening fiscal capacity is usually acknowledged as one of the most cost-effective instruments of development policy to ensure state control over a country, make it less dependent on foreign creditors or donors but also enhance quality of governance by increasing accountability of public authorities and supporting decentralization.
This is the point where our proposol goes beyond existing projects such as the Extractive Industries Transparency Initiative (EITI). Indeed, though both ideas are based on similar assumptions, the first and most striking limit of EITI is that only two countries of our sample are considered as “compliant” (Iraq and Nigeria), with a third having a candidate status (Indonesia). More fundamentally, EITI reports published up to now do not mention where the money collected by the government goes. For Nigeria, the lack of data expressed in volume makes it difficult to know whether the nation really receives all the benefits from underground resources, as government and company figures can match while a part of the production is left outside statistics or misinvoiced.
In our view, one of the core principles of the EITI, i.e. the reconciliation by an independent auditor of data provided both by governments and companies, should be maintained: it is the main trust-building measure of the programme. The EITI standard should at the same time extend “upstream” by disclosing physical resource streams – also important from a sustainable development point of view – and “downstream” by showing what the rent is used for.
There are therefore complementarities to be sought between EITI and other initiatives more focused on budget accountability such as the Open Budget Survey carried out by the International Budget Partnership . The wider publicity of EITI and its greater political weight, with the support of states like Norway and the United Kingdom as well as of major corporations of the extractive sector, could be a lever on developing countries to make their budgeting procedures more transparent and inclusive.
One may object that a tax on the extraction of non-renewable natural resources will have little effect on the link between citizens and public authorities because it would be mainly paid by big companies and not by a large group of taxpayers. However, keeping in mind in the framework of this essay the primary objective of curtailing illegal capital flight, we must concentrate on sectors and actors involved in international trade, which is not the case of the majority of employees or small businesses.
We find nevertheless that more transparent and inclusive decision-making procedures on how to distribute the proceeds of the tax could be a first step to enhance civic culture and show citizens that paying taxes can improve their well-being through the financing of public services like healthcare and education. This strenghthened sense of ownership may in turn make people more inclined to pay taxes with a broader base such as personal income tax, corporate income tax or value-added tax.
In situations where governments are reluctant to implement this kind of measure, foreign companies, with the support of political authories of their country of origin, may still have an influence by unilaterally disclosing payments they make to these governments. The adoption in 2010 by the United States of the Dodd-Frank Financial Reform and Consumer Protection Act and in 2013 by the European Union of a new version of the Accounting Directive has even turned country-by-country reporting and payment disclosure into legal obligations for extractive industries.
Implementing measures, at the moment hotly discussed, should make sure that data provided by companies respect certain technical standards to facilitate their manipulation by statistical offices or civil society organizations and be actionable. In parallel, technical cooperation and development policy should seize the opportunities offered by the big data revolution to strengthen statistical capacity in developing states and assist in the creation or building up of independent watchdogs – with the status of independent administrative institutions or non-governmental organizations (NGO) – in order to reap the full benefits of new disclosure obligations, investigate on possible capital leakages and empower citizens to hold their government accountable.
Toward consumers who will in the end foot the bill, companies might find useful to display how much they pay for this tax or to create a label on the model of what exists for fair trade. The goal is to gain public acceptance for higher final prices and to establish a link between what consumers pay – and the resources they use – and what goes to lower-income countries for their development. In the longer perspective, this might in turn change consuming behaviours in favour of more sustainable schemes, such as recycling or collaborative consumption.
We are aware of the limits of this essay, which addresses only a fraction of the illicit financial flows issue. The definition itself of this phenomenon is blurry, since it is often unclear where the boundaries lie between strictly illegal techniques and tax evasion schemes which respect the letter of the law but are unambiguously against its spirit. We have here chosen to retain only the narrower definition of illicit financial flows, but one should bear in mind that they can hardly be dealt with in isolation from a deeper reflection on how to adapt our tax systems to the second wave of globalization we are currently experiencing.
For instance, questions of tax information exchanges or control over flows with tax havens are common challenges for developing countries as well as richer nations. Yet as even these last have trouble in forcing tax havens to cease non-cooperative practices or even to disclose information, one can argue that less developed countries should in priority focus on what they have an influence on.
No silver bullet
This is one of the reasons we have concentrated on natural resources, even if they do not represent their whole economies not do they exhaust the issue of illicit financial flows. We have no pretention to proposing a silver bullet which would work for all sectors and tackle the entire mass of illegal capital outflows and aware of these limitations, we think that a tax on the extraction of non-renewable natural resources is the best compromise between political and technical feasibility, effectiveness in regard of the goal of curtailing illicit financial flows without endangering economic development, and social and environmental consequences.
One may notice that it is in line with general OECD policy recommandations for the future, according to which we should progressively shift from income taxes – be they personal or corporate – to “less distorsive taxes (e.g., on consumption, property or environmentally-related taxes)” . Although it does not mean that personal or corporate income taxes should be scrapped altogether, in the light of globalization and high mobility of financial capital and skilled workers, it is logical that in absence of an effective regulation system at the global level, nation states – which remain at the core of tax policy – should define tax bases that fall under their sovereignty.
A more social aspect is also pushing for a heavier taxation of capital. As Thomas Piketty convincingly argues, without major war or social conflict to reset the clock to zero and in a context of slow economic and demographic growth, capital incomes tend to rise faster than labour gains, thus perpetuating and even deepening inequalities between capital owners and those who are deprived of it.
This reasoning can be extended to the realm of natural resources, which is also a form of capital. The mere phenomenon of illegal financial flows precisely demonstrates that with no political action undertaken to limit the use or transfer of this wealth, economic agents who exert control over it will try to convert it into more profitable and durable assets, such as property or stocks, and to build rents for themselves with no or little gain for the rest of the community. In this scenario, the community can even experience a net loss because when fossil fuel is extracted from the soil, it ceases to be capital and is irremediably lost.
This is why it makes sense for nations to convert a large part of resource rents into long-term investments, so that the extracted capital remains productive, although in a different form. That logic is behind the creation of sovereign wealth funds, but re-investing part of the gains in programmes to develop “human capital” or new sectors of the economy can also be a viable strategy. We shall not give here very precise directions on how exactly the rent should be spent as this decision belongs above all to the political community which has sovereignty over the territory and its resources.
One final word should be said about international coordination. Although, in our assumption, it is possible to introduce such a tax in only one country – with probably a lower rate due to international competition –, it would be more advantageous for groups of countries to align their practices to limit the risks of offshoring business. Existing associations of producing states, such as the Organization of the Petroleum Exporting Countries (OPEC) or the Gas Exporting Countries Forum (GECF) could this way find a new raison d’être by acting not only as cartels but also as responsible organizations against illegal financial flows and environmental degradation.
– Daubanes, Julien, Saraly Andrade de Sá, “Taxing the Rent of Non-Renewable Resource Sectors: A Theoretical Note”, OECD Economics Department Working Papers, No. 1149, OECD Publishing, 2014.
– European Commission, Communication from the Commission to the European Parliament, the Council and the European Economic and Social Committee. Smarter energy taxation for the EU: proposal for a revision of the Energy Taxation Directive, COM(2011) 168/3, Brussels, 2011.
– International Monetary Fund, Fiscal Regimes for Extractive Industries: Design and Implementation, 2012.
– Kar, Dev, Brian LeBlanc, Illicit Financial Flows from Developing Countries: 2002-2011, Global Financial Integrity, 2013.
– OECD, DAC Members’ Net Official Development Assistance in 2012, http://www.oecd.org/dac/stats/tab01e.xls. Retrieved on 29 September 2014.
– OECD, Tax Policy Reform and Economic Growth, OECD Tax Policy Studies, No. 20, OECD Publishing, 2010.
– Pfeiffer, Michaela, Francesca Viliani, Carlos Dora, Managing the public health impacts of natural resource extraction activities. A framework for national and local health authorities (discussion draft), World Health Organization, 2010.
– Piketty, Thomas, Le capital au XXIe siècle, Seuil, Paris, 2013.