Download WA Iron Ore Royalty Analysis - Minerals Council of Australia

WA Iron Ore Royalty
Analysis
Minerals Council of
Australia
7 November 2016
Deloitte Access Economics Pty Ltd
ACN: 149 633 116
James Sorahan
Director – Tax
Minerals Council of Australia
Level 8, 10-16 Queen Street
Melbourne VIC 3000
Level 2
8 Brindabella Circuit
Brindabella Business Park
Canberra Airport
Brindabella ACT 2600
Tel: +61 2 6263 7000
www.deloitte.com.au
7 November 2016
Dear James
Western Australia iron ore royalty analysis
This report outlines the broad economic and budget effects of increasing a volumetric tax on
iron ore production in Western Australia.
Specifically, this report finds that:

Different taxes cause different degrees of damage to the economy. The type of tax under
review here would lift the production costs of some Australian iron ore producers without
affecting their domestic and foreign competitors. Its impact would see the Australian
economy eventually shrink by $2.9 billion a year as a result of a tax that raised $2.3 billion.

That said, because the tax would initially hit lower cost mines, some of that damage would
appear over time rather than immediately. If any higher cost mines were to be affected, the
effect on them could be more notable: the global iron ore market remains under pressure.

Moreover, while the damage to the economy would tend to ultimately be concentrated in
the Pilbara – Australia’s key iron ore producing area – the process of ‘horizontal fiscal
equalisation’ would adjust the distribution of Good and Services Tax (GST) to account for
WA’s additional mining revenue. The net effect would leave WA with something less than a
net $300 million of the total extra of $2.3 billion raised every year.

That is, the State hardest hit by the tax would eventually see little benefit from the revenue
it raised: over the longer term, Western Australia would ultimately suffer the majority of
the economic cost, while receiving only a small share of the benefit from additional
government revenues.

The amount of tax and royalties paid by miners as a share of their income has increased
steadily in recent years. This share reached 46.8% of income in 2013-14 as falling mineral
prices led to an increasing share of royalty payments.
Yours sincerely,
Chris Richardson
Director
Deloitte Access Economics Pty Ltd
Liability limited by a scheme approved under Professional Standards Legislation.
© 2016 Deloitte Access Economics Pty Ltd
Contents
Glossary ..................................................................................................................................... i
Executive Summary................................................................................................................... ii
1
Background ..................................................................................................................... 1
2
Setting the scene ............................................................................................................ 2
3
4
2.1
What does the literature say? ................................................................................ 2
2.2
2.3
The global iron ore market ..................................................................................... 3
Tax rates are rising – with royalties the key reason ................................................. 4
Royalties and additional rentals ...................................................................................... 7
3.1
The background ..................................................................................................... 7
3.2
The CGC effect – budget benefits get spread .......................................................... 9
CGE modelling............................................................................................................... 10
4.1
The headline numbers.......................................................................................... 10
4.2
Computable general equilibrium modelling .......................................................... 11
4.3
4.4
Inputs to the modelling ........................................................................................ 12
The economy-wide impacts of the tax .................................................................. 13
Conclusions............................................................................................................................. 16
Limitation of our work .................................................................................................... 17
Charts
Chart 2.1 : Marginal excess burdens of taxes for Australia ........................................................ 3
Chart 2.2 : WA iron ore export volumes and values ................................................................... 4
Chart 2.3 : Share of income paid in taxation – all minerals......................................................... 5
Chart 2.4 : Contribution of iron ore royalties to WA Government Budget .................................. 6
Chart 3.1 : 2015 royalty receipts ............................................................................................... 7
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Tables
Impact on economy and jobs (relative to where they’d otherwise have been) .......................... ii
Table 4.1 : Impact on economy and jobs (relative to where they’d otherwise have been) ....... 10
Figures
Figure 4.1 : The components of DAE-RGEM and their relationships ........................................ 12
Figure 4.2 : Decomposition of the change in real GRP............................................................. 14
Glossary
CGC
Commonwealth Grants Commission
CGE
Computerised general equilibrium
DAE
Deloitte Access Economics
DAE-RGEM
DAE – Regional General Equilibrium Model
DMP
Department of Mines and Petroleum
FIFO
Fly-in-fly-out
GRP
Gross regional product
GST
Goods and services tax
MCA
Minerals Council of Australia
MEB
Marginal excess burden
RSPT
Resource super profits tax
WA
Western Australia
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Executive Summary
Raising royalties on some iron ore miners would initially generate a net increase in revenues
for the Western Australian State Budget of around $2.3 billion a year.1
However, Australia is a federation, and under the Intergovernmental Agreement on Federal
Financial Relations the process of fiscal equalisation would gradually adjust the distribution
of the Goods and Services Tax (GST) to account for WA’s additional mining revenue. Western
Australia would still earn a share but, after allowing for the resultant loss in GST grants, the
net impact would be something less than a net $300 million a year.
That is, the budgetary benefit earned by Western Australia wouldn’t last. Yet whereas the
extra budgetary dollars would flow to the nation as a whole, the economic costs of poor
taxation would mostly hit WA – indeed, they’d disproportionately hit the Pilbara – and they’d
grow over time rather than shrink:

The tax take ratio, the amount of tax and royalties paid by Australian miners as a share
of their income, has increased steadily in recent times. This share reached 46.8% of
income in 2013-14 due to the increasing share of royalty payments. Royalty payments
now account for around half (22.8% of the 46.8%) contribution of mining companies to
Australia’s Federal and State government coffers (with the rest made up by company
taxes), having risen from 17.3% in 2007-08.

The nation had a tumultuous mining tax debate in 2010, but one of the few points of
broad consensus among economists was that royalties prematurely shortened the life of
otherwise viable mines, and discouraged investment in new mines that were otherwise
worthwhile to both miners and to society as a whole.

In fact most models of the relative efficiency of taxes – how much damage they do to the
economy – rank royalties as among the worst taxes in terms of the damage that they
cause to economies.
The net outcome is that, measured in today’s dollars, the modelling spelled out in this report
estimates that the annual cost to the economy of $2.9 billion is in excess of the amount of
revenue raised ($2.3 billion).
Impact on economy and jobs (relative to where they’d otherwise have been)
GRP deviation (% deviation)
Employment (% deviation)
Employment (persons)
Pilbara
WA
Australia
-4.8
-4.3
-2,900
-1.1
-0.5
-3,400
-0.17
-0.06
-7,200
Source: Deloitte Access Economics
In particular, the type of tax under review here would lift the production costs of some
Australian iron ore producers without affecting their domestic and foreign competitors, and
the modelling shows that the proposed changes would have a significant impact on the
1
Assuming an extra $4.75 a tonne charge on iron ore production from affected mines.
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Pilbara. Relative to where it would otherwise have been by then, the Pilbara economy would
be 4.8% smaller, with a 4.3% reduction in employment (some 2,900 jobs).
In fact the only part of the Australian economy that would be even harder hit than the Pilbara
is the iron ore mining sector itself. Once the impact of this additional tax was mature, then
iron ore mining would be 6.3% smaller than it would otherwise have been.
With lower returns, fewer projects would become viable, and marginal deposits in existing
mines may remain untapped – causing those mines to close sooner than they’d otherwise
have done. Over time, the imposition of this type of tax reduces the amount of iron ore
production relative to where it would otherwise have been, with flow on effects for the
sector and the economy more broadly.
Accordingly, a policy to raise royalties would lead to:

an improvement in net revenues available to the WA Government that wouldn’t last
(because Australia’s Federation would hand most of the extra taxes raised to the other
States, and also because such policies would – over time – lead more mines to close and
fewer to open, thereby slowly reducing the taxpaying potential of the sector being taxed
relative to what it would otherwise have been), but

costs that would last, with the relative burden of those costs rising over time, and being
felt most on the Pilbara.
To be fair, some of these costs would be slow to be felt. This tax would hit longer established
mines first, and longer established mines typically have the best iron ore deposits – which
means they also tend to be more profitable than average. That position on the cost curve
means this tax would initially mimic some of the effects of a higher profit tax, transferring
some profits from more profitable miners to taxpayers across Australia.
Yet today’s low cost deposits eventually become tomorrow’s marginal mines. It is at that
point in time that this tax would cause most damage.
And this is a tax on successful mines instituted after they became successful. That raises
issues of sovereign risk, because it leads to an effect on incentives:

On the one hand the perception of increased sovereign risk would weigh on future
investment potential.

On the other hand it would weigh on efficiency: if the best mines become the mines
most likely to be hit by an after-the-fact tax, then that blunts commercial incentives for
miners to be the best that they can be.
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1 Background
The Minerals Council of Australia (MCA) commissioned Deloitte Access Economics to prepare
a report which outlines the broad economic and government budget effects of increasing a
volumetric tax on iron ore production in Western Australia (WA).
The rest of the report is as follows:

Chapter 2 sets the context for the report. It provides a brief overview of the academic
literature on the effect of export taxes on the economy. It also outlines the current state
of the global iron ore market and the current contribution of WA’s iron ore miners to the
WA Government Budget.

Chapter 3 outlines the proposed change to the iron ore production rental charge and its
expected effect on government revenues.

Chapter 4 presents CGE modelling which details the range of effects arising from
increasing the iron ore rental rate applied to ore mined in WA from 25 cents to $5 per
tonne on each of the Pilbara, West Australian and Australian economies.
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2 Setting the scene
2.1 What does the literature say?
Economists have long known that taxes create distortions that hurt the economy – that each
dollar of revenue raised comes with a cost. Economists also know that some taxes generate
more harm than others 2.
This understanding has underpinned previous periods of tax reform, and it forms much of
the narrative around the current broader reform debate.
At the heart of those reform attempts was the preference to move from ‘bad taxes’ to ‘good
taxes’ – from taxes which do more damage to the economy to those which do less. The aim
is to raise the revenue required for government to achieve its goals while doing the least
damage to the economy.
While much can be said about the 2010 mining tax debate, there was a broad consensus
among economists that mining royalties cause relatively more economic damage than most
other types of taxation.
Royalties raise the cost of production, and they do not respond to changing profitability. That
creates a deadweight loss – benefits which are now unable to be claimed by society.
The resultant higher cost structure means that fewer projects are viable and marginal
deposits in existing mines may remain untapped. Over time, the imposition of this type of
tax reduces the amount of iron ore production relative to where it would otherwise have
been, with flow on effects for the sector and the economy more broadly:

Mining firms would hire fewer employees than they’d otherwise do because not as many
people are needed to operate the mines or to build additional production capacity.

Less activity in the mining industry would have flow on effects for other industries which
provide it with inputs such as the construction, manufacturing and business services
sectors.

This would also spread the pain across Western Australia (and the rest of Australia), as
many of these other affected businesses are located in other areas, as are some of the
workers operating in Pilbara mines.
Estimates for the size of this effect (known as the marginal excess burden (MEB)) were
prepared for the Henry Tax Review. They are shown in Chart 2.1. That modelling found that
the MEB for this tax is a relatively high 0.70. This means that for every additional dollar of
tax raised 70 cents of consumer welfare (a measure of household wellbeing) is lost.
(Chapter 4 presents the results of our own modelling of this, which shows a loss of 75 cents
of consumer welfare for every dollar that this tax would raise.)
2
Both the Henry Tax Review and Treasury’s Re:Think paper provide estimates for just ‘how bad’ certain taxes are
in the Australian context.
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For some context, we have also included estimates for MEBs for labour and capital income
taxes. The MEBs for both these taxes are 0.24 and 0.40 respectively, both considerably lower
than the estimates for mining royalties.
Chart 2.1: Marginal excess burdens of taxes for Australia
0.8
Cents of consumer welfare per $ of revenue
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
GST
Labour income tax
Corporate income tax Royalties and crude oil
excise
Source: KPMG Econtech
2.2 The global iron ore market
The global market for iron ore is exactly that – global. Foreign capital is needed to invest in
building the mines, while the production from the mines is sold onto a world market almost
entirely to foreigners.
This meant that, when global trends moved in our direction through the 2000s thanks to
China, this nation benefited from historically high prices and the significant investments in
increasing capacity in the sector.
More recently times have changed. Iron ore prices averaged US$162 a tonne at the top of
the cycle in 2011, but since then spot prices have declined notably.
Falling prices reflects the fact that, while Australia is a large player in the market, our iron ore
producers are largely price takers in a global market.
The fall in global prices reflects the twin negative forces acting in the market:

The substantial investments made in increasing capacity (both in Australia and overseas)
have lifted the supply of iron ore to the market.
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
At the same time, global demand – China – has not increased by a commensurate
amount.
China’s development model has relied heavily – and overly – on construction. But now it has
built too much, and it has relied too much on debt in doing so.
Acknowledging this, the Chinese Government is attempting to transition the economy away
from heavy industry (which relies on a lot of iron ore) towards a consumption growth model,
leaving the outlook for iron ore prices under pressure.
The chart below reflects how the changes in the global market are affecting WA. The chart
shows substantial increases in the volume of iron ore exports from WA (green bars).
However, while the amount of ore being shipped out has increased, the value of those
exports has actually fallen (blue line).
Chart 2.2: WA iron ore export volumes and values
$billions
Million tonnes
$80
800
$70
700
$60
600
$50
500
$40
400
$30
300
$20
200
$10
100
$
0
1999
2001
2003
2005
2007
Quantity (RHS)
2009
2011
2013
2015
Value (LHS)
Source: WA Department of Mines and Petroleum
In summary then, prices are already low and global pricing is competitive – a challenging
backdrop into which to boost an already inefficient tax.
2.3 Tax rates are rising – with royalties the key
reason
Falling prices (and hence profits) have not translated to lower rates of tax. As Chart 2.3
shows, the converse is actually true.
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The tax take ratio, the amount of tax and royalties paid by Australian miners as a share of
their income, has increased steadily in recent times. This share reached 46.8% of income in
2013-14 due to the increasing share of royalty payments.
Royalty payments now account for around half (22.8% of the 46.8%) of the contribution of
mining companies to Australia’s Federal and State government coffers (with the rest made
up by company taxes), having risen from 17.3% in 2007-08.
Chart 2.3: Share of income paid in taxation – all minerals
Source: MCA Tax Survey
Note: Data is for all of Australia, and covers all minerals.
The rising share of iron ore royalty payments can also be seen in the WA Government Budget
figures.

The amount of iron ore royalties paid to the WA Government has increased from
$465 million in 2004-05 to be around $4.0 billion in 2014-15 (as seen in Chart 2.4).

As a result, iron ore royalties accounted for 14.7% of all WA revenue in 2014-15, up from
3.3% in 2004-05.

In 2014-15 the WA Government received around $1,550 in iron ore royalties for each
resident of the State. This is almost seven times the $231 per resident received a decade
ago in 2004-05.
Overall, WA’s iron ore miners have contributed more than $27 billion in royalties to the WA
Budget over the last 10 years.
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Chart 2.4: Contribution of iron ore royalties to WA Government Budget
$billions
Share of total revenue
25%
$6
$5
20%
$4
15%
$3
10%
$2
5%
$1
0%
$0
Iron ore royalties
Share of total
Source: WA Department of Treasury; WA Department of Mines and Petroleum
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3 Royalties and additional rentals
3.1 The background
An 8 September 2016 release from the WA Department of Mines and Petroleum (see
http://www.dmp.wa.gov.au/News/Iron-ore-royalties-and-19354.aspx) headed Iron ore
royalties and additional rentals set out some useful background to the issues explored in this
report.
A full extract follows:
“Recent media reports have placed considerable focus on WA’s iron ore royalties
and additional rental payments.
In 2015 the Department of Mines and Petroleum (DMP) collected $5.2 billion in
royalties from mineral and petroleum producers in Western Australia, and
almost three-quarters of this was from the iron ore industry.
Western Australia has a three-tiered royalty system. The royalty rate depends on
the level of processing and the form in which a mineral is first sold – 7.5 per cent
for ore, 5 per cent for concentrate and 2.5 per cent for final form. All iron ore
companies pay royalties at 7.5 per cent. However, if the iron ore is concentrated,
the rate is 5 per cent. Based on recent prices of A$60 per tonne, iron ore royalty
payments equate to $4.50 a tonne or $3 a tonne for concentrate.
Chart 3.1: 2015 royalty receipts
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“Iron ore producers are also required to pay an additional rental of 25 cents per
tonne on their mining lease after 15 years of production on a mining lease. This
charge is specific to iron ore producers and originates from the 1960s when State
Agreements were introduced for operations in the Pilbara. The additional rental
provided a mechanism for the Government to recoup some of its investment in
infrastructure in the region. It was later incorporated into the Mining Act and
now applies to all iron ore producers after 15 years. At present three companies,
Rio Tinto, BHP Billiton and Cliffs Natural Resources Pty Ltd, pay the additional
rental.
In 2015 DMP collected $120 million in additional mining lease rental from iron
ore producers in Western Australia.”
That is, under the Mining Act 1978, iron ore miners are required to pay a production rental
charge of 25 cents for each tonne of iron ore produced from mines once the mine has been
in operation for at least fifteen years.
One potential policy which has received publicity of late would see this charge increase from
25 cents to $5.00 per tonne. Given that the Department of Mines and Petroleum (DMP)
indicates that the current charge of 25 cents a tonne raised some $120 million in 2015,
Deloitte Access Economics estimates that this change would raise an additional $2.3 billion a
year in revenue3.
To the extent that the mines affected are lower cost, some of the effects of this would initially
mimic a rent tax, transferring some profits from miners to taxpayers without a major impact
on behaviour.
However, the type of tax under review here would lift the production costs of some
Australian iron ore producers without affecting their domestic and foreign competitors.
Moreover:

The quality of mineral deposits tends to decline over time as the mineral is mined, making
any given mine more marginal. That means this tax would tend to become more
damaging over time for any individual mine (as that mine ages and its relative costs rise).

And, over time, more and more mines will be covered. This would see the additional
charge placed on more marginal mines, thereby increasing costs.

It would also lift the production costs of some Australian iron ore producers without
affecting their domestic and foreign competitors.

Ultimately, the imposition of this additional tax would reduce mining production and
with it the number of jobs required to operate the mines.

Finally, because of the Commonwealth Grants Commission (CGC) process, Western
Australia will not actually benefit all that much from the additional revenue.
3
The proposal sees an additional $4.75 a tonne charged only on mines operated by BHP Billiton and Rio Tinto.
Deloitte Access Economics has assumed that this additional charge would apply to all other iron ore producers in
WA when their mines meet the criteria currently set out in section 28(A) of the Mining Regulations 1981. As of
today, Cliffs Resources is the other producer who pays this additional rental charge. That said, the specific
operations affected would depend on the detail of any legislation that were to ultimately pass Parliament.
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3.2 The CGC effect – budget benefits get spread
That last point is worth setting out more fully.
Australia is a federation founded on the basis that citizens across the nation should have
access to the same level of government services irrespective of where they live. This system
is maintained through the distribution of revenues from the goods and services tax (GST)
with States that have greater means to provide services for their citizens receiving a lower
share of the GST funding pool than States with less capacity to provide services.
As part of this system of fiscal equalisation, any increase in revenues obtained by the WA
Government from raising taxes on iron ore production would effectively be distributed across
the other States and Territories by reducing the amount of GST funding that WA receives and
increasing the GST provided to other States.
This process of horizontal fiscal equalisation already sees the WA Government receive a
fraction of the GST payments it would otherwise receive on a per capita basis, in large part
due to the additional revenue raising capacity of the State from mining royalties.
The CGC is the body which makes this assessment each year based on the revenue raising
capacity (and cost of providing public services) of each State and Territory over the previous
three years in its determination.4
When the combined effect of the additional revenue raised under this type of proposal and
GST distribution are considered, then the total revenue impacts are not large.
In net benefit terms, WA would only be better off by about 11% of the additional tax it raised
(the difference between the State’s share of national iron ore revenue and its population
share). That would be something less than $300 million a year.
So whereas the previous section noted the long-lasting economic costs of such a policy
change, this section notes that the benefits – mostly a share of extra tax revenues – would
fade over time.
Western Australia could try to avoid such an outcome through two different channels:

Within the ordinary processes of the CGC, it could try to argue that – as effectively the
only State in Australia with iron ore mines – it was increasing its “revenue effort”, and so
should be allowed to hold onto more of the revenue in question.

Or it could appeal directly to the Federal Government, arguing that the revenue from the
increase in this tax should be quarantined from the ordinary processes of the CGC.
That said, the expected outcome would be that Western Australia would bear the ongoing
economic cost of the policy, but ultimately would not receive all (or even most) of the
increase in revenue.
4
2017 GST Distribution Model.
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4 CGE modelling
4.1 The headline numbers
This chapter presents the results of Deloitte Access Economics’ CGE model which has been
used to examine the economy-wide impacts of the proposed tax change on the Pilbara
region, Western Australia, and Australia.
These impacts are evaluated over the medium to longer term – that is, the phase in which
the mines affected by this tax are broadly representative of iron ore mines across the Pilbara
as a whole. That could occur either because those mines first caught up in the new tax
become marginal over time, or because other iron ore operations pass the 15 year threshold
for coverage by the tax.
The modelling shows that the proposed changes would have a significant impact on the
Pilbara. Relative to where it would otherwise have been by then, the local economy would
be 4.8% smaller, with a 4.3% reduction in employment (some 2,900 jobs).
In fact the only part of the Australian economy that would be even harder hit than the Pilbara
is the iron ore mining sector itself. Once the impact of this additional tax was mature, then
iron ore mining would be 6.3% smaller than it would otherwise have been.
The contraction in the Pilbara’s economy is much starker than that seen in the rest of the
State but, on the whole, Western Australia is also worse off. Over the medium to long-run,
Gross State Product (GSP) is 1.1% lower and employment is 0.5% lower than it would
otherwise have been (some 3,400 jobs).
Much like the rest of Western Australia, the impact on the Australian economy is smalleriron ore is huge for the Pilbara, but less so for the nation as a whole. Australian output is
projected to be 0.17% smaller, while there would also be 0.06% fewer employed persons
(some 7,200 jobs).
Table 4.1 below shows the headline results from this modelling.
Table 4.1: Impact on economy and jobs (relative to where they’d otherwise have been)
GRP deviation (% deviation)
Employment (% deviation)
Employment (persons)
Pilbara
WA
Australia
-4.8
-4.3
-2,900
-1.1
-0.5
-3,400
-0.17
-0.06
-7,200
Source: Deloitte Access Economics
Measured in today’s dollars, that says the annual cost to the economy of $2.9 billion is in
excess of the amount of revenue raised ($2.3 billion).
The cost arises due to the reduction in production and investment related to the higher tax
(section 2.1). Deloitte Access Economics estimates that for every dollar of additional revenue
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raised from the proposed increase in iron ore rentals, consumer welfare (consumption) falls
by 75 cents.
(Chart 2.1 earlier presented estimates for the MEB associated with mining royalties prepared
for the Henry Tax Review. That modelling found that the MEB for royalties was a relatively
high 0.70. Our modelling finds a slightly higher impact, at 75 cents.)
Because consumption accounts for around 60% of the Australian economy, this translates to
a loss in output in excess of the amount of revenue raised.
(That is, $2.3 billion in revenue raised multiplied by the MEB of 0.75 divided by the share of
the economy made up by household consumption of 0.6 equals an output loss of $2.9 billion.)
The fall in national income is smaller, at $1.2 billion a year.
Importantly, the results presented in this chapter reflect the estimated impact of the policy
change over the medium to long-run.
The initial impacts of this tax are more like a resource rent tax, because the additional charge
is mostly applied to lower cost iron ore deposits. This means that the increase in the rental
rate would be less harmful in the short term than in the longer term results presented here.
4.2 Computable general equilibrium modelling
A change (or shock) in any part of the economy has impacts that reverberate throughout the
economy as a whole. For example, in the current context, the proposed changes to Western
Australia’s taxes (the shock) would result in a reduction in mining output and a reduction in
economic activity in associated sectors in Pilbara, as well as lower consumer spending
associated resulting from lower wages and less employment.
The project utilises the Deloitte Access Economics’ – Regional General Equilibrium Model
(DAE-RGEM). DAE-RGEM is a large scale, dynamic, multi-region, multi-commodity CGE model
of the world economy with bottom-up modelling of Australian regions. DAE-RGEM
encompasses all economic activity in an economy – including production, consumption,
employment, taxes and trade – and the inter-linkages between them. For this project, the
model has been customised to explicitly identify the Pilbara economy, including some of its
unique economic characteristics.5
Figure 4.1 is a stylised diagram showing the circular flow of income and spending that occurs
in any particular region of DAE-RGEM, excluding inter-regional interdependences:

To meet demand for products, firms purchase inputs from other producers and hire
factors of production (labour and capital).

Producers pay wages and rent (factor income) which accrue to households.
5
Australia has been divided into three regions: Pilbara, Rest of Western Australia and Rest of Australia. With Rest
of the world and these three Australian regions, the DAE-RGEM divides the world into four regions and solves like
any other dynamic, multi-sectoral global CGE model. The model is calibrated using Deloitte Access Economics’ inhouse database developed from the GTAP database v9 and ABS data.
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
Households spend their income on goods and services, pay taxes and put some away
for savings.

The government uses tax revenue to purchase goods and services, while savings are
used by investors to buy capital goods to facilitate future consumption.

As DAE-RGEM is an open economy model, it also includes trade flows with other
regions, states, and foreign countries.
Figure 4.1: The components of DAE-RGEM and their relationships
The model compares a baseline scenario where the proposed tax change doesn’t occur with
a counterfactual scenario where in addition to what happens in the baseline scenario the tax
change does occur.
That is, as noted above, the losses to the economy and to jobs don’t mean – for example –
that there is a loss of 4.3% of all the jobs in the Pilbara, but that there are 4.3% fewer jobs in
the Pilbara compared to what is projected to occur in the absence of the tax increase.
The difference between outcomes of the two scenarios gives the projected impact of the
policy change. It is assumed that the proposed tax applies to all iron ore mining activities
irrespective of their ages.
More detail on the modelling framework used is provided in Appendix A.
4.3 Inputs to the modelling
The key difference between the scenario discussed here and the baseline is the proposed tax
change. This is initially modelled as a $2.3 billion increase in the revenue collected by the
Western Australian government through changes to a production-based royalty on the
output of the iron ore mining sector. That then converts to an equivalent cost per unit of
natural resource production thereafter.
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The majority of West Australian iron ore operations occur in the Pilbara, and so the modelling
assumes the majority of the revenue comes from this region.
Yet there would also be effects in other regions in Australia:

The use of fly-in-fly-out (FIFO) workers in the mining sector would spread the effect
of reduced employment over other regions in WA, as well as to some other States.

Additionally, headquarters for the affected companies are located elsewhere in
Australia such as in Melbourne. This would also spread some of the economic cost
to other States.
4.4 The economy-wide impacts of the tax
As highlighted in Chart 2.1, royalties are among the more damaging taxes to the economy.
This is borne out by the CGE modelling discussed here, which shows strong negative impacts
from raising production-based royalties.
But it is worth stepping through the logic of this and what is driving these changes, because
doing so showcases some of the key issues to consider with this tax change and how taking
different views on these issues can produce quite different outcomes.
As a back-of-the-envelope calculation, economists use MEBs and multiply them by the
revenue raised to get a dollar loss in consumption (or GDP, if that is how the MEB has been
measured).
Relying on MEBs alone, however, may understate the potential economic impacts, because
they are primarily concerned with what economists call ‘allocative efficiency’.
This is fine in a static environment. In a dynamic environment, however, you also need to be
aware of the possible impact the policy change can have on the supply of factors (labour,
capital and natural resources)) and the productivity environment in which the (additional)
factors will be employed, including the possible impact on the terms of trade and other
international transfers.
Figure 4.2 (below) shows how the impact on both the Pilbara and WA as a whole is
apportioned between allocative efficiency, factor supply and technical change.
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Figure 4.2: Decomposition of the change in real GRP
Note: This is the total effect over the medium to long-term. In the short term, the allocative efficiency effect
dominates but this effect diminishes over time and the factor supply effect dominates the total effect of the
policy change.
As has been highlighted in Chapter 3, the tax change will drive up the cost of producing iron
ore but, in the short term, the increased cost of production for the affected operations may
not be significant enough to shift the aggregate cost of production in the Pilbara or WA. It
could simply reduce the rents of those mines.
Unfortunately though, iron ore is in relatively fixed supply, and as production goes on the
operations will become more marginal, meaning the tax will increasingly start to ‘bite’.
Two further factors are worth noting:


World buyers of our iron ore would bear a small share of the pain of the tax: Australia’s
terms of trade increases slightly due to the imposition of the tax. This is because
Australian producers have a minor impact on pricing in the iron ore market.6 A portion
of the higher domestic price of production is transferred onto the world market, which
shifts up the price of iron ore and with it the price of Australia’s exports relative to
imports. However, the income effect is less than the volume effect, which results in an
overall loss.
Foreign shareholders bear some of the pain of the tax – though this would have a
dampening impact on future investment: Additionally, foreigners lose out as well, as
they have a stake in Australia’s mining assets. While this cushions the impact on
6
Remember that our results reflect the mature case – when the mines affected by the extra tax are representative
of the sector in WA as a whole. That could occur either because those mines first caught up in the new tax become
marginal over time, or because other iron ore operations pass the 15 year threshold for coverage by the tax.
Accordingly, a portion of the world’s marginal mines would – by that stage – be hit by the tax. Because miners
have to make sufficient return on their capital for it to be worthwhile for them to be in business, then prices have
to be higher. After all, costs (in this case, taxes) are higher.
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domestic incomes initially, there is some risk in increasing taxes on foreigners as in the
long term this may impact on future investment decisions, leading overseas investors to
invest elsewhere.
The shock results in less foreign investment than would otherwise be the case. This is part of
the reason for the loss in gross regional product (GRP); as there is less capital to work with,
meaning lower potential output. Also, less capital per workers means they are less
productive and will receive lower wages. However, lower foreign investment also means
lower foreign debt and lower interest (or dividend) payments to overseas.
Consequently, the loss in gross national income (GNI, at $1.2 billion a year in today’s money)
is less than the loss in GDP (at $2.9 billion a year in today’s money) resulting from the
proposed increase in the production tax rate applied on iron ore mining.
That said:

Given how large the reduction in the economy is, there is still a very large loss of national
income relative to the size of the tax.

And, looking ahead, there’s further damage that the model doesn’t pick up. As the
proposed tax simply gathers some existing mines up into the tax base straight away, that
sees the tax taking an additional share of existing successes.
Like most taxes with a retrospective impact, this latter feature of the proposed tax would
boost perceptions of ‘sovereign risk’ in Australia.
In turn, that would tend to reduce foreign investment over the longer term by more than the
model is assuming.
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Conclusions
This report outlines the broad economic and budget effects of increasing a volumetric tax on
iron ore production in Western Australia.
It finds that:

Different taxes cause different degrees of damage to the economy. The type of tax under
review here would lift the production costs of some Australian iron ore producers
without affecting their domestic and foreign competitors. Its impact would see the
Australian economy eventually shrink by $2.9 billion a year as a result of a tax that raised
$2.3 billion.

That said, because the tax would initially hit lower cost mines, some of that damage
would appear over time rather than immediately. If any higher cost mines were to be
affected, the effect on them could be more notable: the global iron ore market remains
under pressure.

Moreover, while the damage to the economy would tend to ultimately be concentrated
in the Pilbara – Australia’s key iron ore producing area – the process of ‘horizontal fiscal
equalisation’ would adjust the distribution of Good and Services Tax (GST) to account for
WA’s additional mining revenue. The net effect would leave WA with something less than
a net $300 million of the total extra of $2.3 billion raised every year.

That is, the State hardest hit by the tax would eventually see little benefit from the
revenue it raised: over the longer term, Western Australia would ultimately suffer the
majority of the economic cost, while receiving only a small share of the benefit from
additional government revenues.

The amount of tax and royalties paid by miners as a share of their income has increased
steadily in recent years. This share reached 46.8% of income in 2013-14 as falling mineral
prices led to an increasing share of royalty payments.
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Limitation of our work
General use restriction
This report is prepared solely for the internal use of Minerals Council of Australia. This report
is not intended to and should not be used or relied upon by anyone else and we accept no
duty of care to any other person or entity. The report has been prepared for the purpose of
providing the Minerals Council of Australia with analysis and modelling of the global market
for iron ore and the effect of increasing iron ore rentals from 25 cents to $5 on the Pilbara,
Western Australian and Australian economies. You should not refer to or use our name or the
advice for any other purpose.
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