Clipping the Wings of Eagles: Artificial Impediments to Mining and Minerals Processing in Australia

INTRODUCTION

For decades, politicians, industry leaders and senior public servants have bemoaned the limited amount of minerals and energy processing undertaken in Australia.  Advocacy of more local processing in order to "add value" and increase income and employment in Australia has become very common in recent times as public figures have become increasingly concerned and outspoken about Australia's poor economic performance and current account deficit.

It is not surprising that processing has been seen as a potential major source of new economic activity in Australia.  After all, Australia is blessed with abundant world-class mineral and energy resources, has a substantial infrastructure base and is politically and socially stable.  Yet Australia's potential comparative advantage in minerals and energy processing has not been fully exploited.  Performance has fallen far short of expectations.

The continuing complaints about Australia's underperformance as a processor stand in stark contrast to the widespread smugness regarding the performance of the mining sector.  Governments, and those whose views mould public opinion, have become complacent because Australia is a low-cost producer of mine products by world standards.  Is this complacency justified, or has the underperformance of the mining sector been masked in some way?  Available evidence indicates the latter.  Although Australia has some outstanding mines, the return on aggregate exploration and mining investment in Australia has been no better than the national industrial average.

Two important questions need to be answered for policy purposes.  First, have "artificial impediments" arising from past government policies and neglect been primarily responsible for the poorer profitability of the mining industry overall and the smaller amount of mining and processing than resource endowments indicate is possible in Australia?  Alternatively, is Australia's underperformance explained mainly by various "natural disadvantages" that offset favourable resource endowments?  Second, if "artificial impediments" have inhibited mining and processing in Australia, what policy measures should be implemented to correct the situation?

Australian governments have created a multitude of artificial impediments to mining and minerals/energy processing and other potential high flyers in Australia.  These impediments are side-effects of their numerous interventions in economic affairs to achieve other purposes.  Governments have created further artificial impediments by sheer neglect.  Artificial impediments falling into one or both of these categories include poor tax system design;  protection and "special incentives" for other industries;  inefficiencies in transportation systems and energy supply for which governments are responsible;  labour market regulation;  overzealous environmental protection measures;  flawed macroeconomic policies;  and government-induced uncertainties.

Even more perverse is the fact that the government authorities whose rhetoric most favours mining have created a major artificial impediment in the form of an exploration and mining tenement system which is nearly uniform across Australia and characterised by bureaucratic direction and discretion.  This system has induced uncertainties and substantial misallocation of resources that have further frittered away the potential economic surpluses arising from Australia's comparative advantage in mining.

The various artificial impediments have clipped the wings of potential high-flying industries such as mining and processing, turning soaring eagles into common chooks scratching out an existence in a barren fowl yard, and causing national income and economic growth to fall well short of their potential.

The silliest aspect of this economic cruelty is that it is self-inflicted, not out of masochism, but through sheer ineptitude.  Artificial impediments are the national equivalent of "shooting oneself in the foot".  Both are self-inflicted, crippling and imply bumbling ineptitude.

This paper does not discuss every artificial impediment to mining and processing in Australia:  that would require a very large paper indeed.  Instead, it focuses on a limited number of artificial impediments that do not appear to have been sufficiently exposed and indicted by politicians, other public figures, the media and economic commentators who collectively mould public opinion.  The paper concludes with a package of policy measures designed to deal with these impediments.

The key to improving Australia's underperformance in the exploitation of its mining and processing potential is not the common proposal of "special incentives" for mining and processing activity.  "Special incentives" mask the symptoms of the underlying economic malaise and create additional burdens (more artificial impediments) for others to carry.  "Special incentives" to some industries are artificial impediments to others.  The answer is to remove swiftly and decisively the basic causes of underperformance and economic malaise:  existing artificial impediments.

THE CONCEPT AND IMPORTANCE OF ARTIFICIAL IMPEDIMENTS

DEFINITION OF ARTIFICIAL IMPEDIMENTS

Australia's underperformance in exploiting its mining and mineral/energy processing potential can be attributed to various "barriers".  These fall into two broad categories:  natural disadvantages and artificial impediments.

Natural disadvantages are not of our making and cannot be changed.  We just have to cope with them or surmount them.  Australia's remoteness from overseas markets is a natural barrier to mining and minerals processing in Australia.  The remoteness of most of Australia's major mining centres from local markets and major population centres is an example of a natural barrier to mining and processing in remote areas.  Another example of a remote area natural disadvantage is the fact that the climate in most of Australia's major mining centres is not appealing to many people.

Artificial impediments arise from government action or inaction.  They can be removed by governments.

Artificial impediments induce producers to alter otherwise efficient input mixes, production methods and locational decisions.  That is, artificial impediments cause production inefficiencies in the economy.  The result is that outputs in adversely affected industries and the economy as a whole will be less than they could be.

Artificial impediments involve government action or inaction that discriminates against particular types of economic activity or locations without valid economic reasons.  Well-designed government measures that discriminate against certain activities in order to improve efficiency by correcting market failure (excessive pollution, abuse of monopoly power, etc), are not artificial impediments.

In a perfect world, we could correct all inefficiencies in the economy that arise from market failure, and eliminate all government-induced inefficiencies.  As a result, everyone could be made better off.

In reality, some inefficiencies are inevitable.  Governments intervene to make the distribution of income and wealth more to their liking, to correct market failure and to stabilise the economy.  In the process, they may cause inefficiencies through distortions which arise from imperfect knowledge, poor selection of policy instruments and the impracticality of raising all the revenue they require from taxes and charges that do not distort economic decisions.

When there are numerous inefficiencies, as in Australia, we need to consider the possibility that removing an individual inefficiency by eliminating its cause may result in an overall reduction in economic welfare rather than an increase.  If a distortionary action by the government is the best way of avoiding a government measure that would cause a greater inefficiency (that cannot be avoided in some better way), removing the former distortion would do more economic harm than good.  For example, removal of one distorting tax may result in another tax rate being raised.  This could lead to a greater overall distortion.  Another example is that one distortionary government action may offset an inefficiency caused by some other government action.  Removing just one of these distortions may make matters worse, not better.

When the presence of constraints makes some important distortions inevitable, the aim should be to minimise aggregate inefficiencies subject to the various constraints.  Analysis of this type has become known as the economics of "second-best". ⁽¹⁾

In this paper, causes of production inefficiencies will be labelled as artificial impediments only when their removal will unambiguously lead to an improvement in economic welfare.

CHARACTERISTICS OF ARTIFICIAL IMPEDIMENTS

A common characteristic of artificial impediments is that they are unintended side-effects of government intervention or inaction.  Quite often, artificial barriers are not recognised, since their unintended effects are not perceived or understood.  For example, in the past, governments have often seen tariffs as devices to assist certain local manufacturing industries and to provide jobs.  They probably did not intend that others be adversely affected.  Furthermore, they probably failed to perceive the adverse impact that tariffs have on jobs and the level of activity in other industries, through their impact on the exchange rate, the wage structure and other costs.

Often, artificial impediments are described as "special incentives".  When public figures have presumed that Australia does not have enough of some sort of activity, they call for "special incentives" to encourage the expansion or establishment of that activity.  "Special incentives" can take the form of import tariffs and quotas, government subsidies in the form of grants of land and cash, special tax breaks, mineral royalty relief, and so on.

Unfortunately, "special incentives" to some industries are other industries' artificial impediments.  "There is no such thing as a free lunch".  Someone always has to pay.  Import protection for some industries imposes higher costs and a higher exchange rate on other industries.  A subsidy or special tax break for one industry means higher tax burdens, fewer benefits and/or more inflation for others in the economy.

Some artificial impediments may not be recognised as inhibiting economic activity because they arise from inaction by governments when action is warranted.  For example, there may be an uncorrected infrastructural deficiency in circumstances where improvements are economically justified.  Government failure to correct the deficiency would be an artificial impediment to economic activities that would use that infrastructure.  Because the economic activities do not materialise and the case for provision of the infrastructure depends on the existence of users, the artificial impediment may never be recognised.

RESPONSIBILITY FOR ARTIFICIAL IMPEDIMENTS

There is no doubt that numerous artificial impediments have combined to cause extensive underexploitation of mining and processing opportunities in Australia.  Remote area mining sites and potential remote area processing sites such as the Pilbara, the Kimberleys, north-west Queensland and the Northern Territory have suffered particularly grave artificial handicaps, accentuating the natural disadvantages of these locations.

Governments are responsible for these artificial impediments because their source is government intervention or inaction.  The Industry Commission made this very plain in its 1991 report on "Mining and Minerals Processing in Australia":

[T]he Commission is convinced that the potential of mineral resource-based industries -- in terms of the contribution they make to the Australian economy -- has yet to be realised. ... A major reason for this underperformance is that mining and early-stage mineral processing activities are hindered by numerous impediments.  The Commonwealth and State/Territory and local governments are largely to blame for this sorry state of affairs, however well meaning and apparently justified the intent of their myriad interventions. ... Stripping away unnecessary regulation and simplifying the remainder, combined with successfully addressing impediments in other parts of the economy which restrain mining (and processing), would dramatically improve the cost competitiveness of these industries. ... Importantly, acceptance of recommendations contained in this report should lead to more "value adding" activity being undertaken in this country. ... Current government policies toward mining and mineral processing are not "clever".  It is not clever to erect a whole range of impediments to one of the few activities in which Australia enjoys a clear comparative advantage. ⁽²⁾

Industries in which Australia has an actual or potential comparative advantage have had their wings clipped by governments.  Graceful, soaring, high-flying eagles have been transformed into common chooks scratching out an existence in a barren fowl yard. ⁽³⁾

The silliest aspect of this economic cruelty is that it is self-inflicted, not because of masochistic tendencies, but because of sheer ineptitude.  The artificial impediments created by government intervention and neglect are the national equivalent of "shooting oneself in the foot".  The muddled thinking of the head (governments) has seriously handicapped the body's (the economy's) ability to survive in the jungle of international competition by ineptly putting a bullet (artificial impediments) through its own foot (fleet-footed industries in which the economy has a potential comparative advantage).

THE SUBSTANTIAL AGGREGATE EFFECTS OF ARTIFICIAL IMPEDIMENTS

In the "Mineral Extraction" chapter of its report on "Mining and Minerals Processing in Australia", the Industry Commission concluded:

A wide range of government interventions affecting the "mining stage" of the process of producing saleable mineral outputs artificially alters the economics of mineral development, in the process unnecessarily imposing significant costs on the nation. ⁽⁴⁾

In the "Further Processing" chapter, the Commission indicated that artificial impediments were responsible for preventing potentially viable further processing of Australian raw materials in Australia. ⁽⁵⁾  In the "Conclusions" chapter, it stated that, taken together, the various artificial impediments represent a "substantial impediment to the efficiency, international competitiveness and further development" of mining and minerals processing, and stripping away these artificial barriers would "dramatically improve the ... competitiveness of these industries". ⁽⁶⁾

The Industry Commission attempted to quantify the impact of some artificial impediments to mining and mineral processing activity in Australia using a special version of the ORANI model of the Australian Economy, known as ORANI-MINE, which allows detailed attention to be given to matters affecting mining and minerals processing.  The impacts the Industry Commission studied were:  complete removal of assistance to manufacturing industries, a 25 per cent reduction in 1987 levels of agricultural assistance, removal of rail and sea transport impediments, and improved efficiency in electricity supply.

The Industry Commission found that this package of reforms would improve the competitiveness of Australia's mining and minerals processing industries sufficiently to induce substantial increases in output.  The Commission's estimates indicate that, in the long run, mining output would expand by 14.2 per cent, with sectoral expansions ranging from 7.8 per cent for iron ore up to 12.4 per cent for nickel ore, and 35.4 per cent for black coal.  In the long run, alumina refining would expand by 16.5 per cent, aluminium smelting would grow by 6.3 per cent, nickel smelting and refining would increase output by 12.6 per cent, silver, lead and zinc processing would grow by 11.8 per cent, other non-ferrous metals processing would expand by 7.3 per cent, and basic iron and steel manufacturing would increase output by 1.3 per cent. ⁽⁷⁾

Removal of artificial impediments to mineral processing is good for the economy as a whole, as well as for mining and processing industries in particular.  When the impediments take the form of featherbedding other industries, there will be losses in the feather-bedded industries as their "special incentives" are removed, but the economy as a whole will gain.  The nett effect of the reduction of artificial impediments, as estimated by the Industry Commission, was an expansion of Australia's Gross Domestic Product by over $11 thousand million per year in the long run. ⁽⁸⁾

Unfortunately, the Commission was unable to quantify the impact of many other artificial impediments, the removal of which it considered could lead to further substantial benefits to mining, minerals processing, and the economy as a whole.

WHY DOES PROCESSING APPEAR TO HAVE BEEN INHIBITED MORE THAN MINING?

The dismay expressed by many public figures regarding Australia's underexploitation of its potential as a processor of minerals and energy stands in stark contrast to a widespread smugness regarding the performance of Australia's mining sector.  This complacency is understandable because, by world standards, Australia is a highly efficient producer of minerals and primary energy commodities.  However, complacency is misplaced.  Australia's potential comparative advantage in mining has been frittered away substantially just as it has for processing.  The Industry Commission's findings, summarised above, confirm this point.  Indeed those results indicate that, in general, mining has been hit just as hard by artificial impediments as processing.  The underperformance of the mining sector has simply not been as noticeable.

Mining faces most of the same natural and artificial barriers as mineral processing, but the impact on processing has been much more noticeable.  The basic reason is that superior mining sites are better able to carry the burden of artificial impediments than potentially good processing sites.  Outstanding mineral deposits are very scarce but good mineral processing sites are much more plentiful.  Moreover, the "man-made" element is relatively much more important in determining a good processing site than a superior mineral deposit, while natural factors are relatively much more important in determining an outstanding mineral deposit than a superior processing site.  As a result, superior mineral deposits, such as the Pilbara iron ore deposits and Central Queensland coking coal deposits, attract much bigger long-term scarcity values (pure economic surpluses known as economic rents) than superior processing sites.

Artificial impediments tend to dissipate scarcity values that good mineral deposits or processing sites would otherwise have.  If a deposit or site doesn't have substantial advantages over the competition, the artificial barriers can render it unattractive compared with competing locations.  If a deposit or processing site is really outstanding, artificial barriers will reduce the size of (without completely eliminating) the economic surplus it can yield.  Really good mineral deposits are much more likely to survive the scarcity-value-dissipating effects of artificial barriers than superior processing sites, simply because the differential scarcity value of the better mineral deposits can be so much bigger.

Nonetheless, artificial barriers impose costs upon even the superior mineral and energy deposits.  The harm that artificial impediments do is manifested in the forms of higher cut-off grades, reduced mining depths, smaller reserves, shorter mine lives, lower outputs per period and reduced profitability.  The very fact that these superior mining opportunities continue to exist, albeit at performance levels below their potential, has tended to mask the effect of artificial impediments to a much greater extent than in the case of processing opportunities, which are more likely to be rendered completely uneconomic.  For example, this analysis helps explain why the Western Australian and Queensland Governments' desires for steel industries in their states have not been realised, despite their world-class iron ore and coking coal mining industries respectively.  It also helps explain why the Western Australian Government's dreams of a petrochemical complex based on the North-West Shelf Gas Project have not come to fruition.  The fact that Australia's base metals processing industries are struggling can be explained in the same way.

Similar reasoning explains why the handicapping of processing of agricultural, pastoral and mineral commodities has been more noticeable than the inhibiting of agricultural and pastoral activity.  Superior agricultural and pastoral lands yield economic rents which soften the impact of the artificial impediments.

SOME IMPORTANT UNDEREXPOSED ARTIFICIAL IMPEDIMENTS

Government intervention and inaction have produced a plethora of artificial impediments to mining and minerals/energy processing in Australia.  Because they are so numerous, it is not practical to deal with all of them in this paper.  Instead, attention has been focused on identifying and succinctly discussing some of the more important artificial barriers to mining and processing that have not been adequately exposed or condemned by politicians, business leaders, trade union spokesmen and economic commentators.

The recent resurgence of protectionist sentiment requires that import barriers be discussed in detail here.  Although the adverse effects of barriers to imports on the economy have long been understood and criticised by most economists, there are still some public figures and economists who defend their retention despite the considerable damage import barriers do to potential high fliers like mining and processing and to the economy as a whole.

The exclusion of some artificial impediments from detailed scrutiny in this paper should not be construed as implying that these artificial impediments are unimportant.  Even if individually the effects of some are not great, taken together they are still likely to matter.

Of course, some artificial impediments not discussed in detail here are very important.  Examples include inefficiencies in electricity and natural gas supply and pricing, inefficient government railway systems transporting minerals, overzealous protection of the natural environment and Aboriginal heritage, and the delays and frustrations involved in dealing with a multitude of different government agencies as part of the process of getting approvals for large projects.  However, impediments such as these are easily understood and are more controversial.  As a result, they have already been given considerable public exposure in recent times.  Therefore, they will not be dealt with in detail here.

The hotchpotch of distorting royalty and de facto royalty arrangements applying in Australia has been subjected to close scrutiny by various government inquiries and by academic economists over the past 16 years. ⁽⁹⁾  The discussion has frequently spilled over into the media.  Despite strong condemnation of these arrangements from many sources, most of the inefficiencies remain.  As a result of the substantial exposure already received by this collection of artificial impediments, they will not be subjected to further detailed examination here.  They will be discussed only as they relate to other impediments.

Mining and minerals/energy processing are not the only industries adversely affected by many of the impediments mentioned.  Many industries (existing and potential) are affected by at least some of them.  However, mining and processing enterprises tend to be particularly hard hit because they are (a) unable to shift the burden of the impediments to customers, because of exposure to international competition, and (b) burdened by such a wide range of artificial barriers, the number and intensity of which tend to be greater in remote areas.

The following artificial impediments will be discussed in detail:

1. taxes on intermediate inputs;
2. deficiencies in the income tax regime;
3. barriers to imports;
4. water transport inefficiencies;
5. high real interest rates;
6. labour market impediments;
7. exploration and mining tenure;  and
8. "sovereign risk".

TAXES ON INTERMEDIATE INPUTS

Intermediate inputs are produced goods and services that are used to produce other goods and services, as distinct from primary inputs or factors of production, such as land, mineral deposits, labour and capital.  When an intermediate input is taxed, the costs of using it in production of other goods and services will rise.  To the extent that the price of the other goods and services can be raised, part of the tax will be passed on to consumers/users of the other goods and services.  The rest of the tax will be borne by suppliers of factors of production to the industries using the taxed intermediate input and producing it.  The primary inputs used to produce the taxed intermediate input, industries using relatively more of the taxed intermediate input, and industries less able to shift the tax forward to consumers/users through higher prices will be hardest hit.  The supply of factors to those industries and output therein will contract relatively more.  Aggregate output in the economy will fall because of the less efficient use of primary and intermediate inputs in the economy. ⁽¹⁰⁾

Because they will tend to be price takers in world markets, export and unprotected import-competing industries have very limited prospects of shifting forward taxes on intermediate inputs to customers.  (These industries include mining and processing.)  So the primary inputs used by these industries will be hit relatively hard by wholesale sales taxes, import tariffs and fuel excises applying directly to their intermediate inputs or shifted forward in the prices of inputs.

The resulting reduction of the supply of factors to, and output of, these traded goods industries will induce a lower Australian dollar.  This will at least partly offset the contraction induced by the taxes on intermediate inputs.

Some inputs to mining and processing in Australia have been subjected to Australia's hotchpotch of wholesale sales taxes and taxes on transactions, but some have not.  For example, mining machinery and equipment and certain "aids to manufacture" are exempt from wholesale sales tax, but electricity generation equipment, road vehicles and office equipment are not.  Also, some mining and processing companies have been given stamp-duty exemptions for transactions and agreements associated with projects, but some have not.  All mining and processing activities bear intermediate input taxes in the form of financial institutions duties and debits taxes.

Another form of input taxation, Federal and State fuel taxes, deserves special attention for three reasons.  First, the tax-take is very high, being close to 60 per cent of the pre-tax price, or 37 per cent of the retail price.  State fuel levies increase these percentages to around 93 per cent and 49 per cent respectively.  Second, mining and processing tend to be liquid-fuel intensive, particularly in remote areas.  Third, arguments have sometimes been put forward which purport to justify taxation of fuel used as an intermediate input.

Mining is largely, but not entirely, exempt from diesel fuel taxes for off-road uses.  Processing receives no relief.

Mining and minerals processing activities in remote areas such as the Pilbara, the Northern Territory and Far North Queensland are even more fuel intensive than in major industrial centres because of the relatively high transport costs borne.  Transport is fuel intensive and bears heavy fuel excise burdens.

Fuel taxes have sometimes been cited as an example of a case in which taxation of an intermediate input may be justified because it provides a way of indirectly taxing final consumption of transport services (for example, car and bus journeys for non-business purposes).  But this can be justified only if the administrative costs of distinguishing between uses exceed the losses from production inefficiencies.  That is something lazily taken for granted even though it is unlikely to be provable.  Also, the case for taxing all fuel assumes rather than proves that it is not possible to tax final consumption of transport services in some other less distortionary way.

Fuel taxes on intermediate inputs have also been defended as a charge for provision and maintenance of roads.  But fuel tax revenues greatly exceed road expenditures.  Indeed, only 5.31 cents per litre of the current Commonwealth excise rate of about 26 cents per litre has been directly earmarked for road construction and maintenance. ⁽¹¹⁾  So most of fuel tax must still be regarded as an impost on intermediate inputs.

Removal of taxes on intermediate inputs throughout the economy would lead to larger government deficits, an increase in other taxes, or lower government expenditure.  To ensure that the gains from eliminating taxes on intermediate inputs are not at least partly dissipated by higher inflation or inefficiencies arising from other taxes, the removal of intermediate input taxation should be implemented by replacing the present set of wholesale sales taxes, excises and other Commonwealth and State Government levies on intermediate inputs with a revenue-neutral value-added tax (with appropriate transfers from the Commonwealth to other levels of government).

If a value judgment is made that it is appropriate to compensate certain poorer sections of the community for any real disposable income losses, that compensation should be financed by cuts in government spending.  The cuts should be concentrated where there is duplication of effort at the same and different levels of government;  provision of "special incentives" for particular industries;  over-zealous regulation of industry and protection of the environment and other heritage;  and pandering to special interest groups.

Clearly, such a programme will eliminate important sources of production inefficiencies, benefit the economy as a whole and provide unambiguous improvements in economic welfare.  Of course, these reforms would particularly benefit mining and minerals processing, especially in remote areas.

CAPITAL ALLOWANCES AND TAX RATES UNDER THE INCOME TAX REGIME

Before the tax reforms of the mid-to-late-1980s, the income tax regime "double-taxed" dividends and strongly favoured capital gains, encouraging "speculative" investments at the expense of "productive" activities such as mining and minerals processing.  It also taxed companies more heavily than unincorporated enterprises.  Moreover, the higher tax rates levied under the old system tended to accentuate distortions.  The old structure clearly biased investment decisions away from many business activities, including mining and minerals processing, and caused inefficiencies in production (with lower aggregate output) via differential taxation of capital in different uses.

After the mid-to-late-1980's tax reforms, full dividend imputation began to apply under the income tax regime with the result that double taxation of dividends is avoided.  Although the top marginal personal income tax rate and the company income tax rate have been lowered substantially, the personal rate remains significantly above the corporate rate.  This provides an incentive to retain earnings.  But, it is offset by the "double-taxation" of retained earnings, which are taxed once by corporate income tax and taxed again by capital gains tax when they increase asset backing and thereby enhance the value of shares in the enterprise.  This "double-taxing" effect is, however, watered down significantly by taxing only realised (rather than accrued) and real (rather than nominal) capital gains.

On balance, the present income and capital gains tax structure is less distorting than the regime it replaced, but it still differentially taxes capital in different uses.  For example, owner-occupied housing is exempt from capital gains tax and various infrastructural expenditures that would be necessary for processing in remote areas have been denied deductibility.

Mining and minerals processing are not among the more favoured investments.  Therefore, activity in industries attracting higher effective tax rates (particularly capital intensive industries such as mining and minerals processing) and aggregate output in the economy are likely to be less than they could be if the production inefficiencies arising from differential tax treatment of returns to capital were completely eliminated.

The system could be made neutral in its impact on the cost of equity capital (as well as debt capital) by bringing down the top marginal personal income tax rate to align it with the corporate rate;  by taxing all capital gains;  by using accrued capital gains as the tax base;  by eliminating the "double" taxation of retained earnings;  and by correcting discriminatory capital write-off arrangements.

Discriminatory capital write-off arrangements that impede mining and processing fall into two categories:  inappropriate depreciation deductions, and legitimate capital costs not being afforded any deduction.

Depreciation Allowances

Ideally, depreciation allowances for tax purposes should reflect true economic depreciation -- the actual decline (or increase) in the value of an asset during a particular time period.  But depreciation rates allowable under the income tax laws will not adequately reflect true economic depreciation in all (and perhaps not in any) circumstances, because of the arbitrariness of rate selection, technological change, inflation, changes in markets and so on.  Departures from economic depreciation translate into differential taxation of capital in different uses, and induce production inefficiencies in the economy.

Slow depreciation relative to true economic depreciation will bias investment decisions away from capital intensive activities such as mining and minerals/energy processing, away from more capital intensive production methods and away from longer-lived assets.  Accelerated depreciation will have the opposite effect.

Departure from true economic depreciation will affect not only capital intensity and asset life, but also investment ranking.  Historical cost-based depreciation rates under the income tax laws will also distort investment decisions in different ways at different times, depending on the expected inflation rate.

Unfortunately, true economic depreciation would involve high administration and compliance costs, so it is unlikely that any government would try to implement it precisely.  Nevertheless, they should be attempting to get much closer than in the past.

The available evidence suggests that, from the time of the abolition of a form of accelerated depreciation in 1988 until early-1992, Australian tax laws tended not to be sufficiently generous with regard to depreciation, particularly in respect of long-lived assets and equipment subject to rapid technological change.  This would have tended to bias investment decisions away from long-lived, capital intensive activities, and those industries in which technological change is rapid.

Because major minerals and energy processing projects tend to be highly capital intensive and based on long-lived assets, these activities have been disadvantaged.

Mining (including petroleum extraction) has fared better, because some capital expenditures on mining (including basic treatment) and infrastructure are deductible over the shorter of mine life or ten years, and some transport expenditures may be written-off over ten years.  However, other assets, including some long-lived assets are still subject to normal depreciation allowances.

The Australian Government, in its February 1992 Economic Statement, responded to criticism of the lack of generosity of depreciation allowances under Australian tax laws by introducing new forms of "accelerated depreciation" for assets purchased or constructed after 26 February 1992.  The improvements favoured long-lived assets and large projects.

Under these new arrangements, assets previously written-off over a 5-year "effective life" will have a "write-off life equivalent of 3.75 years".  The "write-off life equivalents" of assets with "effective lives" of 10 and 20 years will be reduced to 6 and 7.5 years, respectively.  Industrial buildings will attract a 4 per cent per year straight-line depreciation rate instead of 2.5 per cent. ⁽¹²⁾

Provided the new "accelerated depreciation" arrangements stay in place in the long term, they will provide Australia with a less distorting corporate income tax, with assets of the type involved in minerals processing being a beneficiary of the reforms.  However, the treatment of industrial buildings remains a notable lingering deficiency, particularly for processing in remote areas where buildings are unlikely to have the alternative uses available in major industrial centres.  Unfortunately, successive Australian Governments have a history of introducing various accelerated depreciation and investment allowance schemes in times of recession and then withdrawing them in boom times.  As a result, the life of the new accelerated depreciation arrangements is problematical.  The proclivity of Australian governments to keep tinkering with the system in this way has itself been an artificial impediment to capital intensive mining and minerals processing activities in Australia.  This is one aspect of the "sovereign risk" impediment discussed later.

Capital Costs Denied Deductions

It is not practical to provide a comprehensive discussion of every legitimate category of capital expenditure that has been denied deductions in the past, but four stand out.

One is expenditure on feasibility studies (in any industry).  This should be deductible whether or not a project proceeds.  The denial of such expenditure deductions particularly discriminates against investment decisions in large, complex, highly capital-intensive, risky projects such as mining and minerals processing where feasibility study costs can be substantial.

In the case of manufacturing-type activities such as minerals and energy processing (other than basic treatment at the mine site), other types of capital expenditure that have been denied deductibility include certain types of structural and infrastructure expenditures, such as roads, pipelines, retaining walls and runways.  Expenditure on housing and social infrastructure facilities is also not deductible for manufacturing-type activities such as minerals processing.

The February 1992 Economic Statement only partly corrected the deficiencies in the taxation laws relating to infrastructure by announcing that certain structural type infrastructure expenditures could be depreciated at a rate of 2.5 per cent per year on a straight line basis.  However, the correction is far from complete and the rate is inconsistent with new "accelerated depreciation" rates that will apply to other parts of processing projects.

The unavailability or inadequacy of deductions for structural and infrastructural expenditures discourages investment in industries where large expenditures by private developers are essential components of a project.  Not allowing deductions for these expenditures clearly biases processing investment decisions against remote areas where private developers, rather than governments, are likely to provide infrastructure.  Different taxation of capital in different uses causes losses of overall production efficiency.

Various mandatory environmental expenditures have been denied income tax deductions in the past.  The cost of environmental impact assessment studies is still not deductible.  This tends to discriminate against mining and processing activities, which typically are confronted by more stringent environmental requirements than most other activities.  Such expenditures should be allowable deductions.

Until the 1990-91 financial year, another type of environmental expenditure, mine rehabilitation and plant demolition costs, was not deductible.  Expenditures of this type can be important in mining.  As of 1990-91, they have been deductible in the year incurred.  However, some of this expenditure will be incurred after production ceases.  If a company lacks other income or does not have other income for some years, it will be disadvantaged.  This problem should be rectified by allowing these expenditures to be carried back to an earlier year for deduction.

Deductible exploration expenditures are restricted to those incurred on tenements, except in the case of petroleum.  This does not recognise the nature of modern exploration techniques, which often include preliminary exploration over broad areas using sophisticated technology.  It also denies mining companies a legitimate deduction for expenditures needed to establish a mining operation.  This discriminates against the mining industry.

PERSONAL INCOME TAX AND FBT IN REMOTE AREAS

Living and working in remote areas usually involves uncomfortable climatic conditions and inferior amenities.  This is unattractive to many workers and their families.  If workers are to be attracted to such areas, they have to be offered an income and benefits package that sufficiently compensates them for the perceived nett disadvantages.  In the presence of income taxation, they have to be paid sufficient additional gross salary and benefits to cover the perceived nett disadvantages and the extra tax associated with the extra nett income required.  For example, let us assume that a worker requires an extra $10,000 per year of nett income to compensate for the perceived nett disadvantages of a particular remote area location.  If he were on a marginal tax rate of 48.25 per cent and eligible for the existing "Special Area, Zone A" tax rebate of $938 per year, he would need additional gross income of $17,511 to yield the required increase in nett income.  So the employer has to cover $7,511 of the employee's annual personal income tax and provide $10,000 of compensation for perceived nett disadvantages of the area to attract him to the remote area.  Also, the payroll tax bill borne by the employer rises by $1,050 (using Western Australian rates) as a result of the increase in gross salary.

If activities are to be treated evenhandedly by the tax system in remote and established areas, allowance has to be made in the income and payroll tax regimes for the fact that the nett disadvantages in remote areas necessitate higher payments to labour.  This does not mean that companies and individuals should be subsidised to compensate for the naturally higher costs of being located in remote areas.  However, they should not be penalised by the tax system for engaging in economic activities in remote areas.  It follows that adjustments to the tax regime should be directed towards eliminating tax disadvantages arising from working and living in remote areas;  not towards compensating for the natural disadvantages of remoteness, climate, etc.  The former approach will remove a tax-induced inefficiency, but the latter approach will add one.

Before the tax reforms of the mid-1980s, operators of major mines compensated workers for the disadvantages of working and living in remote areas by a combination of wage/salary premiums, which were taxed, and housing and travel fringe benefits, which were tax-free.  The bias to provide fringe benefits inherent in the tax regime helped facilitate realisation of State Governments' desires for relatively stable, reasonable-quality, permanent-looking towns in remote areas rather than slum-style boom towns or fly-in-fly-out arrangements.

When it was announced that employers would be required to pay fringe benefits tax at the top marginal personal income tax rate, remote area employers protested strongly with a range of arguments against fringe benefits tax on remote area housing and travel benefits.  The Commonwealth Government responded by providing a 50 per cent fringe benefits tax concession for remote area housing and holiday travel benefits, and full exemption of travel in respect of fly-in-fly-out arrangements.  In the case of housing benefits, the eligibility conditions for the concession, according to the Income Tax Assessment Act, are:

1. it is normal in the industry concerned for employers to provide these particular benefits free or on a subsidised basis, and
2. it is necessary for the employer to provide the accommodation because either it is the custom in the industry, or employees are liable to change location frequently, or there is insufficient suitable residential accommodation.

By discriminating in favour of certain industries (mining is one of them but minerals processing appears not to be) and certain types of benefits, the fringe benefits tax concession results in different taxation of factors of production (ultimately labour) in different uses in remote areas.  The discriminatory and arbitrary nature of the concession means factors of production (ultimately labour) are not taxed evenhandedly either in different parts of the nation or in different industries in remote areas.

In its report on "Mining and Minerals Processing in Australia", the Industry Commission noted that income tax zone rebates were originally provided to compensate for the nett disadvantages of remote areas and that zone rebates would not discriminate between different industries. ⁽¹³⁾  Therefore, the Commission recommended that the existing 50 per cent fringe benefits tax concession, which has limited application, be replaced by generally applicable "equivalent offsetting changes in zone rebates ... in recognition of the purpose the concession is meant to serve". ⁽¹⁴⁾

Income tax zone rebates provide a sensible solution provided their size is commensurate with the tax penalty arising from paying people more to compensate for the nett natural disadvantages of remote areas.  It is clear that the present income tax zone rebates are totally inadequate and would need to rise substantially.  For example, in our hypothetical illustration above, the worker would need an income tax rebate of $8,449, rather than the existing $938, to attract him to a remote area without an artificial impediment arising from income tax being imposed on the remote area employer.

Similarly, the payroll tax impediment in remote areas could be eliminated by a payroll tax zone rebate system.  In our example, the employer would get a rebate of $1,050 for the employee.

A complete review (free of political influence) of existing zones and tax disadvantages associated with remote areas should be undertaken before implementation of a revised zone rebate scheme to ensure that the new zone arrangements are as evenhanded (that is, non-distorting with respect to resource allocation) as possible.  This review will need to consider the differing disadvantages faced by workers who work and live full-time in remote areas and those who work and live there part-time under fly-in-fly-out arrangements.  Clearly, the former should be entitled to larger income tax zone rebate allowances than the latter.

Simply replacing the limited remote area fringe benefits tax (FBT) concession by a meaningful income tax remote area zone rebate scheme applicable to all remote area tax payers would cause short-term adjustment problems for employers currently providing housing and travel benefits and receiving the FBT concession, even though these employers will be better off in the long run.  The short-term problem arises because employers are nominally responsible for payment of FBT, while employees would be the nominal beneficiaries of the improved income tax zone rebate scheme.  In the long term, tax (and tax concession shifting) would relieve employers of the extra FBT burden, and would reduce total labour costs below current levels in industries that lost the existing FBT concession.

The short-term adjustment problem can be largely eliminated by application of a transition mechanism.  Employers providing housing and travel fringe benefits to employees in remote areas would be able to offset 50 per cent of FBT liabilities (there is presently a 50 per cent concession) in respect of each employee against personal income tax rebates due to that particular employee via reduced PAYE tax instalments.  That is, the employer would be able to appropriate whatever part of the rebate was needed to cover the FBT liability (after allowing for a 50 per cent concession) in respect of the employee.  The remainder of the rebate would be passed on to the employee through reductions to his or her PAYE income tax instalments.

The improved income tax and payroll tax zone rebate schemes described above would eliminate the existing income and payroll tax bias against all remote area economic activities.  It would also remove discrimination under the FBT regime in favour of mining and pastoral activity and against most other industries in remote areas, without causing significant short-term adjustment problems for mining.  All remote area activities and the economy as a whole will benefit in both the short term and the long run.

THE PROTECTIONISM IMPEDIMENT -- BARRIERS TO IMPORTS

Barriers to imports such as tariffs and quotas cause the domestic market price of both imports and import-competing goods to rise.  The demand price of labour rises as import-competing industries expand.  The supply price of labour also rises in response to the rise in the cost of living.  So the cost structure of the economy rises in response to higher prices of imports, import-competing goods, and labour.  The economy's cost structure rises further because the costs of other inputs also rise because of increases in the cost of imports, substitutes for imports, and labour.  Of course, reduced demand for foreign exchange arising from reduced imports tends to cause appreciation of the exchange rate tending to offset the effects of the import barriers on the cost structure to some extent.

In the short term, producers of protected import-competing goods are better off.  Wage and salary earners don't lose because nominal wages and salaries are higher and import duties result in lower taxes.  Producers of goods and services not competing with imports similarly don't lose.

Who "carries the can"?  Mainly exporters and producers of unprotected import-competing goods.  They compete internationally and usually are unable to influence world prices significantly.  That is, they are largely price-takers, unable to pass on the increased costs imposed on them (directly and indirectly) by the protection of other industries.  They have to carry the increased costs and/or the adverse effects on revenue of a higher exchange rate. ⁽¹⁵⁾

How big is the burden?  K.H. Choi and T.A. Cumming have estimated that import barriers in Australia are equivalent to an ad valorem tax of approximately 9 per cent on all exports. ⁽¹⁶⁾  So, for each $100 of revenue required to produce profitably a mineral product in Australia, import barriers would directly and indirectly contribute $9.00 to the cost of production.

An effective 9 per cent ad valorem tax on exports is a substantial burden.  There is no doubt that it has resulted in a significant contraction of Australia's traditional export industries:  agriculture, pastoral activity, mining, and minerals and energy processing.  Given the size of the burden it is obvious that many potential export activities, particularly in minerals processing and manufacturing, which do not have a significant economic rent cushion, would have been rendered uneconomic by protection of other industries and therefore not established.

Does this really matter?  After all, we have explained that, in the short term, protected import-competing producers are better off and producers of goods and services not competing with imports and wage and salary earners are probably at least no worse off.  The answer is "yes" -- it matters to exporters and unprotected producers of import-competing goods and, in the long term, it matters to everyone, including those involved or previously involved in protected manufacturing industries, because protection ultimately makes us all worse-off. ⁽¹⁷⁾

The Industry Commission has estimated that total removal of tariff and other assistance to manufacturing industries would stimulate long-run expansions of 2.5 per cent for copper ore mining, between 5.1 per cent and 8.8 per cent for other mining industries, and from 4.7 per cent to 7.5 per cent in the non-ferrous metals smelting and refining industries.  The only minerals processing industry to decline (-0.7 per cent) in response to removal of assistance to manufacturing industries would be basic iron and steel manufacturing, which has been a beneficiary of government assistance. ⁽¹⁸⁾

Elimination of import barriers would, inter alia, dispose of another cause of production inefficiencies in the economy.  Of course, removal of manufacturing assistance will result in contraction of certain parts of the manufacturing sector while stimulating those manufacturing activities with negative or low effective protection:  the agricultural industries and the services sector of the economy, particularly tourism, as well as mining and mineral processing.  However, the nett effect on Gross Domestic Product (GDP) and aggregate employment in the long run would be positive.  The Industry Commission's modelling indicates that GDP would expand by almost $3 thousand million in the long run as a consequence of better use of resources following the removal of government assistance to manufacturing. ⁽¹⁹⁾

In addition, there are positive dynamic effects to be derived from eliminating import barriers.  These are discussed briefly below.

Import barriers have made Australia unduly reliant on those export activities that have been able to cope with the implicit tax on exports -- viz., mining, agricultural and pastoral activities -- because of the efficiency of these industries and the high scarcity values (economic rents) imputable to Australia's endowment of superior mineral and energy deposits and agricultural and pastoral lands.  Unfortunately, rates of growth of demand for products of these industries have been low compared to those for processed and manufactured goods and services.  Also, our ability to grow by increasing market share in primary commodity markets is handicapped by the adverse effects of various artificial impediments on the cost structures of these industries.

Not only are those processing and manufacturing activities, which we could be good at, handicapped by protection afforded to activities that we aren't good at, but also the protected industries have no incentive to become more efficient.  Indeed, they stagnate behind protective barriers, becoming less able to compete with imports from dynamic foreign manufacturers.  Instead of acting decades ago, Australian governments have worried about how these industries will survive if protection is lowered too quickly, and worried further about the effect of more imports of manufactured goods on the balance of payments.  So they procrastinated:  increasing "sovereign risk" and prolonging the handicaps imposed on efficient mining, agricultural and pastoral activities;  and maintaining barriers which prevented the further development of efficient processing and manufacturing industries based on our superior natural resources.  As a result, efficient economic activity and trade have been stifled, the economy has lost its potential dynamism, and economic growth has been seriously retarded.

Can a "second-best" argument be developed to justify continued or more industry protection?  Some politicians and spokespersons for protected industries and industries disadvantaged by protectionist policies in foreign countries have tried.  The argument runs along the following lines:  many foreign governments protect or provide "special incentives" to particular industries.  (The most commonly cited examples are subsidies or other types of protection for European Community and Japanese agriculture.)  Because we are largely powerless to "level the playing field" in international trade, it is argued that it makes no sense to have a "level playing field" in Australia.  Therefore, we should not lower protection for our protected industries and we should provide assistance to industries that are adversely affected by the unfair practices of other countries.

The argument is fatally flawed.  It is driven by narrow self-interest rather than the national interest.  Maintaining existing protection and adding further assistance to compensate industries adversely affected by foreign trade policies, simply penalises other Australian industries which have to bear higher taxes and higher costs.  Aggregate inefficiencies in the economy will rise.  But to sustain an argument for continued or more protection, one has to demonstrate that these policies will result in lower aggregate inefficiencies than in the absence of protection and special incentives case.  This cannot be done.  If other countries want to pursue stupid protectionist policies that harm their economies, why should Australia try to match or outdo their stupidity?

A more efficient, more dynamic and faster growing minerals processing sector and economy can be achieved by removing artificial impediments such as import barriers.  The size of the barrier erected by past protectionist policies is very large and the effects of its removal on the mining and processing sectors and the economy as a whole should be substantial.

Fortunately, reform of Australia's past protectionist policies is now under way.  General tariff rates are being phased down, reaching 10 per cent and 15 per cent in 1992 and they are scheduled to fall to 5 per cent in 1996.  Significant cuts in protection for the more highly protected motor vehicle manufacturing and textiles, clothing and footwear industries are also scheduled.  Tariffs on passenger vehicles are scheduled to fall to 15 per cent by the year 2000.  In the case of textiles, clothing and footwear, quotas and tariff quotas are to disappear by 1 March 1993 and tariffs are to be phased down to rates of 25 per cent or less by the year 2000.

In late March 1992, in the heat of a by-election campaign, Prime Minister Keating said that protection would not be reduced beyond the rates specified in the current phase down programmes.  So far, however, the Federal Opposition has persisted with its policy of cutting tariffs to zero or negligible levels by the year 2000.  This is preferable to the Government's programme.

Unfortunately, the pace of reform under both policies is painfully slow and highly vocal vested interests continue to argue that the reforms proposed by the Federal Government and Opposition should be abandoned or the pace slowed even more.  These vested interests have sympathisers within both the Government and Opposition parties.  It can only be hoped that those with the national interest in mind prevail over those who are serving only narrow, short-sighted self-interest.

WATER TRANSPORT IMPEDIMENTS

The Industry Commission identified artificially high coastal shipping freight rates and waterfront costs as significant artificial impediments to mining and processing of Australia's minerals.  The Commission concluded that if international rates applied to the Australian coastal trade, ship- and shore-based services would cost 20 per cent to 50 per cent less. ⁽²⁰⁾

Although the Navigation Act of 1912 does not totally reserve coastal trade for Australian vessels, it has resulted in the elimination of effective competition from foreign-flag vessels.  Foreign vessels are not permitted to operate on the coastal trade unless they obtain a licence.  This requires the satisfaction of certain conditions covering, inter alia, crewing levels, wage rates and conditions of service.  Foreign ship operators have not been prepared to meet these conditions because the additional business has not been sufficient to justify the extra costs.

As a result, Australian ship operators have not been subjected to sufficient competitive pressure to contain costs, with the result that Australian maritime unions have been able to win working conditions that impose much higher costs on Australian ship operators than those borne by operators of foreign-flag vessels on other routes. ⁽²¹⁾

Australian ports have a history of being inefficient as a result of poor work practices and poor management, which are reflected in low productivity of labour and capital;  in overservicing by tugs;  in charges unrelated to the cost of services;  and in poor integration with connecting land-based transport services. ⁽²²⁾

Inefficiencies in coastal shipping and on the waterfront have been documented in reports of numerous inquiries over recent years.  The various reports have proposed many reforms aimed at improving efficiency, primarily through modification of work practices and the introduction of competition.

Reforms introduced or proposed to date have focused on improving efficiency within the existing framework of "no direct competition".  The Industry Commission correctly has expressed concern that unless coastal shipping and cargo handling services are subjected to effective competition, some of the benefits of reform will probably be appropriated by the coastal shipping and cargo handling industries through higher wages, improved work conditions, higher profits and new inefficiencies, rather than passed on to customers through lower shipping and cargo-handling rates. ⁽²³⁾

Lower coastal shipping and cargo-handling costs would benefit mining and mineral processing in Australia in three ways.  First, the cost of carrying minerals from mining areas to distant industrial centres would fall.  This would lower costs of processing in Australia away from mining areas, improving the attraction of such sites relative to foreign sites.  Alternatively, the cost of carrying products from processing plants located near mineral deposits to distant industrial centres would fall.  This would assist mineral processing in remote areas.  Second, the cost of transporting inputs (other than raw materials covered above) to mining and processing operations would fall, particularly in remote area operations.  Third, the general cost structure of the economy would fall, reducing labour and other costs in mining and minerals processing throughout the economy.

In a sense, artificially high coastal shipping costs may favour processing of local commodities near remote mining sites compared to other Australian sites, provided the processed products are shipped overseas rather than to other locations in Australia.  But it doesn't make sense to penalise the Australian economy by sustaining coastal shipping inefficiencies just to bias processing decisions in favour of remote sites, particularly as these inefficiencies also benefit foreign sites.  In any event, eliminating coastal shipping and waterfront inefficiencies will indirectly help processing in remote areas by lowering the cost structure of the economy, and by increasing competitive pressures on road transport services to remote sites.

The economy as a whole (not just the mining and mineral processing industries) would gain from the reduction of artificially high coastal shipping and cargo handling costs in Australia, as indicated by the Industry Commission's modelling results using ORANI-MINE.  Although there would be losses to the coastal shipping and waterfront industries, the overall effect on the economy would be positive.  GDP would expand by about $700 million per year in the long run.

Minerals processing would benefit substantially more than any other sector in the economy from removal of inefficiencies in coastal shipping and in waterfront activities.  Such reform would induce long-run expansions of minerals processing industries ranging from 0.4 per cent for basic iron and steel up to 4.1 per cent for silver, lead and zinc processing and 4.9 per cent for nickel smelting and refining.  Inefficient coastal shipping and waterfront activities were the second most important of the artificial impediments to minerals processing in Australia that the Industry Commission quantified.

Mining will also benefit from the removal of inefficiencies in coastal shipping and waterfront activities, but to a much smaller extent than processing will.  The Industry Commission's economic modelling estimated mining output would expand by 0.3 per cent overall.  The mining activity that will benefit most is extraction of nickel ores, which is predicted to expand by 4.8 per cent following effective coastal shipping and waterfront reforms. ⁽²⁴⁾

Although reforms are in progress, they are far from complete and the pace of reform is painfully slow.  Moreover, unless reforms to work practices and inefficient regulation are complemented by the introduction of effective competition, mining, minerals/energy processing and the economy as a whole will continue to be handicapped by artificially inflated coastal shipping rates and cargo handling charges.

HIGH REAL INTEREST RATES

Mining and minerals processing are highly capital-intensive.  In remote areas, a project's capital-intensity is likely to be higher than in or near established industrial centres because the remote area developer may have to provide infrastructure.  In or near established industrial centres, infrastructure is likely to be already available or accessible at incremental costs.  These factors increase the importance of the cost of capital -- the "hurdle rate" of return for new investments -- as a determinant of the viability of mining and mineral processing investments.

The cost of capital is driven by interest rates (the precise relationship between interest rates, the tax system and the cost of capital is beyond the scope of this paper).  In recent years, real interest rates in Australia have been substantially above those in Japan and the United States.  To mid-May 1992, despite a substantial fall in the Australian inflation rate and nominal interest rates, real interest rates, as indicated by relatively risk free 10-year government bonds, still remained at historically high levels and generally double those in most major economies.

Australia's relatively high interest rates have attracted funds from overseas seeking higher rates of return.  This has placed upward pressure on the exchange rate, reducing revenues to import-competing and export activities, including mining and minerals/energy processing.  Although the higher exchange rate means lower prices for imported capital equipment and other imported inputs, the revenue effect is larger, adversely affecting profitability.

So Australia's relatively high interest rates have reduced the attractiveness of investments in import-competing and export activities in Australia, by raising the "hurdle" rate of return and reducing revenues.  Mining and processing activities have been disadvantaged more than most industries because of their relatively high capital-intensity and export orientation.  The last thing that export industries (and import-competing industries) need is perverse macroeconomic policy that pushes up the cost of capital and the exchange rate.

The high real interest rates and exchange rate resulted from the Australian Government's heavy reliance on monetary policy as an instrument of macroeconomic stabilisation policy in dealing with concerns about an overheated economy in the late-1980s.  Concerns about losing the hard-won gains in the form of a current low inflation rate by world standards have resulted in the maintenance of high real interests rates by the monetary authorities.  Apparently, greater reliance on tighter fiscal policy was considered by the government to involve too many hard decisions.

In part, the concerns about the booming economy in the late-1980s derived from adverse publicity about the current account deficit.  Yet, the policy instrument upon which the Government relied almost exclusively was particularly hard on capital-intensive, export-orientated activities like mining and processing in which Australia has a comparative advantage or potential comparative advantage.

If the Australian Government is concerned about Australia's current account performance, it should be speeding up the elimination of various artificial barriers to exporters and unprotected import-competing industries.  For example, elimination of import barriers would allow the exchange rate to depreciate, tending to enhance export performance and to offset the effects of reduced import barriers on imports.  Elimination of various other artificial impediments would reduce the cost structure of these industries, thereby improving their competitiveness.

The Industry Commission accepted in its report on "Mining and Minerals Processing in Australia" in 1991 that the use of high real interest rates and the concomitant high exchange rate for economic stabilisation purposes had significantly affected the competitiveness and performance of the mining and minerals processing sectors and had impacted on these sectors to a greater extent than most activities. ⁽²⁵⁾  So what did the Commission recommend?  It simply avoided the issue saying, "There is no reason to single out mining and minerals processing industries for special dispensation by insulating them from the effects of macroeconomic policies directed at all activities." ⁽²⁶⁾  This is true, but it ignores the point that sensible macroeconomic and microeconomic policy settings in the first place would have avoided penalising efficient, internationally-competitive industries, such as mining and minerals processing, through artificially high interest and exchange rates.

LABOUR MARKET REGULATION AND RESTRICTIONS

Contrary to the common view, Australia's labour costs are not high.  In 1988, skilled and unskilled labour costs in Australia were less than half those in the United States and Switzerland, slightly more than half West German labour costs, and significantly less than those in (descending order) Norway, Denmark, Belgium, Austria, Canada, France and Italy, and slightly lower than those in Sweden.  In 1988, Australian labour costs were significantly higher than those in (descending order) New Zealand, Ireland and the United Kingdom, and substantially higher than labour costs in (descending order) Spain, Greece, Singapore, Hong Kong, Portugal, Saudi Arabia and Malaysia. ⁽²⁷⁾

Australia's ranking below most of the developed countries and well above the developing countries in terms of labour costs is nothing to cheer about.  The main point it indicates (apart from the fact that labour costs alone are not necessarily the source of all our problems), is that the Australian economy has performed badly over the decades, despite its rich resources, and has failed to deliver income growth to its workers comparable to many other developed countries.  In other words, Australia has managed to fritter away its comparative advantages.

In this paper, the focus of attention is artificial impediments, which by definition, arise from government intervention or neglect.  So, we are interested not in whether Australian labour costs are high compared to other countries, but in whether they are artificially high relative to performance because of inappropriate government intervention or government neglect.  We have already seen that labour costs have been artificially raised because of various artificial impediments, such as import barriers, and that they will be artificially higher still in remote areas because of the discriminatory aspects of the income tax regime and certain other impediments.

However, labour costs are also artificially high relative to performance because of artificial impediments inhibiting the efficient operation of labour markets.

Australian labour markets are highly regulated with intervention being pervasive.  That alone should warn us that artificial impediments adversely affecting the efficient operation of labour markets are numerous and important.

When discussing intervention in Australian labour markets, it is appropriate to distinguish between the Prices and Incomes Accord (the Accord) era which was phased in from 1983, and the judicially-based, centralised wage-fixing system which preceded the Accord.

John Stone has colourfully described how, historically, government intervention in labour markets, including the establishment and maintenance of the judicially-based, centralised wage-fixing system, has contributed to the dissipation of Australia's comparative advantages:

In the early years of this century, Australians enjoyed the highest standard of living in the world.  At that time our great pastoral, agricultural and mining industries -- the industrial eagles of that day -- provided ... the wherewithal to sustain a much larger population than those merely employed directly in those pursuits.  Manufacturing had also begun to develop -- including, of course, what would today be called "value adding" or "resource processing" industries associated with our major resources. ...

After Federation, Alfred Deakin passed through the Commonwealth Parliament ... the Excise Tariff Act of 1906.  This Act ... imposed an excise duty on agricultural implements of various kinds.  However, the Act was not to apply to goods manufactured by any person in any part of the Commonwealth under conditions as to the remuneration of labour which ... the President of the Commonwealth Court of Conciliation and Arbitration ... declared to be "fair and reasonable". ...

On the basis, at least ostensibly, of a "survey" whose statistical construction would today have been laughed out of sight for its crudeness, Mr Justice Higgins arrived at the figure for "fair and reasonable" remuneration which he had first thought of -- namely, 42 shillings per week for an unskilled worker.  This was the wage being paid in Victoria by the Metropolitan Board and many municipal councils.  In 1907 the average wage being paid to unskilled workers was 33 shillings per week.  Higgins himself claimed that he had "raised the standard of living (of unskilled workers) by at least 27 per cent" (i.e. a 9-shilling increase on a 33-shilling base).

As any fifth form student of economics today could have told Mr Justice Higgins, the only way in which the standard of living of workers generally can be raised in any economy is through raising the physical productivity of that economy.  In other words, Higgins J. had no power to "raise the standard of living" of anyone other than by lowering the standard of living of somebody else.  That is precisely what he did;  and as a result his disastrous place in our history has been assured.

Ironically, it was not long before the Excise Tariff Act 1906 was found by the High Court to be invalid.  Although purporting to be "an Act relating to excise" (within the powers of the Commonwealth), it was in reality an Act relating to the determination of wages, where the Commonwealth's powers generally did not run.

Nevertheless, the "Harvester judgment", and the import tariff duties which succeeding Commonwealth Governments then introduced to protect domestic manufacturers burdened by the wage levels which it had sanctified, remained.  They represented, in effect, the two blades of the shears [used to trim the wings of eagles].  The first blade required employers to pay wages in excess of those that could be afforded by internationally competing manufacturers, and the second blade protected those manufacturers from being put out of business by the first blade.  Between them over the next eight decades, those twin blades steadily shore away the wings of our internationally competitive eagles [agricultural, pastoral, mining and processing industries] ...

As their costs rose -- and despite relatively superior performances in raising their own productivity -- these industries gradually dwindled as, at the margin, higher cost producers among them went to the wall [or never started operations] ...

Everyone -- and not least anyone previously employed by manufacturers -- was worse off. ⁽²⁸⁾

A major flaw of the centralised wage-fixing system in the past was that changes to terms and conditions of employment were influenced more by judicial concepts of equity than by market forces.  The "Harvester Judgment" was a classical example of this.

Also, legalistic and philosophical (as distinct from substantive) debate about economic stabilisation policy and productivity versus cost of living adjustments, received much more attention than critically important microeconomic issues.

The judicial concept of equity also contributed to the blunting of incentives to improve skill levels.  In this regard, a review of skilled and unskilled labour costs in about 30 developed and underdeveloped countries in 1988 indicated that the ratio of skilled to unskilled labour costs in Australia was lower than in every other country except Sweden and Nigeria! ⁽²⁹⁾  Another deficiency of the system, which is related to those already mentioned, is that incentives for workers to perform were blunted by the averaging system whereby all workers tended to get similar improvements in pay and conditions.

An additional flaw in Australia's centralised wage- and dispute-settling system is that it tended to reinforce the exploitation of market power rather than curb it, by adopting a "squeaky wheel gets the oil" approach and by imposing judicial solutions rather than proposing economically sensible policies that would inhibit exercise of market power.  Judicial, rather than economic, reasoning also sanctioned flow-on effects from "squeaky wheel" and special circumstances wage claims and disputes.

In addition, the judicially-based dispute-settling mechanism has to exacerbate the amount of disputation, simply because it could be relied on to come up with a compromise settlement if things became bad enough.  That is, its existence reduced incentives to avoid industrial disputes or to settle them quickly.

The efficient operation of Australian labour markets has been inhibited by numerous, judicially-sanctioned restrictive work practices and demarcation obstacles to efficient use of labour.  Unions have tended to defend these with misguided zeal.  Management has too readily made incremental work practice concessions to meet short-run pressures and some of these concessions have gradually developed into major inefficiencies.  The judiciary has sanctioned compromises without due regard to economic efficiency implications, partly to justify its own existence and partly through lack of knowledge of the big economic picture.  Meanwhile, governments have facilitated these steps, at times, by validating the accumulated inefficiencies through loose economic stabilisation policies and increases in protection.  It is to be hoped that the tariff reduction process which began in 1988 will end the use of the latter mechanism to protect labour market inefficiencies.

The result of all this has been to raise effective labour costs in Australia relative to performance, and to inhibit the efficient use of labour, reducing employment and production in the economy as a whole.  In the mining sector, the economic surpluses available for capture or dissipation have exacerbated the tendency of the judicially-sanctioned labour market farce to raise labour costs in this sector relative to performance.

A problem that remote-area processing has faced is an expectation that the work conditions applying in the mining sector, where there are economic rents up for grabs, will apply undiluted to processing in remote areas.  Processing does not yield sufficient economic surpluses to carry such a burden.  However, the trend towards enterprise-based bargaining which is being pushed as part of the government's labour market reform process may help quarantine remote-area processing from mining sector conditions of employment.

While mining and processing have been handicapped by impediments associated with the judicially-based/sanctioned system of determining labour costs, it must be recognised that they are capital-intensive industries.  Therefore, they have a comparative advantage vis-à-vis labour-intensive industries competing with imports, or in export markets.

Since 1983, the judicially-based centralised wage-fixing system has been gradually undermined.  There has been a process of transition to a de facto centralised wage-fixing system run by the Federal Government and the ACTU under the Accord negotiating arrangements.  While the Accord mechanism has helped deliver a significant reduction in real unit labour costs since the early-1980s, it has been a mechanism to restrain wages for macroeconomic purposes rather than an instrument of microeconomic reform. ⁽³⁰⁾  The centralised nature of the Accord process makes it susceptible to many of the flaws of the old judicially-based system.

Although various labour market (microeconomic) reforms are under way (such as award restructuring and moves towards industry-based unions and more decentralised negotiations), the pace of reform is slow and artificial impediments are still numerous.

Only 100 enterprise-based bargaining proposals have been sent for ratification to the Industrial Relations Commission (IRC) and most states have yet to alter legislation to allow enterprise-based bargaining.

Moreover, the substance of the Government's reforms has yet to be tested.  Although the Government is mouthing the correct words -- productivity, enterprise-based bargaining, flexibility, etc -- it continues to pursue policies that conflict with the spirit and substance of a system based on the efficient operation of labour markets.  Specifically, the Government continues to:

• require the IRC to vet all enterprise-based contracts;
• require employers to negotiate with unions rather than directly with their workers;
• restrict the range of issues open to negotiation;
• allow unions numerous avenues for reneging on agreements;
• force amalgamation of unions on a national and multi-industry basis;
• bring sub-contractors under tighter union control;  and
• persist with national awards and the Accord.

In summary, the substance of the Government's labour reforms is questionable.  Until the position of union hierarchies, the IRC and the Government in the wage determination process becomes open to competition, labour productivity relative to labour costs in Australia will continue to languish behind our competitors, particularly as most of them have already adopted more market-oriented, productivity-focused, wage-fixing systems.  These are problems for all industries competing with imports and in export markets, including mining and processing.  However, mining and processing are not as exposed as industries that are more labour intensive.

EXPLORATION AND MINING TENURE ⁽³¹⁾

In Australia, mineral (including petroleum) resources are owned by the Crown.  Onshore, the State Governments have constitutional authority to allocate rights to explore and mine.  Offshore, this authority is vested in the Commonwealth Government.

Exploration licences for minerals have most commonly been allocated by a conditional first-come-first-served system.  This system is used in all States and the Northern Territory.

Sometimes, work programme bidding has been used to allocate exploration licences for minerals or petroleum.  This system has been used most commonly to allocate offshore petroleum licences.

A conditional first-come-first-served system allocates exploration licences to the first applicant for a vacant area, subject to certain conditions.  These conditions usually include a commitment to undertake an exploration programme considered "satisfactory" by the administering authority, and a fixed term with compulsory relinquishment of portions of the original tenement over time.  To retain tenure, the explorer has to comply with the conditions of the licence and ultimately, find a deposit.

The administering authority usually assesses the suitability of the exploration programme using subjective criteria such as quality, quantity and timing of the proposed exploration work, financial capacity, expertise available to the applicant and past performance.  When conflicting applications are received, the administering authority makes a choice using the same criteria.

Under a work programme bidding system, areas available for exploration are divided into separate tracts, and explorers are invited to submit applications detailing work programmes and technical and financial capabilities.  The administering authority allocates each tract to the applicant judged to have the "best" programme, provided the authority is satisfied the applicant has the technical and financial capacity to perform the work programme offered.

Finding a deposit does not guarantee a right to mine under either system.  A right to mine will require the granting of a mining or production lease and compliance with a range of other conditions, such as environmental requirements.  Some of these conditions may not be known when the exploration licence is granted or the deposit is discovered.

Both systems increase uncertainty because of their highly conditional nature and heavy reliance on bureaucratic judgment and discretion.  This government-induced uncertainty or "sovereign risk" discourages investment.  "Sovereign risk" is discussed in more detail in the next section.

A conditional first-come-first-served system also distorts the timing of exploration expenditure.  As soon as expected nett returns from exploration are positive, there is an incentive to acquire an exploration licence over the prospective area before another explorer does.  The more prospective an area is, the higher the expected nett returns will be and the stronger will be the incentive to pre-empt the potential resource by acquiring exploration rights before others.  Because holding the tenement depends on "satisfactory" exploration effort, and because the bureaucrats generally like to see exploration take place as soon as possible, the firm is forced to explore early to retain title, regardless of its commercial judgment about the most efficient timing of exploration activity.  The relinquishment conditions and limited term strongly reinforce the pressure to explore early.

The bureaucrats who administer this type of system seem to think that the earlier exploration is undertaken, the better it is for the economy.  But the pre-emptive acquisition and exploration that are induced by this type of system cause economic waste.

Pre-emptive acquisition and exploration of tenements reduces the economic surplus because of interest forgone on the early outlays.  If pre-emptive acquisition and exploration commence as soon as expected discovery value exceeds exploration/discovery costs (that is, when expected nett returns are positive), the entire economic surplus from minerals in the tenement would be dissipated by interest on early expenditures. ⁽³²⁾

The economic efficiency losses from pre-emptive acquisition and premature exploration will vary directly with prospectivity.  Losses can be substantial when prospectivity is high and small when prospectivity is low.

In highly prospective areas, firms will effectively be competing with other applicants or potential applicants on the basis of work programmes.  Then, the conditional first-come-first-served system tends to take on some of the character of work programme bidding.  This reinforces the tendency of the tenement system to dissipate potential economic surpluses from mineral resources.  The analysis of work programme bidding later in this section will make this clear.

However, the conditional first-come-first-served system causes inefficiencies in other ways when prospectivity is low.  Firms may be discouraged from taking out or renewing exploration licences in marginal areas if work or expenditure conditions set by the administering authority are too demanding.  Since areas that appear marginal in advance may become superior areas after some initial work, this distortion can be costly.

Work programme bidding encourages explorers to offer more intensive programmes and earlier activity than necessary for efficient exploration and development, just so they can capture the ground being offered and the expected economic surplus from mineral resources therein.  An explorer could sacrifice nearly all of the expected nett return from a tract (without work programme bidding) by undertaking more or earlier work than is economically desirable, and could still expect to achieve something better than the minimum expected rate of return on capital invested in the tract.  Clearly, work programme bidding can misallocate resources so badly that economic surpluses from tenements are completely dissipated.

If an area allocated by a work programme bidding system turns out to be less attractive than anticipated at the time the winning bid was submitted, the programme offered will not be sustainable.  Attempts by the administering authority to enforce the programme can render resources in the area uneconomic and development will not proceed.  However, if bids are not enforced in these circumstances, the credibility of the system will be undermined.  The system then becomes a method of allocating tenements to those who can make dishonest promises most convincingly.

To the extent that other artificial impediments dissipate mining economic rents, the incentives to undertake too much exploration too soon under the traditional tenement systems will be reduced.  However, we have already seen that the various other artificial impediments should be removed because of the serious inefficiencies they cause.

Some public figures and bureaucrats who administer the conditional first-come-first-served and work programme bidding systems have argued that their tendency to induce earlier or extra exploration outlays is a good thing because it will result in earlier development of resources.  However, earlier and extra exploration does not mean earlier development.  After all, it is well known that prematurely discovered resources can remain undeveloped for years or even decades.  Given secure tenure once a discovery has been made, a rational firm will not seek to exploit a deposit until its nett value stops rising faster than the relevant cost of capital.  This is, commercially and socially, the best possible timing, and forcing earlier exploration will not alter it.

The only possible positive economic feature of the conditional first-come-first-served and work programme bidding systems is a tendency to correct market failure in the form of insufficient incentives to explore as much or as soon as is socially desirable.  When a firm undertakes detailed exploration, announced results provide valuable free information to nearby explorers.  Indeed, some firms may tend to wait for others to explore adjacent areas before committing their own funds.  When formulating their exploration programmes, firms ignore the spillover benefits explorers confer on others.  It follows that private exploration expenditures may be smaller and incurred later than is socially desirable.

In highly prospective areas, the tendency to hang back and underexplore is not likely to be significant, but the incentive arising from the tenement allocation systems in question to explore too much and/or too soon is likely to be strong.  In contrast, in relatively attractive areas, the former tendency will be much stronger and the latter incentive much weaker.

The strong case for abandoning traditional systems for allocating exploration tenements in highly prospective areas on economic efficiency grounds is reinforced by the fact that these systems are expensive to administer, given their heavy reliance on bureaucratic involvement and discretion.

In relatively unattractive areas, the case against the traditional systems on economic efficiency grounds is not a strong one.  However, both systems are still expensive to administer.  Of course, work programme bidding is a waste of time in such areas because of lack of competition.  That leaves the conditional first-come-first-served system.  If that is to be retained for poorer areas, then bureaucratic involvement and discretion must be cut substantially.

It is amazing that mining companies and policy makers have tolerated these appallingly inefficient tenement systems for so long.  Yet the only aspect of them that has been strongly attacked by mining industry spokesmen in the past has been the lack of secure transition from the right to explore to the right to mine, as exemplified by potential projects such as Coronation Hill and Jabiluka.

There appear to be two reasons for the survival of the systems.  First, it has taken a long time for them to be exposed as a major cause of the dissipation of Australia's comparative advantage in mining, and of the economic surpluses that could derive therefrom.  Second, the beneficiaries of these systems (for example, bureaucrats who benefit from a larger bureaucracy and more power, and suppliers of exploration services such as mining company geologists, geological consultants and drilling contractors) have continued to influence their employers to support these systems to the detriment of the mining industry and the economy as a whole.

Existing highly conditional insecure tenure should be replaced by very secure, long-term tenure that is free of bureaucratic influence and carries both exploration and mining rights.  The tenements should be free of conditions apart from limited covenants specified in advance regarding royalty, rental, environmental, rehabilitation and safety obligations.  Tenements should be tradeable without approval of the administering authority.  The allocation mechanism should be free of bureaucratic or ministerial discretion.  The more prospective an area is the more important it is that these requirements prevail.

This should not be construed as partisan pleading on behalf of the mining industry.  Secure tenure that is free of undue bureaucratic influence will allow both the efficient use of resources and the maximisation of economic surpluses from exploration and mining.  The whole community can benefit from this through the sale of tenements by the government in return for lump sums and royalties.

The ideal allocation device, at least in the case of the more prospective areas, is competitive lump-sum cash-bidding.  As well as eliminating bureaucratic discretion and other inefficiency-inducing aspects of the traditional systems, competitive cash-bidding in combination with secure tenure does not cause other distortions and it allows governments to keep down royalty rates and more distorting tax rates with consequent efficiency gains. ⁽³³⁾

"SOVEREIGN RISK"

"Sovereign risk" refers to government-induced uncertainties.  Disincentives to invest which arise from "sovereign risk" cause national income and economic growth to fall short of their potential.  That is, "sovereign risk" can be an important artificial impediment to economic activity.

Government-induced uncertainties tend to fall into two categories:

1. uncertainties arising from the possibility of governments changing the rules relating to an economic activity after capital and effort have been invested in that activity;  and
2. uncertainties arising from failure by governments to specify clearly the long-term rules in advance.

"Sovereign risk" arises from fears relating to possible future actions by governments, rather than from the actual actions themselves.  Past and present government actions can create "sovereign risk" if they induce fears of future changes.  When governments react to the symptoms of the various artificial impediments underlying Australia's economic malaise by dithering, tinkering or undertaking short-term patch-up jobs, they inadvertently add another artificial impediment to the multitude already in existence by maintaining or increasing uncertainty about future government action.

In contrast, sensible, swift, decisive action to deal with artificial impediments (rather than their symptoms), not only yields direct economic benefits, but also can produce a bonus in the form of reduced "sovereign risk".  This bonus is yielded because speedy, thorough elimination of artificial impediments reduces uncertainty regarding further government action by dealing with the problem once and for all.

All industries can be affected by "sovereign risk".  However, mining and processing appear to have been affected more than most.  After taking submissions and holding discussions with numerous mining and processing companies operating in Australia, and as result of its own research, the Industry Commission recently concluded:  "Sovereign risk represents a serious impediment to the efficient development of mining and mineral processing industries in this country, and one which diminishes the value of the mineral estate owned collectively by all Australians." ⁽³⁴⁾

Insecure tenure is a major source of government-induced uncertainty affecting exploration and mining in Australia.  There are several examples of companies spending large sums of money to explore and prove reserves in particular areas, only to be denied the right to exploit their discoveries.  Prominent examples have been the Jabiluka uranium and gold deposit in the Northern Territory, the Hill River coal project in Western Australia and the Coronation Hill gold-platinum-palladium project in the Northern Territory.  In each of these examples, the government decision to block mining was based on a desire to pander to special interest groups rather than on a rational assessment of the facts and alternative arrangements.

Over the past 20 years, successive Commonwealth Governments have tinkered at frequent intervals with capital write-off arrangements under the income tax law.  Both mining and processing have been affected, but the tinkering has been more significant in the case of mining.  Often, the fiddling with the system has been more closely related to countercyclical macroeconomic policies than genuine efforts to reform the tax system.  This has been another significant source of "sovereign risk".

Since 1975, the Commonwealth Government has tinkered regularly with its de facto petroleum royalty regime.  Initially, the system involved an excise tax on crude oil, which was altered, generally upward, from time to time and became progressively more complex.  Then a resource rent tax was added for new offshore discoveries.  After further tinkering with the excise and the resource rent tax, the whole system was rationalised in mid-1990.  This regular tinkering with petroleum taxation arrangements was a significant source of "sovereign risk" for the petroleum extraction industry.

Comparison of royalty regimes applying throughout Australia reveals there is little consistency in royalty rates and bases (methods of calculation).  There are differences between States and variations between minerals in the same State.  There is no logical explanation for the differences, but then most of the royalty systems in operation in Australia at present are not logically based.  The exemption of gold from royalties in Western Australia and Victoria appears to be based on political considerations.

The States have tinkered with their royalty systems or parts of them from time to time, with sensible improvements being the exception rather than the rule.  Sometimes ad hoc relief has been provided to mines experiencing difficulties, and sometimes project-specific arrangements have been negotiated.  In some cases, de facto royalties have been levied as excess rail freight charges often without any clear logical basis.  In some other cases, excessive infrastructure requirements have been stipulated, while other projects have benefited from government generosity concerning infrastructure provision.

In the mid-1980s, the biggest mining State, Western Australia, commissioned a major independent review of its royalty system. ⁽³⁵⁾  Although the review was highly critical of existing arrangements and constructive proposals were put forward to reform the system, nothing was done.  The government of the next biggest mining State, Queensland, reviewed its royalty arrangements in the late-1980s and shelved the proposals for reform.  Apparently, a subsequent Queensland Government is undertaking another internal review of its royalty and de facto royalty arrangements.

The lack of logical foundations for most of the royalty rates and systems applying in Australia, and the frequent tinkering, striking of special deals, reviewing and dithering with regard to royalty arrangements, are precisely the types of government behaviour that create "sovereign risk".  The mining industry would feel much more secure with a once-and-for-all change to a tough but fair and logically-based system than with the unsustainable, uncertain hotchpotch of arrangements to which it is presently subject.

The key to minimising "sovereign risk" as an artificial impediment to mining and processing in Australia is to move swiftly and decisively to establish clear, fair and economically sensible long-term "rules of the game" that will stand the test of time.  Particular attention should be given to adopting this approach in respect of exploration and mining tenure and the transition between the two;  environmental and Aboriginal and heritage requirements;  taxation laws;  royalty arrangements;  and infrastructure provision requirements.

SOLVING THE PROBLEM OF ARTIFICIAL IMPEDIMENTS

ELIMINATION OF ARTIFICIAL IMPEDIMENTS VERSUS COMPENSATION

Removal of all of the artificial impediments discussed or alluded to in this paper would be good for the Australian economy as a whole in the long run, as well as being beneficial to mining and minerals processing throughout Australia.  The cumulative nett benefits in the long run will be very substantial, although there will be some short-term adjustment pain, particularly in protected manufacturing industries;  in the coastal shipping and waterfront cargo handling industries;  in some segments of the labour market;  and in government bureaucracies.

The removal of all artificial impediments will involve wide-ranging microeconomic and taxation reforms, but that is precisely what the Australian economy needs.  The major artificial impediments to mining and processing disadvantage a number of industries in which Australia has a comparative advantage despite the impediments (for example, mining, broad-acre farming and pastoral activity and tourism);  and others in which it has a potential comparative advantage (for example, minerals processing, specialist mining and processing techniques).  These artificial impediments also harm the economy as a whole, reducing its output and growth below their real potential.  When there are wide-ranging problems arising from a multitude of artificial impediments, wide-ranging action is necessary.

If the aim is to encourage larger and more profitable mining and processing sectors, it may seem simpler to provide tax breaks or various types of direct and indirect subsidies, particularly if this will avoid the pain associated with short-term adjustments arising from elimination of artificial impediments.  However, this approach is seriously flawed.  There are several ways of explaining or supporting this very important point.

First, a special deal for mining and processing would just be adding another distortion to the Australian economy.  Others would then have to pay for the new tax breaks or subsidies for mining and processing, just as mining, processing and other presently unfavoured industries have to bear the burden of the special deals that some parts of the economy now receive.

Second, special assistance for mining or processing would be treating symptoms rather than causes of underperformance in these sectors.  Treating the symptoms of artificial impediments is not going to eliminate the impediments.  Instead, it will mask the symptoms in this area while adding to the malaise in the rest of the economy, creating new symptoms or exacerbating existing symptoms elsewhere.

Third, covering up some of the more prominent symptoms of the economic malaise caused by artificial impediments will reduce the incentive to deal with the causes, because the damage will not be as easily seen and the size of the job of eliminating causes will be bigger.

Fourth, the adverse effects of the artificial impediments identified herein extend beyond mining and processing.  Compensating for the damage caused in these segments of the economy is not going to compensate for the damage caused by the same artificial impediments elsewhere in the economy.  Indeed, it will increase the damage elsewhere.

Fifth, artificial impediments harm the economy by misallocating resources, causing them to be used less productively than they could be, thereby reducing national income and growth below their real potential.  Removing artificial impediments is the least expensive method of dealing with this problem, because it corrects the original misallocation of resources while avoiding further resource misallocation.  Indeed, it is the only way of fixing the problem properly.  Other methods that involve compensating specific losers only mask the symptoms of the problem.

Sixth, the availability of special compensating assistance can re-orientate efforts away from competing for a cost or quality advantage, towards seeking hand-outs from bureaucrats.

A package of measures directed towards offsetting the damage to mining and processing from artificial impediments without dealing directly with the causes would be just another of those politically expedient, short-term patch-up jobs at which Australian policy-makers have become so adept.

POLICY RECOMMENDATIONS

The basic recommendation flowing logically from the preceding analysis is that all of the artificial impediments to mining and processing in Australia, including those peculiar to remote areas, should be removed.  In those cases in which reforms are occurring, the pace of reform should be speeded up and the reforms expanded to encompass full elimination of the artificial impediments.  This package of new and enhanced reforms should be implemented without delay and the reform process should be completed quickly.

This basic recommendation can be translated into a number of specific actions.  Many of these are summarised in the list below.  The list is not complete because it deals only with artificial impediments discussed in detail in this paper.  A number of other apparent artificial impediments beyond the scope of this paper should also be investigated and if warranted, they should be eliminated in a similar fashion to those covered here.

The following specific reforms should be implemented as a minimum package:

1. Replace excises, wholesale sales taxes, and taxes on transactions between businesses and between businesses and governments (at all levels of government) with a broadly-based, single-rate, value-added tax.  This will eliminate taxes on intermediate inputs.  Value-added tax on inputs should be fully rebated, and value-added tax should not apply to export sales.

   Ideally, the change should be revenue-neutral to minimise the possibility of a resurgence of inflation (particularly in the context of recommendation 7 below, which will tend to be inflationary in the short term).  If a value judgement is made that it is appropriate to compensate certain poorer sections of the community for any real disposable income losses, that compensation should be financed by cutting government expenditure rather than increasing tax revenue.  Also, since the value-added tax will be implemented at the national level, while some of the taxes on intermediate inputs will be eliminated at lower levels of government, transfers from the Commonwealth Government (or sharing of the value-added or other tax bases by different levels of government) will be necessary to compensate the other levels of government for revenue losses.

2. Adjust the system of depreciation allowances under the income tax regime to get as close to true economic depreciation as possible, having regard to high information and administration costs.  While the new "accelerated depreciation" allowances announced in the February 1992 Economic Statement reduced discrimination against long-lived assets, some fine-tuning is still necessary.

3. Eliminate the favoured treatment of capital gains and the "double taxation" of retained earnings under the tax regime, and lower the top personal income tax rate to the corporate income tax rate.  These measures will help remove differential treatment of capital in different uses.

4. Remove the existing 50 per cent fringe benefits tax concession for holiday travel from remote areas and housing benefits in remote areas for those few industries that enjoy them.  Substitute income tax zone rebates designed to overcome the bias in the personal income tax regime against remote areas.  These rebates should be directed towards offsetting the tax penalties arising from paying people more to live and work in remote areas, rather than providing subsidies to offset the natural disadvantages.  To minimise short-term adjustment problems for recipients of the 50 per cent remote area fringe benefits tax concession, the transition scheme described in the relevant section above should be implemented.

5. Provide payroll tax zone rebates to overcome the bias in the payroll tax regime against remote areas.

6. Speed up the pace of reduction of import barriers by eliminating all remaining barriers by 1996.  This will induce depreciation of the exchange rate, watering down the adverse effects on protected import-competing industries and accentuating the positive effects on export industries.  Removal of import barriers, and depreciation of the Australian dollar induced by this measure (and the cutting of real interest rates proposed in recommendation 7 below) will encourage capital and other resources to flow into export industries (such as mining and processing) and import-competing industries presently at the lower end of the effective protection scale.  The lower real interest rates proposed in recommendation 7 below will also facilitate expansion of such industries by reducing the required rate of return on investment.

7. Reduce real interest rates to levels within the range of rates applying in Australia's major trading partners and competing capital-importing countries in the South Eastern Asian region.  This will induce depreciation of the exchange rate in the short term, but nowhere near as large a depreciation as would occur in the absence of the rest of this wide-ranging reform package.

8. Recommendations 2, 3, 4, 5 and 6 will tend to add to public sector deficits.  If recipients of low incomes are to be compensated for losses arising from introduction of a broad-based, value-added tax in place of the existing indirect tax regime (recommendation 1), public sector deficits will tend to rise further.  When combined with the real interest rate cut proposed in recommendation 7 and the exchange rate depreciation that will result, the effect will be inflationary.

   To ensure that the gains from the reforms recommended above and below are not dissipated by higher inflation, it is imperative that compensatory cuts be made to public sector expenditures.  Consistent with the broad thrust of this paper, priority should be given to expenditure cuts where there is:

   • duplication of effort at the same or different levels of government, particularly in relation to regulation of industry and administration of industry policies;
   • provision of "special incentives" to particular industries (one industry's special incentives is others' artificial impediment);
   • interjurisdictional competition for industry through provision of various assistance or "incentives";
   • overzealous protection of the natural environment and other types of heritage;  and
   • other excessive pandering to special interest groups.
   
   

   Cuts in these areas will reduce artificial impediments by reducing the burden of red tape and/or the burden of financing redundant public sector activity.

9. Speed up the pace of reforms of the coastal shipping and onshore cargo-handling industries.  The introduction of effective competition as part of the reform process is critically important for ensuring that substantive reform takes place for the benefit of the Australian economy.

10. Accelerate labour market reforms with an emphasis on deregulation of the labour market, decentralisation of wage bargaining/fixing and removal of restrictive work practices (with benefits to be shared between employers and employees).

11. Allocate exploration and mining tenements in a way that is free of bureaucratic discretion.  Competitive lump-sum cash-bidding could be used at least in the case of more prospective areas.  Secure, long-term, tradeable tenure should be provided.  It should carry both exploration and mining rights and be free of bureaucratic influence.  Conditions should be limited to matters such as royalty, rental, environmental, rehabilitation and safety arrangements and these should be specified clearly and in advance.

12. Minimise "sovereign risk" by taking swift, decisive government action to implement the reforms recommended above and to establish clear, fair and economically sensible long-term "rules of the game" for mining and processing that will stand the test of time.

---

ENDNOTES

1.  R.G. Lipsey and K. Lancaster, "The General Theory of Second Best", Review of Economic Studies, Volume 24, Number 1, 1956-57, pages 11-32.

2.  Commonwealth of Australia, Industry Commission, Mining and Minerals Processing in Australia, Canberra:  Australian Government Publishing Service, 25 February 1991, Volume 1:  "Report", page 169.

3.  The analogy between grounding eagles by clipping their wings and handicapping our internationally competitive industries by protecting other sectors of the economy was used by John Stone in "Paying for Protection", Review, Volume 44, Number 4, 1991, pages 13-15.  However, John Stone is not responsible for the analogy between handicapped industries and land-bound chooks.

4.  Ibid., Volume 1, Chapter 6, page 99, (emphasis added).

5.  Ibid., Volume 1, Chapter 7.

6.  Ibid., Volume 1, Chapter 9, pages 169, 170, (emphasis added).

7.  Ibid., Volume 2, Appendix F:  "The Costs of Impediments to Mining and Minerals Processing".

8.  Ibid., Volume 2, Appendix F, page 205.

9.  For example, see Ben Smith (ed.), "Taxation of the Mining Industry:  Papers Presented to a Workshop on Mining Industry Taxation", Centre for Resource and Environmental Studies, Australian National University, 1979, pages 1-40;  Northern Territory of Australia, "Green Paper on Mining Royalty Policy for the Northern Territory", Department of Mines and Energy, Darwin, February 1981;  Ken Willett, "Mining Taxation Issues in the Australian Federal System", in P. Drysdale and H. Shibata (eds), Federal and Resource Development:  The Australian Case, Sydney:  George Allen & Unwin in Association with the Australia Japan Research Centre, Australian National University, 1985;  Paul Bradley, "Mineral Revenues Inquiry Final Report:  The Study into Mineral (Including Petroleum) Revenues in Western Australia", August 1986;  Industry Commission, op. cit., Volume 3, Chapter 14, "Royalties".

10.  A valuable, more detailed discussion of intermediate input taxation and production inefficiencies in the context of the economics of second-best can be found in Commonwealth of Australia, Industries Assistance Commission, "Certain Petroleum Products -- Taxation Measures", Canberra:  Australian Government Publishing Service, 1986, Appendix K:  "The Inefficiency of Intermediate Input Taxation".

11.  A Griffiths, Federal Minister for Resources, "The Facts on Fuel Excise and Energy Efficiency", letter to The Australian Financial Review, 2 September 1992.

12.  The Economic Statement also announced supplementary "development allowances".  (The announcement was modified slightly on 5 April 1992.)  From 27 February 1992, "for a limited period", projects with a capital cost of $50 million or more that are "completed within a tight time frame" will be allowed an additional "development allowance" of 10 per cent of the plant and equipment component of the investment when the plant is first installed ready for use.  To qualify, a project will need to meet certain other criteria including "the absence of any substantial assistance or protection".  From 1993, there will also be a requirement that the project be "world competitive" with respect to work practices and input prices.  Mineral processing was specifically mentioned in the Economic Statement as an activity that could qualify for the "development allowance".

The Australian Government has made it clear that the "development allowance" is a short-term measure, meant to stimulate an economy in recession.  Therefore, it is not relevant when discussing departures from true economic depreciation in the medium to long term future.

13.  Industry Commission, op. cit., Volume 3:  "Issues in Detail", Chapter 13, "Taxation", page 345.

14.  Ibid., Volume 1:  "Report", page xxix.

15.  A detailed discussion of how protection penalises exporters can be found in K.W. Clements and L.A. Sjaastad, "How Protection Taxes Exporters", Thames Essay No. 39, London:  Trevor-Hobbs for Trade Policy Research Centre, 1984.

16.  K.H. Choi and T.A. Cumming, "Who Pays for Protection in Australia?", Economic Record, Volume 62, 1986, pages 490-496.

17.  For a colourful, well written exposition of this point and some other issues discussed in this section of the paper, see John Stone, "Paying for Protection", Review, Volume 44, Number 4, 1991.

18.  Industry Commission, op. cit., Volume 2:  "Commentary Statistics and Analysis", pages 201-203.

19.  Ibid., page 201.

20.  Ibid., Volume 3:  "Issues in Detail", Chapter 16, "Transport of Minerals", page 425.

21.  Ibid., page 422.

22.  Ibid., page 423.

23.  Ibid., page 427.

24.  Ibid., Volume 2, Appendix F, "The Costs of Impediments to Mining and Minerals Processing", pages 195-199.

25.  Ibid., Volume 3:  "Issues in Detail", Chapter 19, "Macroeconomic Factors", pages 488-492.

26.  Ibid., Volume 1:  "Report", "Findings and Recommendations", page lvii.

27.  Confederation of Western Australian Industry, "Major Project Construction Costs in Australia", Submission to the Industry Commission, 1990, page 2.4.

28.  J. Stone, op. cit., pages 13-14.  [Interpolations in square brackets were provided by the author.  Others were inserted by John Stone].

29.  Confederation of Western Australian Industry, op. cit., page 2.4.

30.  Bruce Chapman, "The Labour Market" in S. Grenville (ed.), The Australian Macro-Economy in the 1980s, Proceedings of a Conference, 20-21 June 1990, Sydney, Reserve Bank of Australia, 1990, page 7.

31.  The analysis in this section draws heavily on previous work by Ken Willett, which was the first detailed critical analysis undertaken of the conditional first-come-first-served and work programme bidding systems so widely used in Australia.  See Ken Willett, "Mining Taxation Issues in the Australian Federal System", in P. Drysdale and H. Shibata (eds), Federalism and Resource Development:  The Australian Case, Sydney:  George Allen & Unwin in association with the Australia Japan Research Centre, Australian National University, 1985, pages 116-126;  and Northern Territory of Australia, "Green Paper on Mining Royalty Policy for the Northern Territory", Department of Mines and Energy, Darwin, February 1981, Chapter 5 and Appendix B.  This analysis was inspired by a discussion of imperfect tenure in the United States in the "Editor's Conclusion" in Mason Gaffney (ed.), Extractive Resources and Taxation, Madison:  University of Wisconsin Press, 1967, pages 338, 383-386, 388, 391-392.  The Industry Commission, op. cit., Volume 3, Chapter 3, has reached similar conclusions to Ken Willett.

32.  A simple demonstration of this can be found in Northern Territory of Australia, op. cit., Appendix B, pages 158-163.

33.  Detailed analyses of competitive cash-bidding alone and in conjunction with royalties can be found in Willett, op. cit., pages 124-126;  Industry Commission, op. cit., Volume 3, pages 370-371;  and G. Fane and B. Smith, "Resource Rent Tax", in C.D. Trengove (ed.), Australian Energy Policy in the 80's, Sydney:  Allen & Unwin, 1986, pages 209-237.  All three favour combining competitive cash-bidding with royalties based on pure economic surpluses rather than with traditional royalty systems that are based on revenue, output and, occasionally, accounting profits.

34.  Industry Commission, op. cit., Volume 1:  "Report", "Overview", page xxiv.

35.  See Bradley, op. cit.