Annex 7: Resource Revenues

How should the capacity to raise resource revenues be measured?

An RTS tax base should measure how much a province could raise from the revenue source if it levied the national average tax rate. In the case of resources, provinces attempt to capture or tax the economic rent.

What is economic rent?

Economic rent is the difference between the selling price of a good or service and the cost of producing it, including a normal return to capital employed. Economic rent is often generated with natural resources, as there is usually a world price for commodities and the cost of bringing natural resources to market is considerably less for some producers, leaving surplus economic rent for provincial governments to capture.

For production to be viable at all, the value of resources must at least cover the up-front fixed costs of exploration and development, including the costs of the inevitable dry holes, the operating costs of actually bringing the resource to market, and a normal rate of return to investors. This is the total economic cost of producing the resource.

The remaining value is the economic rent available to be shared between the resources’ owner (i.e., the province) and the producers.

Figure 1 illustrates the way in which the total value of natural resources produced in a jurisdiction is apportioned among the various economic players involved.

Figure 1 – Illustrative break-down of the value of natural resource production by its ultimate uses

Differences in the nature of various natural resources, including location and geological factors that are site-specific, translate into large and systematic differences in the economic costs of production and widely differing levels of rent. For example, the cost of production differs for each dollar of output, varies greatly among producers across different resource sectors (e.g., ranging from high-rent oil and gas fields to low-rent gravel deposits), or even in the same resource sector (e.g., between conventional oil and oilsands) and across different provinces (some provinces have oil that is less expensive to extract).

Provincial revenue-raising practices

In order to collect resource rents, provinces use tax structures that take into account the differing levels of rent due to location and geophysical factors. In addition, the revenue-raising systems attempt to take into consideration the high degree of volatility in commodity prices, the difficulty of knowing precisely how large a deposit may ultimately prove to be, and the significant changes in profitability over the various phases of the life cycle of a deposit. As a result, the simple conceptual framework shown in Figure 1 typically translates into very complex revenue-raising mechanisms where provinces attempt to extract economic rents.

Royalty regimes are often the primary vehicle for collecting economic rents. Royalty regimes vary by natural resource type (e.g., various classes of oil, gas, and minerals), and are generally applied to the value of production. Royalty regimes are also sensitive to commodity prices, the volume of output from particular deposits, stage of production, ownership (e.g., production from leases on Crown land vs. freehold lands), and exploration and development costs.

In addition, provinces collect rents through:

• Auctions for exploratory leases on Crown lands
• Resource sector-specific corporate income tax provisions
• Remittances from Crown corporations involved in natural resource extraction.

Measuring revenue-raising capacity in the Equalization program

The RTS system currently uses 14 tax bases to measure the capacity of provinces to raise revenues from natural resources. Most use value of production as the tax base and, in this respect, emulate an important but very basic element of the royalty and stumpage regimes. Using value in the Equalization tax base means that, for example, a province that extracts 20 percent of the value of logs in Canada is assumed to have 20 percent of total provincial fiscal capacity related to forestry stumpage fees. Similarly, a province that extracts 20 percent of the value of natural gas is assumed to have 20 percent of the revenue-raising capacity from natural gas.³

This approach is, at best, an extremely crude approximation of the economic rent that is captured by provinces. Most importantly, it fails to take into account different cost structures across provinces and producers. For example, the Equalization tax base implicitly assumes that the cost structure of harvesting one dollar of difficult-to-access small pine trees in one province is identical to the cost structure of harvesting easy-to-access large cedar trees in another province, whereas stumpage fees are determined by such factors. As a result, the Equalization tax bases do not accurately reflect the differences in economic rent that are available for provinces to capture.

The current Equalization program has tried to take these different costs into account by dividing tax bases according to resources that have similar cost structures. For example, a separate tax base has been created for heavy oil to recognize that the cost of generating one dollar of oil production is greater for heavy than conventional oil (and accordingly, each dollar of output generates less economic rent). Again, this is a crude approximation since costs vary not just among the different types of oil, but also among heavy oil mining developments across provinces.

The current system also does not deal with other realities of economic rent, such as the high degree of volatility in commodity prices, the difficulty of knowing precisely how large a deposit may ultimately prove to be, and the significant changes in profitability over the various phases of the life cycle. All of these factors are taken into account when provinces collect resource revenues with their full complement of revenue-raising practices.

For example, a mechanism for dealing with this uncertainty, as discussed earlier in this annex, is the use of auctions for exploratory leases on Crown land. While actual revenue collected by provinces is based on numerous complex factors, including speculation on future prices and the size of yet-to-be exploited deposits, the current system assumes that a province with 20 percent of the current fiscal capacity for oil and gas output has the capacity to raise 20 percent of revenues from Crown land. This is clearly not an accurate measure of a province’s ability to raise revenues from lease auctions.

Other approaches to measuring fiscal capacity

A much better way to measure fiscal capacity from natural resources would be to equalize all resource revenues into a single tax base that measures the economic rent generated by all natural resources in a province. In other words, create an economic rent tax base. This approach has a precedent: the mineral resources tax base was created in 1999 by combining several distinct tax bases into a single base that attempted to approximate rent by using a measure of profitability in the sector. Unfortunately, due to conceptual and data problems, the measure of profitability used in the mineral tax base did not work well, and created results that were inconsistent with revenues raised.

An alternative approach is to use an aggregate measure of the value of production for all resource sectors in a province as the tax base (i.e., create a resource GDP tax base). This approach would be much cruder than a rent approach, but would likely be less demanding in terms of data requirements.

The Panel’s view on measuring fiscal capacity of resource revenues

The Panel believes that the current approach to measuring the capacity to raise resource revenues needs fundamental change. The 14 tax bases are complex and do not accurately take into account the multitude of factors that determine a province’s capacity to generate resource revenues.

Alternatives to the RTS such as economic rent or resource sector GDP deserve further consideration. However, the Panel believes that both data shortcomings and conceptual challenges would make it extremely difficult, if not impossible, to create a reliable tax base for all resource-related economic rent. Moreover, it will take time, perhaps years, before a reasonably reliable approach could be devised and implemented.

In the meantime, the Panel recommends using actual revenues. If all provinces are extracting as much of the available rent as possible, there is no need to use an RTS structure to hypothesize how much a province could raise if it levied average tax rates. Actual revenues would be an accurate and fair measure of fiscal capacity. In the Panel’s view, the assumption that provinces try to maximize their revenues from resource rents is quite reasonable.

Not only would the use of actual revenues be more accurate than the current approach, it would also greatly simplify the program and make it administratively easier to treat all resource revenues the same way.

A key concern is that actual revenues might provide a disincentive for provinces to extract resource rents because they would lose Equalization as their resource revenues increased (and vice versa). The Panel believes that using a 50 percent inclusion rate and a two-year lag with a three-year moving average would address this concern. A province that decided to reduce its royalty rates, for example, would generally have to wait five years until Equalization payments fully increased. Even then, Equalization would generally only compensate 50 cents for every dollar of reduced resource revenue. This structure should help to ensure that provinces
continue to maximize their resource rent revenues.

The Panel’s view on hydroelectricity

The measurement of fiscal capacity related to hydroelectricity deserves special mention. Provinces with substantial hydroelectric resources have typically opted to develop and distribute these resources through Crown corporations. They have also chosen in many instances to provide electricity to their residents at close to cost, thus distributing a part of the economic rent directly to their residents in the form of lower prices rather than capturing the rent as revenues.

Under the current RTS, provincial revenues from hydroelectricity are counted in two tax bases, depending on the form they take. Charges for the use of hydrological potential enter into the waterpower rentals base. Remittances from provincial Crown corporations engaged in hydroelectric production and distribution are treated as if they are business revenues. Because of its direct control, a province can ensure that its hydroelectricity revenues enter the two revenue bases in a way that minimizes the negative impact on its Equalization entitlement from the production of hydroelectricity.

If a comprehensive rent base for provincial resources was developed in the future, then hydroelectric rents should be calculated and imputed whether they are left in the hands of hydro consumers or accrue to the provincial government. This would, however, be difficult and controversial. The Panel is not recommending such an approach. It is, however, recommending that the playing field be somewhat levelled by treating the remittances to governments from Crown corporations engaged in resource extraction and development as resource revenues, rather than treating them as business income for Equalization purposes.

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