Article The changing value of money

Taxing Resources, funding development

Africa is a rich continent. In 2010, the value of natural resources extracted on the African continent was $788 per capita. In comparison, development aid only contributed $30 to the income of the average African.

At the same time, the median income of an African is only $945, suggesting that a large part of the continent’s resource wealth isn’t benefiting the majority of the population. A good example is Equatorial Guinea, a country that has a GDP of $17.7 billion at a population of just 760,000 people, almost exclusively fuelled by oil windfalls. Despite this, 77 percent of the population lives below the national poverty line.

In fact, Africa is estimated to lose between 40 and 80 billion dollars per year to illicit financial flows, e.g. tax evasion, alone. Much of this money probably originates in the resource sector.

For resource rich African countries, answering the question of how to profit more from their natural resources is probably the political challenge with the highest stakes of our time.

The importance of the resource sector for the economic development of Africa will continue to grow in the coming years, thanks to rising prices and new discoveries. “We had a series of major oil and natural gas finds in Africa,” Todd Moss, a senior fellow at the Center for Global Development tells Contributoria. “Basically everybody with a coast has had a discovery.”

The OECD, the African Development Bank and the United Nations Development Programme agree. “With a comparatively high price level remaining for some time and significant expansion of production over the next years,” the organizations write in the 2013 edition of the African Economic Outlook, “Africa faces a window of opportunity to create economic structures that can provide employment and income for all on the back of its resource wealth.”

What taxes got to do with it

There used to be a time when conventional wisdom dictated that the best way for African countries to develop economically was to attract as much foreign direct investments as possible, at all costs.. To attract investments, African governments were pressured to introduce tax regimes and mining codes highly favourable to international companies, with low marginal tax rates and little oversight. Of course, the whole thing didn’t really work out.

Today, taxes have a better reputation. “Taxation provides governments with the funds needed to invest in infrastructure, relieve poverty and deliver public services,” states the 2014 African Economic Outlook self-confidently. Many African governments are tired of of being prescribed their economic policies from abroad and have seized the opportunity of high resource prices to put emphasis on domestic revenue generation through taxation.

Of course, taxing natural resources production is not without its intricacies. Resource extraction, especially mining, is a very costly and time-intensive business. Large projects, like the Simandou iron ore mine in Guinea, cost billions of dollars to develop and often take decades from the beginning of the exploration phase to actual production. This results in the need for governments to balance conflicting desires: high revenues and low risk with a favourable investment climate, for example, or spending revenues immediately versus saving money for future generations.

But as hard as these questions are to answer, the potential benefits of extending taxation are enormous. In 2012, resource taxation accounted for $242 billion, almost half of all taxes paid in Africa. But those $242 billion are less than a quarter of the more than one trillion dollars worth of natural resources that are produced in Africa each year. Even assuming stable production and world market prices, African countries could increase their tax base by several hundred billion dollars, if they would tax resources with the same effectiveness as European countries.

Beyond their obvious benefit of bringing money into the bank, taxes also fulfill an important social function. If done right, tax regimes can catalyze state building, because if important stakeholders are taxed by governments, they have an interest in holding these governments accountable for how “their” money is spent.

Of course, this is also one of the biggest weaknesses of natural resource revenues, also known as the “Resource Curse”. Because governments of resource-rich countries do not rely on the taxation of their citizens, they can afford to ignore them. This leads to authoritarian, badly governed and corrupt states where elites survive by handing out a small share of the country’s riches to their own supporters, while the majority of the population is left behind. Both Angola and the Democratic Republic of the Congo are excellent examples of this..

The Resource Curse makes it even more important that natural resources are taxed and governed fairly and equitable. In the absence of fair and transparent taxation, resources are unable to fulfill their promises for African development. Unfortunately, one of the biggest hindrances on the road to better resource taxation are not only the governments, but also the resource companies, which invest heavily in undermining and evading taxation.

Transfer pricing and other tricks

The reason that African countries so far profit comparatively little from their resource wealth, explains Anne-Sophie Simpere, a tax justice expert for the international advocacy organization Oxfam, is that companies intelligently limit their exposure to taxes at several points. “When a mining company enters a country,” she tells Contributoria, “they will have the normal tax regime which is often quite favourable to the company, because of pressure from the IMF, World Bank and other institutions in the 1990s to attract investors. Then the company will negotiate more tax breaks into the contract and then they will have their tax optimization schemes or their tax avoidance strategies.”

Tax regimes and mining codes that hail from the era of the Washington Consensus are still an issue in Africa, though many countries that only recently discovered their resources use more modern approaches to tax legislation. But even if a country’s tax regime is favourable for the government, international corporations can often pressure governments to give them preferential treatment and outright tax holidays, because resource projects involve such huge amounts of money.

These individual contracts are a problem, because often, African countries are not really aware of what they are signing away. “Governments don’t have the necessary financial and human resources to negotiate these contracts,” argues Myriam Carius, who works as a legal counsel to African governments during resource contract negotiations. Before she took her job at the African Legal Support Facility, she sat at the other side of the table, representing financial institutions and resource companies. She quit the private sector, she says, because she was shocked by how easily countries like her native Côte d’Ivoire let themselves get pulled over the barrel during negotiations.

But even if companies formally agree to pay taxes on their activities in an African country, they have a number of strategies at their disposal to greatly limit their exposure, says Logan Wort, Executive Secretary of the African Tax Administration Forum. “The most important,” he explains, “is something called transfer pricing.”

This term describes a process by which a mining or oil company sells the resources it produces at a very low price to a subsidiary company that is located in a tax haven, like the Cayman Islands. Of course, this is purely a financial transaction, the actual resources never pass through the tax havens.

Subsidiary A then sells the product to another subsidiary, this time located in the market that the resources are actually destined for. This time, the price is inflated as much as possible. Subsidiary B then sells the resources to the final consumer at a minimum profit.

Using this transfer pricing scheme, almost all of the taxable value of the resource is realised in the tax haven where the company has to pay no or very little tax. Both the African country and the country of destination, for example the U.S. or a European Union member state, are left empty handed.

There are of course other tricks in the book of international tax evasion. Logan Wort can enumerate a whole list of them: Companies routinely declare second hand exploration and extraction tools as new and claim tax benefits of them; especially in the oil business, exploration activities are often taxed differently from actual production, giving companies the opportunity to artificially extend exploration and enjoy lower tax rates on their exports; and sometimes, companies resort to plain bribery and extortion of government officials to “optimize” their tax burden.

“For developing countries,” says Oxfam’s Simpere, this kind of tax optimization “is really difficult to tackle.” Like Myriam Carius, she sees huge deficits in the capability of African countries to negotiate the terms and contracts for proper resource taxation.

In the case of Zambia, she says, “they were privatizing copper in the late nineties, when copper prices were very low. So they were told for companies to come, they would have to introduce a very preferential tax regime. The problem is that some years later the price for copper was very high and Zambia didn’t get anything of that,” because the government had not considered the possibility of price fluctuations during the negotiations.

But designing good frameworks for the taxation and profit sharing of natural resources is possible for African countries, a point that all experts can agree on.

The art of designing a tax regime

Designing a resource tax regime is an art, rather than a science. There are too many variables involved to provide hard and fast rules, says Logan Wort. Taxation will differ depending on the type of resource, its location and local characteristics the political priorities of the country and many other factors.

“There is not a figure for everything,” says Anne-Sophie Simpere when asked about a fair share of profits for governments for the resource sector, “but in the oil sector you can make a comparison with Norway. Norway receives something like 75 percent of the value of the oil produced in the country.” In many African countries, this figure is probably closer to 20 percent.

As a rule of thumb, says Logan Wort, countries should “have certain principles that drive their natural resource taxation policies and these should apply to everyone.” For example, companies should be able to own the land on which they build facilities, but they should never be allowed to own the resources under the land.

These principles should be codified in taxation laws and mining codes and they can provide the framework for contract negotiations with individual companies, when these become necessary, says Wort, laying the basis for effective tax collection.

But to design these legal frameworks, Logan Wort says, governments and tax administrations need competent personnel. Simple accountants don’t suffice. “The problem is, we often do not understand the profits. What makes a good tax regime is knowledge of the industry beyond accounting.” Only an intimate understanding of the inner workings of, for example, copper mining, will allow governments to assess the activities of private companies.

Equally important are good IT systems, says Wort. Governments need direct access to the financial transactions of a company, which is especially important to counter strategies like transfer pricing, he argues. These systems already exist to counter the financing of international organized crime and terrorism, but not enough countries have access and the knowledge to use them properly.

Access to a company’s financial transactions would also increase the transparency of the sector as a whole, something that practically everybody – except the companies themselves – agree is essential for a working tax regime. Only if the taxation process itself, as well as the management of tax revenues, is handled transparently, it can contribute to fostering a stronger relationship between the government and those it governs.

Of course, developing these kinds of capacities needs money. After all, tax administrators have to be trained and paid competitive wages. But while this would be the surest way to increase the income of African governments, the international community doesn’t seem to be particularly interested in it. International aid to support tax activities has remained marginal in the overall aid budget to African countries.

African countries can take the necessary steps on their own, though. Several countries have implemented at least parts of the above recommendations, among them Botswana, Tanzania and Ghana.

But even without optimizing tax regimes, African countries already earn huge amounts of money from natural resources, raising the question how this money should be invested to contribute optimally to a nation’s development.

What to do with all the money?

“Most countries just put the money right into the budget,” says Todd Moss of the Center for Global Development. And while this is the most common strategy, it is also the worst, in his view. By just transferring resource revenues into the yearly budget, governments create huge opportunities for mismanagement and graft. “Countries in Africa have tended not to spend windfall gains very well. Very rarely do regular citizens see any benefit,” says Moss and cites Equatorial Guinea as an example.

One of the issues with just spending resource revenues, apart from outright corruption, is that those revenues are inherently volatile. Resource prices fluctuate heavily from year to year – the price of gold has doubled from 2008 to 2012 and has since again fallen substantially. These fluctuations are reflected one to one in national budgets, making long-term investments very challenging.

To alleviate this problem, “some countries have been experimenting with stabilization funds,” says Moss. These funds are designed to pay out only the rolling average of several years of earnings, but because they remain under the direct control of the government, they remain susceptible to mismanagement, says Moss.

A few countries, especially those that only recently have discovered resources, have taken a different path. They put all or a large part of the money in sovereign wealth funds. These investment vehicles are usually managed independently from the government and are at least partly removed from the desires of day-to-day politics. The most famous example of these is the Norwegian Pension Fund, which is fed by oil revenues and estimated to be the largest pension fund in the world. In Africa, sovereign wealth funds are usually charged with investing heavily in infrastructure and social services.

This, says Todd Moss, is only partly a good idea. “Large-scale construction is probably the most corrupt sector globally with big opportunities for graft and fraud,” he cautions, adding that “Tanzania tripled its education budget [with the help of resource revenues] and learning outcomes actually got worse.”

Instead of investing the majority of resource revenues directly in infrastructure or social services, he advocates for a different strategy: pay out a large share of taxes on natural resources directly to all citizens, with everyone getting the same piece of the cake.

This idea, called Direct Dividend Transfer, is not as radical as it sounds. Many African and South American countries have experimented successfully with non-conditional cash transfers to the poor, although this is rarely coupled directly to resource revenues. There is a huge body of science that makes it clear that the poor usually make good use of their money and don’t squander it, as one may assume.

For Moss, DDTs would have several benefits. Obviously, giving cash to the poor would increase their spending power, allowing them to invest in the education and health care of their families. It would also increase the accountability of the government, he argues, because any mismanagement will directly impact the amount of cash that each citizen receives in a year. This, Moss says, is exemplified perfectly in the Alaska Permanent Fund, which pays out a dividend from oil revenues of around $1,000 to every Alaskan each year and has produced unprecedented public interest in the financial matters of the state..

But the biggest benefit of DDTs, Moss argues, is that they contribute to the establishment of taxation institutions. “[DDTs do] not mean defunding the state, it means that some significant portion goes directly to citizens,” Moss says, pointing out that for transferring the cash, the state will need to develop a payment infrastructure, a national ID database and essentially give every citizen a bank account. Citizens will of course have a great self interest to cooperate in this endeavour. This would put the government into the position to radically increase the reach of its tax base, pushing back the informal economy that is prevalent in many African countries and which is virtually impossible to tax efficiently.

According to a study by the Center for Global Development, there are several African countries where resource revenues could already pay every citizen the equivalent of 10 percent of the national poverty line, among them Angola, The Republic of the Congo, South Sudan and Nigeria. This translates to a few dozen dollars per year, depending on the country. While it doesn’t sound like much, when living on less than $1.25 per day, this kind of money can make a huge difference.

So far, no African country has committed itself to this approach, although several governments “have indicated their interest”, says Moss. But whether using DDTs or not, resource rich African states will have to work hard to increase their share of resource revenues and to manage them transparently and effectively, if they want to deliver on their promise of quick and equitable development.

About the Author: Peter Dörrie is a freelance journalist specializing in resource and security politics on the African continent. This is his third published story on Contributoria, others are in preparation. You can follow him on Twitter and Facebook.

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