Efficient taxes, how not to kill the goose that lays the golden eggs

15 Nov Efficient taxes, how not to kill the goose that lays the golden eggs

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Several people have asked me about the draft incentives law (applied to the hydrocarbon sector) currently under discussion in the Bolivian Congress (sorry, the Assembly—I’m still not used to calling it that). While I try to obtain the draft law, I’d like to share a brief post with you on efficient taxation. This will help me later to discuss aspects of this incentives law.

A brief technical note (which you may skip): “There’s something in common between singing romantic songs about an abstract homeland and performing optimization exercises for a society with an arbitrary objective function. While both activities are worthwhile and often pursued, I’m afraid this book addresses neither”.

With this hilariously sharp observation, Professor Amartya Sen begins the introductory chapter of his remarkable book Collective Choice and Social Welfare. Why do I highlight this paragraph? Because in economic, the efficiency of a public policy is often evaluated according to an arbitrary objective function, making the question “What is efficient?” a difficult to answer.

Now, let’s focus on tax efficiency, evaluated in terms of fiscal revenue. Imagine, dear reader, that in a moment of perplexing benevolence, the government decides to set a tax rate (the tax rate percentage) at 0%. In this scenario, what would the government’s fiscal revenue be? The immediate answer is zero; if the tax rate is 0%, the revenue is also 0. This situation is represented by the “red” point in the following figure.

Now, assume the government decides to increase the tax rate to 100%. Yes, 100%. What would the fiscal revenues be? I often use this example in petroleum taxation classes to “catch” participants. Typically, the response to this question is, “Revenue will be 100%” Well, in normal conditions, revenue would actually be 0. The reason is simple: if the government takes all the income (or profit), there is no incentive to work in that industry. Consequently, production would drop to zero, and so would fiscal revenues. This is represented by a new “red” point on the right side of the figure.

If both points are true, it means there is a curve of this nature between the two:

That is, as the tax rate increases from 0%, revenue rises, reaches a maximum point, and then begins to fall—discouraging investment, and thus production. This is known as the “Laffer Curve,” and I owe this clever example to my good friend Luis Carlos Jemio.

This way, we can find an optimal tax rate “t*” that maximizes government revenue, represented as follows:

In the hydrocarbon sector, this optimal tax rate varies depending on several factors:

The level of reserves.

The field’s production levels.

Selling prices.

Whether gas or oil is being produced.

Geological conditions.

Production costs.

Etc.

The current Bolivian hydrocarbons law, clumsily, establishes that all fields in Bolivia must pay 50% of their gross wellhead income as taxes. This is as absurd as assuming that a single shirt size will fit all Bolivians—tall, short, fat, and thin alike.

This law has been in place for ten years, and while it achieved success in terms of fiscal revenue, it has severely harmed investment in hydrocarbon exploration and production, particularly oil. It’s worth reminding the kind reader that Bolivia’s diesel imports in 2000 amounted to nearly USD 100 million, while in 2014, they reached a staggering USD 1.2 billion. Why? Because Bolivia’s oil production has performed very poorly.

This note serves as an appetizer for the discussion on the incentives law for hydrocarbon exploration and production currently under debate in Bolivia. For now, I’ll ask Santi what he wants for lunch—on weekends, he’s not just the little boss; he also acts like one.

S. Mauricio Medinaceli Monrroy

La Paz

November 15th, 2015