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Averting theResource Curse

A World Growth Report

April 2008

Path to ProsperityProject Mongolia


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Table of Contents

1. Introduction ........................................................1

2. Executive Summary............................................3

3. Optimizing Minings Contribution toEconomic Development ......................................7

4. Lessons from International Experience ..........15

5. Implications for Mongolia ................................25

6. Conclusion ........................................................35

Annex A ....................................................................41


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According to Mongolias Foreign Investment and

Foreign Trade Agency, the Mongolian mining sector

received nearly $200 million in foreign direct invest-

ment (FDI) in 2006, compared to just $40 million in

2002; thereby accounting for nearly half of all FDI in

Mongolia in 2006. Despite this investment, the sector

contributed only 4 percentage points to the countrys

economic growth in 2007 and its contribution was

largely due to increases in world-wide minerals prices.

Mongolias geological prospects are very bright. It has

world class mineral deposits that are ripe for develop-

ment such as the Oyu Tolgoi copper and gold proj-

ect and the Tavan Tolgoi coal project but they are

often in remote and commercially challenging loca-

tions. Their successful development will therefore

require considerable amounts of capital and sophisti-

cated mining know-how, most of which will have to be

sourced internationally.

The Mongolian tax, regulatory and institutional envi-

ronment exerts a profound influence on the returns

that international investors can expect from in-coun-try mineral development. The quality of the local pol-

icy environment in terms of its attractiveness to

investors is therefore critical to Mongolias future eco-

nomic development and mining role in that future.

Favorable geology must be accompanied by balanced

and compatible policy to enable a viable mining

industry to be achieved.

This paper will canvass the requirements of a mining

policy framework for Mongolia that would deliver

international best practices in terms of investment

attraction. In doing so, the paper will focus on the

prospects and opportunities of the Oyu Tolgoi project,using a three-part approach.

First, the paper will articulate the principles for devel-

oping a policy framework that will optimize the mining

sectors contribution to Mongolias economic develop-

ment. In doing so it will canvass the issues of mining

taxation and regulation, the provision of infrastructure

services to the sector, macroeconomic stability, distrib-

uting the benefits of mining and sovereign risk.

Second, the paper will review recent international expe-

rience through the prism of these policy principles. Thereview will consist of two distinct but complementary

components: a high level cross sectional review of

recent results of surveys of investor perceptions; and

three case studies of mineral-rich, developing countries

with quite different experiences with mining policy

reform. A set of best practice policy measures and s

ettings will be synthesized from the review..

Finally, the paper we will draw on this best practice to

highlight the key policy changes that Mongolia should

adopt for mining generally and the Oyu Tolgoi project

in particular. Oyu Tolgoi could be the largest gold and

copper mine in the world, but needs massive capitalinvestment to realize this potential. The project is a

litmus test for the Mongolian mining tax and regula-

tory regimes and for the Mongolian governments

proposals to lock in key policy parameters for the

project in an investment agreement with its investors

and license holders.

Mining Report on Mongolia Averting the Resource Curse 1

INTRODUCTION

Their successful development will therefore require

considerable amounts of capital and sophisticated

mining know-how, most of which will have to be

sourced internationally.

Mongolia is a developing country that is heavily dependent upon its mining sector, which is

directly responsible for nearly one-fifth of the countrys GDP, two-thirds of its industrial

output, three-quarters of its export earnings and one-half of its public revenue.


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2 Mining Report on Mongolia Averting the Resource Curse


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Mongolia Needs Oyu Tolgoi to Proceed

Oyu Tolgoi has the potential to become the worlds

largest copper and gold producer, but realizing that

potential will require investment on a scale that is

unprecedented, certainly for Mongolia. Once under-

way, the project stands to generate substantial eco-

nomic benefits for Mongolia via its contributions to

gross domestic product, employment, exports, infra-

structure and public revenue. But these opportunities

may all be lost if the window for development of the

mines at Oyu Tolgoi miss the commodities market

since such large mines cannot be built overnight.

Ivanhoe Mines, the owner of the Oyu Tolgoi minerallicenses, proposes to invest in excess of US$7 billion in

the project over a period of 35 years. More than half of

this amount would be committed in the first 15 years

of the life of the project.

Mining investment, particularly on this scale, is huge-

ly sensitive to the quality of the institutions and the

policy framework that exists in the host country. The

policy framework consists of the taxation and regula-

tory arrangements that the host government imposes

on the mining sector. The greater the economic bur-

den that is placed on mineral exploration and devel-

opment, the less attractive the country will be to inter-national mining companies.

but Mongolia Discourages Investors

Mongolia has made commendable progress in trans-

forming itself into a democracy and free market econ-

omy. This progress has been reflected in its adoption,

early in its transition, of a modern legal architecture,

with which to tax and regulate mining. Sadly, manysignificant practical details were left for later develop-

ment but have never been completed. More unfortu-

nately, the most recent policy innovations have begun

to reverse the earlier progress.

Put simply, the current institutions and the policy

regime in Mongolia are not internationally competi-

tive in terms of attracting and retaining mining

investment, and it is a long way from being so. Its lack

of competitiveness represents a major economic cost

for ordinary Mongolians who seek jobs and a better

way of life, given the economys present reliance on

agriculture and the countrys inability to capitalize onits rich geological potential.

The gap in international competitiveness has been

highlighted by a recent survey of mining companies

around the world. The Fraser Institute asked the com-

panies to rate the policy regime in 68 mining jurisdic-

tions around the world.

In 2007-08 the companies surveyed ranked Mongolia

as the 8thworst of the 68 countries in terms of invest-

ment attractiveness. This is in sharp contrast to other

mineral-rich developing countries, such as Chile and

Botswana, which were at the top of the rankings.Papua New Guinea, on the other hand, has shown

how even highly selective reforms, when well target-

ed, can dramatically improve a countrys standing.

Part of Mongolias problem is the poor quality of some

of its institutions, such as those concerned with secur-

ing property rights and preventing corruption. For


EXECUTIVE SUMMARY

Mongolia is in the process of transforming itself into a nation that is based on secure prop-

erty rights, economic freedom and democratic government and even though it has lost its

way in that regard over the past several years it is believed that it can and will get itself

back on course. A major test of the progress it has made, as well as its resolve to continue

with that process, will be how it handles the challenge represented by Oyu Tolgoi, a mas-

sive, world class mineral deposit located in the remote South Gobi region of Mongolia, near

the China border.


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Deposit. The other concerns the legal alternatives for

the government to compulsorily acquire substantial

equity interests in such Strategic Mineral Deposits

without remotely coming close to paying anything

related to fair market value for such interests. At the

same time, the government would continue to regu-

late the very mineral projects in which it has equity

interests. In fact, in a heretofore unprecedented move,

the Mongolian government recently announced that

it would obtain a 96 percent equity interest in the

Tavan Tolgoi coal deposit.

The mere possibility of the government doing so is a

significantly negative factor from the perspective of

international mining investors. This would increase

the international perception of the risks of investing

in Mongolia and thereby reduce the amount of inter-national capital available for investment in the coun-

try. In such circumstances, the government as well as

the people of Mongolia should ask themselves what

western mining company would risk investing sub-

stantial funds in exploration activities that may result

in the discovery of a commercial deposit only to have

the government take it away or at least a substantial

portion of it?

Draft Investment Agreement only a

Partial Solution

To make Oyu Tolgoi a reality, the Mongolian govern-ment has been negotiating with Ivanhoe Mines and

Rio Tinto to conclude an investment agreement.

These negotiations started in late 2003 and are con-

tinuing to the present time. The current Minerals Law

allows such agreements to lock in key tax and fiscal

issues and regulatory parameters for establishing a

mining project for up to 30 years or more.

The governments latest proposals for the draft agree-

ment have a major advantage. They would effectively

eliminate the most serious shortcoming of the

Mongolian mining tax regime the 68 percent tax on

windfall profits albeit at a cost to the company andthe country.

The windfalls profits tax is without precedent else-

where in the world and is the major reason behind

Mongolias lack of investment competitiveness. So-

called windfall profits perform an essential function.

They reward the entrepreneurial effort that brings

example, the Heritage Foundations Index of

Economic Freedom report for 2008 noted that the

enforcement of laws protecting private property was

weak in Mongolia and its judges generally did not

understand commercial principles such as the sanctity

of contract. Moreover Transparency International

ranked Mongolia 99th out of 163 countries on its 2006

Corruption Perception Index. The latter was due, in

part, to allegations of public sector corruption that, in

some cases, appeared to involve cabinet-level officials.

Corruption, incomplete or insecure property rights,

and absence of the rule of law inhibit Mongolias abili-

ty to profit off of its extensive mineral resources.

The competitiveness gap between the Mongolian pol-

icy regime and international best practice has beenquantified by Professor James Otto, an international

expert in mining taxation and regulation. On the basis

of independent research, Professor Otto has estimated

that the current regime in Mongolia captures nearly 70

percent of the gross profitability of a representative

large-scale copper mine. This is twice as much as

occurs with international best practice.

Given the overall tax burden under the Mongolian

mining tax regime, Professor Otto estimated that the

internal rate of return to a foreign mine owner would

be less than 8 percent per year. This is just over half

the minimum rate of return that international miningcompanies expect from such investments and not suf-

ficient to entice any western mining company to

invest large capital or to do business in Mongolia.

Taxation aside, there are two serious flaws in the reg-

ulatory regime for mining in Mongolia. One involves

the creation of the concept of a Strategic Mineral


On the basis of independent research, Professor

Otto has estimated that the current regime in

Mongolia captures nearly 70 percent of the gross

profitability of a representative large-scale copper

mine. This is twice as much as occurs with interna-

tional best practice.


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as any Equity Acquisition would be a

Serious Mistake

The acquisition of an equity share in the Oyu Tolgoi

project would be viewed negatively by international

mining investors. More importantly for Mongolia, it

would put at risk the substantial economic benefits

that the project would deliver for the Mongolian com-

munity as a whole.

Regardless of how the terms for the acquisition are

eventually reached, this would increase perceptions of

the risks of investing in Mongolia and reduce the

amount of capital for investment in the country.

Acquisition would also undermine the financial via-

bility of the project, increase the risks associated withit, and potentially complicate its management. These

impacts would lower the value of equity in the project,

which would be reflected in a reduction in its prof-

itability and in the net present value of the dividend

and public revenue streams from it.

Partly for this reason, most countries have realized that

the standard corporate income tax is a much less risky

and more effective way of ensuring that the communi-

ty as a whole shares in the benefits of mining develop-

ments. There is no empirical evidence that acquisition

or equity participation would yield more revenue for

the public purse, quite the contrary, in fact.

Finally acquisition would create a serious conflict of

interest for the government. It would be expected to

regulate mining at Oyu Tolgoi in the public interest.

At the same time, it would have a strong financial

interest in not doing anything that would reduce its

profitability.

Any exercise of the acquisition option in the case of Oyu

Tolgoi would be seen as increasing the risks of mining

investment in Mongolia more generally, which would

have negative consequences for mineral exploration

and development. This perception will have been rein-forced by the governments proposal to completely

nationalize the Tavan Tolgoi coal mine and would be

reinforced further if the government completes that

acquisition.

together the capital and sophisticated knowledge,

which is the foundation of successful minerals devel-

opment. Taxing this incentive makes no sense. It only

reduces the flow of investment and may destroy it

completely.

Unfortunately, eliminating the windfall profits tax in

the context of the proposed agreement would unneces-

sarily restrict the economic benefits to Mongolia from

the reform. The more desirable solution would be to

repeal the tax completely. No repairs can be made to

such a tax law as the concept is fundamentally flawed.

Elimination of the windfall profits tax for Oyu Tolgoi,

however, will come at an apparent cost to the compa-

ny and to Mongolia, although the extent of that cost is

unclear.

To avoid imposition of the windfall profits tax, the

Mongolian government has proposed that Ivanhoe

must have a 500,000 tonne copper smelter built in

Mongolia within five years of the commencement of

mining operations at Oyu Tolgoi. In the absence of

any legislative restrictions or mandates, a smelter

would ordinarily be built only if it makes commercial

sense. There would be no net economic benefit to

Mongolia in forcing an uneconomic investment on

Ivanhoe or anyone else, including the Mongolian gov-

ernment. It would simply divert capital from more

rewarding applications, such as the subsequentexpansion or upkeep of the proposed mines.

The windfall profits tax aside, the governments other

proposals for the investment agreement would

entrench the serious flaws in the Mongolian regulato-

ry regime. These relate to the legislative option for the

compulsory acquisition of some, if not all, of the equi-

ty in a mineral project by the Mongolian government:

Although the relevant regulations have yet to be

developed, the governments proposals for the agree-

ment envisage it acquiring 34 percent of the equity in

Oyu Tolgoi without any payment close to present fairmarket value. Moreover, the government has subse-

quently suggested that the acquisition level should be

raised to at least 51 percent. The terms of any acquisi-

tion have yet to be agreed between the parties.



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3. Optimizing Minings Contribution toEconomic Development

Mining is a source of wealth creation. The economic

surpluses that are generated by successful mining

developments drive private companies to explore for

minerals and develop mines to extract the ores from

them. In some cases, the surplus can be very substan-

tial, even after allowing for the risk-adjusted return

that investors require for them to proceed with an

investment. Such surpluses are known as economic

rents.1

The process of initial mineral exploration and subse-

quent mine development is generally economically

beneficial to a host country in two different ways.

Mineral exploration and mining generates addi-

tional economic activity. In the case of developing

countries, this generally takes the form of employ-

ing local people and using locally-produced goods

and services, i.e., building complementary manu-

facturing and services industries to support the

mining industry.

Mining provides a host government with an oppor-

tunity to redistribute some of the economic rents

from mining by way of mining regulation and tax-

ation.2

To the extent that such redistribution does not alter the

incentives for mineral exploration and mining develop-

ment, the host country would be a net beneficiary and

the only losers would be the foreign shareholders of the

relevant mining companies. Successful mineral devel-

opment involves overcoming the inherent ignorance

and uncertainty about ore bodies and how best to

exploit them. The economic rents generated by mining

are the returns to the entrepreneurial insight, which is

essential to finding potentially valuable ore bodies and

then finding an economic way to extract the value from

them..3 Exploration can inform mining investment

decisions but it can never eliminate the profound

uncertainty that is part and parcel of every exploration

project and every mine development.

This chapter will outline the principles by which

countries can optimize the contribution that the min-

ing sector makes to their economic development.

Economic development is broadly conceived and

refers to development that benefits the community as

a whole, rather than simply one section of it. In doing

so, the chapter will concentrate on the principles of

most relevance to mineral-rich developing countries,

such as Mongolia.

3.1 Investment & Mineral Development

Modern mining technologies are capital-intensive by

nature and need to be deployed at a large scale to real-

ize the significant economies of scale that they offer.

Mining developments also tend to occur in remote

and sparsely populated locations, which lack access to

basic transport, power and water infrastructure.

All of this means that successful mineral exploration

and mine development involves the mobilization and

deployment of large amounts of financial capital and

sophisticated know-how. For this reason, the global

mining sector is dominated by a relatively small num-

ber of international companies that are well-financedand technologically advanced. They are also risk

averse, highly selective in the projects they undertake

and sensitive to changes in the investment climate

and government policy in which they operate.


1 The concept of economic rent was developed by David Ricardo to analyse land-use in 19th Century Britain. It reflects the natural differ-ences in productivity between different natural resources, such as mineral deposits. Such differences are a function of the cost of extrac-tion and the price of the output.

2 A government can take part of the economic surplus generated by mining in a pecuniary form (as tax revenues) or in a non-pecuniaryone (as regulatory restrictions that add to production costs). Other things being equal, they have exactly the same effect on the incen-tives for mineral exploration and development.

3 If mining were restricted to a risk-adjusted rate of return, the owners of the capital and labour used by the sector could be fully compen-sated for their inputs but there would be nothing left for the entrepreneurial effort in bringing them together in the right combination,in the right place, at the right time.

Mining developments also tend to occur in remote

and sparsely populated locations, which lack access

to basic transport, power and water infrastructure.


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A United Nations/World Bank survey of international

mining companies has identified the decision criteria

which they use to evaluate mineral projects and

potential investments Table 1 has the key results. In

addition to a host countrys geological prospectivity

and its mining tradition, this survey makes clear that

mining investors are particularly sensitive to:

attractive and competitive fiscal conditions;

clear mining rights and title;

retaining ownership and control of mining

operations;

availability of infrastructure; and political stability

and transparency of governance with sound and

supportive government policy.

Each of these characteristics of the investment envi-ronment in a jurisdiction is a direct consequence of the

quality of the institutions in the jurisdiction and public

policy regime that it applies to the mining sector. In

other words, the greater the share of the economic sur-

plus that the government takes away from the

investors through its taxation, regulatory and institu-

tional arrangements and settings, the less incentive

they have to explore for minerals or to extract them

from the ground once they have been found. If the

investors share becomes too small, exploration for

new mineral deposits, reinvestment in existing mines

and development of new mines would cease complete-

ly. This would, of course, involve consequential lossesin employment and other economic activity that were

associated with these operations, some of which occur

outside the mining sector. It would be akin to killing

the goose that laid the golden egg.

From the economic perspective of the host country,

there is an optimal burden to be imposed on its min-

ing sector by way of the taxation, regulatory and insti-

tutional arrangements and settings under which the

sector is expected to operate. The international com-

petitiveness of such a framework is necessarily a

dynamic concept. Most mining jurisdictions around

the world are more or less constantly seeking reformsto their policy framework to increase their ability to

attract mining investment. This means that policy

reform remains a continual process for most countries

rather than an ad hoc development.

In practice, the principles that determine the optimal

public policy framework and settings are difficult to

determine with precision. This reflects fundamental

constraints on our knowledge of the relevant informa-

tion, such as how the individuals and companies in

question may be expected to react in response to par-

ticular changes in key prices and costs. Each of the

elements of this assessment is dealt with in the rest of

this chapter.

3.1 Taxation of the Mining Sector

The mining taxation regime needs to recognize the

unique characteristics of the mining industry. Mining

operations are generally:

relatively high risk; highly capital intensive and often large in scale;

cyclical by nature;

conducted in remote areas which lack access to

basic infrastructure and a working population;

characterized by long but finite project lives; and

associated with significant restoration obligations

at their conclusion.4

The risk and cyclical nature of mining operations are

due to the long and uncertain lead times from explo-

ration to mine development, the significant sovereign

risk of mineral exploration and development, and the

substantial volatility in mineral commodity prices.

Any assessment of the implications of a mining taxa-

tion regime has to take into account how the regime

interacts with the general system of business taxation.

At the end of the day, it is the combined effect of the

two that really matters in determining whether a

jurisdiction is internationally competitive in attract-

ing and retaining investment. The issue for the taxa-

tion treatment of artisanal versus commercial mining

can also be important from a competitive neutrality

perspective.

3.1.1 Level of Mining Taxation

This section will focus on the combined effect of all

taxes, fees and charges imposed on the mining sector

by the legislature. It covers the taxes, fees and charges

levied on all business activity in a jurisdiction, includ-


4 The World Bank, 2004,Mongolian Mining Sector: Managing the Future, The World Bank, Washington, DC.


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Exploration Mining Decision Criterion

1 NA Geological potential for target mineral

NA 3 Measure of profitability

2 1 Security of tenure

3 2 Ability to repatriate profits

4 9 Consistency & constancy of mineral policies

5 7 Company has management control

6 11 Mineral ownership

7 6 Realistic foreign exchange regulations

8 4 Stability of terms for exploration & mining

9 5 Ability to predetermine tax liability

10 8 Ability to predetermine environmental obligations

11 10 Stability of fiscal regime

12 12 Ability to raise external financing13 16 Long term national stability

14 17 Established system of mineral titles

15 NA Ability to apply geological assessment techniques

16 13 Method & level of tax levies

17 15 Import & export policies

18 18 Majority equity ownership held by company

19 21 Right to transfer ownership

20 20 Internal (armed) conflicts

21 14 Permitted external accounts

22 19 Modern minerals legislation

Source: James Otto, 1992, A Global Survey of Mineral Company Investment Preferences, Mineral Investment Conditions in Selected Countries of the Asia-Pacific

Region, United Nations ST/ESCAP/1197, pp. 330-342

Table 1Ranking of decision criteria for investment by international mining companies

ing mining operations, as well as those that are only

levied on mining operations.

The combined effect may be expressed in terms of the

effective tax rate (ETR). The ETR is the net effect of

all taxation provisions, including:

income tax;

dividend and interest withholding taxes;

mining royalties;

any taxes on windfall or excess profits; export and import tariffs and excise duties;

value-added or sales taxes;

the taxation treatment of past losses, depreciation,

depletion allowances, exploration expenses, envi-

ronmental expenses, and mine closure costs; and

tax holidays.

To facilitate comparisons on a consistent basis, ETR is

usually expressed as a share of gross operating surplus

(GOS) in national accounting or a share of earnings

before interest, taxes, depreciation and amortization

(EBITDA) in commercial accounting.

Raising the ETR will change the extent of the eco-

nomic benefits that accrue to the host country from a

given mining project. It will also shift the time profile

of those benefits. In the short run an increase in the

ETR will almost always raise the total tax revenuereceived by the government. Over the longer run,

however, the increase is likely to discourage minerals

exploration and mining development. Tax revenues

are likely to fall compared to what would have hap-

pened otherwise. Beyond some point, the long-run

revenue loss will outweigh the short run gain from the

increase in the ETR.


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The shape of the tax revenue profile over time will, to

a significant degree, depend upon the ETR that is

levied on mining operations in other countries.

Footloose international mining investment will tend

to avoid the higher taxing jurisdictions in favor of the

lower taxing ones.

Other things being equal, the most successful coun-

tries will tend to be those with the lowest ETRs. They

will also be characterized by even-handed taxation

treatment of informal or artisanal mining compared

to commercial mining operations.

3.1.2 Composition of Mining Taxation

Governments around the world impose a wide range

of taxes, fees and charges on the mining activities thatare conducted within their jurisdiction. Most of these

are also imposed on other business activities, such as

corporate income tax, value-added tax, or sales tax.

Others, however, may be specific to mining, such as

mining royalties.

Each tax can have quite different implications for eco-

nomic efficiency, revenue yield, the division of risks

between the public and private sectors, the costs of

public administration and compliance, and trans-

parency. Moreover, these implications may need to be

assessed comprehensively due to the interactions

between different taxes. This is certainly the case forthe overall tax burden.

Other things being equal, economic efficiency generally

prefers taxes to be levied on a base that is as broad as

possible and is least likely to change economic behav-

ior, and at a rate that is as low as possible. Doing so

helps to minimize losses in economic efficiency.

On this basis, product taxes are generally preferred to

input taxes and comprehensive tax regimes are gener-

ally preferred to selective ones. For this reason, econ-

omists are generally lukewarm about any regime of

product-specific taxes, such as mining royalties, in

contrast to the more broadly-based regimes such as a

single rate of tax on all corporate profits or a single

rate of value-added tax on all goods and services.

One of the arguments advanced to justify specific

mining taxation is based on the twin facts that most

mineral resources are publicly owned and that their

successful exploitation can generate substantial eco-

nomic rents. The argument is that specific mining tax-

ation ensures that the resource owners will share in

these rents but it suffers from several significant

weaknesses: The corporate income tax will ensure that mining

rents are shared with the public.

Most mining royalties do not tax the economic

rents from minerals development.

The few countries that have attempted to do so

have not been successful in attracting subsequent

investment into their mining sector.5

Most mining royalties are a tax on mining output.

They reduce mineral exploration and exploitation

compared to what would otherwise occur.

Economic rents are generated by other natural

resources, such as agricultural land, forestry and

fisheries, but they are generally not subjected toroyalties.

Economic rents are purposefully generated by pub-

lic policy, such as intellectual property law, but they

are never subjected to specific taxation measures.

The different taxes have different implications for risk

sharing between the private and the public sectors.

This is highly significant given the substantial risks

associated with mining exploration and development.

A single rate of tax on corporate profits will share these

risks more or less evenly. In contrast, a royalty, which is

based on either volume or value, will tend to shift moreof the risk onto the mining company and less onto the

government, as mining royalties are generally payable


5 The Government of Papua New Guinea (PNG) introduced a tax on the economic rent that it expected to be generated by the Pangunacopper mine on Bougainville after the mine commenced operations in 1969. While operational, the mine made major contributions tothe countrys GDP, exports and public revenues. Civil insurrection on Bougainville closed the mine in 1989. Although a political settle-ment to the conflict was reached in 2001, the mine owner and operator, Bougainville Cooper Limited, has been unable to access themine site, even though it has expressed interest in re-commissioning the mine. The PNG Government abolished the tax in 2003.

The shape of the tax revenue profile over time will,

to a significant degree, depend upon the ETR that

is levied on mining operations in other countries.


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6 Otto et al 20067 Otto et al 20068 Otto et al 2006

even if the mine is not making profits. Conversely a pro-

gressive income tax will shift more of the risks onto the

government, other things being equal.

Although a mining company may be in a better position

to assume more of the risk than the government, partic-

ularly one in a developing or transition country, doing

so always involves a cost. Accordingly, the government

will need to compensate the mining company for

assuming this additional risk by imposing a lower rate

of tax rate than would otherwise have been the case.

Similar considerations apply to the revenue yieldthat

may be expected from the different taxes on mining.

Generally speaking, the greater the risks that are

imposed on the mining company by the tax legisla-

tion, the lower the revenue yield to the government.This conclusion, of course, depends on other things

being equal.

There are pronounced differences between the

administrative and compliance costs of the various

tax instruments applied to mining. Some taxes are rel-

atively easy for the public sector to administer and for

mining companies to demonstrate their compliance.

This keeps the costs down for both parties and mini-

mizes the opportunities for corruption. Both repre-

sent significant advantages in the context of a devel-

oping or transition economy. Many types of mining

royalty fall into this category.

In contrast, corporate income taxes are much harder

to administer, particularly for developing and transi-

tion countries. They often lack the relatively sophisti-

cated institutional capacity that is required to admin-

ister income taxes in very complex and highly capital

intensive sectors, such as mining. Such contexts are

also much more susceptible to tax avoidance and eva-

sion, as well as corruption.

Overall then, the case for mining royalties is relatively

weak from the perspectives of economic efficiency, risk

sharing and revenue yield compared to the corporateincome tax. On the other hand, the case is on much

firmer ground when it comes to the costs of tax admin-

istration and compliance. This advantage is, however,

more or less neutralized where a country already has a

corporate tax regime in place. Nevertheless, most

countries have both a general regime to tax corpo-

rate income and a specific regime to impose royalties

on the mining of selected minerals.6 The major excep-

tions are some provinces in Argentina, Chile, some

Canadian provinces, Mexico, South Africa, Zimbabwe,

and some States of the U.S. Of these, Chile, South Africa, and Zimbabwe are each actively considering

the introduction of a royalty on mining.7 China intro-

duced a royalty tax in 2007.

Research shows that not having a mining royalty does

not necessarily guarantee a low ETR overall.8 On the

one hand, Mexico and Greenland have high ETRs but

do not levy mining royalties. On the other hand,

Western Australia, which does levy a royalty, has a

lower ETR than Chile, which does not. In Chile, how-

ever, the absence of the royalty means that a mine

would earn a higher internal rate of return for the

owners than what it would have earned had it beenlocated in Western Australia, other things being

equal. This is because royalties are payable in Western

Australia over the early years of a mines operation

before it becomes profitable and therefore before it

would be liable to income tax in Chile.

Regulation of Mining

The commercial viability of a mining project is

dependent upon the regulatory burden that is imposed

on it by the host government. Since 1990 there has

been an emerging recognition that there is a trade-off

between the regulatory and tax obligations, which canbe imposed on a mining project, if it is to be interna-

tionally competitive and to be capable of attracting

direct foreign investment, technology and know how.

Although a mining company may be in a better

position to assume more of the risk than the gov-

ernment, particularly one in a developing or transi-

tion country, doing so always involves a cost.


14/48

In parallel, there has been increased pressure to

address the social and environmental impacts of min-

ing projects. Local communities who stand to be affect-

ed by such projects have demanded a greater say in the

terms on which they may proceed and a greater share in

the revenues that they are expected to generate.

As a consequence of these pressures, jurisdictions

around the world have had to revise their policy

approach to mining. This has lead to a wide range of

legal and institutional changes. A series of public pol-

icy principles and practices have emerged from this

legal and institutional evolution, which are now rec-

ognized as representing international best practice for

mining regulation. According to the World Bank, the

international consensus is that modern mining regu-

lation should adhere to the principles of:

transparency and fairness; clarity;

non-discretionary license administration;

conclusive decision-making within specified time

frames;

non-discrimination;

uniform standards and administrative proce-

dures;

a lead agency being the coordinating authority

within government; and

coordination with other regulatory agencies.9

Provision of Infrastructure Services

A mining prospects proximity to roads, railways and

power has a major impact on the capital costs of its

development. Many countries leave the provision of

infrastructure to the relevant mining companies or

require them to provide what the countries specify.

For example, it is not uncommon for a mine to provide

local communities, which would be affected by a min-

ing project, support for expanding their transportation,

educational, medical and sporting facilities. Because

mines are often located in remote regions or regions

with low population densities, there may be little or no

political incentive for the central, or even provincial,

governments to provide public funds for this purpose.

Geological prospects that would normally be com-

mercially viable become uneconomic if the costs of

providing the necessary infrastructure are too high.

Governments, therefore, need to give serious consid-

eration to developing infrastructure in such areas, as

its availability can have a major impact on subsequenteconomic development.

3.4 Macroeconomic Stability

One of the outcomes of the resource curse debate is

the realization that mineral projects can foster overall

economic development or hinder it. The difference

depends on how the windfall in public revenue, which

mining usually generates, is applied. That windfall

can flow from an increase in metal prices and/or min-

ing production

A sustained increase in mineral output can also affectthe international competitiveness of other sectors of

the economy, notably manufacturing. The expansion

puts upwards pressure on the exchange rate of the

host country against all other currencies. This tends

to lower export prices in the local currency and raise

import prices in that currency. As a consequence the

mining expansion will tend to crowd out other export

industries. The phenomenon is popularly known as

the resource curse or the Dutch Disease.

The main thrust of macroeconomic management

should be to prevent a spending spree by the public

sector in response to a significant expansion of miningrevenues. Allowing the public and financial sectors to

invest in foreign financial assets can help to sterilize

the windfall in public revenue and offset an economys

absorptive constraints.


9 The World Bank 2004

Because mines are often located in remote regions

or regions with low population densities, there may

be little or no political incentive for the central, or

even provincial, governments to provide public

funds for this purpose.


15/48


10 James Otto, 2001, Fiscal Decentralisation and Mining Taxation,Mimeo, Report prepared for The World Bank Mining DevelopmentGroup, The World Bank, March.

11 Otto 2001

3.5 Distributing the Benefits

Much of the debate over the role of mining to eco-

nomic development tends to focus on the division

between the mining companies and the host govern-

ments of the economic surplus generated by mining

projects. The more important question is how to dis-

tribute the potential public revenue windfall from

mining within the host country.

This can be done by either fiscal decentralization or

revenue sharing. Fiscal decentralization is the

process by which some taxation powers are given to

provincial or local government, either by the constitu-

tion or by delegation from the central government. In

contrast, under revenue sharing, the central govern-

ment collects the taxes but simply distributes a por-tion of the revenue to the lower levels of government.

All countries practice some degree of fiscal decentral-

ization or revenue sharing in relation to mining proj-

ects.10 This is thought to reflect the fact that a mining

project:

can have a more concentrated environmental

impact than other industries;

may result in the local economy undergoing pro-

nounced boom-bust cycles; and

may lead to significant changes in the social fabric

of the local area.11

For example, the immigration of mine workers may

sharply add to the burden on the social and economic

infrastructure in the area. It may also be accompanied

by increased prostitution, drug use and alcohol abuse.

All of these impacts will require additional expendi-

tures by local and/or provincial governments.

Without adequate taxing powers, lower levels of gov-

ernment are dependent on the central governments

budget processes to allocate revenue to it to meet such

expenditure demands.

Local communities affected by mining operationsneed to see that they benefit directly from those oper-

ations. Failure to do so can result in conflict, which

can affect the viability of the mining project. This was

the case with the Panguna copper mine in the

Bougainville province of Papua New Guinea. A pre-

ferred way to avert this threat is to have at least a por-

tion of mineral royalties paid directly to local govern-

ments or local land holders, as is now done in Papua

New Guinea.

That said, not all those who are affected by a mining

project will benefit from spending by the relevant

local government. Taxation mechanisms are one way

of recognizing the unique impacts that mines can

have on a locality for example, by allowing the min-

ing company in question a tax deduction or tax credit

for investing in community infrastructure. Of course,

doing so then raises questions about what and who

determines whether a specific expenditure is an

allowable deduction or credit, and what limits, if any,should apply. Another way is to ensure that those who

are affected share in the royalties that are paid by

mining companies.

As we saw earlier, most jurisdictions extend special

taxation treatment to mining. This fiscal discrimina-

tion may be justified by the need to pay compensation

to the mineral owners or local land holders, and the

fact that mining is a risky and capital intensive busi-

ness. It may also be necessary to influence taxpayer

behavior.

3.8 Addressing Sovereign Risk

Due to the substantial amounts of capital that are typ-

ically involved, companies looking to invest in a min-eral project are particularly sensitive to the risks

involved and put considerable effort into trying to

identify, measure, diversify and control those risks.

As a consequence the mining expansion will tend

to crowd out other export industries. The phe-

nomenon is popularly known as the resource

curse or the Dutch Disease.


16/48

Once the capital has been invested, the nature of min-

ing assets means that the residual value at any given

time cannot be withdrawn from the country or readi-

ly liquidated.

One of these is the risk that the host government will

unilaterally change the rules of the game during the

life of the project. This is termed sovereign risk. It

principally applies to changes to the taxation and reg-

ulatory regimes that can affect the financial returns

from the project to its sponsors and investors. In those

cases where the host government is financially or

operationally involved in the project in some way,

such as by providing equity, debt, or infrastructure

services, the term also applies to the risk of the gov-

ernment not honoring its contractual obligations.

Sovereign risk is generally driven by rent-seeking inthe host countries, which can take the form of trans-

parent advocacy within the rule of law, or corruption.

Minimizing sovereign risk is clearly in the interests of

the host country, even if it is not necessarily in the

interests of those who make up its government. The

lower the sovereign risk, the more investment a host

country will be able to attract, other things being

equal, across the board. This is particularly important

for developing countries as they have an acute need


for the jobs, technology and know-how that inwards

foreign investment generally brings with it. Less

investment also means a smaller public revenue

stream from the countrys taxation system.

Stability agreements have been used to place strict

limits on the fiscal and regulatory obligations

imposed by government on a mining project for a

fixed period of time. Unfortunately, the enforcement

of such agreements can rarely, if ever, be formally

guaranteed. In the absence of specific constitutional

limitations, governments typically cannot bind their

successors so any such guarantee essentially rests on

political convention and moral suasion.

A stability agreement is essentially a way for a host

government to express their countrys commitment tothe project in question. By making that commitment

more explicit and more transparent, such agreements

have the advantage of being able to increase the sub-

sequent costs to the host country of any abrogation of

an agreement by a subsequent government. This is

likely to reduce a governments preparedness to break

the agreement but it may not enough to avert every

opportunity to do so.

Stability agreements can, however, be counterproduc-

tive if they are not handled in a transparent and con-

sistent manner, and in accordance with clear guide-

lines laid down beforehand. Governments also needto consider measures that would complement and

reinforce stability agreements, such as by:

enhancing the institutions that may be involved in

conflict management within the host country;

improving the transparency and accountability of

public management of mining revenues, and

implementing measures to limit the scope for

rent-seeking behavior and corruption.

Stability agreements have been used to place strict

limits on the fiscal and regulatory obligations

imposed by government on a mining project for a

fixed period of time. Unfortunately, the enforcement

of such agreements can rarely, if ever, be formally

guaranteed.


17/48


4. Lessons from International Experience

This chapter will canvass the more recent experience of

countries in applying the policy principles, which were

outlined in the previous chapter, to the development of

the taxation, regulatory and institutional framework

under which their mining sector is expected to operate.

In canvassing the international experience in applying

these policy principles, the assessment will be conduct-

ed in two distinct but complementary parts.

The first part will be a high level and broadly based

assessment of the essential differences in the practical

application of these policy principles across countries.

The focus will be on the overall consequences of the

policy framework in each country for its international

competitiveness in attracting mining investment, par-ticularly in minerals exploration.

By its very nature, investment in minerals exploration

is much more sensitive to changes in the policy frame-

work than mines that are already operational. In the

case of mineral exploration, most of the investment

has yet to come and the risks are generally very high.

In the case of operational mines, most of the invest-

ment has been sunk and is therefore of little relevance

to decisions about the future. Moreover, the risks are

generally lower. It is for these reasons investment in

exploration is both a much better indicator, as well as

a leading indicator, of the economic wisdom of suchpolicy changes for the country that implements them.

The other part of the approach will consist of a series

of case studies. These will explore the experience of

selected mineral rich developing countries in greater

depth, as their experience is of the most direct rele-

vance to Mongolia. The selection has sought to iden-

tify a series of countries which have had quite differ-

ent experiences in applying the policy principles

enunciated earlier.

One case study involves a country which has been

internationally competitive in attracting mininginvestment for a number of decades (Chile). The sec-

12 The latest survey is published in The Fraser Institute, 2008, The Fraser Institute Annual Survey of mining Companies 2007-08, TheFraser Institute, Vancouver, BC

13 The countries covered by the survey are: Botswana, Burkina Faso, the Democratic Republic of the Congo, Ghana, Mali, Namibia, SouthAfrica, Tanzania, Zambia and Zimbabwe (Africa); China, India, Indonesia, Kazakhstan, Mongolia, and Turkey (Asia); Australia, NewZealand and Papua New Guinea (Australasia); Finland, Ireland, Russia, Spain and Sweden (Europe); Canada, Honduras, Mexico,Panama, and the US (North America); Argentina, Bolivia, Brazil, Chile, Columbia, Ecuador, Peru and Venezuela (South America).

ond case study captures the experience of a country

that has recently undertaken fundamental and com-

prehensive policy reform and is now regarded as

among the best of places in which to invest in mining

(Botswana). The third case study is about a country

that has had a number of unsuccessful attempts at

policy reform but is now making real progress

towards that goal (Papua New Guinea).

On the basis of these reviews, the chapter will conclude

with a distillation of international best practice in terms

of the preferred policy measures and settings that may

be expected to facilitate a countrys international com-

petitiveness in attracting mining investment.

4.1 International Experience in Cross Section

Since 1997, the Fraser Institute of Canada has conduct-

ed an annual survey of mining and exploration compa-

nies to assess how mineral endowments and public

policy factors, such as the taxation and regulation

regimes, affect investment in minerals exploration.12

The survey results reflect the opinions of executives

and exploration managers in mining and mining con-

sulting companies operating in 68 mining jurisdic-

tions spread over six continents, including sub-

national jurisdictions in Canada, Australia, and the

United States.13 Both large and small companies are

covered by the survey.

While geological prospects and economic outlook

clearly influence the extent of investment in minerals

exploration in a jurisdiction, the public policy, regula-

tory and institutional framework that exists there is a

By its very nature, investment in minerals explo-

ration is much more sensitive to changes in the

policy framework than mines that are already

operational.


18/48

critical determinant of the observed investment out-

comes. In the decade of the surveys existence, the

quality of this framework has taken on increasing

importance in a jurisdictions ability to attract inter-

national mining investment.

The respondents to the survey were asked to assessthe impact of a series of public policy, regulatory and

institutional factors on a five point scale, which ranges

from encourages investment to would not invest due

to this factor.14 The factors explicitly nominated for

assessment are:

the uncertainty concerning the administration,

interpretation, and enforcement of existing regu-

lations;

environmental regulation;

regulatory duplication and inconsistencies

(includes inter- and intra-governmental overlaps);

the mining taxation regime (includes personal,

corporate, payroll, capital and other taxes, as wellas the complexity of taxation compliance);

uncertainty concerning native land claims and

protected areas;

the quality of the infrastructure (includes access

to roads and power);

socio-economic agreements and community

development conditions (includes local purchas-

ing and processing requirements and require-

ments to supply social infrastructure such as

schools or hospitals, etc.);

political stability;

labor market regulation;

the quality of the geological database (includesquality and extent of the information and ease of

access to it); and


14 The other assessment categories were: not a deterrent to investment; a mild deterrent to investment; and a strong deterrent to investment.15 For each factor, a jurisdictions rank is based on the percentage of respondents who judged that it encourages investment. The jurisdic-

tion with the highest percentage of such responses is ranked first on that factor and the jurisdiction with the lowest percentage is rankedlast. The ranking of each jurisdiction across all the factors is averaged and indexed to a base of 100. A jurisdiction that is ranked first inevery category would score 100; one that is ranked last in every category would score 0.

security situation (includes physical security from

threat of attack by terrorists, criminals, guerrilla

groups, etc).

The Fraser Institute has developed the following

indexes to present the different perspectives that may

be gleaned from the responses to its surveys:

Policy Potential Index (PPI);

Current Mineral Potential Index (CMPI);

Best Practices Mineral Potential Index (BPMPI);

and

Room for Improvement Index (RII)

A brief discussion of the survey results for each index

for 2007-08 follows. In doing so, the discussion high-

lights the best and worst in class.

4.1.1 Policy Potential Index

The Policy Potential Index (PPI) is a composite index.

It measures how attractive the policy, regulatory and

institutional framework in a mining jurisdiction is

from the perspective of a mining investor. It is based

on country rankings on each of the above assessment

factors that have been indexed to a base of 100. 15

In the 2007-08 Survey the highest score on the PPI

went to Quebec with an index of 97.0. The other top

ten jurisdictions on the PPI were Nevada, Finland, Alberta, Manitoba, Chile, Utah, Wyoming, Ireland,

and Sweden.

For the first time in the ten-year history of the survey,

a jurisdiction Honduras failed to achieve any

positive responses on any of the assessment factors

and scored 0 on the PPI. The other bottom ten juris-

dictions were Zimbabwe, Ecuador, Panama, Bolivia,

India, Indonesia, Mongolia, Philippines, and

Venezuela.

4.1.2 Current Mineral Potential Index

The Current Mineral Potential Index is based on

respondents answers to a survey question about

The Policy Potential Index (PPI) is a composite

index. It measures how attractive the policy, regula-

tory and institutional framework in a mining juris-

diction is from the perspective of a mining investor.


19/48


16 IMF [International Monetary Fund], 2007,Botswana: Selected Issues and Statistical Appendix , IMF Country Report 07/228,International Monetary Fund, Washington, DC, July [accessed at www.imf.org/external/pubs/ft/scr/2007/cr07228.pdf ]

17 The World Bank 2004

whether or not a jurisdictions mineral investment

potential under the current policy framework encour-

ages or discourages investment in mineral explo-

ration. Some jurisdictions with a high PPI but limited

hard mineral potential will receive a lower score on

the CMPI, while others with a low PPI but strong

mineral potential will do better. There is, however,

considerable overlap between the two indices.

In the 2007-08 survey, the top five jurisdictions on the

CMPI were Mexico, Quebec, Chile, Burkina Faso, and

South Australia. The bottom five jurisdictions were

Venezuela, Zimbabwe, Montana, Wisconsin and

Ecuador.

4.1.3 Best Practices Mineral Potential Index

The Best Practices Mineral Potential Index (BPMPI)

reflects respondents assessments of the mineral

investment potential of a jurisdiction were it to adopt

a best practice policy framework. In other words, this

index represents a jurisdictions pure or highest possi-

ble mineral potential given the most comprehensive

and extensive set of taxation, regulatory and institu-

tional reform.

The differences between a jurisdictions score on the

BPMPI and those on the previous two indices are very

informative. In 2007-08 Indonesia ranked near the glob-

al bottom on the PPI but tied for top place on the BPMPI.

In 2007-08 the other top ranked jurisdictions were

Russia, Brazil, Ghana, the Philippines, Minnesota,

and Papua New Guinea. The least attractive jurisdic-

tions in this regard were Honduras, South Dakota,

New Zealand, California, and Washington State.

4.1.4 Room for Improvement Index

The Room for Improvement Index (RII) is perhaps

the most revealing of the four indices. It is the differ-

ence in mineral potential under a best practice

framework and that based on current practice. This isa measure of the scope for a jurisdiction to increase its

international competitiveness in attracting mining

investment by reforms to its policy, regulatory and

institutional framework.

The survey responses on Russia in 2007-08 illustrate

the measure. When asked about Russias mineral

potential under current practices, only 45 percent of

respondents assessed its potential as either neutral or

encouraging. In contrast all respondents assessed

Russias mineral potential as being either neutral or

encouraging were it to adopt a best practices taxa-

tion, regulatory and institutional framework. Thus

Russia scored 55 percent on the RII.

In 2007-08 the jurisdictions with the greatest room

for improvement were Montana, Venezuela,

Wisconsin, Ecuador, and Minnesota. The jurisdic-

tions with the least were Ireland, Chile, Alberta,Namibia, and Burkina Faso.

4.2 Case Study: Botswana

The economy of Botswana is dominated by the min-

ing sector, which is in turn dominated by diamonds.

Over the past 10 years, the mining sector has con-

tributed an average of 35 percent of the countrys

GDP, with diamonds constituting nearly 94 percent of

all mineral exports.16

Botswana is the worlds largest diamond producer,

measured by both carats and value. Its diamond boombegan in 1965 and followed the discovery and devel-

opment of large amounts of high quality diamonds.

Between 1966 and 1989 its GDP grew at over 8 per-

cent a year, which was the fastest growth at that time.17

A large part of the windfall was put in foreign savings

and only used when the absorptive capacity of the

economy was thought to be sufficient. Fiscal and

monetary policy was disciplined.

The governments successful partnership with De

Beers, the worlds largest diamond mining company,

has helped develop the countrys mining sector.

Botswanas diamond deposits are in kimberlite pipes,which concentrate the gemstones. This makes large-

scale low cost production possible, which in turn con-


20/48

tributes to high levels of public revenue through cor-

porate taxes, royalties, and dividends from the gov-

ernments 50 percent share in Debswana, its joint

venture with De Beers to mine diamonds in

Botswana, as well as the governments 15 percent

stake in De Beers itself.18

In July 1999 Botswanas Parliament passed a com-

pletely newMines and Minerals Act. The policy objec-

tive was to make the legislation investor friendly and

to deal with the criticisms of property tenure and

ministerial discretion under the previous mining law.

The new act does not apply to petroleum which is reg-ulated by the Petroleum (Exploration and

Production) Act, nor does it regulate the mining of

diamonds which will continue to be determined by

negotiated agreement with the government.

TheMines and Minerals Actprovides for:

The retention of rights over a mineral deposit

where it cannot be exploited immediately.

Retention licenses may be granted initially for

three years and renewed once for up to three

years. This contrasts with the previous use it or

lose it policy, which allowed a license to be termi-nated if work was stopped.

The prospecting license covers up to 1,000 km2 is

initially for up to three years and is renewable for


18 Botswana Department of Mines, 2006,Mining Investment Opportunities in Botswana, Republic of Botswana, Gaborone, 24 February[accessed at www.gov.bw/docs/ ]

19 Botswana Department of Mines 2006

two periods of two years each. Mining licenses are

issued for up to 25 years, renewable for periods of

25 years at a time.

The abolition of the governments previous right

to free equity participation. It can now acquire up

to 15 percent of a new mining venture on com-

mercial terms.

Restrictions on the transfer of mineral conces-

sions were liberalized explicit environmental pro-

tection measures incorporated into the act.

A reduction in mining royalties for all minerals,

except precious stones and precious metals.

The granting, renewal and transfer of licenses wasmade more automatic and predictable with little

or no scope for Ministerial discretion.

A new mining taxation system was introduced.

Companies that already operating mines have a

once only option to continue under existing tax

agreement.19

Highlights of the new mining tax regime are in Table

2. The general corporate income tax regime applies to

mining but the latter is subject to a variable tax rate.

The tax rate cannot be less than the standard corpo-

rate tax rate (25 percent). The variable rate formula

only kicks in only when taxable income as a percent-age of gross revenue the profitability ratio is

more than 33.3 percent. The tax rate then rises with

the profitability ratio to a theoretical maximum of

Taxation Provision Policy Setting

Corporate income tax rate Variable rate, from 25% (rate for the non-mining sectors) up to 55%

Withholding tax rate on dividends 15%

Mining royalty 10% (precious stones)

5% (precious metals)

3% (other minerals)

Import duty on mining plant & equipment

Export duty on mineral commodities None

Value-added tax 10%, refundable on exports

Depreciation of mining plant & equipment Immediate 100% write off

Carry forward of losses Unlimited

Source: Botswana Department of Mines 2006

Table 2Policy Settings for Mining Taxation Regime, Botswana


21/48

The Real Climate Threat to Developing Countries Early, Deep Cuts in Emissions 19

55 percent when taxable income equals gross income.

Under the previous mining tax regime, companies

could only write off their capital expenditure against

taxable income over the lesser of ten years or the

remainder of the life of the mine. Given the more

favorable treatment of depreciation and the unlimited

ability to carry forward loses under the new taxation

regime, it is unlikely that any significant tax will be

paid until the mining company has recovered all of its

investment in a mine.

As a consequence of the above policy reforms,

Botswana broke several records on the Fraser

Institute Survey for 2007-08.20 Botswanas score for

investment attractiveness score on the PPI was the

highest ever for an African country in the ten-yearhistory of the survey. It was ranked at 11th place (out

of 68) in terms of investment attractiveness in 2007-

08 and missed out from being placed among the top

ten countries by the smallest of margins.

Of perhaps even greater significance is the fact that

Botswana has had the greatest increase in its invest-

ment attractiveness score on the PPI out of all the

countries surveyed by the Institute over the past four

years. In this period it also experienced the greatest

improvement in its investment attractiveness ranking,

rising from 50th place in 2004-05 to 11th in 2007-08.

4.3 Case Study: Chile

Foreign mining companies created the Chilean cop-

per industry in the 20th Century.21 By the 1960s two

US mining companies Anaconda and Kennecott

owned the four mines that accounted for most of the

countrys copper output. Successive Chilean

Governments progressively increased their control

over and equity interest in these mines. The Allende

Government finished the process by nationalizing

them within Codelco, a company owned by the

Chilean government.

Following his overthrow of the Allende Government in

1973, the Pinochet regime rejected socialism and

20 Fraser Institute 200821 The following history is based on The World Bank 200622 The Fraser Institute 200823 Otto et al 2000

embraced more market-oriented economic policies.

The government liberalized foreign investment to

attract private investment. Although Codelco contin-

ued to operate the former Anaconda and Kennecott

mines, direct foreign investment, played an increasing

role in the development of the Chilean copper industry.

In 1978, Exxon bought the Disputada Company from

the Empresa Nacional de Mineria (ENAMI), another

state-owned company with mining assets. Subsequently,

private mining companies developed a series of new

large-scale mines in Chile, including Escondida the

worlds largest copper mine. As a consequence, copper

production in Chile rose rapidly and Codelcos share

more than halved. For nearly two decades, Chile has

enjoyed rapid economic growth, in large part due to the

massive expansion of its copper industry.

For over two decades Chile has offered private

investors a very favorable investment climate in the

mining sector. The Fraser Institute Mining Survey has

consistently put Chile at the top of its rankings of

overall investment attractiveness in 2007-08 it was

in 6th place.22 In large part this attractiveness rests on

Chiles very favorable mineral taxation regime, partic-

ularly its general corporate tax regime see Table 3

for the details of its key policy parameters.

Extensive research has shown that the effective tax

rate of the Chilean taxation regime has consistently

been among the lowest of the worlds mining jurisdic-tions.23 Perhaps most telling of all is that, of all the

copper mines that have been opened around the

Of perhaps even greater significance is the fact

that Botswana has had the greatest increase in its

investment attractiveness score on the PPI out of

all the countries surveyed by the Institute over the

past four years.


22/48


24 The Fraser Institute 200825 The Additional Profits Tax was a form of resource rent tax. It was levied on the profits that are earned above a threshold internal rate of

return. Footnote 5 has more background on the PNG experience with it.

world in the past two decades, the bulk of the new

productive capacity has been in Chile.

As Chile does not levy royalties on minerals produc-

tion, one might conclude the best policy is to eschew

royalties all together. This misses the point, which is

that the overall burden of regulation and taxation on

the mining sector is the most important factor in

being internationally competitive in attracting mininginvestment. The composition of any given burden is

generally of secondary importance.

4.3 Case Study: Papua New Guinea

In terms of its mineral development potential, Papua

New Guinea ranked near the top of the Fraser

Institutes global rankings in 2007-08 (based on its

Current Mineral Potential Index).24 In sharp contrast,

however, it only ranked 55th (out of 68) on the

Institutes measure of the investment attractiveness of

Papua New Guineas current policy framework.

The evolution of the Papua New Guinea taxation and

regulatory and tax regimes for the mining sector

explain, at least in part, the countrys poor showing in

terms of investment attractiveness. Table 4 has the

key taxation parameters that applied in Papua New

Guinea in January 2008.

Between 1996 and 2000 the Papua New Guinea gov-

ernment raised the rate of its mining royalty from

1.25 percent to 2 percent and introduced a 4 percent

levy on assessable mining income, which was, in

effect, a supplementary royalty.

These mining-specific taxes were in addition to those

imposed by the corporate income tax regime, which

includes withholding taxes on dividends, interest pay-

ments and off-shore services. They were also on top of the

Additional Profits Tax (APT) levied on resource projects25

and the significant restrictions on the tax deductibility of

exploration expenditures, which are part and parcel of

the treatment of mining by the corporate tax regime.

During this period, the government enacted legisla-

tion to give it the right to acquire up to 30 percent of

the equity in a mining lease when the lease is issued.The acquisition price to the paid by the government is

based on the exploration costs involved and not on the

full market value of a lease.


Corporate income tax rate 15% (two elective regimes are available)


Withholding tax rate on interest payments 4% (payments to foreign bank)

35% (otherwise)

Withholding tax rate on foreign services 20% (for technical services)

Mining royalty None

Import duty on mining plant & equipment 10%


Value-added tax Refundable on exports

Depreciation of mining plant & equipment Accelerated depreciation

Tax holiday None

Ring fencing of tax liability of nominated

activities from the rest None

Source: James Otto, John Cordes, and Maria Batarseh, 2000, Global Mining Taxation Comparative Study, 2nd edition, Institute for Global Resources Policy and

Management, Colorado School of Mines, Golden CO

Table 3Policy Settings for Mining Taxation Regime, Chile


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26 The phasing-out of the levy was expected to be completed by the end of 2007 (see IMF [International Monetary Fund], 2008,PapuaNew Guinea: Selected Issues and Statistical Appendix , IMF Country Report No. 08/93, International Monetary Fund, Washington, DC,March [accessed at www.imf.org/external/pubs/ft/scr/2008/cr0893.pdf ])

These tax and regulatory changes were implementedby the Papua New Guinea government in an environ-

ment of depressed metals prices, widespread concerns

over sovereign risk and a deteriorating political situa-

tion within the country. By 2000 it was clear that

Papua New Guinea was uncompetitive in attracting

mining investment. Although global minerals explo-

ration declined between 1996 and 2000 due to

depressed metals prices, exploration in Papua New

Guinea contracted even more. As a consequence, the

countrys share of global exploration investment fell

significantly.

As a consequence of the countrys loss of global explo-ration investment, the Papua New Guinea government

initiated a review of its fiscal regimes for minerals and

petroleum, which proposed a number of policy


Corporate income tax rate 30%


Withholding tax rate on interest payments 15%

Withholding tax rate on foreign services 25%

Mining royalty (to be paid to provincial

governments & landowners) 2% of value of output

Import duty on mining plant & equipment None


Value-added tax 10%, refundable on exports

Depreciation of mining plant & equipment Straight line basis over 10 yrs (assets with a life > 10 yrs)

Residual balance basis over lesser of 4 yrs or rest of project life

(assets with a life 10 yrs)

Tax holiday NoneRing fencing of tax liability of nominated

activities from the rest Mines on Special Mining Leases are ring fenced

Exploration expenses Amortized on residual balance basis over lesser of 4 yrs or

rest of project life

Expenses on multiple licenses may be pooled

Expenses may be carried forward for up to 20 years

Infrastructure expenses Tax credit equal to lesser of 0.75 of expenses or the tax

payable for the year

Notes: (a) excludes both interest receipts and payments

Source: IMF 2008

Table 4Policy Settings for Mining Taxation Regime, PNG as of January 2008

changes. In response, Papua New Guinea scrappedthe mining levy for all new projects in 2000 and

announced it would phase it out on existing projects.26

It also cut the tax rate for the APT but simultaneous-

ly lowered the threshold internal rate of return, which

triggers the APT, from 20 percent to 15 percent.

The mining industry and international investors wel-

comed the elimination of the mining levy but not the

lowering of the APT threshold. The negative implica-

tions of the APT for mining investment have been a

consistent concern since its introduction. Despite the

scrapping of the mining levy, Papua New Guinea

remained internationally uncompetitive in attractingmining investment and its share of global mineral

exploration did not recover.


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27 James Otto, 2002, Materials for a Workshop on the Provision of the Papua New Guinea Tax System as Compared to Mining TaxationSystems of other Nations,Report Prepared for the PNG Department of Mining and The World Bank, as quoted in Otto et al 2006.

28 James Otto, Craig Andrews, Fred Cawood, Michael Doggett, Peitro Guj, Frank Stermole, John Stermole, and John Tilton, 2006,MiningRoyalties: A Global Study of their Impact on Investors, Government, and Civil Society, The World Bank, Washington, DC

29 James Otto, 2004, International Comparative Tax Regimes, 50Rocky Mountain Mineral Law Institute , 17:1-45 The 24 jurisdictionsthat were analysed by were Argentina, Arizona (US), Bolivia, Chile, Cte dIvoire, Ghana, Indonesia, Kazakhstan, Mongolia, Ontario(Canada), Papua New Guinea, Peru, the Philippines, Poland, South Africa, Sweden, Tanzania, Uzbekistan, Western Australia (Australia).

30 This approach is the cash-flow equivalent of the national accounting measurement of GOS and the commercial accounting measure-ment of EBITDA.

In 2002 the government conducted another review of

its mining taxation regime. This led to the complete

elimination of the APT in early 2003, as well as cuts

in the corporate income tax to 30percent and the div-idend withholding tax to 10 percent. The mining roy-

alty rate was fixed at 2 percent of net smelter returns

and the restrictions on deducting off-site exploration

expenditures were relaxed. The government also

undertook to reassess the option in its mining law to

acquire up to 30 percent of the equity in any new min-

ing project.

The evidence to date suggests these policy changes are

having a positive economic impact. Investment in

minerals exploration in Papua New Guinea has risen

to the point where the countrys share of global explo-

ration has begun to recover. Recent research has esti-mated that that returns to mining investment in

Papua New Guinea have increased compared to other

mining jurisdictions.27 On the basis of the internal

rate of return to a representative copper mine, Papua

New Guinea was ranked 20th out of 24 mining juris-

dictions in 1999 compared to 4th in 2003.

Despite the significant progress that has been made

since 2002, a number of policy factors continue to

have a substantially negative impact of the mining

investment climate in Papua New Guinea, a fact that

is highlighted by the latest Fraser Institute rankings.

For example, as measured by the Institutes Room to

Improve Index, Papua New Guinea ranked at 16th

(out of 68) in 2007-08. The negatives include thesevere uncertainties associated with the system of cus-

tomary land title in Papua New Guinea, the deteriora-

tion in security, and widespread corruption.

4.4 Summary of International Best Practice

A recent World Bank study28 has reported the results

of earlier research to estimate the overall effective tax

rate (ETR) that is imposed on the mining sector by

the policy regime that is applied to the sector by lead-

ing mining jurisdictions across six continents.29 These

ETRs were expressed as a percentage of the gross

return to the owners of the mine over the assumed lifeof the project.30 The results for the quartile of jurisdic-

tions which had the lowest ETRs in 2004 are set out

in Table 5. The Table also contains estimates of the

corresponding internal rates of return to mine owners

after the payment of all government taxes, fees and

charges, as well as operating expenses.

The original research quoted by the World Bank mod-

eled the financial impact on the profitability of a sim-

ulated copper mine project of all major taxes, fees and

charges, including mining royalties, that were levied

Jurisdiction Internal Rate of Return (%) Effective Tax Rate (%)

Sweden 15.7 28.6

Western Australia 12.7 36.4

Chile 15.0 36.6

Zimbabwe 13.5 39.8

Argentina 13.9 40.0

China 12.7 41.7

Source: Otto 2004

Table 5Total Taxation Liabilityfor a Model CopperMine, Lowest Quartileof Taxing Jurisdictions,2004


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Taxation Provision Best Practice Policy Setting

Corporate income tax rate 25% to 30%


Mining royalty rate (ad valorembasis) 2% to 4%

Tax on windfall profits None

Import duty on mining plant & equipment None


Value-added tax Refundable

Depreciation of mining plant & equipment Accelerated & pooled depreciation

Depletion allowances None

Ring fencing of tax liability of nominated

activities from the rest None

Treatment of mineral exploration expenses Amortized over 5 years

Treatment of environmental expenses ExpensedTreatment of mine closure &

rehabilitation expenses Tax deductible contributions into sinking fund

Tax holidays None

Carry forward of tax losses Unlimited or Available for up to 7 years

Source: World Bank 2008

Table 6International Best Practice Policy Setting for Mining Taxation Regimes

at the time of that research (2004). Such financial

models are particularly useful for comparative taxa-

tion purposes as all they enable the non-taxation

parameters of the project, such as the mine capacity,

the technology it uses and the revenue it earns, to be

held constant.

This research shows that a low ETR does not guaran-

tee a thriving mining sector. Zimbabwe is a case in

point. Although it had the 4th lowest ETR out of the

24 jurisdictions that were examined, there are many

other factors that make Zimbabwe an unattractive

place in which to conduct business or invest, particu-

31 They include: declining gross domestic product, hyperinflation, political instability, official hostility to foreigners, and endemic corrup-tion (Otto et al 2006).

32 The World Bank, 2008,Mongolia Quarterly , The World Bank, Washington, DC, 28 January.

larly for foreign companies.31 Overall these results

suggest that an internationally competitive ETR was

around 35 percent in 2004. It is unlikely to have risen

since that time.

Recently, the World Bank benchmarked the settingsfor the policy regime to be applied to minerals explo-

ration and mining around the world.32 Th

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