3. Characteristics of fiscal instruments
Certain qualities are desirable in fiscal instruments. These are:
A fiscal instrument is neutral when it has no impact on investor decisions, i.e. the investor would have made the same decision regardless of the instrument chosen. This recognises that taxes and fees affect investment in mainly negative ways. Policy makers should therefore aim to minimise this impact by ensuring fiscal policy has a ‘neutral’ effect on investment to the greatest extent possible.
This refers to an instrument’s sensitivity to industry profits, The more progressive the instrument the greater will be the government share of the revenues as profits increase. A regressive instrument will have a minimal or even zero impact on government revenues as profits from a project increase.
Extractive industry (EI) projects are long-term enterprises which take many years before becoming profitable, sometimes for decades thereafter. Governments often prefer fiscal instruments that generate revenues early in the process, whereas they are generally off-putting to investors who seek to minimise tax payments so projects can become profitable more quickly. This is especially true in volatile commodity markets.
A stable fiscal regime is a major factor for investors whose decisions to make long-term investments depend on predictability. Changes in the fiscal regimes can cause negative effects over the lifetime of the project. ‘Fiscal stability’ clauses are thus common/standard articles in contracts with investors who seek to minimise the risks of ‘time inconsistency’, whereby government preferences change over time. Initially, governments may set up a generous fiscal regime to attract investors to start projects. However, after investors make substantial fixed capital investments, governments may seek to increase revenues in the knowledge that the investor cannot reclaim their investments (sunk costs).
Governments also want to ‘guarantee’ stable revenues from extractives projects. This means selecting instruments which are dependable-- i.e. providing predictable revenues under often shifting market conditions.
Governments and investors have an interest in ensuring that the payment and collection of taxes are simple for both parties. The fiscal instrument must involve minimal burdens for the revenue authority and minimal compliance costs for investors.