Assessing the Economic Impacts of the Gold Windfall Tax

The unanticipated changes made in the past couple of years in the core mineral legislations, such as minerals law, however, have negatively affected the investments and output of the mining and minerals sector of Mongolia.

Mongolian parliament adopted a law on imposing 68% tax on the price increases for gold and copper concentrate in May 2006, which were an outrageous change in the mining tax regime for the investors in Mongolia. It has been evident that there has not been done any research on the economic impacts and justifications before and after the law were enacted. Therefore, the Mongolian National Mining Association’s Research and Training Unit has carried out a study for assessing the economic impacts and justifications of the law.

This article is based on our research findings of the study and consists of the following sections. Section 2 gives a descriptive picture of the 68% tax law and discuss similar cases of the windfall taxes implemented in other countries and their learned lessons. Section 3 reviews the studies and policy recommendations given by mining experts, scholars and international organizations on the law of 68% taxes imposed on gold and copper concentrate. The macroeconomic effects of the law and analysis of gold production costs based on the sample survey conducted among the Mongolian gold producers are discussed in section 4. Section 5 analyzes how the windfall tax on gold affected the gold production and exports. Following that, section 6 analyzes gold production costs dynamics and determines major factors affecting the unit costs of the Mongolian gold producers. Section 7 carries out a simulation analysis on the total tax rate, taking the different levels of gold production costs into account. Gold price sensitivity analysis for evaluating tax burden for the gold producers with different unit costs are also done in the same section. The final section summarizes the research findings and provides recommendations on the windfall profits tax.

II.On the windfall profits tax (WPT) law and learned lessons

“Mongolian Law on Imposing Tax on the Price Increases of the Certain Commodities”, which publicly known as ”windfall profits tax law”, was adopted by the Mongolian Parliament on May 12, 2006. Although it seems that the law is applicable to several commodities, as seen from the title of the law, it is a legislation only for gold and copper concentrate produced in Mongolia. The main purpose of the law was to get more portions of the gold and copper windfalls resulted from the favorable world commodity markets and finance the social welfare programs and public investments by establishing a special purpose-fund called ”Development Fund of Mongolia”.
According to the Law, the copper concentrate and gold producers pay 68% tax on the prices exceeding the threshold prices of 500 US dollars per ounce for gold and 2600 US dollars per tons for copper concentrate. This law does not belong to the entities, which made ”Stability Agreements” with the Mongolian government, and the threshold prices are independent of the changes in macroeconomic fundamentals such as inflation and exchange rates. Moreover, the corporate income tax law ensures that the windfall profit tax is deductable from the taxable income.

The windfall profits tax have been rarely used in the world resource-rich countries. There were some cases, but they all existed for a very short time period. For example, in the US economic history the windfall profits tax has been used several times usually during the war times when the commodity prices soared significantly. The most recent case was between 1978 and 1988. There were popular view that the sharp increase in crude oil price occurred during the Iran-Iraq conflict should be taxed, and consequently, the US President James Carter enacted a law of windfall profits tax on crude oil in 1980. In fact, it was an excise tax, but not a windfall tax in the sense that the tax was imposed on price exceeding a certain threshold. Government analysts projected that the tax would generate over US$ 390 billion in gross revenues between 1980 and 1988, but the actual tax revenues from the windfall profits were only about US$ 80 billion. Starting from 1981 crude oil price declined rapidly, and later in 1987 and 1988 the windfall profts tax generated very little or almost no tax revenues. According to the studies done by Salvatore Lazzari (1990) on the effects of the tax on the US economy, the windfall profits tax on crude oil reduced the US domestic oil production by 3-6 percent, and increased oil imports, that is US oil dependence, by 8-16 percent. The windfall profits tax also increased substantially the law compliance burden and administrative costs for the US Tax administration offices. Because of all these negative outcomes, the law of windfall profits tax on crude oil was repealed in 1988.

In 1997 after privatizing the government-owned utility companies by selling companies’ shares to the public, the UK Parliament adopted a law on windfall profits tax, one-time windfall tax on excess profits of certain utility companies, raising the argument that the share prices of the privatized companies were far below the market values. The tax was designed to collect 5.2 billion pound in total from the excess profits of 33 privatized utility companies, including water, electricity supply, communication and transportation companies, and to be used for the Welfare to Work program for raising the youth employment.
In April 2008, the Government of Zambia made amendments to the tax legislation pertaining to the copper concentrate production and introduced a new windfall profits tax on copper concentrate. As a result, the total effective tax rate increased from 31 to 47 percent for Zambia’s copper sector, which generates more than 70 percent of its total export revenues. There have not been done any studies, at the moment, on examining the impacts  of this new tax regime on the investments in copper mining, industrial outputs and overall economy of Zambia.


III.Previous studies on the WPT in Mongolia

In his study ”Competitive position of Mongolia’s mineral sector fiscal system”James Otto (2001) shows that Mongolia’s 68% windfall profits tax on gold and copper concentrate signicantly reduces country’s investment competitiveness for the mining industry, specifically the gold and copper sector because the tax substantially reduces the Internal Rate of Return (IRR) to 8.6 percent, which should be 12 percent, at minimum, for mining investors, and increases the total effective tax rate to 67.9 percent, making Mongolia a country with highest mineral taxes among the comparing 20 countries in the study.  

IMF experts warn that the 68% windfall profits tax on gold and copper concentrate becomes a sole financial source for the noticeable increase in the public investments and introduction of social welfare programs such as ”Child Money” through the Development Fund, and consequently, it links the government budget with the price volatility at the world commodity markets, and it significantly increases the risks of extensive budget deficits in the long run.

Since 1997 the Fraser Institute’s annual Mining Survey has been conducted among the exploration companies operating around the world. It provides valuable insights to the current and future potential investors in mining and exploration businesses. According to the 2005 Survey’s Policy Potential Index that measures overall policy attractiveness of the countries included in the survey, Mongolia’s rank was 33 in 64 countries, following right after the North American and Australian states and was a leader in Asia. However, the same survey conducted in 2007 gave extremely opposite results for Mongolia due the sudden changes in the minerals legislation in 2006. According to the 2007 survey, Mongolia’s rank fell down sharply from 33 to 62 and it has now been considered as one of the countries with worst and most unstable mineral policies.


IV.Macroeconomic effects of the windfall profits tax

The windfall profits tax generated 15.7 percent of the total tax revenues of the government budget of Mongolia, which was equivalent to 5.6 percent of GDP in 2006. These numbers climbed even further to 23.6 percent and 7.8 percent, respectively, in 2007. However, the corporate income tax revenues collected from the gold producers accounted for only 0.3 percent of the total tax revenues, 0.7 percent of the total income tax revenues, and 1.5 percent of the total corporate income tax revenues of the government budget in 2006. The windfall profits tax revenues paid by the gold producers were estimated to be 0.4 percent of the total tax revenues, 1 percent of the total income tax revenues, and 2.6 percent of the total windfall profits tax revenues for the same year.

Since the Corporate Income Tax Law specifies that the windfall profits tax on gold and copper concentrate is deductible from the taxable incomes of the gold and copper concentrate producers, the income tax revenues collected from those producers declined, compared with the income tax revenues that had showed an increasing trend before the law was into effect. For instance, the gold producers used to pay 4.4-5.1 billion togrogs of corporate income tax before the windfall profits tax was introduced, but they paid only 3 billion togrogs in 2006.

The windfall profits tax affected significantly the government budget revenues and expenses, and overall fiscal policy. Before introducing the tax, the government’s budget revenues were increasing, on average, by 19 percent annually between 2001 and 2005. However, the tax revenues soared by 48 percent, on average, between 2006 and 2008 (August). More specifically, the windfall profits tax revenues accounted for 34 and 41 percent of the additional budget and tax revenues, respectively, earned between 2005 and 2006, 35 and 47 percent, respectively, between 2006 and 2007.  In total, the windfall profits tax revenues generated more than one thirds of the additional budget revenues that have been created since 2005. Together with budget revenue expansion, the government expenses have increased substantially since 2005. For example, the government expenditure grew by 13 percent, on average, in 2004 and 2005. After the windfall profits tax law, it skyrocketed at unprecedentedly high rates, averaged on 56 percent between 2006 and 2008.

/see Figure 1/

The macroeconomic theory says that general price level goes up if an expansionary fiscal policy is into effect when there is no capacity expansion in the production of an economy. This theory has been applied to or proved for the Mongolian economy today. International financial organizations, specifically IMF, repetitively warned the Mongolian government that the money supply had been growing too fast, which might deteriorate the macroeconomic stability. Regrettably, the Mongolian government, simultaneously with the alarming high growth of the money supply, increased its expenditures to an unprecedented extent. As a result, the Mongolian economy shifted into overheating mode and CPI-measured inflation rate reached its highest-ever level since the transitional crisis occurred in the early 1990s. According to the Bureau of National Statistics report, inflation rate reached already 25 percent in August 2008 from the beginning of the year, and 34 percent year-on-year basis.


V.Impacts on gold production and exports

In 2005, that is, before the windfall profits tax law came into effect, the Mongolian gold producers, including not only companies and corporations but also individuals, extracted 24.1 tons of gold, but the gold production shrank to 22.5 tons in 2006, and 17.4 tons in 2007. Moreover, the General Customs Department’s report states that Mongolia exported 23.8 tons of gold in 2005, but only 11.5 tons in 2007.

/see Figure 2/

As can be seen from the gold production dynamics shown in Figure 3, there were only two drops in the gold production between 1990 and 2007 and for both cases gold price in the world markets was not the determinant factor, instead the changes in mineral policies and legislation pertaining to the gold production sector and deteriorated geo-technical conditions for gold extraction determined the drops in gold production. More specifically, the decline in the number of placer gold deposits and proven reserves was the major reason for the drop in gold production in 2001-2003, and it has been evident that the windfall profits tax has negatively affected the gold production since 2006 regardless of the favorable world gold market conditions existed for the past years.

As Mongolian Mineral Resources and Petroleum Agency’s report states, the leading gold producers (the Top 10 gold producers) in Mongolia generated 82 percent of the total extracted gold in 2006, out of which 61 percent was produced by only 2 foreign-invested entities (Boroo Gold and Altan Dornod). The report further reveals that the gold production of the two companies were quite stable during 2005-2007, but total gold production declined by 6.7 tons for the same time period.

/see Figure 3/

Although Boroo Gold’s production fell down a bit in 2007, it was not due to the windfall profits tax since the company has been exempt from the tax thanks to its stability agreement made with the Mongolian government prior to the law. As can be seen from these statistics and the fact that the share of the two companies gold production in the total has been increasing since 2006, the windfall profits tax penalized more severely the domestic small and medium-sized gold producers as well as individuals. It is supported by the fact that domestic gold companies produced 12.1 tons of gold in 2005, which accounted for half of the total, but generated only 5.6 tons, accounting for less than one thirds of the total gold production in 2007.
As stated previously, gold sold to the Mongolian central bank and gold exports that is one of the major contributors to the total exports revenues declined considerably since the windfall tax law was enacted in 2006. It implies that the informal gold sector in Mongolia has expanded to the extent to which the formal gold sector has been contracted. More serious impacts of the gold windfall tax is that Mongolia would have produced 20.6 tons of gold more since 2006 if the windfall profits tax had not been enacted and the gold production had been kept, at least, at the same level as in 2005, implying that Mongolia has already lost a revenue of 565 million US dollars (assuming gold price is averaged at US$ 850 per ounce)