ASSESSING THE ECOMOMIC IMPACTS OF THE GOLD WINDFALL TAX

VI.       Production costs analysis

Gold price is a reflection of not only supply and demand at the world gold market, but also of production costs incurred during the gold extraction. Gold production costs, specifically unit cost is subject to vary depending on various factors such as production technology, geological potential and conditions, and prices of production inputs. All these factors can be different for gold producers as well as for deposits of a gold producer. For example, in terms of production technology, large-scale gold producers usually have financial capacity to invest in an advanced and cost-efficient technology, while the small ones tend to utilize obsolete technology that results in higher production costs. Moreover, those large-scale producers might have financial potential to invest in different deposits in terms of geo-technical conditions and production costs, which result in different unit costs for the deposits: some deposits may require relatively low unit production costs to extract the gold, while some deposits may have higher than average unit costs.

To analyze gold production costs, we conducted sample survey covered gold producer companies operating in Mongolia. According to the analysis, average gold unit cost for those companies increased from US$ 584 per ounce in 2006 to US$ 685 per ounce in 2007. Especially, the unit cost for the large- and medium-scale gold producers has climbed up by US$ 200 per ounce since the windfall profits tax law was enacted in 2006. Although there can be some biases and measurement errors from the true value, it has been clear that the unit cost of gold production approached or exceeded already the threshold price, which is US$ 500 per ounce, of  the 68% windfall profits tax on gold. It implies that it is highly unlikely that the gold producers admit the windfall profits tax and operate with financial profits. Instead, it has been evident that the 68% tax has pushed the gold producers to tax evasions, gold smuggling, or at harshest case, to a bankruptcy.

Table 1. 

Since the threshold prices of the windfall profits tax on gold and copper concentrate (for example, US$ 500 per ounce for gold) were set as fixed not depending on major macroeconomic indices such as inflation rate, the tax burden on the gold and copper concentrate producers would be increased, at least, due to inflation rate. It is obvious that price is a reflection of not only demand and supply at the market, but also of production costs. The production costs are not fixed over time because prices of the production inputs do not stay at the same level over time due to rising inflationary pressure on overall price level in the economy, unless there is a significant change in the production technology that reduces unit costs.

Out of various inputs, such as labor, electricity, spare parts, fuels, and expenses for fixed assets depreciation, safety and security, in gold production, fuel expenses account for considerable share of the total operating expenses due to its massive usage of heavy-load trucks, bulldozers, excavators, and other heavy-duty machinery and equipment. As can be seen Table 2, fuel costs control bit over one thirds of the unit cost of gold production for the gold producer companies participated in our survey, and the average share of fuel cost in unit production cost has been relatively stable over the last couple of years.

Table 2.

Since oil products such as gas and diesel fuels are utilized extensively in gold production as being one of the critical production input, gold production costs are changed in line with crude oil price. To analyze dynamics of unit production cost of the world’s gold producers and to examine the relationship between gold production costs and crude oil price at world markets, we have analyzed the gold production costs (total cash costs) of the world’s leading gold mining companies (7 companies such as Barrick Gold, Newmont, Goldfields), by investigating their financial statements and annual reports for 2000-2007. According to the gold companies financial reports, the total cash costs were, on average, US$ 150 per ounce in 2001. However, just in 6 years, the total cash costs more than doubled, reaching US$ 310 per ounce in 2007. As can be seen from the standard deviations, the average unit cost for those gold producers was between US$ 200 and US$ 400 per ounce as of 2007.

Figure 4.

Crude oil price per barrel increased by 15 times, reaching 139 US dollars as of  June  06, 2008, while it was only 9.12 US dollars (the lowest price in last 10 years) at the end of 1998. Taking more recent price comparison into account, in May 2006, that is before the windfall profits tax on gold and copper concentrate was enacted, the crude oil price was averaged 65 US dollars, but since then it has more than doubled. Gold price has also increased dramatically. In 2001 the yellow precious metal was priced at 271 US dollars, but it reached 942 US dollars (1050 US dollars per ounce in March 2008) in July 2008, meaning that gold price more than tripled in 6-7 years. As the coefficient of correlation between gold unit cost and crude oil price is estimated to be 0.85, which is considered as sufficiently high, gold and crude oil prices are highly likely to pursue the same dynamics over time.

According to the forecasts of some commodity experts at investment banks and research institutes, crude oil price is projected to be 99.88 US dollar per barrel, on average, in 2008, 160.91 US dollars per barrel in 2009. If we use these forecasts and projections over the next couple years, in Mongolia the total cash costs per ounce of gold would be 373.97 US dollars in 2008 and 547.24 US dollars in 2009. If we project the crude oil price to be 140 US dollars in 2008, raising the above-mentioned forecasts a bit more, then the total cash costs would be US$ 487.87 per ounce in 2008.

In Mongolia that is almost 100% dependent on imported oil products from Russia, prices of gasoline, diesel fuels, jet fuels etc. increased dramatically in line with the oil price soaring at the world markets for the last 5-6 years. From 2006 (before the windfall profits tax law was enacted) until September 2008 the prices of major oil products, such as A-80, A-92 gasoline and diesel fuels, which have been widely used in gold production in Mongolia, more than doubled. Due to such a high price increase for the oil products in Mongolia, it is inevitable that gold production costs have also increased significantly.

Table 3. 

According to our estimations, gold unit cost might have climbed up by 60 to 84 percent since 2006 (before the tax law was adopted) if we assume that the prices of oil products used in gold extraction doubled just in two years and the other costs remained the same. It implies that gold production has already become a costly business in Mongolia and the gold unit costs, specifically for the small- and medium-sized gold producers have already approached or may be exceeded the threshold price of US$ 500 per ounce due to the dramatic increase in the prices of oil products used in gold production.

 VII.Simulation and gold price sensitivity analysis

We carried out a simulation analysis to investigate how the total tax rate varies for different cases where gold mining companies have different level of gold production unit costs as well as for different cases where a gold mining compay has several gold mines where the gold unit costs are not the same. The cases include gold mining companies or gold mines where the gold unit costs are higher, lower and equal to the threshold price of US$ 500 per ounce for the windfall profits tax on gold. In addition, there is a case in which a gold mining company is exempted from the windfall profits tax and its gold unit cost is lower than the threshold price.

The following assumptions are made for all the cases (from Company A to E) to calculate the total tax rates:

1) Gold price is US$ 900 per ounce.

2) Royalty is 5% in accordance with the current Minerals Law adopted in 2006.

3) For all cases, companies produce 525 kg gold annually, i.e., taxable income of the gold mining companies is below 3 billion togrogs, and therefore, the companies pay 10% of corporate income tax.

4) For simplification purpose, we assume that 1 ounce of gold is produced and sold, and only royalty, windfall profits tax where applicable, and corporate income tax are considered for estimating the total tax rate.

Table 4.

Let’s consider the cases “A“ and “B“, at first. The first two cases differs only with the windfall profits tax. For the case “A“ a company does not pay the windfall profits tax, but has quite high unit cost, which is US$ 500 per ounce. Case “B“ considers the same company, but it pays the 68% of windfall profits tax on its sold 1 ounce of gold. As can be seen from the total tax rates in the first two columns, company’s total tax rate jumps from 20.13% to 81.33%, increasing by 61 percentage points!

For the cases “C“ and “D“, since gold mining companies have unit costs that are less than US$ 500 per ounce, the total tax rates are lower than that in case “B“, but they are still much higher than that in case “A“ due to the windfall tax.  More specifically, a gold mining company whose unit cost is US$ 350 per ounce have to pay more than 60 per cent of the total net income in the form of only 3 types of taxes (royalty, corporate income tax and windfall profits tax).

If a gold mining company“s unit cost exceeds US$ 500 per ounce (the threshold price of the 68% windfall tax), the total tax rate would be even higher. As the last column of Table 4 shows, a gold mining company incurs relatively high unit cost, which is US$ 527 per ounce, to produce gold, and therefore, its total tax rate (that covers only 3 types of taxes - royalty, corporate income tax and windfall profits tax) would be 86.5%.

In fact, besides these 3 types of taxes, the gold mining companies operating in Mongolia are liable to pay around 20 types of taxes, fees, and charges, including license fees, property and vehicle taxes, land and water use charges. If all types of taxes, fees and charges are included in our estimation of the total tax rate, then it would be even higher than those in all the cases we analyzed earlier.

The simulation analysis has been carried out by assuming that gold price will be US$ 900 per ounce, which is fixed and relatively higher than the current price level. The price sensitivity analysis is done by considering various prices ranging from US$ 600 to US$ 1000 per ounce to analyze how gold price affects the total tax rate (the sum of royalty, corporate income tax, windfall profits tax) for the gold producers in Mongolia. Our hypothesis is that the total tax rate increases when gold price falls down at the world commodity markets. For each case from “A“ to “E“, we analyze the relationship between gold price and total tax rate by considering different gold unit cost and gold prices ranging from 600 to 1000 US dollars per ounce. The results are shown in Table 5 and Figure 5 below.

Table 5. 

For the case “A“ where companies do not pay the windfall profits tax, the total tax rate declines when gold price increases. For example, companies pay 37% tax as total tax when gold price is US$ 600 per ounce, but only 19% in total when gold price reaches US$ 1000 per ounce. For case “B“ companies produce gold with the same unit cost of US$ 500 per ounce as companies in case “A“, but pay the windfall profits tax, which makes the total tax rate much higher. In addition to the windfall tax, gold price reduction penalizes the gold producer even further with higher total tax rate. For example, as seen from the second column of the table, the companies pay 81% total tax when gold price is US$ 950 per ounce, but the total tax rate climbes to 98% if gold price declines to US$ 600 per ounce. The effect of gold price decline on the total tax rate becomes even harsher when gold unit cost exceeds the threshold price (US$ 500 per ounce) of gold in estimating the windfall profits tax. For example, as seen from case “E“ since a company’s unit cost is US$ 527 per ounce, the total tax rate is highest at all price levels.

The total tax rate increases dramatically from 84% to 131% when gold price slides from US$ 1000 to US$ 600.

Although companies in cases “C“ and “D“  pay the windfall profits tax, their estimated total tax rates are relatively lower than companies in the cases “B“ and “E“ thanks to their lower unit costs than the threshold price of US$ 500 per ounce for the windfall profits tax. However, the total tax rate increases when gold price goes up.  For example, for a company in case “D“ whose unit production cost is US$ 350 the total tax rate is estimated to be 45% when gold price is US$ 600 per ounce, but it climbes significantly to 64% when gold price reaches US$ 1000 per ounce.

As can be seen from the previous gold price sensitivity analysis, the total tax rate has a positive or an inverse relationship with gold price, depending on gold unit costs of producer companies. In our case study, the total tax rate has a positive correlation with gold price when gold unit cost is lower than US$ 500 per ounce, but a negative correlation when gold unit cost exceeds US$ 500. To interprete this puzzling relationship between the gold price and total tax rate, we carried out more detailed analysis by developing total tax rate model as a function of gold price and gold unit cost and estimating marginal tax rate or price elasticity of total tax rate.

From our model development and specifications the marginal tax rate (MTR), which measures a change in total tax rate when gold price changes by one unit, is estimated to be as follows:

It can be seen from the marginal tax rate that there are following two cases (the marginal tax rate can be negative or positive):

a)    -0.757c + 356 > 0     c < 470.27

b)    -0.757c + 356 < 0     c > 470.27

Figure 5.

The marginal tax rate is positive, that is the total tax rate has a positive relationship with gold price when gold unit cost is less than US$ 470.27 per ounce. An inverse relationship between the two variables exists when gold unit cost exceeds US$470.27. This is confirmed by our previous 5 case studies. In the cases “A“, “B“ and “E“ companies gold unit costs are higher than US$ 470.27 per ounce, and the total tax rate decreases when gold price increases. In the cases “C“ and “D“ companies incur gold unit costs that are lower than US$ 470.27, and the total tax rate and gold price change in the same direction.

What do all these analysis tell us? A change in gold price can have different effects on the gold producers, depending how cost-efficient technology they utilize in their productions of gold.  For example, a gold price increase allows the gold producers, who might have obsolete and cost-inefficient technology, and therefore, have higher gold unit costs, to reduce their total tax rate. Unfortunately, in the current commodity market situation where gold price declines the total tax rate for those gold producers is getting higher, implying that the gold price slides raise the total tax burden for the gold producers with high unit costs.

 VIII.Summary and recommendations

As a result of dramatic short-term increase in the prices of base and precious metals and energy commodities such as gold, copper, zinc and coal that account for more than 70 percent of Mongolia’s total export revenues, Mongolian parliament adopted a new law on windfall profits tax on gold and copper concentrate in May 2006. This law has become a major source of many complicated problems and disputes in the economy, and has affected negatively the competitiveness of the mining industry’s tax system of Mongolia, and therefore, mining investments and production, and even the macroeconomic stability.

Although the windfall profits tax law has only been applicable to gold and copper concentrate produced in Mongolia, it has had negative impacts only on the gold production as seen from the previous analysis. Since the copper concentrate is produced by the state-owned company that is the only producer of copper concentrate in Mongolia, the windfall profits tax paid by the state-owned company is considered as just cash flow from one to another pocket of the government, implying that there is no difference of imposing windfall tax or any other types of taxes on the goverment’s own factory. Therefore, we have studied only the economic impacts of the tax on gold producers.

Mining policy experts and international organizations warn that the windfall profits tax have significantly deteriorated the competitiveness of Mongolia’s tax system for the mining industry and have raised the risks of weakening the budget sustainability by linking the price volatility of the world commodity markets with the government budget. Furthermore, the tax has spoiled significantly the hardly-won reputation of the mining industry among the foreign as well as domestic investors as seen from the mineral policy attractiveness indices produced by international organizations.

Since the adoption of the windfall profits tax law Mongolia have faced a considerable declines in its gold production and exports. In 2005 the gold production and exports reached its record-highs as 24.1 and 23.8 tons, respectively. But they have dropped by 7 and 11 tons, respectively, as of 2007. The study shows that the windfall tax have had more severe effects  on the small- and medium-sized gold producers. In 2005 they generated 12.1 tons of gold that accounted for a half of the total gold produced in Mongolia, but as of 2007 they produced only 5.6 tons of gold, which accounted less than one thirds of the total gold production.

Gold production costs (total cash costs) have been increasing year by year due to the annual hikes in the prices of major inputs of the gold production. For instance, the average total cash costs for the world leading (top 7) gold producers have more than doubled, climbing from US$ 150 per ounce in 2005 to US$ 310 per ounce in 2007. The gold unit costs for the Mongolian gold mining companies averaged at US$ 582 per ounce in 2005, but they have reached US$ 682 per ounce in 2007. Expenses for oil products such as gasoline and diesel fuels, which are used extensively in mining industry, account for significant shares in gold production costs. As our costs survey of the gold mining companies in Mongolia shows, the fuel costs have been responsible for 35-38 percent of the total production costs. On the other hand, the prices of gasoline and diesel fuels that are used as major imput in gold production have almost doubled since 2005, that is before the windfall profits tax law was enacted. As a result, the gold production costs (or total cash costs) significantly increased, and the gold unit costs might have reached or exceeded already the threshold price (US$500 per ounce) of the 68% windfall profits tax on gold.

As can be seen from the simulation analysis done for assessing how the burden of the windfall profits tax on gold varies when the unit production costs differ among the gold producers, the total tax rate is estimated to be around 62 percent for the most cost-efficient case (gold mining company) and 86.5 percent for the gold producers with the highest unit costs (exceeding the threshold price of the windfall tax). The total tax  includes only 3 types of taxes that are royalty, corporate income tax and windfall profits tax. It is clear that the actual total tax rates would have been even higher the estimated total tax rates if all types of taxes, fees and charges were included in our estimations.

Taking the permanently changing gold price into account, gold price sensitivity analysis have also been done to examine how gold price affects the total tax rate and burden of the windfall profits tax on the gold producers in Mongolia. As can be seen from the analysis, gold price and total tax rate have an inverse relationship when gold unit costs exceed US$ 470 per ounce, but they have a positive correlation in an opposite case of unit costs. More specifically, if we assume that large-sized gold mining companies incur lower unit costs than US$ 470 per ounce due to their advanced and cost-efficient technology, the total tax rate for them would increase when gold price goes up. In opposite case, i.e., if we assume small- and medium-sized gold producers have higher unit production costs than US$ 470 per ounce due to their obsolete and cost-inefficient technology, their total tax burden would climb up when gold price declines.

Based on all these results and findings of our research and analysis, we raise the following recommendations on the windfall profits tax on gold:

• Re-consider the tax rate (68%) of the windfall profits tax law and set an optimal rate. When tax rate is high, more tax revenues, in absolute term, are paid by the existing tax payers in short run, but in the long run government earns much less tax revenues due to rapid shrinkage of the tax base (less and less tax payers are willing to pay the new high tax). However, in an opposite case, if tax rate is set too low, the tax base (number of tax payers) gets narrow, and governments lose a lot of potential tax revenues. Therefore, policy makers should set an optimal tax rate that ensures the maximum tax revenues.

• Change the windfall profits tax law to set an adequate and optimal system of tax in the mining and minerals sector in order for the government to earn maximum level of budget revenues, and especially, the corporate income tax revenues. According to the Corporate Income Tax Law, the windfall profits tax is deductible from taxable income for the gold and copper concentrate producers in Mongolia. Therefore, the windfall profits tax reduces the potential corporate income tax revenues to be paid by the gold and copper concentrate producers.

• Repeal the windfall profits tax law wholly or amend the gold-related provisions. More specifically, the threshold prices (US$ 500 per ounce for gold and US$ 2600 per ton of copper concentrate) of the windfall profits tax should be indexed annually in correspondence with macroeconomic indicators such as inflation.