Royalties - theory

To introduce a discussion about royalties it is helpful to outline what other charging mechanisms exist. This is followed by a brief review of the theoretical foundation underlying royalties, a discussion of possible policy rationales, and reasons for waiving royalties in specific circumstances.

Royalties and other charging mechanisms

There are a range of charging mechanisms and a range of reasons for charging. It is important to distinguish between these mechanisms and purposes to ensure that each regime is correctly focused and to identify any gaps. The table below summarises reasons for charging, which can overlap.

We charge in order to:

• fund activities ;
• recover costs; and
• achieve a return on assets and create incentives for efficient use.

Table 1 – reasons for charging for resource use

Principles of general tax system design are well established.

Royalties primarily address the first item under the economic category, but can address externalities if structured appropriately.

General revenue related charges fall outside the scope of this paper (except for defining categories as above) as the Government’s overall tax policy focus is to raise revenue at the lowest economic cost. Although there may be exceptions, it is generally accepted that taxes levied on specific activities or commodities (to the extent they exceed economic rents) have a higher economic cost than broad based taxes such as income tax or Goods and Services Tax.[7]

There is adequate high-level guidance on cost recovery, and successful systems are in place.

Cost recovery principles are already well understood in both theory and practice in New Zealand. “Treasury Guidelines for Setting Charges in the Public Sector” were issued in 1999, revised in 2002, and have been endorsed by the Government (Treasury, 2002). They focus on recovering costs rather than encouraging efficient use or creating a revenue surplus.[8] Significant cost recovery systems already in place include those for fisheries research and biosecurity.[9] Cost recovery as such will not be discussed here in any detail because the current situation is well settled.

As noted above, there are no equivalent general principles for royalties in New Zealand so this paper addresses that gap in relation to the use of natural resources (other than minerals) owned by the Crown or otherwise managed by the Crown on behalf of New Zealanders (major examples are freshwater, coastal space and Crown land).

Minerals are excluded because a comprehensive regime exists for Crown minerals but only within the objectives of the Crown Minerals Act (CMA). Minerals programmes are intended to provide for the efficient allocation of rights in respect of Crown owned minerals and the obtaining by the Crown of a fair financial return from its minerals. That is consistent with the approach proposed in this paper to the extent that extraction is the highest value use of the resource.

Economic or resource rent and externalities

As noted above royalties can serve as a way of collecting economic rent or taking account of externalities.[10]

Economic rent in broad terms is the margin between the income realized by an owner of a factor of production (such as land, minerals, or water), and the cost of development, including financing costs and compensation for risk. This margin can vary dramatically. For example, it may cost the same to run a marine farm in each of two bays but the return on one is much higher because of natural productivity due to sea currents or river flows. Rent may also be driven by scarcity: for example where demand grows for a naturally occurring resource but the supply cannot be increased as much or at all, the rent increases as the price rises.

In strict theoretical terms, collecting economic rent can be seen as the sole justification for charging a royalty.    Other arguments for charging or not charging are discussed in the paper.

Collecting economic rent is one possible rationale for imposing royalties, either for equity (fair distribution of returns from public resources) or efficiency reasons (achieving optimal resource allocation or avoiding resource dissipation). Whether collecting economic rent is desirable will also depend on social objectives and efficiency considerations such as the cost of collection.

This paper does not attempt to evaluate the presence or size of any economic rents on natural resources owned or managed by the New Zealand government.

Externalities of resource use (effects of use that are not reflected in market prices) can be an important consideration in design of regulatory regimes. Examples include runoff from farms or sewage that pollutes marine farms, air pollution from a power plant, or, on the positive side, any enhanced public ocean access from a wharf built for business use.

Applying a royalty is one means of ensuring users take into account the externalities created by their decisions.

Whether externalities can be practically identified and addressed will vary. Where they can be addressed the appropriate response may be anything from quantity constraints to behavioural constraints or a charge on inputs or outputs. No general conclusion is possible on whether a royalty will be an appropriate tool to achieve this response, but externalities should be considered when a royalty is being designed.