Efficient Tax Policy

Efficient Tax Policy

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Several people have asked me about the Incentives Law (applied to the oil and gas sector) currently being discussed in Bolivian Congress. While I am trying to get the draft of the bill, I would like to share with you a brief post about efficient taxation. This will help me in the future, to discuss aspects of the Incentives Law mentioned before.

Small technical note (which may be waived): «There is something in common between singing romantic songs about an abstract motherland and doing optimization exercises with an arbitrary objective function for a society. While both activities are worthy, and certainly both are frequently performed, this book, I fear, will not be concerned with either.» With this hilarious words Professor Sen begins the introductory chapter of his remarkable work «Collective Choice and Social Welfare». Why I rescued this paragraph? Because usually from an economic perspective the efficiency of some public policy is evaluated according an arbitrary objective function; therefore, the question “what is efficient?” is very complex to answer.Now let me focus on the efficiency of a tax assessed only in terms of tax revenues. Imagine, dear reader, that in a moment of confused benevolence the government decides that the percentage of a tax (the tax rate) is 0% (zero percent). In this context, what is the level of tax revenue for the government? The short answer is 0… if the tax is 0% then the revenues are 0. In this case, the situation is reflected with the «red dot» of the figure below.

Now assume that the government decides to increase the tax to 100%… yes 100%. How much would be the amount of fiscal revenues? I usually use this example in my classes to confuse to the participants, they typically answer to this question with: «fiscal revenues are 100%.» Well, it turns out that under normal conditions revenues are 0 (zero). The reason is simple, if the government appropriates all income (or profit) there is no incentive to work in this industry, therefore, the production is zero and hence, revenue is zero. This is shown in the following figure with the new red dot on the right.

If both red dots are true, it means that there is a curve of this nature between the two of them:

That is, when the tax rate is increased from 0% then revenues rises, reaches a peak and then begins to fall, say discourages investment and therefore production falls … this is the «Laffer Curve.”

On this way, we could find a percentage for the optimal tax «t *» that maximizes the level of revenue by the Government, that is something like this:

In the hydrocarbons sector this optimal tax varies according to several factors: 1) the level of reserves; 2) the level of production of the field; 3) prices; 4) if gas or oil is produced; 5) geological conditions; 5) production costs; 6) etc. The current Bolivian Hydrocarbons Law states that all fields in Bolivia should be taxed 50% of their gross income at the wellhead. This is so crazy as to claim that one size of shirts feel good all Bolivians, tall, short, fat and thin.

The current Bolivian Hydrocarbons Law has already 10 years with interesting success in tax revenues but with a lot of damage to encourage new investment in exploration and exploitation of hydrocarbons, in particular oil. It is good to remind the reader that Bolivian diesel imports in 2000 were nearly $ 100 million by 2014 this concept reached the monumental figure of US$ 1,200 million. Why? Because Bolivian oil production had a very, very modest performance.

Well, this post will serve as a appetizer for the discussion on the Incentives for the Hydrocarbon Exploration and Exploitation Law currently being discussed in Bolivia. For now, I will ask my son Santi what he wants for lunch, on weekends he’s not only called «little chief»…he also acts as such.

Mauricio Medinaceli Monrroy

La Paz, November 15th., 2015

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