Fiscal Policy Formulation and Implementation in Oil-Producing Countries
Chapter

10 Oil Revenue and Fiscal Federalism

Author(s):
Jeffrey Davis, Annalisa Fedelino, and Rolando Ossowski
Published Date:
August 2003
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Introduction

Although the theory hardly recommends revenues from oil and gas as an ideal source of finance for subnational governments—with the exception of funds to compensate social and environment damages and to finance additional needs for infrastructure in the producing areas—the role these revenues play in subnational budgets is expanding worldwide. Matching the current general trend toward more decentralized governments, national regulation and taxation policies of the oil sector are increasingly recognizing the right of subnational governments to have a greater share of the resources generated by this sector. In fact, a large number of oil- and natural gas-producing countries have recently introduced sharing arrangements among different levels of government (see Table 10.1). A similar trend is taking place in favor of indigenous peoples and their formal, or informal, organizations (see Andrews-Speed and Rogers, 1999; Clark and Clark, 1999; O’Faircheallaigh, 1998; United Nations ESCAP, 2001). Basically, the allocation of oil rents among levels of governments is following a pattern quite similar to that of other mineral rents.

Table 10.1.Systems for Sharing Oil Revenue in Selected Countries
CountryOnshore ProductionOffshore ProductionEqualization System for Oil RevenueLegal Basis or Source
ArgentinaRoyalties up to a maximum rate of 12.0 percent paid to producing provinces.Fondo de Regalías Petroleras distributes collections between federal government and provinces.Ley de federalización de hidrocarburos 24,145.
AustraliaStates impose royalties and excise tax on onshore projects and coastal waters. Share royalties on coastal waters with Commonwealth.Commonwealth levies a Petroleum Resource Rent Tax (PRRT) or crude oil excise and royalty on offshore projects. Shares royalty with states. The PRRT on offshore projects is shared 75 percent federal, 25 percent to Western Australia (WA).See sources.
BoliviaOil royalties are attributed to provincial governments and also 25 percent of collections from the special hydrocarbons tax.Up to 10 percent of taxes on oil are distributed by the Fondo Compensatorio Departamental to provinces with below the national average per capita royalties.Law 1702 of 1996. (Ley de Participatión Popular, 1994 www.congreso.gov.bo/11leyes/leyes/1551.htm.)
BrazilShare of royalties exceeding 5 percent of value of production is distributed as follows:

52.5 percent to producing states; 15 percent to producing municipalities;

7.5 percent to transporting municipalities.

Remaining 25 percent goes to federal government.

In addition, there is a sharing system by which gross revenue on production (minus investments, costs, taxes, and royalties) is distributed:

40 percent to producing states; 10 percent to producing municipalities;

50 percent to federal ministries.
Royalties referring to continental shelf are distributed as follows: 22.5 percent to facing producing states; 22.5 percent to facing producing municipalities; 7.5 percent to transporting municipalities; 7.5 percent to Fundo Especial to be distributed to all states and municipalities. Remaining share goes to the federal government.Law 9478 of 1997. The proceeds of the first 5 percent share are distributed according to law 7990 of 1989.
CanadaProvinces are free to levy taxes and royalties on natural resources.The federal government has the right to levy royalties. A sharing system with the province of Labrador and Newfoundland is in operation.See sources.
ColombiaRoyalty rates are determined by central government. A ceiling determined on the basis of production is imposed on royalty earnings.

Proceeds are distributed as follows:

47.5 percent to producing departments;

25 percent to producing municipalities;

8 percent to transporting municipalities and harbors;

19.5 percent to Fondo Nacional de Regalías.
Fondo Nacional de Regalías. Distributes proceeds according to development projects presented by departments and municipalities (including the producing ones).The constitution assigns property rights on land to the states. Offshore projects are governed by the Offshore Constitutional Settlement of 1979. Royalties by Petroleum (Submerged Lands) Act of 1967.
Indonesia70 percent of royalties from the sale of oil and natural gas to the provinces of Aceh and Irian Jaya, which have a special autonomous status. Other producing provinces receive 3 percent of royalties on oil and 6 percent on gas. Local governments receive 6 percent and 12 percent.Mining Royalties Act, 1992.
ItalyOnshore royalties are set at 7 percent of annual net production, or the equivalent value. No royalties have to be paid on annual production up to 20,000 metric tons of liquid oil. Producing regions receive 55 percent of royalties; municipalities where facilities and wells are located receive a share of 15 percent.Four percent of offshore royalties are paid to the regions. Royalties on production in territorial waters are also attributed to the regions.Law 141 of 1994.
Malaysia5 percent of oil royalties are attributed to the states of Sabah, Sarawak, and Terengganu.Decree no. 625/96.
NigeriaThe constitution mandates 13 percent of total oil revenue to be distributed to the producing states. These states also have access to general transfers.Constitution.
Papua New GuineaA royalty of 2 percent on sales revenue is shared between provincial government (80 percent) and landowners (20 percent). In addition, the Special Support Grant—equivalent to a royalty of 1 percent—is paid on a derivation basis to the provincial government (20 percent goes to the producing local government).See sources.
Peru20 percent of income taxes collected from mining activities are distributed to regional and 30 percent to local governments.Law of July 2001.
PhilippinesAccording to the “National Wealth Revenue Sharing,” 40 percent of mining revenues are returned to the producing subnational governments.See sources.
RussiaA petroleum royalty with a tax rate of 6-16 percent is shared: 40 percent to federation; 30 percent to producing oblasts, republics; 30 percent to rayon and cities. Excise tax: variable specific rates. Shared: 30 percent to federation; 70 percent to first tier governments.Royalties are federally determined and shared: 40 percent to federation; 60 percent to producing oblasts, rayons, or cities.Russian Federation Law on the Subsoil, 1992, and later changes.
United StatesThe states are free to levy taxes and royalties, but not on federally owned land.
Sources: Garnaut and Ross (1983); PricewaterhouseCoopers (1998); Otto (2001); Daniel and others (2000). In addition, legal texts shown in the table can be found on the official government websites of the concerned countries. Additional country-specific sources are: for Argentina, San Miguel (1999); for Australia, Government of Australia (2001); for Canada, Government of Canada, The Atlantic Accord (1985), and Rodgers (1998); for Indonesia, Malaysia, and the Philippines, United Nations Economic and Social Commission for Asia and the Pacific (2001); for Papua New Guinea, Daniel and others (2000); for Russia, Gray (1998).
Sources: Garnaut and Ross (1983); PricewaterhouseCoopers (1998); Otto (2001); Daniel and others (2000). In addition, legal texts shown in the table can be found on the official government websites of the concerned countries. Additional country-specific sources are: for Argentina, San Miguel (1999); for Australia, Government of Australia (2001); for Canada, Government of Canada, The Atlantic Accord (1985), and Rodgers (1998); for Indonesia, Malaysia, and the Philippines, United Nations Economic and Social Commission for Asia and the Pacific (2001); for Papua New Guinea, Daniel and others (2000); for Russia, Gray (1998).

Decentralization expands the bargaining power of subnational governments by institutionalizing their demands, particularly where centrifugal forces are in action. These demands have been strengthened by frequent disregard of the problems created to local communities by exploration and exploitation activities. In fact, sound theoretical principles and technical arguments stressing the merits of national governance of natural resources are not easily expendable among local politicians when the central government neglects their problems.

Harmonizing conflicting claims and making efficient use of the revenue generated by oil and natural gas resources are therefore daunting tasks. There are, however, instruments available to governments, along with evidence showing how these conflicts can be softened and related problems can be alleviated. For example, when it is not politically feasible to resist the demands from producing areas for a share of the resource, a revenue-sharing scheme that leaves the taxing decisions to the central government is a better system than devolving oil taxation power to local governments. This is because, as will be shown in Box 10.1 later, taxation of oil is better managed at the central than at the local government level. Equalization mechanisms also have to be used to allow nonproducing regions to share a part of the oil revenue and to alleviate the equity and efficiency problems deriving from assigning oil revenue to the producing regions.

The paper is organized as follows. Section II presents the main features of oil exploitation activities that impact on intergovernmental relations. Section III reviews the pros and cons of assigning oil revenue to subnational governments. While the main argument against revenue sharing is the sizable geographical concentration of these revenues, claims by the producing areas cannot be completely dismissed on efficiency and equity grounds. Systems for sharing oil revenue and their main features—with a stronger emphasis on sharing of tax bases—are examined in Section IV, focusing on the unsuitability of natural resources to form the base of local taxes; evidence showing the increasing access by subnational governments to oil revenue is also presented. Equalization mechanisms are analyzed in Section V, where the focus is on how and to what extent these mechanisms can be adjusted to accommodate large disparities in oil revenue across regions. Section VI concludes.

Although the paper does not focus explicitly on developing countries, the arguments presented are of relevance to them.

Features of Oil Exploitation Impacting on the Assignment of Revenue

A few features concerning oil exploitation are important when discussing its implications for intergovernmental relations.

The first and most important feature is the sizable geographic concentration of oil production—the most common case in large and medium-sized countries. Oil production in Colombia is located in only two provinces; the Siberian oblast of Tyumen produces almost two-thirds of total Russian oil; and in Argentina a single province, Neuquen, produces more than one-third of total oil output. In addition, in a number of countries, oil is discovered and exploited in sparsely populated areas. Russia shows, possibly, the most striking case, with the oblast of Tyumen having only 1 percent of the Russian population. The province of Neuquén in Argentina comes close: its inhabitants are a mere 1.5 percent of the total population.

When oil rents are assigned exclusively to subnational governments, they tend to produce vast horizontal imbalances—that is, extremely large disparities in per capita revenues of subnational units. In Alaska, for example, petroleum revenue peaked in 1981 at US$3.3 billion, equivalent to about US$8,000 per capita. Presently, dividends from Alaska’s Permanent Fund, where most oil revenue is accumulated, are close to US$2,000 per capita (see Eifert, Gelb, and Tallroth, Chapter 4 in this volume). Obviously, large imbalances across subnational jurisdictions foster political pressures and provide theoretical ground for national equalization of these resources. At the same time, sparsely populated regions carry little weight in national politics, particularly in weak democracies with limited mechanisms of checks and balances. This factor increases subnational jurisdictions’ perceived risks of having to bear the costs of exploitation without reaping the benefits, if oil revenue entitlements are transferred to the national government. In general, when local jurisdictions have little power at the central level, they make increased demands for decentralization of powers and resources.

Secondly, oil and natural gas are rapidly depleting resources, sometimes creating the typical “boomtown” phenomenon. Exploration and production attract individuals and capital, but reserves can be rapidly exhausted. Large-scale projects require vast investments and impact geographically on small areas. Even when local governments do not benefit from oil revenue, the economic impact of oil on local communities is large and difficult to regulate. Inflow of workers1 and population can be significant, with related substantial risks of social disruption and environmental damage. In addition, oil exploration and, to a lesser extent, its production entail large pecuniary externalities, such as higher land rents and increased local costs of living in the nearby communities. Potentially, those risks could be compensated by higher development at the local level (however, pecuniary externalities impacting on the price of inputs and factors can seriously hamper it) and by construction of infrastructure in transport and communications. Local governments’ involvement in controlling damages, providing infrastructure, and diversifying growth can hardly be denied, but it requires resources and skills.

Thirdly, oil prices show large and unpredictable fluctuations. According to empirical evidence (Barnett and Vivanco, Chapter 5 in this volume; and Davis and others, Chapter 11 in this volume) prices do not seem to have a well-defined time-invariant average. In other words, there is no notion of a “normal” price toward which actual price reverts to at the end of boom or slump periods. Hence, volatility of oil revenue is much higher than for other sources of fiscal revenue. This compromises fiscal management and the efficiency of spending, particularly in countries whose revenue base is highly dependent on natural resources.

Finally, energy policy is mostly a national responsibility, worldwide. This is particularly the case when the oil sector represents a large share of economic activity and is the dominant source of public revenue.2 High shares of oil revenue in total revenue also reflect the disincentive effects of oil discovery on tax efforts and on the diversification of the economy. At the same time, high oil revenue shares give rise to an intense struggle for the division of the “pie” among a number of organized and strongly competing parties. These include, in addition to the producing companies, national and subnational governments, local communities, and, in some countries, the army.3

III. Theoretical Arguments for and against Funding Subnational Governments with Revenues from Natural Resources

This section considers the general issue of the suitability of oil revenue as a source of finance for subnational governments. Since on equity and efficiency grounds, producing areas have to be compensated for oil exploitation and production costs, the assignment of net, rather than gross, revenue is considered. These costs will be briefly addressed before analyzing the revenue assignment issue.

Additional Costs of Investment in Infrastructure

Although most investment for the exploitation of oil and other natural resources is made directly by the producing companies, additional investment in local infrastructure is usually needed. Roads to the producing fields have to be built; airports and ports may have to be upgraded; school, health, and social services have to be expanded to serve the growing population attracted to the area. If the demand for these services exceeds the level that would have prevailed in the absence of oil and natural resources extraction, the governments of the producing jurisdictions are entitled to have these additional costs funded. Since the oil rent is the income in excess of that required to cover the costs of all inputs necessary for production, both efficiency and equity considerations suggest that the costs faced by subnational governments are refunded before this rent is distributed. In other words, only the net rent has to be allocated.

In a way this amounts to applying the peak load pricing principle to oil exploration and production expenses (McLure, 1983). The principle says that the cost of expansion of the capacity has to be borne by those who make use of it. Those companies are the equivalent of peak-hours users of mass transportation. However, effective implementation of the peak load principle is far from easy, since the effective beneficiary of the expansion has to be determined, that is, oil-producing companies or the local population.

Compensation of Environmental Damages

The same arguments apply to environmental costs. These social costs have to be added to those borne by the producing companies to determine the total rent generated by a project and should be refunded to the concerned jurisdictions. Environmental damages caused by oil can be substantial and the cost of correcting them can be large. The most obvious example is environmental degradation caused by burning natural gas at the wellhead instead of exploiting it. There are well-established techniques for assessing environmental damages; uniform national standards have to be used, so that environmental standards set up for oil-producing areas are not higher or lower than those set up for areas concerned with other economic activities. As in the case of infrastructure capacity costs, environmental damages require joint assessment and negotiation among different levels of government.

Assignment of Net Rent and Efficiency

Possible distortions can arise from the way oil resources are spent. In this sense, revenue from natural resources is similar to that from any other tax base. Unequal access to revenue allows governments to spend it inappropriately. As shown in the literature (Boadway and Flatters, 1982; McLure, 1983), unless beneficiary subnational governments spend these revenues for “country building policies”—such as the provision of purely national public goods, the construction of truly national infrastructure, or portfolio investments in financial assets made according to the same principles followed by private investors—labor and capital allocation distortions are inevitable. This is because energy-rich subnational governments can apply lower tax rates, or grant higher subsidies, to suppliers of labor and capital. Since the location of individuals (and capital) would be dictated by after-tax and subsidy income, the migration of production factors would not be related to factor productivity, or to the living amenities of oil-producing areas, thus potentially leading to efficiency losses.4

Substantial efficiency losses can also derive from misspending of oil revenue in oil-rich jurisdictions. In turn, misspending can derive from insufficient absorption capacity and/or from corruption; this problem is exacerbated by the regional concentration of oil rents. While the central government is not inherently superior in administering funds, the sheer size of oil revenue constitutes a larger challenge for smaller governments, especially in developing countries with recent traditions of local self-administration.5

Similar arguments apply regarding the evaluation of the likely impact of corruption. The prevalence of corruption depends, among other things, on the level of information, political system, administrative traditions, homogeneity of local jurisdictions, and sectoral composition of expenditure at the national and local levels. However, concentration of resources within a small jurisdiction may weaken the constraints on corrupt behavior. In a number of countries, access to oil revenue has produced corruption and a generalized weakening of public institutions. However, empirical evidence refers almost exclusively to central governments, because until recently oil rents were reserved to the center, as noted above (for example, Bergesen, Haugland, and Lunde, 2000; Oxfam, 2001).

Assignment of Net Revenue and Constitutional Arrangements

Constitutional arrangements cannot be invoked in setting equity criteria for the intergovernmental allocation of oil rents, apart from the case of confederations, where oil and its revenue are property of the members of the confederation and not of the confederation itself. This is because the primary allegiance of citizens is to the confederated states, and nothing is due to the confederation that does not derive from a decision of each distinct confederated state.6 In the more common case of federations, their nature does not help per se to settle disputes over property rights. In other words, while the constitution of a federal state may attribute property rights to its states, the constitution of another one may actually mandate the reverse. Furthermore, constitutions can be amended and be subject to contrasting interpretations.

Canada and Nigeria provide good examples of the latitude of possible interpretations of constitutional arrangements and of the conflicting views about possible amendments. Canadian non-oil-producing provinces have traditionally adhered to the principle that Canada is a single nation and a single community. If so, natural resources belong to the federal government and should be shared among all provinces, and/or used for country-building purposes. Oil-producing provinces held the opposite view, stressing the primacy of provincial communities; national majorities should not be entitled to take natural resources away from where they are produced.7

In Nigeria, interregional conflict on oil has originated secessions, civil wars, and the frequent demise of democracy. Oil-producing federated states have traditionally taken on the view that “equitable federalism” implies the adoption of the derivation principle (resources stay where they are produced). Producing states have brought forward the principle that equitable federalism means redistribution (Ikein and Briggs-Anigboh, 1998).

Assignment of Net Revenue and Principles of Distributive Justice

Theories of distributive justice are useful for understanding the evolution of constitutional arrangements concerning the allocation of rents from natural resources, rather than for setting up specific criteria for revenue assignments.

An example is offered by a positive interpretation of the Rawlsian approach. When little or nothing is known about oil reserves and their value, a proponent of Rawls’ theory of justice would suggest that these revenues should be centralized because of the large uncertainty concerning the distribution of oil reserves among the various areas of the country. In other words, every individual would vote for centralization, if he or she had to decide under a “veil of ignorance” and faced with the possible risk of receiving no revenue, if it turns out that his or her region has no reserves at all and oil property rights are decentralized. Experience shows that, when the vast potentials associated with oil discoveries became common knowledge, but the actual distribution among regions remained unknown because no exploration had yet been made, constitutional provisions about property rights on natural resources became more detailed and ownership and control of natural resources were vested to the central government.8

However, when the veil of ignorance about the effective location of oil disappears, as happened in some Latin American countries in the early 1990s, constitutions adopted in that period showed a shift toward the explicit recognition of subnational government entitlement to oil revenue (for example, in Argentina and Colombia). This is because resource-rich jurisdictions exerted increasing pressures on the writers of those constitutions to see that their property rights were recognized.

The same rich jurisdictions would not appeal to Rawlsian principles of justice, which would protect the right of the less endowed areas, but rather to Nozick’s criteria of justice. Specifically, they would argue that oil reserves and the benefits from their exploitation are legally acquired property rights and that there is no way of dispossessing the jurisdictions that benefit from these rights.

On the basis of countries’ current social and redistribution policies, it is hard to imagine a country’s social welfare function that would assign the entire oil revenue to producing jurisdictions. At the same time, it would be hard to imagine a social welfare function that would totally disregard the claims of the producing jurisdictions to have a share of net oil rents. In other words, present-day political orientations are for redistribution of wealth, but not for total equalization, which translates into centralized assignment of most net oil rent and recognition of a small share to the producing jurisdictions. This recognition is also attributable to political expediency, as it can be essential for keeping countries together and for fostering nation building. To this end, national and local shares should be negotiated and subject to continuous renegotiation, while no party holding a stake should have a veto power concerning the allocation.

In any negotiation, the result depends on the distribution of bargaining power among contestants. In the case of natural resources, the central government has plenty of instruments to bend negotiations to its favor, or to correct their result. This is clearly shown by the moves of the federal government in Canada after the first oil shock (McLure, 1983). To counteract the excessive shift of resource in favor of Alberta, Canada resorted to a few but quite effective decisions, including

  • holding domestic prices below market prices. This system benefits consumers (but has efficiency and equity costs);

  • levying export taxes on foreign sales of oil, reducing room for subnational taxes;

  • eliminating deductions for subnational taxes and royalties in the calculation of central income (company) tax liability; and

  • modifying the formula used for equalization in a way that penalized producing and too tax-prone subnational governments.

IV. Sharing Oil Revenue Among Levels of Government

Three systems are used for sharing revenue from natural resources among the central and the subnational levels of government:

Tax base sharing. In this system, subnational governments can levy specific taxes on natural resources situated within their jurisdiction. Subnational governments can determine the tax bases and the tax rates freely, as found mostly in old federations. In otherwise decentralized systems, tax rates are set within the limits imposed by the central government. In a number of countries, there is an overlapping of tax bases, that is, more than one level of government has access to the same oil-tax base.

Tax revenue sharing. In this system, tax bases, tax rates, and revenue shares accruing to the producing and/or transporting subnational governments are determined by the central government.9 This is now the most common system. Examples are provided both by federal countries, such as Australia, Brazil, Argentina, Russia, and Canada (in the case of the “Atlantic Accord” concerning the Newfoundland and Labrador provincial government) and by nonfederal countries, such as Colombia, Bolivia, Papua New Guinea, and Italy (a more complete list of these arrangements is provided in Table 10.1). A recent trend shows that revenue from offshore oil, which is everywhere property of the central government, is being shared also among neighboring subnational governments. This is the case of Canada, Australia, Brazil, and Italy. Since there are much lower infrastructure costs and almost no externalities from offshore exploration and production, sharing with subnational governments shows the intensity of their pressures and the difficulties of resisting them.10

In a number of countries, such as Bolivia and Colombia, a part of revenue from natural resources is kept in separate equalization funds and then used for allocations to nonproducing local jurisdictions. Well-structured fiscal equalization systems for subnational governments, such as the Australian and Canadian ones, include revenue from natural resources in the determination of the fiscal capacity of beneficiary jurisdictions. An implication of this is that, even in nonproducing jurisdictions, subnational government revenue is somehow determined by the availability of natural resources and their fluctuating trends.

In-kind revenue sharing. According to this system—which plays a minor role in the allocation of oil revenue—the producing and/or transporting subnational governments have access to a share of natural resource revenue generated within their jurisdiction via the provision of infrastructure by the companies that exploit these resources and on the basis of an explicit national regulation. The most quoted example is provided by the “Infrastructure Tax Credit Scheme” of Papua New Guinea, whereby up to 2 percent of a developer’s total tax obligation can be spent on infrastructure within the province in a given year, providing the infrastructure is approved by the department of mining and petroleum, the provincial government, and the taxation office (Andrews-Speed and Rogers, 1999). This system is not to be confused with the common practice by producing companies of providing, on a voluntary basis, infrastructure and services to the areas concerned by their operations. This is done to alleviate the problems created by their activity and to promote better relations with local communities and local governments (see, for illustration, Davy and McPhail, 1998; Filer, 1995; and Labonne, 1995).

These three systems are not mutually exclusive. For example, in Papua New Guinea the Infrastructure Tax Credit Scheme coexists with the sharing of revenue from royalties on oil, while in other countries tax-base sharing coexists with revenue sharing. An evaluation of the three systems is provided in Box 10.1.

V. Oil Revenues and Equalization Systems

Disparities in the revenues from oil, and the problems arising from them, can be attenuated through equalization mechanisms, especially when the constitution, or previous agreements that are not easily renegotiable, grant a large share of oil revenues to producing jurisdictions.

Equalization of Net Against Gross Revenues

To the extent that oil revenue represents a compensation for environmental damages and a refund of industry-specific infrastructure costs, it does not constitute additional resources. As noted above, only revenue in excess of those compensations and costs should be subject to equalization.

Netting revenues is not usually done for nonnatural resource taxes. Equalization systems assume that there are no collection costs for the taxes they include in the equalization process. This is a reasonable and simplifying assumption, when all the concerned subnational government units have access to the same tax bases, as collection costs should be broadly similar across the various areas. However, in the case of oil and other natural resources this may not be the case. Hence, including gross revenues in equalization schemes without any consideration of what producing jurisdictions have spent for generating the tax base amplifies the revenue capacity from natural resources compared with other tax bases, or to the same tax base in other jurisdictions.

Canada has partly solved this problem by scaling back by 30 percent the natural resource revenue subject to equalization. This offset provision applies only to those provinces that have 70 percent or more of the total tax base from a revenue source (Courchène, 1998). An alternative solution, much fairer but more difficult to implement, would be to equalize effective net revenues, by itemizing infrastructure costs, as broadly done in Australia.

Box 10.1.Evaluation of Oil-Revenue-Sharing Systems

Sharing Tax Bases

From the point of view of local governments, natural resources would provide an optimal tax base for the following reasons:

  • the tax base is immobile, so the imposition of the tax does not affect its location;

  • to a large extent, the burden of natural resource taxes is borne outside the producing jurisdictions; this avoids the political pressure that is usually associated with the imposition of taxes;

  • local jurisdictions can fully exploit the favorable location of natural resources.

However, the need for choosing efficient systems of taxation, administration difficulties, and the relevance of national interests in energy policy weigh against revenue assignment to subnational governments. For example, a tax on the actual cash flow of producing firms (also called the rent resource tax)1 has a complex design, and its administration is exceedingly difficult for subnational governments. General (or oil-industry-tailored) income taxes also present problems, due to their complex information requirements and the need for a sophisticated tax administration to deal with large international companies.2 Moreover, the application of cash flow or income taxes implies that tax liabilities will be negative at the start of new projects. Thus, tax collections will flow in only after the project is operational, a burden that subnational governments are unlikely to be able to bear (particularly considering their need to build the infrastructure before the start of production).

Consequently, the choice of tax instruments comes down to production-based taxes, such as royalties and severance taxes.3 These are in fact the most common instruments used for obtaining a share of rents by subnational governments (Otto, 2001, and Table 10.1). They present clear advantages for subnational governments over the previous instruments, mainly by ensuring steadier revenue flows.4 However, they still pose policy coordination issues in the energy field. In other words, the choice of the tax rates will impinge on energy policy—determining the flow of production—which is clearly a national policy priority, especially in oil-specialized economies.

Based on this discussion, a locally collected unit royalty (with a ceiling on the total amount of collections) may be advisable, to ensure subnational governments that their oil-determined needs—for environmental protection and infrastructure building—are sheltered against the vagaries of national coalitions and their appetites.

Revenue-Sharing Schemes

This system may not be recommended as a general instrument for financing subnational governments, as these governments would not be responsible for the determination of their tax rates. However, in the case of oil revenue, it can actually provide a better alternative to tax-base sharing, because tax rate setting should be better left to the central government.

Infrastructure Tax Credit Schemes

These schemes are suited to very small governments and local informal communities with insufficient administrative capacity. Infrastructure credit schemes help to establish working relations between producing companies and local stakeholders. Higher levels of government should still be involved in the decision-making process, particularly in monitoring the execution of projects.

1Garnaut and Clunies Ross (1975 and 1983); Boadway and Flatters (1993); Otto (1995); Emerson (2000); Sunley and Baunsgaard (2001).2For example, apportioning of collections among different jurisdictions may be difficult when the same company operates across different jurisdictions.3These are excise taxes levied on oil production by states in the United States.4Some of the present schemes use regressive tax rates to ensure that collections do not skyrocket during periods of rapid increases in oil prices.

Systems for Equalization

There are two main equalization systems, based on

  • bringing oil revenue within the general equalization framework, as in Australia and Canada; and

  • using a distinct equalization system for oil and other natural resources, as in Bolivia and Colombia.

The main advantage of general equalization systems is to bring together revenues from oil and non-oil and hence increase the equity content of equalization. In principle (and also in practice if there are sufficient resources), general equalization systems could entirely compensate for the vagaries of the geographic distribution of natural resources. However, when oil is vastly concentrated, (i) full compensation may no longer be feasible because either it exerts an excessive strain on central government resources, or it has to severely reverse preequalization agreed subnational shares—which would be politically unacceptable; and (ii) the implementation of the system has to solve a few difficult technical problems, that are illustrated in the next section.

There are two versions of equalization mechanisms: the vertical equalization model, such as the Australian and the Canadian systems, whereby grants are paid by central to the subnational governments; and the horizontal equalization model, such as the German one, whereby grants are paid from relatively richer jurisdictions to relatively poorer jurisdictions, without central government funding.11

In the vertical model the skewness of the distribution of the revenues to be equalized influences the total amount of the grant.12 More precisely, in open-ended systems, such as in Canada in the early days, with no upper limit to the total amount disbursed by the federal government, whenever the standard tax base—the tax base of the jurisdictions with reference to which revenues are equalized—increases, the total amount of the grant is bound to increase also, other things being equal. Thus, central government resources may be subject to such a severe strain as to require a change in the formula, as happened in Canada with the first oil shock. The large increase in oil prices at that time bloated the revenues of Alberta, where almost all Canadian oil production was taking place. The standard tax base (then the national average) took off, requiring, other things being equal, a similar expansion of grants. Since the federal government had access to only 10 percent of oil revenues, sticking to the formula would have implied equalization payments to be financed with its own tax revenues, thus having to face the choice of either incurring deficits or squeezing its own expenditure. Furthermore, the gap between Alberta and the other provinces became so large that even the rich provinces, such as Ontario, became beneficiaries of equalization transfers (although in the end they were financed through the use, by the federal government, of the tax base located in their jurisdiction).

Over the years Canadian governments have made basic corrections to the formula, including: (i) the exclusion of Alberta’s tax base from the equalization standard; (ii) the exclusion from equalization payments of those provinces, such as Ontario, with a non-oil tax base above the national average; (iii) the exclusion of a share of the oil-tax base from the equalization system; and (iv) the introduction of a ceiling to the total amount paid for equalization. Obviously, these changes implied a curtailment of the equalizing impact of the mechanism.13

Vertical closed-ended equalization systems such as the Australian one—where, starting from the year 2001, the equalization system is funded by the Goods and Services Tax collections—do not by definition put severe strains on the federal finances. However, when distribution of oil revenues is highly skewed, their equalizing capacity faces the same problems as the open-ended systems.

Horizontal models do not by construction have the same difficulties. The degree of equalization is written in the formula. It is not imperiled by sudden changes in the total amount of oil revenue and/or in the skewness of their distribution. Moreover, strains on central government finances cannot arise because, if the standard is set at the national average, the total grant from net paying jurisdictions is equal to the total grant received by beneficiary jurisdictions.14

The strain is rather put on the oil-producing jurisdictions, particularly if they represent a minor share of the total national population. More specifically, the share of oil revenue they can retain is directly related to the share of their population on the total national population. If equalization is geared to fully equalize per capita revenues, then the share of retained revenues for the producing jurisdictions is equal to the share of their population.15

The two systems—vertical and horizontal—could be combined, as proposed by Courchène (1979). For example, the vertical system could be reserved to non-oil revenue, while oil revenue would be subjected to a horizontal system. However, the basic properties and difficulties of implementing equalization would be essentially unaltered.

Separate equalization systems are generally funded only by oil revenue and do not include other sources of revenue. They amount basically to reserving a share of total national revenue from oil to the non-producing, or little-producing jurisdictions, and to distributing it according either to the difference between their resource revenue and the national average (as in Bolivia16), or to other needs, or to revenue capacity-related indicators. In Colombia, for example, the Fondo Nacional de Regalías (National Royalties Fund) is allocated on the basis of development projects presented by subnational jurisdictions. The idea is to allow nonproducing jurisdictions to share some of the growth opportunities created by the exploitation of oil and natural gas resources.

The equalizing impact of separate mechanisms derives, as in the case of the general equalization systems, from the relative shares of natural resource revenue granted to producing and nonproducing jurisdictions and their relative shares in the total population. The effectiveness of equalization is imperiled by the exclusion of non-oil sources of revenue. Thus, a rich (with high non-oil tax revenue) department can receive, as in the Bolivian case, the same amount of resources as a poor department, if the difference between oil revenue and the national average happens to be the same in both departments.

In industrial countries with a well-developed national statistical system, separate systems have practically no raison d’être. In developing countries, however, where equalization systems have to rely mostly on rapidly obsolete population figures for the allocation of funds, separate systems may be considered on a temporary basis because of their greater simplicity.

Technicalities of Natural Resource Equalization Schemes

The implementation of natural resource equalization schemes presents some difficulties, particularly when natural resources are concentrated in one or in a few provinces. First, it has to be decided if natural resources must be considered separately for equalization purposes. Second, a common criterion for the determination of the tax base has to be found.

When a single resource is concentrated in only one subnational jurisdiction, the equalization of the tax capacity is transformed into a simple revenue equalization. This is because only a single tax rate is applied. By definition, then, actual collections are equal to tax capacity.

The second problem relates to the use of common criteria for the determination of the tax base. When the distribution of mines and oil fields is geographically concentrated,17 and/or when subnational governments use different taxes and/or different criteria for the determination of the tax base, then a common tax base has to be used. Australia is presently using a value-added approach to calculate the comparable revenue base from natural resources for each state. The revenue base is currently calculated as the value added by the whole mining industry, including oil and gas, less: (i) some exploration expenditure and (ii) some allowance for future capital expenditure.18

VI. Conclusions

This paper has explored methods, merits, and drawbacks of assigning net oil and natural gas revenue to subnational governments. There are two main arguments against local assignment, namely the usually vast geographical concentration of this revenue and its volatility. Recent international experience shows, however, a growing trend to share oil revenue among all levels of government. In addition, offshore oil revenue tends to be shared, although there are very few theoretical arguments in favor of this policy.

These trends are to be explained mainly in terms of political expediency. Decentralization, that is, devolution of powers to subnational governments, increases the weight of these governments and institutionalizes their demand for a (growing) share of natural resources located in their jurisdiction.

Concerning the instruments used for revenue assignments, the paper has argued that revenue sharing is the most appropriate one, while local taxes on oil can be problematic. This is because of the complexity of administration and collection and because locally determined taxes will impinge on energy policy, which is mainly a central government responsibility.

When oil revenue is shared with subnational governments, equalization is needed to attenuate disparities and to alleviate problems. There are, however, limits to the intensity of equalization, when oil revenue is large and highly concentrated in spatial terms.

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For example, in the oil-producing department of Casanare in Colombia, more than 7,000 workers, in a population of fewer than 200,000, were attracted to the area during the construction period.

For example, in Nigeria, about 82 percent of total public revenue is currently derived from oil, and in Venezuela more than 50 percent.

In November 2000, the Congressional Economic Committee of Ecuador established a formula whereby the military would receive 45 percent of the royalties of state-owned Petroecuador’s production (about US$127 million based on 1999 output), against a request from the military of 50 percent of all crude oil royalties. Furthermore, the formula limits the military share to a three-year period, ending the previous military’s 30-year stake.

The magnitude of the loss depends on migration elasticities, that is, on region-specific factors. For example, migration elasticities in Alaska are surely much lower than in other U.S. states. They can, however, be substantial in developing countries, where employment opportunities are scarce nationwide, especially when oil is discovered in nonre-mote and hospitable areas.

A World Bank study on the oil-producing department of Casanare in Colombia illustrates the risk of wasting oil revenues when they reach sizable levels in a short period of time. Casanare, created in 1991, is one of the newest departments in Colombia. Oil royalties were negligible until 1994, then reached 73 percent of the department total income by 1997. According to the law, local governments must invest 100 percent of royalties in high-priority projects in the sectors of education, public health, sewage systems, and water supply. However, in 1996 only 40 percent of the royalties had been spent in those high-priority sectors (Davy, McPhail, and Sandoval Moreno, 1999).

Even when simple majority vote is required, confederated states still have a vetoing power that can ultimately be exercised through secession.

It should has also to be noted that the Canadian provinces situated on the Atlantic coast shifted gradually from the nation-building to the province-building approach when their prospects of oil discoveries became brighter (Simeon, 1980; and McMillan, 1982).

Before then, when very little was known about oil, constitutions ignored the issue or left oil to subnational government property.

In lieu of taxation, two alternative systems for diverting to the public sector a share of revenue from natural resources are presently used. Revenue can arise from bidding for the rights to exploit resources and from holding equity in oil companies. In these cases, the central government conducts the bidding and shares its results, or it acquires a share of equity in producing companies and then transfers part of it to subnational entities.

Ahmad amd Mottu (Chapter 9 in this volume) present a summary ofthe most relevant revenue-sharing schemes

For simplicity, the paper focuses on fiscal capacity equalization, leaving aside consideration of expenditure needs.

A simple look at the Canadian formula (the calculation of tax capacity is almost the same in Australia) illustrates the point:

TT = ΣTi and

Ti = ts (TBs/P-TBi/Pi) Pi,

where TT is the total grant; T is the grant to individual provinces; t is the tax rate; TB is the tax base; P is the population; s is the standard (it may be the national average, or the average of a selected group of provinces above the average, as in Canada); and i stands for beneficiary provinces, that is, those for which the difference in the expression between brackets is positive.

These measures can be and have been variously combined, and they do not exhaust the range of instruments needed to dampen the impact of exceptional circumstances on the sustainability of equalization mechanisms.

A typical formula based on the equalization of tax capacity—that is, on standardization of revenues—would be:

TTJ = α [ts(TBJ - TBs)] and

TTI = α [ts(TBs - TBI)],

where, in addition to the previously mentioned symbols, J stands for paying jurisdictions; and I stands for the beneficiary jurisdictions. Thus, TTj is the total grant paid by the contributing jurisdictions; TTI is the total grant received by the beneficiary jurisdictions; and α is the degree of equalization attained by the mechanism, varying from 0—no equalization at all—to 1, meaning perfect equalization (that is, equal per capita revenues).

A simple example illustrates the severity of the constraint on the share of the producing jurisdictions. Suppose that there is only a producing region, which represents 5 percent of the national population. If total oil revenue is 10,000 units and total national population is 100, then the national average is 100. To get a level of equalization similar to the German one, where per capita revenue of the less endowed regions is brought to 0.9 times the national average, the share of the producing region should be equal to 14.5 percent of the total. In fact, if per capita equalization payment is 90, that has to be paid to 95 persons. Total payment is thus 8,550, leaving 1,450 units to the producing jurisdiction. The share is far below the sharing rates presently accorded to the producing jurisdictions in all the countries reviewed in Table 10.1.

To this aim revenue from natural resources is supplemented by appropriations from the central government budget. The Bolivian model is thus not a pure version of a separate equalization system. Moreover, it is not restricted to revenues from oil, but it refers to all natural resources.

In Australia, gold and oil are extracted in Western Australia, while coal is extracted in New South Wales and Queensland.

A number of issues have arisen in measuring these two deductions. In the first case, in order to allow mining sectors to continue exploration (at least on operating leases), the value of exploration has to be netted from value added. However, getting comparable data on exploration is problematic, particularly for companies that have both operational and speculative leases. In the second case, the Australian system also deducts from value added a ten-year average of capital expenditure in each jurisdiction. An additional issue has been how to deal with the practice in one state (which owns the rail freight network) of charging much higher freight rates instead of higher royalties on black coal. This quasi-royalty has been added to the value added of the mining industry in that state as it is recorded as an industry expense only because of the unusual freight arrangements. The assumption made in this respect is that the excess freight expense is equivalent to a royalty payment, and therefore should be treated as such (Commonwealth Grants Commission, 2002).

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