Gillard's caught in her own tax trap

Julia Gillard and Wayne Swan are now caught in a trap of their own making. In their haste to end the damaging campaign by the big miners against the resource super profits tax they provided an assurance they couldn't deliver and now their own expert advisers on the minerals resource rent tax regime that displaced the RSPT have sided against them.

The relationship between the miners and the government has been at flash point as the government has sought to distance itself from a key clause of the agreement it signed with the miners in the lead up to the election – a promise that the MRRT would provide a full credit for all state royalties, including an uplift factor for unused credits.

The miners firmly believe that when Gillard and Swan said that they would receive credit for "all" state royalties paid – and signed off on that promise – they actually meant all, including any future increases. They have made it clear they would never have signed the agreement and ended their campaign had that not been the case.

The Gillard government has, however, belatedly recognised the implications of the deal that it struck in desperation. In effect, states could raise their royalty rates up to the level of the federal resources tax take with no adverse impact on their resource companies – they could siphon off the entire MRRT revenue base.

So Swan et al have been arguing that the agreement, despite saying "all", actually only meant existing royalties and therefore in future the miners would not only have to face the new MRRT but would be further exposed to any increase in state royalties.

Today the government's "policy transition group" co-headed by its own resources minister, Martin Ferguson, and former BHP Billiton chairman Don Argus, made it clear that it sided with the miners and that the government would have to find some other means of dealing with the potential revenue leakages to the states.

It recommended full crediting of "all current and future state and territories royalties under the MRRT so as to provide certainty about the overall tax impact on the coal and iron ore mining industries."

"Equally, the MRRT should not be used as a mechanism to enable states and territories to increase inefficient royalties on MRRT taxable commodities. Accordingly, the PTG also recommends the Australian, state and territory governments put in place arrangements to ensure that state and territory governments do not have an incentive to increase royalties on coal and iron ore."

There have been mutterings within the government about using the threat of offsetting any increase in royalties by the states by withholding GST revenue from them.

Given that the GST is an agreement between the federal and state governments under which the states agreed to rationalise their own taxes in return for all the revenue raised by the GST that could trigger an interesting and potentially quite destructive confrontation. It would also create significant political risk for a government already on the knife edge.

The basic problem the Gillard government faces is that it is trying to do something that the Constitution doesn't allow, and effectively tax resources that are actually owned by the states where the resources are located.

It can't do so directly so it is using the device of taxing the profits generated by the resources instead, something that could either be challenged in the High Court by one of the states or undermined by the resource states increasing their royalties to divert all of the MRRT revenue.

State royalties aren't the most efficient or flexible mechanisms for taxing resource profits, given that they are unlikely to be lowered during a downturn in an inherently very cyclical sector. Nor do they capture windfall profits, or economic rents, during commodities booms. A tax that captures a share of genuine super profits, and the MRRT (unlike the RSPT) appears to be such, is far more preferable.

The states, however, aren't going to hand over their own taxing powers to the Commonwealth, or relinquish the independent ability to increase their royalty revenue bases if they deem it necessary and/or appropriate. While this government doesn't necessarily mind making threats to get its way – witness Telstra – the resource states are unlikely to be intimidated easily.

Thus the government faces something of a Catch-22. It can renege on the deal it signed with the miners, and all hell breaks loose (and the issue of sovereign risk is really magnified) or it can try to bully the states into restrictions on their constitutional rights – and all hell breaks loose.