Centralise resource-revenue management to boost economic growth and development

One of the main risks of rising inequality in resource-rich countries; is the response on how to divide resource revenues between central and subnational governments. Indeed, there now appears to be a global trend toward the decentralization of petroleum and other mineral rents (Brosio 2003). While these arrangements may look like an easy way to manage regional tensions over resource rents, they have serious drawbacks.

Most of the oil-rich countries are unitary states and have fully centralized revenue systems. Outside the Middle East, however, many oil exporters divide resource rents between central and subnational governments, regardless of whether they are unitary states (Colombia, Ecuador, Kazakhstan) or federal states (Mexico, Nigeria, Russia, Venezuela and Indonesia) (Ahmad and Mottu 2003).

There are three ways that subnational governments may receive resource revenues:

• They may levy taxes directly on the mineral industry;
• They may receive direct transfers of a share of the central government’s resource revenues, based on some formula;
• They may receive indirect transfers from the central government, once the revenues have been smoothed and allocated according to the national budgeting process.

The first two approaches in particular – subnational taxing authority over resources and direct transfers of mineral revenues – will have serious drawbacks for an economy like Guyana:

• Since central governments have more diversified revenue bases than subnational governments, they are better insulated from the effects of resource revenue volatility.
• The capacity of any subnational region to efficiently absorb new investments from windfall spending will be less than the national capacity to do so.
• Central governments are better able to implement countercyclical fiscal policies – that is, to expand the economy during a recession, or contract it when inflation becomes too high.
• While fiscal discipline is a problem for most central governments, the problem is often worse at the subnational level.
• Allowing subnational governments to impose taxes creates special problems:
• Subnational governments have less ability to administer complex types of taxes, and to tax large foreign firms, than central governments.
• When subnational governments impose their own taxes or royalties.

Subnational governments are clearly entitled to revenues that compensate them for the social, environmental, and infrastructure costs of oil and gas extraction. Nevertheless, beyond these, the arguments in favour of subnational petroleum taxes are political. Local governments find oil and gas taxes attractive, because they are taxing an immobile asset, and the costs are typically borne by those who reside in other jurisdictions. Regional governments often claim ownership of these resources and may threaten secession if they get less than they seek. Moreover, the constitution may give them the right to levy certain kinds of taxes within their jurisdictions.

The first-best arrangement is full centralization of all oil revenue, with carefully designed transfers to subnational governments. Recognizing that this is often politically untenable, the second-best recommendation is to allow subnational governments to levy relatively small, stable types of petroleum taxes ­ such as production excise taxes – while the national government levies taxes and royalties that capture the more volatile forms of revenue (Ahmad and Mottu 2003). Further, any subnational petroleum taxes should be supplemented by more stable revenue sources. This approach is preferable to revenue-sharing arrangements, which may allow subnational governments to avoid accountability, complicate the central government’s macroeconomic planning, fail to provide subnational governments with stable financing for local public services.

Whilst, full centralization is the first-best solution, some may favour a revenue-sharing arrangement as the second-best alternative (Brosio 2003). The process of collecting and administering taxes is too complex for most subnational governments to carry out, at least in developing states; that it makes it harder to equalize revenues across subnational jurisdictions; and that it impinges on national energy policies.

The case for giving subnational governments taxing authority, or a direct share of resource revenues, would be strengthened if there was evident that these measures could help avert secessionist movements. No systematic analyses have been done, however, leaving the issue unclear. On the one hand, bargaining with subnational governments can be an arduous process: the division of oil revenues is a zero-sum game in which every state and local government wants as much as it can get, and there is no magic allocation formula that everyone will think is just. On the other hand, revenue-sharing arrangements have sometimes been important components of broader policies to reduce secessionist pressures in resource-rich regions.

Local and regional governments should be compensated for the cost they bear when resource extraction occurs in their jurisdiction. Local and indigenous people, who live on the land where extraction takes place, deserve special accommodations – beginning with their full recognition as stakeholders whose concerns must be addressed before any new project begins. Nonetheless, giving subnational governments either the authority to levy resource taxes or a fixed share of the nation’s oil revenues should be avoided whenever possible. The best approach is for governments to collect revenues centrally, and make allocation decisions centrally, but with input from local and regional authorities.

If such an arrangement is unobtainable, the government should try to adopt a revenue system that:

• minimizes the volatility of subnational revenues;
• minimizes any inefficiencies created by overlapping tax bases;
• does not exacerbate pre-existing regional inequalities;
• encourages or requires subnational governments to coordinate their fiscal policies with the central government;
• encourages subnational governments to use any oil revenues to complement, not substitute for, their existing tax base;
• is accompanied by expenditure responsibilities, so that the added revenues are targeted toward some type of public good;
• is based on a formula that is stable over time, so that the issue of revenue or tax sharing will not be constantly revised;
• is fully transparent and regularly audited; and
• does not encourage citizens to create new subnational jurisdiction in order to collect rents provided by the central government.

Moreover, many observers assume that resource rents – in the presence of weak institutions – increase the gap between rich and poor. Yet, it is possible that the opposite is true: growth in the government sector may lead wage compression and less inequality.

At a minimum, states facing resource booms should focus their attention on the problem of vertical inequality and pay special attention to the ability of workers to move from the “tradable” sector (typically agriculture and manufacturing) into the “non-tradable” sector (generally services). If an intersectoral shift will leave behind certain groups – such as women, low-income workers, rural workers and older workers – the government should consider countermeasures. Apart from equity considerations, governments should also adopt policies that can help prevent the economy from growing excessively dependent on a single commodity, including prudent exchange-rate policies, and measures to boost productivity and competitiveness in the manufacturing and agricultural sectors.

Resource booms tend to exacerbate regional inequalities under certain conditions when the extractive region was initially wealthy; when growth in the resources sector outpaces growth in other sectors; when the resources sector has strong forward or backward linkages to the local economy; and when the regional government can directly or indirectly tax resource incomes. It can be especially destabilising when, in the extractive regions, expected changes in income outpace real changes in income.

States have a large toolkit for addressing these problems. Unfortunately, one of the most common approaches – decentralizing resource revenues – has many drawbacks and should only be done when it is politically unavoidable. A second approach, the Alaska-type direct distribution plan, has not been tried in a developing state, where institutions tend to be weak. If successful, it would allocate resource revenues in an admirably equitable way; if unsuccessful, it could promote widespread rent-seeking and fraud.

A less risky approach would be to adopt policies that narrow the income gap between the extractive region and the rest of the country, and within the extractive region, policies that reduce the gap between real and expected incomes. These measures include full revenue transparency, promoting good corporate citizenship, restricting migration to the extractive region, fostering the role of non-governmental organisations and curtailing predation by security forces.

A natural resource bonanza encourages productive entrepreneurs to shift to rent seeking. With an aggregate demand externality (and a constant tax rate and no external trade), this lowers income by more than the extra income from the resource revenues and thus, lowers welfare (Torvik 2002). Hence, Guyana must become a country with production-friendly institutions and not one with rent grabbing-friendly institutions.