Eurasia on Peru mining and tax negotiations

No blahblah from me, here's the note, out Wednesday:

PERU/MINING: Tax hike likely to be moderate, but risk of cumbersome burden remains
10 August 2011 12:10 PM EDT
One of President Ollanta Humala's policy priorities will be to raise taxes on mining, but he will probably seek a relatively moderate increase given his desire to keep the sector reasonably attractive for investors. Recent statements by key officials, saying the government will negotiate its proposals with mining companies and that maintaining the sector competitive will be a guiding principle of reform, reinforce this appraisal. Nevertheless, two factors could lead the government to seek a more cumbersome tax increase. The first is Humala's desire to centralize revenue in the hands of the central government, which poses the risk that companies will bear the cost of compensating local and regional governments for any revenue loss. Second and most importantly, a drop in Humala's approval rating suggests he could become politically weaker in the medium term, something that would increase the risk that he will tax more heavily mining production to finance new spending.

The Humala administration is widely expected to increase taxes on the mining sector, but there has been much uncertainty among investors about how far he is willing to go and how the new tax structure for the sector will look like. While Humala views extracting more revenue from mining as an important measure to finance new spending, he will probably seek a relatively moderate increase given his desire to attract more investment to the sector, which is an important driver of economic growth (See PERU/MINING: Humala likely to show some restraint in approach to mining sector from 1 July). A more uncertain international economic environment will probably reinforce views within government that it should take a cautious approach to the sector.

Recent statements by key officials reinforce this appraisal. They have reaffirmed the government's plan to introduce a windfall profit tax on mining, a proposal that had already been included in Humala's campaign manifesto. But new "prime-minister" Salomon Lerner, Minister of Mines and Energy Carlos Herrera Descalzi, and Minister of Finance Luis Castilla have all said that the government will negotiate tax measures with companies and seek to keep the sector competitive. Humala himself said in his 28 July inauguration speech that the government will negotiate higher taxes and respect tax stabilization agreements. While Humala originally proposed a 40%-45% windfall profit tax (without providing any details), now officials say that the government will analyze its options and officials are holding meetings with representatives from private companies to hear their views and suggestions. Some miners are making the case that any tax increase should focus instead on the royalty tax, which is levied on sales at a 1% to 3% rate depending on revenues. And rather than simply raising rates, they propose a shift in the tax base from sales to profits, with a sliding scale based on operating margin -- something similar to what neighboring Chile has done.

Despite the recent signal of moderation, however, two factors indicate that some risk that the government will seek a more ambitious tax increase remains. The first is Humala's desire to centralize more revenue in the hands of the central government. Currently, companies pay a 30% corporate tax, but legislation stipulates that half of these proceeds (the so-called "canon minero", which is a compensation for natural resources extraction) has to be transferred to producing local and regional governments, who also receive all revenues from royalties. Humala appears to believe that the central government should keep all revenue from the corporate tax, and companies should bear the cost of paying the "canon" to local and state governments. He looks unlikely to move forward with such a proposal, since it would place a heavy burden on companies.

But if he decides to go down that path, even if to reduce only partially the current transfers to subnational governments, the burden would probably fall on companies shoulders. Subnational governments have a limited capacity to execute investments and most of them are "siting" on cash transferred from the central government, so one may argue that it would make more sense for the central government to just retain a larger share of the corporate tax and invest directly in producing areas. But Humala probably wouldn't run the risk of picking up a political fight with local and regional governments. While subnational governments in Peru are relatively weak and have limited influence on legislators, if Humala proposes measures that cause them revenue losses, they could, for example, mobilize locals to stage protests, and that could hurt Humala politically. Humala will likely look at the overall burden of new tax measures on the sector when drafting his proposals. But his desire to centralize revenue increases the risk that he will opt for a heavier tax burden then he would otherwise. It also increases the risk of a more cumbersome tax structure in comparison with a scenario in which the government just introduces a new windfall profit tax. This is because the new structure would rely more on taxes levied on "regular" profits (the new "canon", which would be presumably be calculated based on the corporate tax) or sales (royalties) to compensate subnational governments. Humala's desire to centralize revenue also means the government is unlikely to limit tax changes to royalties as proposed by private sector representatives.

Second and most importantly, a drop in Humala's approval rating suggests he could become politically weaker in the medium term, which would give him an incentive to look at new sources of revenue. Humala's approval ratings have already dropped sharply from 70% in June to 41% in July. Support for him will probably bounce back a bit in August due to the positive news cycle related to his inauguration and the announcement of popular measures such as an expansion of social programs and a hardline on the fight against crime and corruption. However, he may start his administration will lower support than his predecessors and his approval ratings will probably suffer during his first year in office. Not only is the economy slowing, but the trajectory of past president's approval ratings show a pattern of rapid decline during their first year in office, suggesting there are structural factors behind low presidential approval ratings in Peru (See PERU: Drop in Humala's approval ratings increases medium term risks from 25 July).If facing declining approval, Humala could be tempted to pursue more aggressive policies to recover support. This could include a more substantial tax hike on mining to finance new spending. Risk for miners who have tax stabilization agreements would also increase. While Humala will most likely respect contracts, he wants to re-negotiate terms and could take a tougher stance with companies if he feels he needs to boost popular support.

This also means that the timing of tax changes will matter. Both the government and the sector have an interest in addressing the issue as soon as possible. Minister of Mines and Energy Deslcalzi said the government hopes to introduce tax changes before the end of this year. But it will probably take at least a few months before the government has a final proposal. Officials are still conducting internal studies to have a clearer sense of the current effective tax burden and the options available for change. Once the government has a proposal, it will conduct additional talks with companies. And then it will need congressional approval, which would probably take at least another few months. With Humala's approval ratings likely to drop, the longer it takes to finalize a proposal, the higher the likelihood that the government's appetite for new revenue will increase.

As for the odds of congressional approval, the government will most likely have enough support for a proposal viewed as relatively moderate. Humala will need votes from centrist legislators given that his party won only 36% of seats in congress. But there is growing consensus among policymakers in Peru that there is room for higher taxes on mining, and members of former President Alejandro Toledo's party, who hold another 16% of seats, will support a moderate tax hike. In case Humala opts for a more cumbersome tax increase, congress would probably be a factor of moderation. If facing strong opposition there, the government would probably make some concessions to make the reform more palatable to investors. Though unlikely, a more negative scenario could also develop. If Humala's approval ratings drop sharply, he could be tempted to use an aggressive tax hike on mining as a way to boost popular support. His weaker political standing would in theory make congressional approval more uncertain, but he could prioritize and politicize the issue, seeking to generate popular pressure on legislators to approve his proposal while also trying to coopt legislators from other parties.

 

Erasto Almeida
Analyst, Latin America