Last Sunday, the Rudd government finally released their plans for Australia?s tax system in response to the Ken Henry?s tax review. To us, this is at best a very uninspiring response. However, the plan to tax the so-called ?super-profits? of mining companies is very disturbing.

Why?

Firstly, to start a mining business from exploration to production is a very risky and capital-intensive business. As we wrote in Real economy suffers while financial markets stuff around with prices,

a mining project from start to finish can take several years. Therefore, you can see that the accumulation of capital goods is long term processes in the economy. As such, all these industrious activities require long-term planning.

Within that several years, commodity prices can change, to the detriment of the viability of the investment. In other words, a starting a mining business is very risky. Since it is risky, an investor will demand high returns as compensation for taking big risks.

Furthermore, since the produce of mining businesses are pretty generic, most of them have no pricing power (except for Rio Tinto, BHP and Vale). Hence, they are at the mercy of international commodity prices, which means they will have good and bad years. Also, even if commodity prices are at a secular uptrend from rising secular Chinese/Indian demand, it does not necessarily mean that mining profits are at secular uptrend too (see Rising metals price=rising mining profits? Think again!).

By imposing a super-profit tax, the Rudd government has destroyed the economic usefulness of many mining projects (e.g. see First miner scraps project on tax concerns). If the rewards for taking big risks are taxed away, then there wouldn?t be any point in investing. In some cases, it will tempt entrepreneurs and investors to put money in the bank instead where there?s no risk. Or invest in overseas projects and change the country of incorporation where the super-profit tax cannot touch.

Kevin Rudd and Wayne Swan argued that since most of the mining profits goes to foreigners as dividends anyway, a super-profit tax will benefit Australia more.

That argument is flawed to the core. It goes to show how economically illiterate the Rudd government is.

First, why are foreigners earning so much of our asset?s income in the first place? The reason is because Australia spends more than it earns. That is manifested in the persistent current account deficits (CAD)- see Understanding the Balance of Payments. The transfer of most of Rio Tinto?s profits to foreigners is a reflection of Australia?s over-consumption, so much so that it has to borrow from foreigners.

To makes matter worse, according to Ken Henry, Australia will have to borrow more from foreigners in the years to come to finance investments in its mining industry. More investments with borrowed money (from foreigners) are required in order to produce more commodities to sell to China/India.

Now, you see where the problem is? By imposing a super-profit tax, foreign investments in our mining industry will be driven away. Mining projects will be at best delayed and at worst cancelled in favour of overseas projects. By driving away foreign investments, who will finance Australia?s over-consumption? Without foreigners lending enough money to Australia to consume, we are afraid the only option is for Australia to tighten its belt (e.g. via the depreciation of the Australian dollar).

Thanks to Rudd?s super-profit tax, there will be fewer investments in mining projects in Australia, which will in turn will crimp the quantity of commodities produced in the longer term, which will certainly not help in lowering commodity prices. That is, it may be more profitable to speculate in commodity prices then invest in mining companies.