Even the Auditors Don’t Understand Profits

The bureaucratic propaganda machine has really ramped up this week. Page 7 of today’s Australian Financial Review (AFR) headlines:

“Super profit tax calls industry’s bluff”

And on the front page the AFR leads with:

“Henry ramps up pressure on miners”

With the subheading, “Claims tax will boost growth.”

To back up the arguments the AFR reproduced a chart and pie chart which I’m pointing at with a red pen while Diggers & Drillers editor Dr. Alex Cowie cleverly took a photo with his fancy iPhone:

In a wonderful piece of casual/causal flummery, the chart on the left shows how oil exports went ballistic after the petroleum resource rent tax was introduced.

Thanks to that piece of, erm, evidence, treasury secretary, emperor Ken Henry believes:

“It is the strong and clearly stated view of Treasury that the resource super profit tax [RSPT] will grow the mining sector and the economy.”

The two pie charts to the right provide more, [hehem], proof that the mining companies are ripping off ordinary Australians.

In case you can’t see it clearly, the pie chart shows how the government swiped an average of 55% of mining profits between 1999-2004, but merely 27% in 2009. Obviously something must be done to redress this heinous crime of profitability.

Fancy making a profit eh? Mining companies should take a leaf out of the government’s book and not make a profit. That’s how it’s done.

But do you see the problem with these claims by the Treasury? I’ll explain in a moment. Before I do, there’s other comments made by the deputy drones at the Reserve Bank of Australia (RBA).

As reported in Tuesday’s AFR, deputy drone Ric Battellino said:

“[F]rom the viewpoint of the whole Australian economy, the best thing that could happen is for one of the big projects to fall over.”

Then there’s the comment from deputy drone Phillip Lowe, sorry, Dr. Phillip Lowe:

“It is obviously not in the individual resource company’s interest, or advantageous to the economy as a whole, if all that investment tries to take place at once. What we need is a gradual and sustained increase in investment over time for the economy to benefit.”

Perhaps we’ve gone over the top on the quotes this morning, but I’ve included them all for a reason. Because they have one thing in common…

The overwhelming belief by the bureaucracy that it can manipulate an economy at will. That it can decide which resources companies will prevail and which won’t. It’s megalomaniacal bureaucratic interfering at its worst.

Anyway, let’s work through these kindergarten-grade arguments put forward by the bureaucrats who seem to be long on qualifications but short on logic.

First up, let’s look at the case that the super profits tax will be great because it will only cream off extra tax from the big profitable companies, but at the same time “smaller and more marginal projects would become more viable.”

This must be true because it’s all according to “modelling” undertaken by KPMG Econtech.

Now, as you’re probably aware, the recent record of “modelling” by the financial industry whizz-kids hasn’t been too good. Remember all those models that said a subprime property crisis wouldn’t spread to other investments?

But don’t take my word for it, just type “KPMG auditing scandal” into your favourite search engine and you’ll get a bunch of records returned. We picked out this one from the Irish Independent: “Were the bank auditors conflicted?”

According to the article, “Irish Nationwide, which last week revealed a loss of €2.5bn for 2009, was also a customer of KPMG… AIB paid KPMG a whopping €11m over nine years for services outside its audit…”

KPMG aren’t the only ones, PricewaterhouseCoopers and Ernst & Young get dishonourable mentions too.

Let’s put it this way, just as the auditors felt compelled to give their banking clients the news they wanted, KPMG has given the Treasury the news it wanted – something to justify the imposition of a new tax.

I mean, how likely is it that KPMG would return a report saying the Super Profits Tax will be bad for the industry?

Not very likely considering KPMG is paid a fee by the government in return for providing the report. You couldn’t imagine KPMG getting asked back again if it proposed something against the government’s intentions.

But look, as with all modelling it can only produce a result based on the parameters it’s given. And just wait until you read what those parameters are. You’ll be flabbergasted…

Take this assumption made by KPMG in its report to the government:

“In the model, this implies a zero economic cost for the new RSPT, since it will simply be a transfer of a portion of the surplus (over and above the required return on capital) from these industries to the government sector.”

Got that? A “transfer of a portion of the surplus from these industries to the government sector.” That’s mindboggling in itself. We do like how they’ve used the word ’surplus’ rather than profit.

What chumps.

Anyway, it goes on:

“In KPMG Econtech’s MM900 model, the RSPT has an excess burden of zero. This outcome rests on the modelling assumption that the RSPT only taxes the economic rents earned from immobile factors, in this case mineral reserves. If only these rents are taxed, then the investment decisions of mining companies will not be distorted. Since the tax base in the RSPT will not shrink in response to the tax, activity in the mining industry will not be distorted, and there will be no economic costs associated with the RSPT in MM900.”

It sums up with:

“The incidence of the RSPT is also a result of the immobile nature of the natural resources on which it is levied. Since there is no change in the supply of mineral resources, their pre-tax price will not change. Instead, the after-tax return that owners of the resources are able to receive falls by the full amount of the tax in MM900.”

Phew! I don’t know about you, but I’m out of breath after that…

OK, now I’ll try to paraphrase that junk into plain English. In other words, what our friends at KPMG Econtech are saying is that – because the government is just creaming off profits then it won’t impact either the cost of the resource in the ground, nor will it put miners off from exploring because the tax will come from the profits.

Correct me if I’m wrong but I’d say that’s the gist of it.

It goes without saying that the “brains” behind KPMG Econtech are clearly professional academics or professional number crunchers or wet-behind-the-ears university graduates with no idea about the concept of risk versus return.

It appears to your editor that the fatal flaw in the KPMG Econtech modelling is that because the model doesn’t see the Super Profits Tax as a cost it assumes that the Super Profits Tax has “zero economic cost.”

What a ridiculous claim.

Think of it this way. Let’s say mining plant equipment company Caterpillar changed its terms for providing big trucks to the mining sector. Let’s say that instead of miners buying or leasing the equipment Caterpillar decided to take 5% of the mining company profits instead, and that this 5% would lead to an increase in the money paid by the miner to Caterpillar.

Now, under that circumstance, would you say that there was now a “zero economic cost” to the mining company for plant and equipment? Would you now say that the mining company was now getting its mining equipment for free because the “cost” was only coming from profits?

Anyone claiming that would be mad.

To claim that something isn’t a cost because it comes from after-profits rather than before-profits is accounting chicanery of the highest order.

It’s no wonder the Irish banking system went to the wall, if this is the kind of auditing those banks were subjected to – “Yeah, don’t worry about those collateralised debt obligations, our modelling says they’re fine!”

As I’ve pointed out before, the bureaucracy and now clearly the auditors, have no concept of profits. And they’ve no concept of the difference a lower anticipated profit has on the willingness of an investor to invest.

I mean, if we tipped a stock in Australian Small-Cap Investigator that was super-high risk but which only offered the prospect of a 9% return would you back it? Probably not. But if it offered a high risk potential of a 286% return then maybe you would.

Then again, maybe you wouldn’t. Maybe you’d want an even bigger potential return.

The point is, the risk to Australian mining companies hasn’t changed one jot. But what has changed is the potential return. In other words, same risk but lower return. Seriously, we’re talking Investing 101 here. It’s not some abstract concept we’re trying to get to the bottom of.

You don’t need a Certificate IV in accounting from Chisholm TAFE to work out that if the potential return is lower, investors will reconsider making the investment.

But it doesn’t end there, KPMG makes another terrible blunder. And it’s this. It assumes that because the minerals are immobile it will have no change on the supply. What?! How does that work. Ah yes, that’s right, “their pre-tax price will not change. Instead, the after-tax return that owners of the resources are able to receive falls by the full amount of the tax in MM900.”

I’ll be straight up with you, this is perhaps the most ludicrous statement we’ve ever seen. It’s claiming that because the Super Profits Tax is being taken out of profits then it will not impact the investment decisions of miners.

Not only that, but according to the pen-pushers and tax-stealers in the Treasury, increasing taxes will not only be a zero cost to the mining industry, but it will actually increase growth… Hahahahahahahaha, stop it guys, seriously.

The evidence? The chart faithfully reproduced by the AFR which shows the CASUAL relationship between the introduction of the petroleum resource rent tax and the increase in oil exports.

For Treasury to claim that the introduction of a tax will actually increase production is absurd. But if it is true then maybe the Treasury should reconsider the tax increase on cigarettes. After all, going by their logic increasing the taxes will increase the supply of cigarettes and most likely increase the number of cigarettes smoked!

Nuff said. Clowns.

Finally there’s the statements from Tweedle-Battellino and Tweedle-Lowe. If you thought the comments from KPMG Econtech and Ken Henry were ridiculous then the comments from the RBA drones really do take the cake.

Their statements that:

“[F]rom the viewpoint of the whole Australian economy, the best thing that could happen is for one of the big projects to fall over.”

And:

“It is obviously not in the individual resource company’s interest, or advantageous to the economy as a whole, if all that investment tries to take place at once. What we need is a gradual and sustained increase in investment over time for the economy to benefit.”

Have you ever come across anything so weird as for a bureaucrat to wish that Australia’s most productive industry suffers the collapse of a big mining project. Is he serious?

We’re talking about something that provides a genuine benefit to the economy. We’re not talking about the Ponzi banks and housing sector that are a drag on the economy. We’re talking about an industry that is the sole reason for the Australian economy not collapsing in 2009.

But then again, these are the same guys who are keen to argue that the property market isn’t in a bubble.

Ah, but now the penny’s dropped. Actually their thinking on the resources sector and the housing market is exactly the same now we think about it.

In both cases they want to see “a gradual and sustained increase in investment over time for the economy to benefit.”

In other words, just as the RBA is keen to keep house prices sky high in order to try to avoid a bursting of the property bubble, it is equally keen to see commodity exploration fall so that prices remain high.

It goes to show you how much the Australian economy relies on the resources sector for economic growth. The obvious fear is that if too many miners extract too much of the natural resources it could push commodity prices lower and therefore have a negative impact on the value Australian exports.

Or, to put it another way, a potential commodity price crash.

You can hardly blame them for being worried. After all, the RBA and the bureaucracy have succeeded in driving all other productive industries offshore or into oblivion.

It figures it can manipulate the resources bubble by increasing taxes and therefore putting a brake on supply.

Talk about playing with fire.

The trouble is that rather than protecting the resources industry, these tax-grabbing measures are more likely to destroy the industry than save it. While it’s true that these resources aren’t movable it’s also true that they are available elsewhere.

Look, I’m not saying that the entire resources sector will collapse, but what I am saying is that in many cases – as we’ve seen already – the Super Profits Tax will be the difference between whether a company explores here or whether it targets projects in countries with a less burdensome taxation regime.

But as usual, what it all really comes down to is the fact that a handful of power-hungry bureaucrats believe that they can manipulate an economy to suit their purpose. That by pushing and pulling levers they can get the economy to move exactly as they planned.

Soon enough they’ll work out it’s not possible. In the short term these things can give the impression of working, but in the long term all it does is increase the distortions in an economy and create a huge mess with massive unexpected (for them) consequences.

It’s proof that bureaucrats and number-crunchers don’t have a clue about how an economy functions.

Cheers,
Kris.