Natural Gas Has Led to a Natural Debate

Until only a few months ago, it had been a virtual axiom that Israel was a mineral-poor country whose only natural resource was its brainpower. Not surprisingly, public policy and policy research in this area were as little developed as the mineral resources themselves. This perception has had to change rapidly as the past year brought confirmation of massive natural gas reserves in the offshore Tamar and Leviathan natural gas and oil fields – very timely findings in light of the interruption of gas flows from Egypt following the recent overthrow of the government.

Israeli policy makers have had to rapidly build a policy that will both make a fair division of benefits between the public and current investors and establish a sound policy foundation for generations to come.  The government appointed a public commission, headed by Hebrew University economist Prof. Eytan Sheshinski, an expert in public finance, and including economists, jurists, and mining experts, to recommend an appropriate taxation regime. The Commission recently completed its work and submitted its report to the government, which endorsed its recommendations and passed them along for approval by the Knesset.

The current taxation formula has been in force since the 1950s, and has applied in practice mainly to the tiny Heletz oil field in the Negev and the comparatively small Mari B gas wells off the coast of Ashkelon. It involves two main levies: ordinary corporate income tax (which would be due the government even if the mineral resources were privately owned), and a royalty of 12.5 percent of the well-head value (which for natural gas is less than the actual sale price) of production. Furthermore, the corporate income tax included a special “depletion deduction” which allowed a tax deduction for the depletion of the mineral inventory.

The Sheshinski Commission proposal would eliminate the depletion deduction, which exists in no other country, and is unjustified insofar as the inventory belongs to the sovereign nation, not to the developer. In addition, it imposes a “super profit tax” common in many mineral-rich countries. Such a levy applies only to revenues which exceed a certain multiple of the cumulative costs of the developer, including upfront investments such as prospecting costs.  The proposal recommends that this tax should kick in at a rate of 20 percent once revenues exceed a multiple (called an “R-factor”) of 1.5 times costs, gradually increasing to 50 percent of revenues that exceed 2.3 times costs.

The proposed imposition of these new levies on wells that are already licensed and nearing production led to considerable public debate in Israel.  Some claim that the Commission’s recommendations are tantamount to retroactive taxation, while others assert that imposing a new tax is no different than any other tax change – such as altering the corporate tax rate – and has no bearing on any sovereign obligations.  The Commission solicited an official legal opinion which affirmed the complete legality of the recommendations insofar as they do not apply to any revenues previously received nor alter the terms of the license.

However, the Commission did recommend a more lenient tax regime for the wells nearing production. For wells which begin production before 2014, the levies will apply only at a 50 percentage point higher multiple, beginning at two times costs (instead of 1.5) and reaching the maximum only at 2.8 times costs (instead of 2.3). This reduction is both to take into account the investors’ initial expectations and also to encourage rapid development of the wells.

The Commission expects these levies to give the country substantial revenues from the gas. The new tax is in addition to the original 12.5 percent royalty tax and in addition to income taxes – not to mention the sales tax that will be collected when the gas is sold to consumers. Beyond the revenue issue, the gas finds raise a host of other policy questions that will have to be considered in the coming years:

1. What is the best use to make of these new revenues? Perhaps Israel should avoid wasteful short-term expenditures by following the example of Norway, which deposits oil revenues in a special sovereign “Petroleum Fund” designated for specific future needs, rather than for ongoing government expenses. A number of proposals in this spirit have been proposed and should be thoroughly evaluated.
2. What are the macroeconomic consequences? A salutary macroeconomic effect is that large amounts of domestic energy, particularly natural gas which is not easily exported, could buffer Israel’s economy from global economic volatility. A problematic consequence is that extensive mineral exports will raise the value of the shekel, which will harm other exporting businesses (a syndrome sometimes known as the “Dutch Disease”). A fund like Norway’s Petroleum Fund could blunt this effect if it invests the tax revenues abroad, thus limiting the impact on the shekel.
3. Energy resources can have strategic as well as economic importance. They could provide Israel a large measure of energy independence  – an outcome that is not lost in light of recent interruptions of gas flows from Egypt.