Labor is caught in a catch-22 of its own creation

THE case for a new profits-based tax to replace state royalties is a strict no-brainer, but the Rudd government forgot the axioms of reform: that timing, consultation and tilling the soil are essential.

Its ambush of the mining industry has been a political blunder. For the industry, the resource super-profits tax was a shock in its content and a surprise in its release. An intelligent government can establish the case for a profits-based resources rent tax short of unleashing sovereign risk for Australia, the world's most stable resource investment destination.

But Labor has failed this test. It is locked into a dangerous brawl with the nation's most global industry. The tragedy for Rudd Labor is that the flaws in its approach have undermined the legitimacy of its in-principle position.

This issue is no longer just about resource taxation rates. It is about Labor's economic reliability and the extent to which it has damaged Australia's investment standing. There is no point Labor winning its battle with the miners if it loses the larger war over financial credibility. These two issues are now dangerously linked.

Reverting to basics: there is a need to reform taxation of the resources sector; the industry concedes the logic of switching to profits-based taxation; Kevin Rudd and Wayne Swan are correct in attacking the Tony Abbott-led Coalition for its apparent resistance to sensible reform principles. But the issue is about Labor, not the Coalition.

The escalating clash between Labor and the miners hurts Australia's financial reputation and its resources investment rating. It cannot help the Rudd government's standing.

Labor is trapped between the need to negotiate and the need to defend its policy. Labor is furious at the industry campaign. Swan said that projects put "on hold" can be taken "off hold" when convenient "as most think they will". He calls the miners' campaign "strategic", as companies "have taken turns issuing threats to investment". In short, he doesn't believe the threats are legitimate. Swan says he expects "argy-bargy and brinkmanship" but it has gone too far. His charge that some miners "are either lying to you or they are ignorant" signals that Labor won't retreat. But it will negotiate.

"The government won't be swayed by a political campaign from the miners," Swan said. "The resource super-profits tax is not going away but generous transitional arrangements will be put in place as we have said all along." On Sunday Swan said talks with industry were aimed at finding "design details" of the tax best able to deliver "the government's policy intent". This puts strict limits on the concessions.

Remember, the tax is critical to Labor's fiscal credentials. The budget shows that in 2012-13 when the $1 billion surplus is projected, the resources tax raises $3bn, and in 2013-14 when a $5.4bn surplus is projected, the tax raises a hefty $9bn. In short, the "return to surplus" strategy depends on the tax. The surplus-resource tax nexus only deepens the stakes. To compromise the budget strategy would be fatal, yet not to compromise on the resources tax may also be fatal. It is Labor's catch-22.

Labor's primary objective is to discredit Abbott, who has declared the resource tax to be the central issue of the campaign. But with Abbott locked into the mining industry Labor can hardly separate them; its attack on Abbott becomes an attack on the industry. And its attack on the industry raises questions about its financial reliability and sovereign risk.

The irony is that Labor finds itself heading into an election campaign with a sweeping new tax central to its political and economic position but that does not begin until 2012. How smart is this? Whether deliberate or accidental, it brands Rudd Labor.

The mining reaction is driven not just by a self-interested campaign but the conviction that Australia has reached a crossroads. Ross Garnaut, a supporter of the Treasury tax model, testifies that he has "many good friends in senior places in the mining industry and most of them are opposed to the new tax with a passion that has no near comparator in my memory". On Monday, the head of Rio Tinto, Tom Albanese, branded the tax his "No 1 sovereign risk on a global basis".

But the messages from Labor are that the 40 per cent rate is non-negotiable and that existing projects must remain included.

Swan needs to refine the design as soon as possible to sell the picture of a government ready to listen and reason.

But this battle is just starting. There is no plan to introduce legislation before the election. It is difficult to envisage any political settlement between Labor and the miners before the election. Obviously, the post-election politics will be different.

Rudd and Swan have drawn their lines of attack. They argue (1) that the industry is under-taxed; (2) that imposing the new tax is an act of "national interest" fairness; and (3) that there will be net economic benefits for both mining and the economy via a lower company tax rate and concessions for small business and superannuation.

Swan yesterday released a Treasury minute dated May 24 saying mining had a company tax rate 12 per cent below the average for all industries in the decade to 2004-05. The analysis revealed vast disparities in average company tax rates across industries, with mining at 17 per cent, construction at 19 per cent and finance at 29 per cent. He released an article by Treasury officers that argued mining enjoyed "generous deductions" due to depreciating assets and its capital intensity, which meant corporate tax was unable to "capture increases in resource rents".

Such material exposes the intensity of the struggle. The Treasury as an institution is operating at the front line of this contest in a fashion that must bring consequences.

Meanwhile, BHP-Billiton chief financial officer Alex Vanselow in effect rejected these argument the previous day, saying BHP paid corporate tax, state royalties and other production taxes totalling $6.3 billion last year at an effective rate of 43 per cent as verified by KPMG. Almost all of its earnings were reinvested in Australia.

The split between Labor and the Coalition on the resources tax is only deepening. To a certain extent, events have got out of control. This looms as a problem for Australia and its ability to manage a critical policy debate. The contest between Labor and the miners is pivotal to Rudd's re-election prospects and Abbott's political hopes. But the national interest is now squarely on the line.

Settlement of this dispute demands a tax outcome that guarantees long-run investment stability and purges the sovereign risk factor that has been unleashed.

The longer this takes, the greater the dangers for Australia and for Rudd Labor.