Optimal choice between local content requirement and fiscal policy in extractive industries: A theoretical analysis

Abstract

This paper develops a simple framework to analyze the links between local contents (LC) promotion in extractive industries and several elements of fiscal policy in a resource-rich host country. Though usually the owner of the natural resources underground is the host government (HG), the main operator in the upstream is mostly a multinational corporation (MNC), which possesses requisite skills to extract resources. We build a game in which these two players negotiate on how to share the profit by means of various fiscal elements. As the goal of HG is obviously not restricted to maximizing resource revenue, it also needs to design a tax system and a LC program consistent with diversification needs of domestic economy. Due to the trade-off between two policies and to accomplish both goals, the HG needs to enforce MNC on how to perform an optimal LC plan. Our principal finding is that, there is an optimal LC that maximizes domestic welfare and it is higher for the resource rich countries that are able to supply better quality inputs. We characterize the optimal LC policy and its interaction with income-tax rate. As a policy experiment, we analyze the effects of world oil price on the incentives of HG as to which policy to implement. To that end, our finding is that as world resource price increases, the optimal LC level remain constant, but optimal tax rate becomes more progressive. In other words, the fiscal policy is predicted to prevail the LC policy in the advent of higher resource prices.